Cost of Capital:

In economics and accounting, the cost of capital is the cost of a company's funds (both debt and
equity), or, from an investor's point of view "the required rate of return on a portfolio company's
existing securities".It is used to evaluate new projects of a company. It is the minimum return
that investors expect for providing capital to the company, thus setting a benchmark that a new
project has to meet.
For an investment to be worthwhile, the expected return on capital has to be higher than the cost
of capital. Given a number of competing investment opportunities, investors are expected to put
their capital to work in order to maximize the return. In other words, the cost of capital is the rate
of return that capital could be expected to earn in the best alternative investment of equivalent
risk. If a project is of similar risk to a company's average business activities it is reasonable to
use the company's average cost of capital as a basis for the evaluation. However, for projects
outside the core business of the company, the current cost of capital may not be the appropriate
yardstick to use, as the risks of the businesses are not the same
A company's securities typically include both debt and equity, one must therefore calculate both
the cost of debt and the cost of equity to determine a company's cost of capital. Importantly, both
cost of debt and equity must be forward looking, and reflect the expectations of risk and return in
the future. This means, for instance, that the past cost of debt is not a good indicator of the actual
forward looking cost of debt.
Once cost of debt and cost of equity have been determined, their blend, the weighted average
cost of capital (WACC), can be calculated. This WACC can then be used as a discount rate for a
project's projected cash flows.

Determining the Cost of Capital

Investing in factories, machinery, and equipment capital requires money. Those funds can
be borrowed (external equity), or the business can raise the funds internally, equity either from
the firms or the owners financial resources.
The cost of using external equity or debt capital is the interest rate you pay lenders. However,
because interest expenses are tax deductible, the after tax cost of debt (kd) is the interest rate (r)
multiplied by 1 minus the firms marginal tax rate (t) or

Internal equity from the firm or the firms owners also has a cost. The opportunity cost of funds
you invest in the firm is the interest you could have earned if you invested those funds elsewhere.
You can choose from among three alternatives to determine the cost of internal or equity capital.

Risk premium method: The risk premium method assumes that you incur some
additional risk in the investment. This methods cost estimation uses a risk-free rate of
return, rf, plus an additional risk premium, rp, or

where ke is the cost of equity capital. The U.S. Treasury Bill rate is often used as the riskfree rate of return.

Dividend valuation method: The dividend valuation method is based on shareholder

attitudes. A shareholders rate of return equals the dividend (D) divided by the stock price
per share (P), plus any expected earnings growth (g). Using this shareholder return as the
cost of equity capital results in

Capital asset pricing method: The final method for determining the cost of internal
equity is the capital-asset-pricing method. This method incorporates a risk premium for
variability in a companys return stocks with greater variability in return have higher
risk premiums. The cost of internal equity using the capital-asset-pricing method is

where rf is the risk free return, km is an average stocks return, and measures the
variability in the specific firms common stock return relative to the variability in the
average stocks return. If equals 1, the firm has average variability or risk. values
greater than 1 indicate higher than average variability or risk, while values less than 1
indicate below-average risk. The term (km - rf) gives the risk premium for holding the
firms common stock.
Problem: The directors of Moorland Co, a company which has 75% of its operations in the retail sector
and 25% in manufacturing, are trying to derive the firm's cost of equity. However, since the company is
not listed, it has been difficult to determine an appropriate beta factor. Instead, the following information
has been researched:

Retail industry quoted retailers have an average equity beta of 1.20, and an average gearing
ratio of 20:80 (debt: equity).
Manufacturing industry quoted manufacturers have an average equity beta of 1.45 and an
average gearing ratio of 45:55 (debt: equity).
The risk free rate is 3% and the equity risk premium is 6%. Tax on corporate profits is 30%.
Moorland Co has gearing of 50% debt and 50% equity by market values. Assume that the risk on
corporate debt is negligible.
Required:
Calculate the cost of equity of Moorland Co using the CAPM model.
Solution: In order to use CAPM we shall need to derive a suitable equity beta for Moorland Co.

This will be done by first finding a suitable asset beta (based on the asset betas of the 2 parts of
the business) and gearing up to reflect Moorland Co's 50:50 gearing level.

Retail industry
The asset beta of retail operations can be found from the industry information as follows:
(assuming the debt beta is zero)
(

= 1.20 (80/(80 + 20(1 0.30)))

= 1.02
Manufacturing industry
Similarly, the asset beta for manufacturing operations is:
(

= 1.45 (55/(55 + 45(1 0.30)))

= 0.92
Moorland Co asset beta
Hence, the asset beta of Moorland will be a weighted average of these two asset betas:
a (Moorland) = (0.75 1.02) + (0.25 0.92) = 1.00
Moorland Co equity beta
So, regearing this asset beta now gives:
1.00 = e [50/(50 + 50(1 0.30))]
So, e = 1.00/0.59 = 1.69
Moorland Co cost of equity
Using CAPM:
Ke = RF + (E(RM) RF) = 3% + (1.69 6%) = 13.1%

Modigliani and Miller's Proposition 2 formula

The ModiglianiMiller theorem (of Franco Modigliani, Merton Miller) is a theorem on capital
structure, arguably forming the basis for modern thinking on capital structure. The basic theorem
states that under a certain market price process (the classical random walk), in the absence of
taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market,
the value of a firm is unaffected by how that firm is financed.[1] Since the value of the firm
depends neither on its dividend policy nor its decision to raise capital by issuing stock or selling
debt, the ModiglianiMiller theorem is often called the capital structure irrelevance principle.
The key Modigliani-Miller theorem was developed in a world without taxes. However, when the
interest on debt is tax deductible, and ignoring other frictions, the value of the company increases
in proportion to the amount of debt used.[2] And the source of additional value is due to the
amount of taxes saved by issuing debt instead of equity.
Modigliani was awarded the 1985 Nobel Prize in Economics for this and other contributions.
As part of their theory, they derived a formula which can be used to derive a firm's cost of
equity:

ke = kei + (1-T)(kei - kd)(Vd / Ve)

Problem:
Moondog Co is a company with a 20:80 debt: equity ratio. Using CAPM, its cost of equity has
been calculated as 12%. It is considering raising some debt finance to change its gearing ratio to
25:75 debt to equity. The expected return to debt holders is 4% per annum, and the rate of
corporate tax is 30%.
Required:
Calculate the theoretical cost of equity in Moondog Co after the refinancing.

Solution:
Using M+M's Proposition 2 equation, we can de-gear the existing ke and then re-gear it to the
new gearing level:
De-gearing:
ke = kei + (1 T)(kei kd )(Vd / Ve)
12% = kei+ (1 0.30)(kei 4% )(20 / 80)
Rearranging carefully gives kei =10.8%
Now re-gearing:
ke = 10.8% + (1 0.30)(10.8% 4%)(25/75)
ke = 12.4%
Many firms finance capital investment with a combination of external and internal funds. The
composite cost of capital (kc) is a weighted average of the cost of internal equity and the cost of
external or debt equity. In the following equation

we and wd are the weights or proportions of internal equity and debt you use to finance the
project.

Logic for WACC

The weighted average cost of capital (WACC) is the rate that a company is expected to pay on
average to all its security holders to finance its assets. The WACC is commonly referred to as the
firms cost of capital. Importantly, it is dictated by the external market and not by management.
The WACC represents the minimum return that a company must earn on an existing asset base to
satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere.

Companies raise money from a number of sources: common stock, preferred stock, straight
debt, convertible debt, exchangeable debt, warrants, options, pension liabilities, executive stock
options, governmental subsidies, and so on. Different securities, which represent different
sources of finance, are expected to generate different returns. The WACC is calculated taking
into account the relative weights of each component of the capital structure. The more complex
the company's capital structure, the more laborious it is to calculate the WACC.
a firm generally uses more than one type of funds to finance its assets, and the costs of, or the
returns associated with, those funds usually are not the same. For example, the existing assets of
firm might be financed with some debt, which has a market return (cost) equal to 8 percent, and
with some stock, or equity, which has a market return (cost) equal to 15 percent. If 50 percent of
the firms financing is debt, then the other 50 percent is equity. Thus, 50 percent of the funds the
firm is using costs 8 percent while the other 50 percent costs 15 percent, and the average rate that
the firm is paying is 11 percent, which is the weighted average of the two costs (11% = 0.50
8% + 0.50 15%).
Cost of Debt, rd: The after-tax cost of debt, which is designated rdT, is simply the yield to
maturity (YTM) of the debt, which represents the bondholders required rate of return, stated on
an after-tax basis:
(

=
=
Where

is the required rate of return of investors who hold the firms bonds and T is the

marginal tax rate of the firm? Remember from the notes titled Risk and Rates of Return that
is the rate of return that investors demand (require) investing in the firms bonds. This rate is
also referred to as the market return or the yield to maturity (YTM) on the bond. Thus,
effectively, investors who are the participants in the financial markets determine the firms cost
of debt.

Problem: Mackay Co has some irredeemable, 5% coupon bonds in issue, which are trading at $94.50
per $100 nominal. The tax rate is 30%.

Required:
Calculate Mackay Co's post tax cost of debt.
Solution : Mackay Co's post tax cost of debt is 5(1 0.30) / 94.50 = 3.7%

Cost of Preferred Stock, rps as with debt, the cost of preferred stock is based on the rate of return
required by the firms preferred stockholders, which is determined by the market price of the
preferred stock. Remember that the dividend associated with preferred stock is a perpetuity, which,
as was noted in previous sections, can be valued as follows:

Where Dps is the constant dividend paid to preferred stockholders and rps represents the rate of
return investors require to purchase the preferred stock. Thus, in general terms, the cost of
preferred stock can be stated as follows:

Where NP0 is the amount per share that the firm receives when issuing preferred stock. NP 0 is the
market price of the stock less expenses that are associated with issuing the stock, which are called
flotation costs (designated F in the above equation). Therefore, NP0 = P0 Flotation costs = P0(1 F),
where F is stated in decimal form.

Cost of Retained Earnings,

This refers to the return that common stockholders require the firm to earn on the funds that have
been retained, thus reinvested in the firm, rather than paid out as dividends. In this case, what we
are saying is that the firm must earn a return on reinvested earnings that is sufficient to satisfy
existing common stockholders investment demands. If this required return is not earned, then
the stockholders will demand that the firm pay them the earnings in the form of dividends so that

they can invest the funds outside the firm at a better rate. In essence, then, the common
stockholders are telling the firm that if it cannot invest at some minimum rate of return, then the
earnings should be paid out as dividends so that the investors can invest in alternatives of their
choice.

From the notes titled Risk and Rates of Return, we know that we can estimate the cost of
retained earnings, ,

using the following relationships:

Required Rate of Return = Expected Rate of Return

Where the variables are as defined previously: rRF is the risk-free rate of return,

is the return

on the market, s is the beta coefficient associated with the firms common stock, is the dividend
the firm expects to pay next year assuming constant growth exists, P0 is the current market price
of the stock, and g is the constant rate at which the firm is expected to grow in the future.

The CAPM Approachusing the CAPM, which is given in the above relationship, the
cost of retained earnings is stated as follows:

Thus, if the risk-free rate of return is 6 percent, the market risk premium is expected to be 8
percent, and the firms beta coefficient is 1.5, then the cost of retained earnings is 18% = 6%
+ (8%)1.5.

Bond-yield-plus-risk-premium approachstudies have shown that the return on equity

for a particular firm is approximately 3 to 5 percentage points higher than the return on
its debt. Thus, as a general rule of thumb, firms often compute the YTM for their bonds
and then add 3 to 5 percent to the result. For example, earlier we found that the beforetax return (YTM) on our illustrative firm is 12 percent. Thus, as a rough estimate, we
might say the cost of retained earnings is 16% = 12% + 4%.

Cost of Newly Issued Common Stock, or External Equity, re:

This refers to the rate of return required by common stockholders after considering the cost
associated with issuing new stock. The cost of external equity is determined in exactly the same
manner as the cost of retained earnings, except we recognize the fact that there are costs involved
with issuing new stock and these costs reduce the total amount of funds that can be used by the
firm for financing new assets. Because the firm has to provide the same gross return to new
stockholders as existing stockholders, when the flotation costs associated with a common stock
issue are considered, the cost of new common stock always must be greater than the cost of
existing stock (that is, the cost of retained earnings). If we modify the DCF approach for
computing the cost of retained earnings to include flotation costs, the cost of newly issued
common stock is stated as follows:
(

Weighted Average Cost of Capital

Weighted Average Cost of Capital, also known by the acronym WACC, is the average cost of
capital (financing) of a firm calculated as weighted arithmetic mean of all components of its
capital.
Components of a firms capital include particularly the following:

common equity,

preferred equity,

bonds,

convertible bonds,

other debt,

options,

warrants, and

Other liabilities.

Calculating Weighted Average Cost of Capital

WACC with Equity and Debt Only
Calculating WACC for small firms or for companies with simple capital structure is quite
straightforward. The two most typical components of a firms capital are common equity and
debt. Weighted Average Cost of Capital is calculated as:

where:

E is the market value of equity

D is the market value of debt issued by the firm

V is the market value of all outstanding securities issued by the firm (E+D)

re is the cost of equity

rd is the cost of debt

t is the corporate tax rate

Multiplying the debt component by (1-t) reflects the fact that interest expense (the cost of debt)
qualifies as cost for tax purposes and therefore reduces the firms payable tax by r d t and the next
cost of debt is rd (t-1).
WACC with Common Equity, Debt, and Preferred Equity
If a company is financed by common stock, preferred stock, and debt, preferred equity also
enters the calculation, using the same logic:

where:

P is the market value of preferred equity

rp is the cost of preferred equity

V equals E+D+P

WACC with Multiple Sources of Capital

Big companies often have complex capital structure, which makes the calculation of WACC
more complicated. In general, for a company with n different sources of capital, weighted
average cost of capital is calculated as:

Where:

Ci is market value of a component of capital (e.g. common stock, preferred stock, or

bonds)

ri is the cost of component Ci

V is the sum of market value of all components (C1+C2++Cn)

Note: If there is debt as one of the components, the ri in this case already reflects the effect of
taxes (1-t).
Weighted Average Cost of Capital Formula
The general formula for WACC with any number of sources of capital is:

where the meaning of individual parameters is the same as in the previous formula.
This is in fact nothing more than weighted arithmetic mean:

Problem:
An entity has the following information in its balance sheet (statement of financial position):
$000
Ordinary shares (50c nominal)

2,500

Debt (8%, redeemable in 5 years)

1,000

The entity's equity beta is 1.25 and its credit rating according to Standard and Poor's is A. The
share price is $1.22 and the debenture price is $110 per $100 nominal.
Extract from Standard and Poor's credit spread tables:
Rating 1 yr

2 yr

3 yr

5 yr

7 yr

10 yr

10

15

22

27

30

55

AA

15

25

30

37

44

50

65

40

50

57

65

71

75

90

AAA

30 yr

The risk free rate of interest is 6% and the equity risk premium is 8%. Tax is payable at 30%.
Required:
Calculate the entity's WACC.
Solution:

* + +

* + + (

Workings:
From CAPM, ke =Rf + i (E(Rm) Rf) = 6% + (1.25 8%) = 16%
Ve = $2,500,000 1.22 / 0.50 = $6.1m

kd (yield on debt) = risk free rate + credit spread = 6% + 65 basis points = 6.65%
Hence, post tax cost of debt = 6.65% (1 0,30) = 4.66%
Vd = $1,000,000 110/100 = $1.1m
Therefore, WACC = (6.1 / 7.2) 16% + (1.1 / 7.2) 4.66% = 14.3%

Why cost of capital is important in financial decision making?

Cost of the capital is the rate of return which is minimum which has to be earned on investments
in order to satisfy the investors of various types who are making investments in the company in
the form of shares, debentures and loans. It is used in financial investment which refers to the
cost of a company's funds or the shareholders return on the company's existing deals. It is the
required rate that a company must achieve to cover the cost of generating funds in the market. By
seeing this only the investor invests the money in the company if the company is giving the
required rate of return. It is a guideline to measure the profitability of different investments.
The importance of cost of capital is that it is used to evaluate new project of company and allows
the calculations to be easy so that it has minimum return that investor expect for providing
investment to the company. It has such an importance in financial decision making. It actually
used in managerial decision making in certain field such as(1) Capital Budgeting Decision. Cost of capital may be used as the measuring road for adopting
an investment proposal. The firm, naturally, will choose the project which gives a satisfactory
return on investment which would in no case be less than the cost of capital incurred for its
financing. In various methods of capital budgeting, cost of capital is the key factor in deciding
the project out of various proposals pending before the management. It measures the financial
performance

and

determines

the

acceptability

of

all

investment

opportunities.

(2) Designing the Corporate Financial Structure. The cost of capital is significant in designing
the firm's capital structure. The cost of capital is influenced by the chances in capital structure. A
capable financial executive always keeps an eye on capital market fluctuations and tries to
achieve the sound and economical capital structure for the firm. He may try to substitute the
various methods of finance in an attempt to minimize the cost of capital so as to increase the
market

price

and

earning

per

share.

(3) Deciding about the Method of Financing. A capable financial executive must have
knowledge of the fluctuations in the capital market and should analyze the rate of interest on
loans and normal dividend rates in the market from time to time. Whenever company requires
additional finance, he may ave a better choice of the source of finance which bears the minimum
cost of capital. Although cost of capital is an important factor in such decisions, but equally
important are the considerations of relating control and of avoiding risk.
(4) Performance of Top Management. The cost of capital can be used to evaluate the financial
performance of the top executives. Evaluation of the financial performance will involve a
comparison of actual profitability of the projects and taken with the projected overall cost of
capital and an appraisal of the actual cost incurred in raising the required funds.
(5) Other Areas. The concept of cost of capital is also important in many others areas of
decision making, such as dividend decisions, working capital policy etc.

Conclusion:
One of the basic issues of financial management is the choice of capital structure, i.e.
combination of debt and equity in order to reduce the cost of capital and increase the value of a
company. The weighted average cost of capital is an important factor when making investment
decisions. The calculation of the weighted average cost of capital implies a combination of
different factors that influence an investor's decision to invest securities. Certainly, one of the
most important components in calculating the weighted average cost of capital is a systemic risk,
represented by the coefficient beta. It is well known that the risk cannot be eliminated, but it is
important to know the degree of exposure of individual securities to that risk so it could be
reduced by proper diversification. This rates usually said to reflect the risk of future cash flows
for creditors and shareholders. Every company whose cash balance exceeds the debt will have a
negative net debt and use the net negative relations to give the beta without the leverage that is
greater than the beta with a lever. Companies that have extensive cash balances that exceed their
borrowing could have a beta with a lever below the beta without leverage for their operations.