CHAPTER 5: Cost of Capital

 The term cost of capital refers to the return a firm intends to pay to its members who
contribute the capital to the firm.

Determination of Cost of Capital

 Cost of capital is determined by taking into account the cost of each component of capital,
known as a specific cost of capital. Specific cost of capital of the given firm is defined as
the cost of equity (returns paid to the equity shareholders) or cost of preference (returns paid
to preference shareholders) or cost of debt (returns paid to the debt holders).

Computation of Specific Costs of Capital

 The cost of capital for any particular capital source or security issue is called specific cost of
capital or component cost of capital. Each type of capital contained the capital structure of a
firm include:
1. Debt 3. Common stock
2. Preferred stock 4. Retained earnings
Two important points you should bear in mind about the specific cost of capital.
1. One is that it is computed on an after-tax basis. Meaning, if there would be any tax
implication on the individual source of capital, it should be considered. In almost all
circumstances, the tax implication is only on debt sources of finance.

2. The second point is that the specific cost of capital is expressed as an annual percentage
or rate like 6%, 9%, or 10%. The cost of capital is not stated in terms of birrs.

1. Cost of Debt cheapest specific cost of capital

 This is the minimum rate of return required by suppliers of debt. The relevant specific
cost of debt is the after-tax cost of new debt. Generally, debt is the cheapest source of
finance to a firm and, hence, the cost of debt is the lowest specific cost of capital.
◦ First, They receive interest payments before preferred and common dividends are paid.
◦ Second, raising capital through debt sources entails interest expense, which reduces cost of debt.
 1. Cost of Debt
Debt capital can also be issued in two types, and they are
(i) Irredeemable debt, and
(ii) Redeemable debt
Computation of debt capital cost is done as follows:

 Cost of Irredeemable Debt (Kd):

Where: Int = Interest on the debt capital

t = corporate tax rate
Po = Issue price of the debt capital
Kd = cost of the debt
..cont’d
Cost of Redeemable Debt (Kd):

Where Kd = Cost of debt

Int = Interest paid/payable on the debt
RV = Redeemable value of the debt
SV = Sales proceeds of the debt, which is debt
security’s sales price minus Flotation cost.
n = Maturity period in years.
t = corporate tax rate applicable to the firm.
Illustrations 1:
Find the cost of Debt from the following information given to you: Int = 9%; tax rate = 40 % and Po = Br.
1000; then Kd =?

Required;
 What will be the cost of debt when it is irredeemable?
 What will be the cost of Debt when it is redeemed after 5 years at (i) 15 % premium and (ii) 10 %
discount?

Solution i: What will be the cost of debt when it is irredeemable?

Kd = Br.54/Br.1000

Kd = 0.054 or 5.4%
ii. What will be the cost of Debt when it is redeemed after 5 years at (a) 15 % premium and (b) 10 % discount?
(a). With 15 % premium
Int (1-t) + [(RV-SV)/n]
Kd = ------------------------ = = 0.0781 or 7.81%
[RV + SV]/2

(b). With 10 % discount

Int (1-t) + [(RV-SV)/n] Br. 90 (1 – 0.4) + [(Br. 900-Br. 1,000)/5 years]
Kd = ------------------------ = -------------------------------------------------- = 0.0358 or 3.58%
[RV + SV]/2 [Br. 900 + Br. 1,000]/2
2. Cost of Preference
The cost of preferred stock is the minimum rate of return a firm must earn
in order to satisfy the required rate of return of the firm’s preferred stock
investors.

A firm can issue preference shares of two types, and they are:
a) Permanent preference shares; are shares issued with a condition of non-
payment of the capital to the shareholders, and if at all the payment of the
capital arises will be in the situation of the winding up of the firm.

b) Redeemable preference shares. They are being issued with a condition to

repay after certain period, say after 10 years or 15 years.
 …CONT’D
 Cost of Irredeemable preference shares (Kp):
Kp = Pd/Po
Where: Kp = cost of preference share
Pd = Preferential dividend for the year
Po = Issue price of the preference share

 Cost of Redeemable preference shares (Kp):

Where Kp= Cost of preference share

Pd= Preferential dividend for the year
RV = Redeemable value of the preference share
SV = Sales proceeds of the preference share
n = Maturity period in years.
 …CONT’D
Illustration 2: Find the cost of the preference from the following information given to you: Pd = Br.7; and Po =
Br. 100; then Kp =?
 What will the cost of preference when the share is redeemed after 5 years at (i) 10 % premium and (ii) 5 %
discount?

Solution: When it is irredeemable.

Kp = Pd/Po = Kp = Br. 7/Br. 100 Kp = 0.07 or 7%

 When the preference share is redeemable with 10% premium:

Pd + [(RV-SV)/n] Br. 7+ [(Br. 110-Br. 100)/5 years]
Kp = ------------------ = ---------------------------------- = 0.0857 or 8.57%
[RV + SV]/2 [Br. 110 + Br. 100]/2

 With 5 % discount = Br. 7+ [(Br. 95-Br. 100)/5 years]/[Br. 95 + Br. 100]/2 = 0.0615 or 6.15%
 3. Cost of Equity

 Cost of Equity- the most expensive cost of capital

 Under this specific cost of capital, we will see cost of new equity/cost of common stock
and cost of retained earnings.

i. The cost of common stock

 The cost of common stock can be computed using the constant growth valuation model.

Where: Ks = The cost of new common stock issue

D1 = The expected dividend payment at the end of next year
NPo = Net proceeds from the sale of each common stock
g = The expected annual dividends growth rate
The net proceeds from the sale of each common stock (NPo) is computed as follows:
NPo = Po – f Where: Po = The current market price of the common stock
f = flotation costs
Illustration 3: An issue of common stock is sold to investors for Br. 20 per share. The
issuing corporation incurs a selling expense of Br. 1 per share. The current dividend is Br.
1.50 per share and it is expected to grow at 6% annual rate. Compute the specific cost of this
common stock issue.

Solution: Given: Po = Br. 20; Do = Br. 1.50; g = 6%; f = Br. 1; Ks =?

 Then apply the two steps:

i) NPo = Br. 20 – Br. 1 = Br. 19

ii) Ks = D1/Npo + g = Br. 1.50(1.06)/Br. 19 + 0.06 = 14.37%

Therefore, the firm should be able to earn a minimum return of 14.37% on investments that
are financed by the new common stock issue.
ii. The cost of Retained Earnings
 Retained earnings represent profits available for common stockholders that the
corporation chooses to reinvest in itself rather than payout as dividends.

 Retained earnings are not securities like stocks and bonds and hence do not have market
price that can be used to compute costs of capital.

 The cost of retained earnings is the rate of return a corporation’s common stockholders
expect the corporation to earn on their reinvested earnings, at least equal to the rate
earned on the outstanding common stock.

 Therefore, the specific cost of capital of retained earnings is equated with the specific
cost of common stock. However, flotation costs are not involved in the case of retained
earnings.
 Computing the cost of retained earnings involves just a single procedure of
applying the following formula:

Where:
Kr = The cost of retained earnings
D1 = The expected dividends payment at the end of next year
Po = The current market price of the firm’s common stock
g = The expected annual dividend growth rate
Illustration 4: Zeila Auto Spare Parts Manufacturing company expects to pay a common stock
dividend of Br. 2.50 per share during the next 12 months. The firm’s current common stock price is
Br. 50 per share and the expected dividend growth rate is 7%. A flotation cost of Br. 3 is involved to
sale a share of common stock.

Required: Compute the cost of retained earnings

Solution Given: Po = Br. 50; D1 = Br. 2.50; g = 7%; Kr =?

Then apply the formula:

Kr = D1+ g = Br. 2.50 + 7% = 12%
Po Br. 50
  Simple average cost of capital
Simple average method is the simple arithmetic mean of the specific costs of capital,

Illustration 5: From the following information supplied to you calculate the overall cost of capital
of the firm. Cost of equity is given as 15%; cost of preference is 8%; and cost of debt is 7%.

Sol: Calculation of simple average cost of capital:

Ko = (Ke + Kp + Kd)/3 Where: Ke = 15%, Kp = 8%, Kd = 7%
Ko = (15% + 8 % + 7 %)/3
Ko = (30%)/3

Ko = 10%
  The weighted Average cost of capital
 A value-maximizing firm will determine its optimal capital structure (defined as that mix of
debt, preferred, and common equity that causes its stock price to be maximized), use it as a
target, and then raise new capital to keep the actual capital structure on target over time.

 The target proportions of debt, preferred stock, and common equity, along with the costs of
those components, are used to calculate the firm’s weighted average cost of capital, WACC.

Illustration 6: Computation of cost of capital using weighted average cost of capital with the
following weights Ke: Kp: Kd in 2 : 1 : 2 proportions and specific cost of capital for Ke : Kp : Kd 15%,
8% and 7% respectively.

Solution: Weighted average cost of capital (WACC) is calculated as follows:

Ko = (We Ke + Wp Kp + Wd Kd)/(We + Wp + Wd)
Ko = (2 X 15% + 1 X 8% + 2 X 7%)/(2 + 1 + 2) = (30% + 8% + 14%)/ (5) = (52%)/ (5) = 10.4%
 …cont’d
To illustrate, suppose a company has a target capital structure calling for 45% debt, 2 percent
preferred stock, and 53% common equity (retained earnings plus common stock). Its after-tax cost of
debt = kd(1 - T) = 10%(0.6) = 6%; its cost of preferred stock, kp, is 10.3%; its cost of common equity,
ks, is 13.4 %; and all of its new equity will come from retained earnings.

Solution: Weighted average cost of capital (WACC) is calculated as follows:

Ko = (We Ke + Wp Kp + Wd Kd)/(We + Wp + Wd)
Ko = WACC = 0.45(6%) + 0.02(10.3%) + 0.53(13.4%)/1 = 10%

 Every dollar of new capital that a company obtains consists of 45 cents of debt with an after-tax
cost of 6%, 2 cents of preferred stock with a cost of 10.3%, and 53 cents of common equity (all
from additions to retained earnings) with a cost of 13.4%. The average cost of each whole dollar,
WACC, is 10%.
 …cont’d
Illustration 7: From the following Statement given to you calculate the cost of capital
using (i) SACC; (ii) WACC using the Book values; and (iii) WACC using market values.

Particulars Book Values in Br. Market values in Br. Specific costs

Common Share Capital Br. 200,000

Br. 500,000 Ke = 13.5%
Retained Earnings 250,000
Preference Share capital 150,000 150,000 Kp = 7.9%
Bonds 150,000 100,000 Kd = 5.8%
 …cont’d
Solution
(i): Calculation of simple average cost of capital:
Ko = (Ke + Kp + Kd)/3 Ko = (13.5% + 7.9% + 5.8%)/3 = Ko = (27.2%)/3 = 9.33 %

(ii) Calculation of WACC using Book weights: WACC Ko = 10.84%

Particulars Book values Specific Cost Book weights Cost X weights

Common Share capital Br. 200,000 13.5 % 0.267 3.6045 %
Retained earnings 250,000 13.5 % 0.333 4.4955 %
Preferred share capital 150,000 7.9 % 0.200 1.5800 %
Bond capital 150,000 5.8 % 0.200 1.1600 %
Total: Br. 750,000   1.000 10.8400 %
 …cont’d
(iii) Calculation of Weighted cost of capital using market weights:

Particulars Market values Specific Market Cost X weights

in Br Cost weights
Common Share capital Br. 500,000 13.5 % 0.667 9.00 %
Preferred share capital 150,000 7.9 % 0.200 1.58 %
Bond capital 100,000 5.8 % 0.133 0.77 %
Total: Br. 750,000   1.000 11.35 %

Ko = 11.35%
 The Retained Earning Breakpoint
 As a firm tries to have more new capital, the cost of each birr will rise at
some point. Thus, the marginal cost of capital (MCC) is the cost of
obtaining additional new capital.

 As a firm raises larger and larger amounts of capital, the weighted average
cost of capital also rises. But the question would be at what point the firm’s
costs of debt, preferred stock, and common equity as well as WACC increase?

 Therefore, the first point in computing the MCC is to determine the

breaking points where the cost of capital will increase.

 The retained earnings breakpoint represents the total amount of financing

that can be raised before the firm is forced to sell new common stock.
…cont’d
Illustration 8: The target capital structure of Sheko Corporation and other
pertinent data are given below.
Long-term debt -------- 40% Cost of preferred stock (Kps) = 12.06%
Preferred stock ----------10% Cost of retained earnings (Kr) = 14%
Common equity ----------50% Cost of common stock (Ks) = 15%

 Sheko Corporation has Br. 900,000 available retained earnings.

 But when the firm fully utilizes its retained earnings, it must use the more expensive new
common stock financing to meet its equity needs.

 In addition, the firm expects that it can borrow up to Br. 1,200,000 of debt at 7.3% after-tax
cost. Additional debt will have an after-tax cost of 9.1%.
…cont’d
Required:
What is the breaking point associated with the
Exhausting of retained earnings?

Increment of debt between Br. 0 to Br. 1,200,000?

Determine the ranges of total new financing where the WACC will rise
Calculate the WACC for each range of finance.
 The Retained Earning Breakpoint
Solutions 1:
a. Breaking point (BP) common equity = Br. 900,000/50% = Br. 1,800,000
b. Breaking point (BP) long-term debt = Br. 1,200,000/40% = Br. 3,000,000

The breaking points computed above can be interpreted as:

 Sheko can meet its equity needs using retained earnings until its total finance need is Br. 1,800,000.
 But when total capital required is more than Br. 1,800,000, its equity needs should be met with common
stock.
 Similarly, until the firm’s total finance need reaches Br. 3,000,000, Sheko can raise any debt at 7.3% cost.
 Any further finance need beyond Br. 3,000,000 will cause the cost of debt to rise to 9.1%.
 …cont’d
Solutions 2:

There are three ranges of finance that could be identified on the basis of the
breaking points:
1st Range: Br. 0 to Br. 1,800,000,

2nd Range: Br. 1,800,000 to Br. 3,000,000, and

3rd Range: Br. 3,000,000 and above

 …cont’d
Solutions 2:
WACC (1st range) = 0.40 (7.3%) + 0.10 (12.06%) + 0.50 (14%)
= 2.92% + 1.21% + 7.00%
= 11.13%

WACC (2nd range) = 0.40 (7.3%) + 0.10 (12.06%) + 0.50 (15%)

= 2.92% + 1.21% + 7.50%
= 11.63%

WACC (3rd range) = 0.40 (9.1%) + 0.10 (12.06%) + 0.50 (15%)

= 3.64% + 1.21% + 7.50%
= 12.35%
The End!