COST OF CAPITAL

➢ Cost of capital is the cost of funds used for financing a business.

➢ Cost of capital is the required return necessary to make a capital budgeting project, such as
building a new factory, worthwhile.
➢ Cost of capital is a key factor in decisions relating to the use of debt versus ownership
(equity) capital.
The Weighted Average Cost of Capital [WACC]
The WACC is commonly referred to as the firm’s cost of capital. It is also known as composite cost of
capital
➢ WACC represents minimum required rate of return on an investment.
➢ WACC serves as the decision making tool to link between two major finance functions: Investment
decision and Financing decision.
➢ WACC is sometimes referred to as hurdle or cut-off rate. For a project to increase shareholders’
value, it must earn more than its hurdle rate.
➢WACC is the aggregate cost of firm’s capital that considers the relative weights of each component
of the capital structure and their costs.
➢ Debt, Preferred stock, and Common equity are the components of capital structure.
➢ Firm can use single or multiple sources of capital. It depends on their cost factor.
➢The optimal capital structure for a company is one which offers a balance between the ideal debt-
to-equity range and minimizes the firm's cost of capital. It is the best composition or ratio of capital
components for a firm that maximizes its value.
Prof. Bijaya G. Shrestha
 Component Cost of Debt
Cost of debt before tax: kd
Cost of debt after tax: kdT = kd (1-T), where T is the firm’s
marginal tax rate.
Component Cost of Preferred Stock
Component
Cost of preferred stock: kP
Costs

Component Cost of Common Equity

Cost of retained earnings: ks [There are three approaches]
(1) The CAPM approach: Ks = kRF + (kM - kRF) bi
(2) Discounted cash flow (DCF) approach:
(3) Bond-yield plus risk premium approach: ks = BY + RP
(Risk premium is a judgmental i.e., 3 to 5 percentage point)
Cost of external equity (New issue):

WACC = wdkdT + wpkp + wcks

Prof. Bijaya G. Shrestha
 COST OF CAPITAL: Problem for discussion
Sahara International Company (SIC) has the following capital structure, which it
considers to be optimal:
Debt 25%
Preferred stock 15%
Common stock 60%
Total capital 100%
SIC’s tax rate is 40 percent and investors expect earnings and dividends to grow at a
constant rate of 9 percent in the future. SIC paid a dividend of Rs 3.60 per share last
year, and its stock currently sells at a price of Rs 60 per share. Treasury bonds yield
11 percent; an average stock has a 14 percent expected rate of return; and SIC’s beta
is 1.51.
These terms would apply to new security offerings:
Preferred: New preferred could be sold to the public at a price of Rs 100 per share,
with a dividend of Rs 11. Flotation costs of Rs 5 per share would be incurred.
Debt: Debt could be sold at an interest rate of 12 percent
(a) Find the component costs of debt, preferred stock, and common stock. Assume
SIC does not have to issue any additional shares of common stock.
(b) What is the WACC? 12.8%

Prof. Bijaya G. Shrestha

 COST OF CAPITAL: Problem for discussion
Using the following information of Sahara International Company (SIC) solve the problems:
Assets Amount Liabilities and Equity Amount
Cash 120,000 Long-term debt 720,000
Account receivable 345,000 Preferred stock 432,000
Inventories 360,000 Common Equity 1,728,000
Plant and equipment 2,160,000 Current liabilities 105,000
Total assets 2,985,000 Total liabilities and equity 2,985,000
SCI’s tax rate is 40 percent and investors expect earnings and dividends to grow at a constant
rate of 9 percent in the future. SIC paid a dividend of Rs 3.60 per share last year, and its stock
currently sells at a price of Rs 60 per share. Treasury bonds yield 11 percent; an average stock
has a 14 percent expected rate of return; and SIC’s beta is 1.51.
These terms would apply to new security offerings:
Preferred: New preferred could be sold to the public at a price of Rs 100 per share, with a
dividend of Rs 11. Flotation costs of Rs 5 per share would be incurred.
Debt: Debt could be sold at an interest rate of 12 percent
(a) Find the component costs of debt, preferred stock, and common stock. Assume SIC does
not have to issue any additional shares of common stock.
(b) What is the WACC?

Prof. Bijaya G. Shrestha

 The level of interest rates: Ups and down of market interest
rate is not in the control of the firm. It affects cost of debt as
Factors the well as cost of common and preferred equity capital.
firm cannot
control
Tax rates: Tax rates, which are largely beyond the control of
an individual firm, have an important effect on the cost of
Factors capital.
that affects
the
composite Capital structure policy: A firm can change its capital
cost of structure, and such a change can affect its cost of capital.
capital Optimal capital structure minimizes its cost of capital.

Factors the Dividend policy: A firm can obtain new equity through
firm can managing dividend policy. Low dividend payout ratio can
control make retained earnings, which is less expensive source.
Because of no flotation cost.

Investment policy: A firm can make investment decision by

considering the riskiness of the project. Because ,required
rate of return is a subject of riskiness of the investment and it
has relationship with cost of capital
Prof. Bijaya Gopal Shrestha
 Adjusting the cost of capital for risk
➢ Companies finance their operations and expansion projects with either equity or debt
capital. Different projects have different degree of risk.
➢ Risk refers to the chance that some unfavorable event will occur.
➢ Investors require higher rate of return for the riskier investment and vice versa.
➢ Therefore, cost of capital must be adjusted by thinking the riskiness of the project.
➢ We have to apply risk adjusted cost of capital for evaluating the project.
➢ For instance, the cost of equity capital, as determined using the CAPM method, is equal
to the risk-free rate plus the market risk premium multiplied by the beta (risk) value of the
stock.
➢ The adjustment of risk in decision making is not a simple task in real life situation.
However, we should acquainted to the following different risks:
 Stand-alone risk and Portfolio risk: The risk if an investor held only one asset. It is
necessary to understand stand-alone risk in order to understand risk in a portfolio
context. Because, the one is a part of portfolio and portfolio risk is the risk in
combined form.
 Diversifiable Risk: It is associated with random events. It is unsystematic. Proper
portfolio can minimize this risk by the investors.
 Market Risk: Inflation, recession, high interest rates. It is systematic and diversification
does not matters. Market volatility affects systematically to the most firms.

Standard deviation, coefficient of variation, beta coefficient are widely practiced tools to
measure risks.
Prof. Bijaya G. Shrestha
 The Marginal Cost of Capital, MCC
➢ MCC is the cost of obtaining another amount of new capital.
➢ MCC is the cost of additional funds to be raised.
➢ In case, a firm employs the existing proportion of capital structure and the component costs
remain the same the marginal cost of capital shall be equal to the weighted average cost of
capital.
➢ But in practice, the proportion and/or the component costs may change for additional funds
to be raised after different limits.
➢ MCC Schedule: It is a graph that shows how the WACC changes as more and more new capital
is raised by the firm.
➢ Break Point (BP) in MCC Schedule: The amount of new capital that can be raised before an
increase occurs in the firm’s WACC.
➢ The cause of BP is high cost source of capital after some limit of capital need. For example,
after some limit, firm may have to issue new share with flotation cost and/or may have to use
high cost debt. WACC

A firm can not raise unlimited amount

of new capital at the same cost.
Therefore, BP occurs in the firm’s
MCC Schedule. Break Points

This issue is addressed in mini case. 0

Amount of Capital

Prof. Bijaya G. Shrestha

 Mini case of cost of capital

The ACE Company has Rs 100 million in total net assets at the end of 2014. The company
has been growing rapidly during for last five years. It has some other good investment
opportunities for which it needs additional long-term funds amounted to Rs 50,000,000.
The company plans to raise required fund through bonds, preferred stocks and common
equity. The Company is interested in measuring its cost of specific types of capital as well as
its overall capital cost.
Current investigations indicate that the following costs would be associated with the sale of
debt, preferred stock and common stock. The company has a 40 percent average tax rate.
Debt: The company can sell a 20 year, Rs 1,000 face value bond with a 8 percent coupon for
Rs 970. A underwriting fee of 2 percent of the face value would be incurred in the process.
Preferred stock: 10 percent preferred stock having face value of Rs 100 can be sold for
Rs 94. A fee of Rs 4 per share must be paid to the underwriters.
Common stock: The company’s common stock is currently selling for Rs 500 per share. The
company expects to pay a dividend of Rs 40 per share at the end of the coming year. Its
dividend is expected to grow 6 percent per year for ever. It is expected that in order to sell
the new common stock it must be under priced Rs 50 and therefore will reach the market at
Rs 450 per share. The company must also pay a Rs 20 per share underwriting fee.
The company is expected to have Rs 10 million in retained earnings available. The present
capital structure shown below is considered optimal:
See next slide … Contd. …

Prof. Bijaya G. Shrestha

 Mini case of cost of capital

Debt Rs 40,000,000
Preferred stocks Rs 10,000,000
Common stock (Rs 100 par) Rs 20,000,000
Retained earnings Rs 30,000,000
Equity Rs 50,000,000
Total: Rs 100,000,000

a. How much of the Rs 50 million must be financed by equity capital if the present capital structure is
to be maintained?
b. How much of the equity funding must come from the sale of new common stock?
c. Calculate the component cost of:
1. New debt
2. New preferred stock
3. Retained earnings
4. New equity
d. What would be company's weighted average cost of capital if only retained earnings were used to
finance additional growth?
e. Determine break point caused by retained earnings in MCC schedule.
f. What is the weighted average cost of capital when Rs 50 million is raised?
g. What is the weighted average cost of capital above the break point caused by retained earnings?
h. Would you prefer market value weight or book value weight? Give reason.
i. Briefly explain the importance of WACC.

Prof. Bijaya G. Shrestha

Don't hesitate to discuss at class, if you feel some problem.

Remember !
Your own effort is the first requirement.
Solving the problem and cases yourself gives you
a great satisfaction.

Prof. Bijaya G. Shrestha