6.

COST OF CAPITAL
The cost of capital represents the return required by the investors (such as equity holders,
preference holders or banks).
 Basically the more risk you take, the more return you expect.
 This risk is the likelihood of actual returns varying from forecast.
 The return for the investors needs to be at least as much as what they can get from
government gilts (these are seen as being risk free). On top of this they would like a return
to cover the extra risk of giving the firm their investment.
 The investors could be debt or shareholders (debt and equity).
 The cost of capital is made up of the cost of debt + cost of equity.
 The cost of normal debt is cheaper than the cost of equity to the company. This is because
interest on debt is paid out before dividends on shares are paid. Therefore the debt holders
are taking less risk than equity holders and so expect less return.
 Also debt is normally secured so again less risk is taken.

Creditor hierarchy
When a company cannot pay its debts and goes into liquidation, it must pay its creditors in the
following order:
1. Creditors with a fixed charge
2. Creditors with a floating charge
3. Unsecured creditors
4. Preference shareholders
5. Ordinary shareholders
Each of the above will cost the company more as it heads down the list. This is because each
is taking more risk itself

Cost of Capital - WACC

 The cost of capital is the rate of return that the suppliers of capital—bondholders and
owners—require as compensation for their contributions of capital.
- This cost reflects the opportunity costs of the suppliers of capital.
 The cost of capital is a marginal cost: the cost of raising additional capital.
 The weighted average cost of capital (WACC) is the cost of raising additional capital, with
the weights representing the proportion of each source of financing that is used.
- Also known as the marginal cost of capital (MCC).

WACC = wdrd (1  t) + wp rp + were

where
wd is the proportion of debt that the company uses when it raises new funds
rd is the before-tax marginal cost of debt
t is the company’s marginal tax rate
wp is the proportion of preferred stock the company uses when it raises new funds

COST OF CAPITAL - 1
 rp is the marginal cost of preferred stock
we is the proportion of equity that the company uses when it raises new funds
re is the marginal cost of equity

Weights of the Weighted Average

• The weights should reflect how the company will raise additional capital.
• Ideally, we would like to know the company’s target capital structure, which is the capital
structure that is the company’s goal, but we cannot observe this goal.
• Alternatives
- Assess the market
value (MV) of the
company’s capital
structure components.
- Examine trends in the
company’s capital
structure.
- Use capital structures
of comparable
companies (e.g.,
weighted average of
comparable’ capital
structure).

 Book values (not to use unless we lack other information)

 Market values (normally used)
 Target capital structure
 Capital structure of industry
 Capital structure of comparable companies

PP1: Suppose the NN Company has a capital structure composed of the following, in billions:
Debt Rs. 10 mi and Equity Rs. 40 mi.
If the before-tax cost of debt is 9%, the required rate of return on equity is 15%, and the
marginal tax rate is 30%, what is Widget’s weighted average cost of capital? Hints: 13.25%.
PP 2: Statement of Financial Position (in $):

Ordinary shares MV = $5,750; Loan note MV $800;

Equity cost of capital = 20%; Debt cost of capital = 7.5% (after tax). Calculate WACC using:

COST OF CAPITAL - 2
 1) Book Values
2) Market Values
Hints: 17.92%, 18.47%

Cost of Capital – Cost of Debt (Redeemable debt)

 The company pays the interest and the original amount (capital) back.
 So the MV is the interest and capital discounted at the investor’s required rate of return.
 Remember the cost of debt to the company is the debtholder’s required rate of return. (Tax
plays a part here as we shall see later)

To calculate the cost of debt in an exam an IRR calculation is required as follows (also called
YTM):
1. Guess the cost of debt is 10 or 15% and calculate the present value of the capital and interest.
2. Compare this to the correct MV
3. Now do the same but guess at 5%
4. Use the IRR formula to calculate the actual cost of capital
IRR = L + (NPV L / (NPV L - NPV H)) x (H - L)

PP 3: 5 years 12% redeemable debt. Market Value (MV) is $107.59.

IRR = L + (NPV L / (NPV L - NPV H)) x (H - L)

IRR = 5 + (22.76 / (22.76+17.67)) x (15-5) = 10.63

Taxes and the Cost of capital

• Interest on debt is tax deductible; therefore, the cost of debt must be adjusted to reflect this
deductibility.
- We multiple the before-tax cost of debt (rd) by the factor (1 – t), with t
as the marginal tax rate.
- Thus, rd × (1  t) is the after-tax cost of debt.
• Payments to owners are not tax deductible, so the required rate of return on equity (whether
preferred or common) is the cost of capital.

PP 4: 20% Redeemable debt. Tax 30%.

What is the interest charge to be used in a cost of capital calculation for a company?
20% x 70% = 14%
Now let’s rework that last example (PP 1) but this time use 10% as a guess and let’s assume
tax of 30%

COST OF CAPITAL - 3
 IRR = L + (NPV L / (NPV L - NPV H)) x (H - L)
IRR = 5 + (7.17 / (7.17 + 13.65)) x (10-5) = 6.72
The cost of capital is lower than the original example as tax effectively reduces the cost to the
company as interest is a tax deductible expense.

 The company just pays back the interest (NOT the capital)
 So the MV should just be all the expected interest discounted at the investor’s required rate
of return.
 The Cost of Debt for this therefore is:
Annual Interest (after tax) / Market Value

PP 5 : 5% Irredeemable Debentures. MV is $90. Tax is 20%.

What is the post-tax cost of debt of these irredeemable debentures?
Solution:
The formula to calculate the post-tax cost of debt is:
I * (1-T) / Market Value x 100%, where I is the Annual interest and T is the tax rate.
(5 x 80%) / 90 x 100% = 4.4%
PP 6: Consider a company that has Rs.100 million of debt outstanding that has a coupon rate of
5%, 10 years to maturity, and is quoted at Rs.98. What is the after-tax cost of debt if the marginal
tax rate is 40%? Assume semi-annual interest.
Hints: rd = 0.0526 (1 – 0.4) = 3.156%

Bank Loans
 The cost of debt is simply the interest charged.
 Do not forget to adjust for tax though if applicable.

PP 7: 10% Bank Loan. Tax 30%.

What is the cost of debt?
Solution: 10 x 70% = 7%

Cost of Convertible Debt

 Here the investor has the choice to either be paid in cash or take shares from the company.
 Hence, the debt is convertible into shares.
 To calculate the cost of capital here, simply follow the same rules as for redeemable debt (an
IRR calculation).

The only difference is that the ‘capital’ figure is the higher of:
 Cash payable
COST OF CAPITAL - 4
 Future share payable

PP 8: 8% Convertible debt. Redeemable in 5 years at:

Cash 5% premium or 20 shares per loan note (current MV $4 and expected to grow at 7%).
The MV is currently $85. Tax 30%.
Hints: 11.4%

Issues in estimating the cost of debt

• The cost of floating-rate debt is difficult because the cost depends not only on current rates
but also on future rates.
- Possible approach: Use current term structure to estimate future rates.
• Option-like features affect the cost of debt.
- If the company already has debt with embedded options similar to what it may issue, then
we can use the yield on current debt.
- If the company is expected to alter the embedded options, then we would need to estimate
the yield on the debt with embedded options.
• Nonrated debt makes it difficult to determine the yield on similarly yielding debt if the
company’s debt is not traded.
- Possible remedy: Estimate rating by using financial ratios.

The Cost of Preferred Stock

 Treat the same as irredeemable debt except that the dividend payments are never tax
deductible.
 The cost of preferred stock that is non-callable and non-convertible is based on the
perpetuity formula:
𝑟 = ( )
When no flotation cost,
Annual Dividend / Market Value

PP 9: 8% Preference Shares. MV $1.20. What is the cost of stock?

Solution: The formula to calculate the post-tax cost of debt is:
Annual Dividend / Market Value = 8 / 120 x = 6.67%
PP 10: Suppose a company has preferred stock outstanding that has a dividend of Rs.1.25 per
share and a price of Rs.20. What is the company’s cost of preferred equity? Hints : 6.25%
PP 11: Suppose that the Carter Company has preferred stock that pays a $13 dividend per share
and sells for $100 per share in the market. The flotation (or underwriting) cost is 3 percent, or
$3 per share. Then the cost of preferred stock is:
Hints: 13.4%
PP 12: A company’s $100, 8% preferred is currently selling for $85. What is the company’s cost
of preferred equity? Hints: 9.4%

COST OF CAPITAL - 5
The Cost of Equity
Methods of estimating the cost of equity:
1. Dividend discount model
2. Capital asset pricing model
3. Bond yield plus risk premium

Dividend Valuation Model (DDM)

• The dividend discount model (DDM) assumes that the value of a stock today is the present
value of all future dividends, discounted at the required rate of return.
• Assuming a constant growth in dividends:
Without Growth (𝑃 ) =
With Constant Growth (𝑃 ) =
which we can rearrange to solve for the required rate of return:
𝑫 𝑫𝟏
𝒓𝒆 = 𝑷𝟏 (Without growth); 𝒓𝒆 = 𝑷𝟎
+ 𝒈 (with constant growth)
𝟎

PP 13: Assume that the market price of the Carter Company’s stock is $40. The dividend to be
paid at the end of the coming year is $4 per share and is expected to grow at a constant annual
rate of 6 percent. Then the cost of this common stock is: Hints: 16%.
Example 14: M Manufacturing will issue common stock to the public for $30. The expected
dividend and the growth in dividends are $3.00 per share and 5%, respectively. If the flotation
cost is 2% of the issue’s gross proceeds, what is the cost of external equity, re? Hints: 15.20%.

The sustainable growth is the product of the return on equity (ROE) and the retention rate (1 minus
the dividend payout ratio, or 1 − ):
𝑔= 1− x ROE
g=rb
i.e. [ROE*Retention Ratio]

PP 15: Suppose the Gadget Company has a current dividend of Rs.2 per share. The current price
of a share of Gadget Company stock is Rs.40. The Gadget Company has a dividend payout of
20% and an expected return on equity of 12%. What is the cost of Gadget common equity?
Hints: g = 9.6%; re = 15.08
PP 16: Z plc has in issue $1 shares with a market value of $2.80 per share. A dividend of 20c
per share has just been paid (earnings per share were 32c).
The company is able to invest so as to earn a return of 18% p.a.
(a) Estimate the rate of growth in dividends
(b) Estimate the cost of equity Hints: 6.75%; 14.375%

COST OF CAPITAL - 6
Past Growth Rate
 Growth rate is also sometimes calculated on the basis of historical data provided to us.
 In such case we only use initial year dividends and terminal year dividends as below.
𝑻𝒆𝒓𝒎𝒊𝒏𝒂𝒍 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅
𝒈= ^(𝟏/𝒏)-1
𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝒀𝒆𝒂𝒓 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅

PP 17 : Calculate cost of equity if company has 1,000 number of shares in 2006 and its market
price is $250.

Hints: g= 9.86%; Ke = 11.26%

PP 18: Armon Brothers, Inc., is attempting to evaluate the costs of internal and external common
equity. The company’s stock is currently selling for $62.50 per share. The company expects to
pay $5.42 per share at the end of the year.
The dividends for the past 5 years are given below:
Year Dividend
20X5 $5.17
20X4 $4.92
20X3 $4.68
20X2 $4.46
20X1 $4.25
The company expects to net $57.50 per share on a new share after flotation costs. Calculate: (a)
the growth rate of dividends; (b) the flotation cost (in percent); (c) the cost of retained earnings
(or internal equity); and (d ) the cost of new common stock (or external equity).
Hints: 5%; 8%; 13.67%14.43%

Cost of Equity- CAPM

 This method looks more closely at the shareholder’s rate of return, in terms of risk.
 The more risk a shareholder takes, the more return he will want, so the cost of equity will
increase.
 For example, a shareholder looking at a new investment in a different business area may have
a different risk.
 It suggests that any investor would at least want the same return that they could get from a
“risk free” investment such as government bonds. This is called the risk free return.
 On top of the risk free return, they would also want a return to reflect the extra risk they are
taking by investing in a market share.

COST OF CAPITAL - 7
Under the capital asset pricing model (CAPM) the expected return on equity, E(Ri) :
E(Ri) = RF + bi [E(RM) – RF]
Where,
RF is the risk free rate of return
bi is the return sensitivity of stock i to changes in the market return
E(RM) is the expected return on the market
E(RM) – RF is the expected market risk premium or equity risk premium (ERP)

Risk Free Rate

A survey of highly regarded companies show that about two-thirds of them use the rate on 10-year
Treasury bonds. The reasons being:
1. Common stocks are long-term securities. Therefore, it is reasonable that stock returns
embody relatively long-term inflation expectations rather than the short-term expectations in
bills.
2. Short-term Treasury bill rates are more volatile than are long-term Treasury bond rates.
3. In theory, the CAPM is supposed to measure the required return over a particular holding
period. Long term bond is a reasonable average for the risk-free rate.

Risk Premium
The risk premium is driven primarily by investors’ attitudes toward risk, and there are good reasons
to believe that investors’ risk aversion changes over time.
Three approaches may be used to estimate the market risk premium:
1. Calculate historical premiums and use them to estimate the current premium;
2. Use the current value of the market to estimate forward-looking premiums; and (predicting
sales, earnings, payouts, etc.)
3. Survey experts [Surveys of CFO, rating agencies, etc.)

Estimating Beta
 The CAPM is based on a comparison of the systematic risk of individual investments with the
risks of all shares in the market.
 The total risk involved in holding securities (shares) divides into risk specific to the company
(unsystematic) and risk due to variations in market activity (systematic).
 Unsystematic risk can be diversified away, while systematic or market risk cannot.
 Investors may mix a diversified market portfolio with risk-free assets to achieve a preferred
mix of risk and return.

Example 19: Based on data over the past five years, TSLA and SPDR S&P 500 ETF Trust
(SPY) have a covariance of 0.032, and the variance of SPY is 0.015.
Hints: β = 2.13. Therefore, TSLA is theoretically 113% more volatile than the SPDR S&P 500
ETF Trust.

COST OF CAPITAL - 8
 Example 20: Based on data over the past five years, the correlation between Apple, and market
is 0.83. Apple has a standard deviation of returns of 23.42% and market has a standard deviation
of returns of 32.21%. Calculate the beta of Apple. Hints: β = 0.6035

Beta factor is the measure of the systematic risk of a security relative to the average market
portfolio.

Where:
 Ri = the return on an individual stock;
 σi = risk of individual stock
 Rm = the return on the overall market;
 σm = risk of overall market

 If an investment has a β of 1 - it has the same risk as the market

 If an investment has a β > 1 - it is more risky than the market
 If an investment has a β < 1 - it is less risky than the market
 If an investment has a β < 1 - it is risk free

Non-systematic risk can be diversified away

 One may mitigate nonsystematic
risk by buying different securities in
the same industry or different
industries.
 For example, a particular oil
company has the diversifiable risk
that it may drill little or no oil in a
given year.
 An investor may mitigate this risk by
investing in several different oil
companies as well as in companies
having nothing to do with oil.
 Nonsystematic risk is also called
diversifiable risk.

COST OF CAPITAL - 9
 So, we can buy more shares and therefore the UNSYSTEMATIC RISK should GET SMALLER
 You will be always left with some risk that can't be diversified away. This risk is called
SYSTEMATIC RISK.
 It is BETA (β) in the CAPM formulae.

Basis for
Systematic Risk Unsystematic Risk
Comparison
Systematic risk refers to the hazard which is Unsystematic risk refers to the risk
Meaning associated with the market or market segment associated with a particular security,
as a whole. company or industry.
Nature Uncontrollable Controllable
Factors External factors Internal factors
Affects Large number of securities in the market. Only particular company.
Interest risk, market risk and purchasing
Types Business risk and financial risk
power risk.

Assumptions of CAPM

Disadvantages of CAPM
 It presumes a well-diversified investor.
 Others, including managers and employees may well want to know about the
unsystematic risk also
 The return level is only seen as important not the way in which it is given.

COST OF CAPITAL - 10
  For example dividends and capital gains have different tax treatments which may be more
or less beneficial to individuals.
 It focuses on one period only.
 Some inputs are very difficult to get hold of.
 For example beta needs a subjective analysis
 Generally CAPM overstates the required return for high beta shares and vice versa

Example 19: Booher Book Stores has a beta of 0.8. The yield on a 3-month T-bill is 4% and the
yield on a 10-year T-bond is 6%. The market risk premium is 5.5%, and the return on an average
stock in the market last year was 15%. What is the estimated cost of common equity using the
CAPM? Hints: 10.4%
Example 20: The earnings, dividends, and stock price of Shelby Inc. are expected to grow at
7% per year in the future. Shelby’s common stock sells for $23 per share, its last dividend was
$2.00, and the company will pay a dividend of $2.14 at the end of the current year.
a. Using the discounted cash flow approach, what is its cost of equity?
b. If the firm’s beta is 1.6, the risk-free rate is 9%, and the expected return on the market is 13%,
then what would be the firm’s cost of equity based on the CAPM approach?
c. If the firm’s bonds earn a return of 12%, then what would be your estimate of cost of equity
using the over-own-bond-yield-plus-judgmental-risk-premium approach?
Hints: 16.3%; 15.4%; 16%

CAPM is generally preferred out of the 2 methods

Ungearing & Regearing

 When to use WACC to appraise investments
 The WACC calculations we made earlier were all based on CURRENT costs and amounts of
debt and equity.

So use this as a cost for other future projects provided:

 Debt/equity amounts remain unchanged
 Operating risk of firm stays same
 Finance is not project specific
 Project is relatively small so any changes to the company are insignificant.

If any if the above do not apply - then we cannot use WACC. We then have to use CAPM..
adapted…

The betas we have been looking at so far are called Equity Betas.
These represent :
 Business Risk
 Our Financial Risk (Our gearing)

COST OF CAPITAL - 11
If we are looking to invest into a different industry we need to use a different beta, one which
represents:
 Business Risk (of new industry)
 Financial Risk (debt and/or equity)

Select a Comparable

Estimate the Beta for

the Comparable

Ungear the Comparable’s Beta to

Estimate the Asset Beta

Gear the Beta for the Project’s

Financial Risk

Project Betas
Mathematical relationship between the 'ungeared' (or asset) and 'geared' betas is as follows.
𝑉𝑒 𝑉𝑑
β = β 𝑥 +β 𝑥
𝑉𝑒 + 𝑉𝑑((1 − 𝑡)) 𝑉𝑒 + 𝑉𝑑((1 − 𝑡))

Gearing and ungearing beta

To ungear beta, remove the comparable’s capital structure from the beta to arrive at the asset beta,
which reflects the company’s business risk:

β = β 𝑂𝑅 β ((
( ) ))

To gear the beta, adjust for the project’s financial risk:

β = β 1 + (1 − 𝑡)

PP 21: Consider the following information for the Whatsit Project and its comparable, Thatsit
Company:
Whatsit Project Thatsit Company
Debt Rs.10 Rs.100
Equity Rs.40 Rs.200
Equity beta ? 1.4
What is the asset beta and equity beta for the Whatsit Project based on the comparable company
information and a tax rate of 40% for both companies?
Hints: The beta of the Whatsit Project is 1.2384 (bequity)
PP 22: Beckman Engineering and Associates (BEA) is considering a change in its capital
structure. BEA currently has $20 million in debt carrying a rate of 8%, and its stock price is $40

COST OF CAPITAL - 12
 per share with 2 million shares outstanding. BEA is a zero-growth firm and pays out all of its
earnings as dividends. The firm’s EBIT is $14.933 million, and it faces a 40% federal-plus-state
tax rate. The market risk premium is 4%, and the risk-free rate is 6%. BEA is considering
increasing its debt level to a capital structure with 40% debt, based on market values, and
repurchasing shares with the extra money that it borrows. BEA will have to retire the old debt
in order to issue new debt, and the rate on the new debt will be 9%. BEA has a beta of 1.0.
a. What is BEA’s unlevered beta? Use market value D/S when unlevering.
b. What are BEA’s new beta and cost of equity if it has 40% debt?
c. What are BEA’s WACC of the firm with 40% debt?
Hints: a) 0.870; b) b = 1.218; r = 10.872%. c) WACC = 8.683%;
Exam standard example (extract)
PP 23: Tisa Co is considering an opportunity to produce an innovative component.
This is an entirely new line of business for Tisa Co. (New business risk)
Tisa Co has 10 million 50c shares trading at 180c each.
Its loans have a current value of $3•6 million and an average after-tax cost of debt of 4.50%.
Tisa Co’s capital structure is unlikely to change significantly following the investment. (No
change in Financial risk)
Elfu Co manufactures electronic parts for cars including the production of a component similar
to the one being considered by Tisa Co.
Elfu Co’s equity beta is 1.40, and it is estimated that the equivalent equity beta for its other
activities, excluding the component production, is 1.25.
Elfu Co has 400 million 25c shares in issue trading at 120c each.
The loans have a current value of $96 million.
It can be assumed that 80% of Elfu Co’s debt finance and 75% of Elfu Co’s equity finance can
be attributed to other activities excluding the component production.
Tax 25%. Risk free rate 3.5%. Market risk premium 5.8%.
Required: Calculate the cost of capital that Tisa Co should use to calculate the net present value
of the project.
Hints: Ke = 14.40%. Kd = 4.5% (after tax)
Component WACC = (14.40% x $18m + 4.5% x $3.6m)/($18m + $3.6m) = 12.75%
Advanced Cost of Capital
PP 24: The treasure of a new venture, Start-Up Scientific, Inc., is trying to determine how to
raise $6 million of long-term capital. Her investment adviser has devised the alternative capital
structures shown below:
Alternative A Alternative B
$2,000,000 9% debt $4,000,000 12% debt
$4,000,000 Equity $2,000,000 Equity
If alternative A is chosen, the firm would sell 200,000 shares of common stock to net $20 per
share. Stockholders would expect an initial dividend of $1 per share and a dividend growth rate
of 7 percent.
Under alternative B, the firm would sell 100,000 shares of common stock to net $20 per share.
The expected initial dividend would be $0.90 per share, and the anticipated dividend growth rate
12 percent.

COST OF CAPITAL - 13
Assume that the firm earns a profit under either capital structure and that the effective tax rate
is 50 percent. (a) What is the cost of capital to the firm under each of the suggested capital
structures? Explain your result. (b) Explain the logic of the anticipated higher interest rate on
debt associated with alternative B. (c) Is it logical for shareholders to expect a higher dividend
growth rate under alternative B? Explain your answer.
Hints: (a) WACC 9.5% in both alternatives.
(b) The interest rate on debt is higher for alternative B because the financial risk is greater due
to the increased use of leverage. As a result, the probability of not being able to meet the high
fixed payment increases, causing the bond market to have a higher required rate of return to
offset this greater risk.
(c) It is logical for shareholders to expect a higher dividend growth rate under alternative B
because of the additional financial risk and increased fixed interest requirement. Equity holders
will demand a higher return to compensate them for the additional financial risk. Dividends per
share should grow at a faster rate than alternative A because earnings per share grow faster
due to the greater amount of leverage (smaller base). In addition, assuming a given payout rate,
it follows that dividends per share would also grow faster than alternative A.
Marginal Cost of Capital (MCC)
PP 25: Georgebear has the following capital structure.
After-tax cost Market value
Source % $m
Equity 12 10
Preference 10 2
Bonds 7.5 8
20 20.0
WACC = 10%.
Georgebear's directors have decided to embark on major capital expenditure, which will be
financed by a major issue of funds. The estimated project cost is $3,000,000, 1/3 of which will
be financed by equity, 2/3 of which will be financed by bonds. As a result of undertaking the
project, the cost of equity (existing and new shares) will rise from 12% to 14%. The cost of
preference shares and the cost of existing bonds will remain the same, while the after-tax cost
of the new bonds will be 9%.
Required
Calculate the company's new weighted average cost of capital, and its marginal cost of capital.
Hints: New WACC = 10.96%; Marginal Cost of Capital = 17.3%

COST OF CAPITAL - 14