CHAPTER 13 COST OF CAPITAL – CONCEPTS

COST OF CAPITAL “Capital” refers to money acquired for long-term use (such as funding
and purchase of long-term assets). On the financial statements, capital
The company’s cost of capital is the average rate it pays for the use of appears on the lower right of the balance sheet.
its capital funds. That rate provides a benchmark against which to
measure investment opportunities in the context of capital budgeting. CAPITAL COMPONENTS

No one should invest in any project that will return less than the cost The components of a firm’s capital are debt, common
of invested funds, and because a firm’s cost of capital is the best equity (ordinary share), preferred stock.
estimate of the cost of any money it invests, it should never take a
project that doesn’t return at least that rate. Capital is divided into components according to how the money was
raised. The common classifications are debt and equity:

The cost of capital is the average rate paid for the use of  Debt – it is borrowed money raised through loans or sale of
capital funds. It is used primarily in capital budgeting. bonds.
 Common equity – it indicates an ownership interest, and comes
from the sale of common stock or retained earnings.
The
cost of capital must be estimated accurately otherwise, the firm will Another kind of capital is the Preferred stock. It is a cross between
make incorrect investment decisions that will jeopardize its debt and equity due to the characteristics it shares with each. Legally,
profitability and long-run survival. preferred stock is equity but for financial purposes, it acts like debt. Its
hybrid nature allows it to combine with one of the components (debt or
The concept of cost of capital is similar to the idea of an individual equity) for analysis.
investor’s required return for a particular stock. Investors wouldn’t buy
a stock unless its expected return was higher than their required return. In the context of the cost of capital, preferred stock offers investors
People base required returns on risk. returns that differ from debt and equity, and thus is handled separately
as a third component.
A company’s cost of capital is the required return for all capital
budgeting projects that have risk levels approximately equal to its own Security terms in this chapter:
risk.  Debt
Terms:  Common equity as Equity
 Preferred stock as Preferred
 Expected Return (IRR)
 Required Return (Cost of Capital) The three capital components are debt, equity, and preferred.

A firm won’t invest in a project unless its IRR exceeds that firm’s cost
of capital. CAPITAL STRUCTURE
 could try to move back toward the target mix the next time it decides
to raise capital.
Capital structure is the mix of the three
capital This implies that for it to be balanced, there should be a mix of capital
Based on Chapter 14, the components.
Capital structure is synonymous with
components.
Financial leverage because the latter refers to debt in the capital
structure; it uses more debt than equity by multiplying the The cost of capital calculations are based on the assumption that
effectiveness of equity but also adds risk. money is raised in the exact proportions of some capital structure.
The mix of capital components in use by a company at a point in time Cost of capital calculations assume that capital is raised in
is its capital structure. We describe the capital structure in percentage the exact proportions of some capital structure.
terms referring to the relative sizes of the components.
Example: Assume that a firm raised its $1 million by selling $300,000
Example: A firm has capital components with 30% debt, 10%
in new bonds and $100,000 in new preferred stock, along with
preferred, and 60% equity.
$600,000 of equity.
The Target Capital Structure it is important that the company
The equity would come from a combination of retained earnings and
operate with the “right” capital structure. The particular mix of a
the sale of new common stock (as defined earlier). Unrealistic
company’s capital components is its target capital structure which
assumption with small distortion.
the management strives to maintain as its money is raised.
RETURNS ON INVESTMENTS AND THE COSTS OF
CAPITAL COMPONENTS
Investors provide capital to companies by purchasing their securities
A firm’s target
The designated targetcapital
capitalstructure
structureiscan
a mix
be of components
used thatthe
in place of and their returns are paid out by companies, which means that those
management considers optimal and strives
actual capital structure for certain calculations. to maintain. returns (that companies pay out) are a cost to the firms that made the
investments.
Raising Money in the Proportions of the Capital Structure An
exact capital structure can’t be maintained continuously because The return received by an investor on any security
money is acquired in finite amounts through the issuance of securities (debt, preferred, or equity) and the cost to the
of one kind or another, one at a time. company of the funds’ returns [funds raised
through that security] are opposite sides of the
same coin.

INSIGHTS
An entrepreneur earning at 12% plans to borrow at 15% is CERTAIN to lose
moneyone
Issuing because it pays more
security funds
for the than it earnsmoney
additional using them. The business
would throwwillproportions
only makes sense if it borrows at 12% or less. We shouldn’t pay more than The income
The of the investor
return earned byis investors
an expenseon or
thecost on the
security part of the
underlying a
in the capitalearns.
structure off target, that is why it is best if the company
the resource firm. capital component is unadjusted cost.
The cost of capital is the rate at which borrowed funds are available.
Cost of Capital Components The WACC is the weighted average of component costs where the
weights reflect the amount of each component used.
Each type of securities offers different returns because each has Computing the WACC to compute for the WACC, we need two
different risks which means that they also have different costs. things:

 Return on equity investment is HIGHER than return on debt or Common 1. Mix of the capital components in use.
preferred because the risk is higher. Its cost of equity capital is Preferred 2. Cost of each component.
also higher than the two.
Steps on computing the capital structure:
 Return or cost of debt is the lowest of the three components Debt
because debt is the least risky (safest) investment. 1. Compute the total of the capital components by adding the
 Return or cost of preferred is between the cost of debt and value of debt, preferred stock, and common stock.
equity. 2. Pro-rata/ allocate the total to the value (cost) of EACH capital
component. Divide the value of each capital component to the
High risk = High return = High cost total to get the weight of that component (percentage).
Low risk = Low return = Low cost 3. Each weight of the component adds up to 1.00 or 100%
Since the cost paid out by the company is the investor’s return, it 4. Multiply the weight of the component to its cost, and then sum
requires adjustments to keep the effective cost and return the same. the values. The resulting sum is the WACC.
Cost and Return are RELATED rather than equal. CAPITAL STRUCTURE AND COST – BOOK VERSUS
There are separate component costs of capital for debt, preferred stock, MARKET VALUE
and equity. Each component cost is related to the return earned by Both capital structure and component costs can be viewed in terms of
investors owning the security underlying that component. either the book or market value of the underlying capital.
THE WEIGHTED AVERAGE CALCULATION – WACC Capital Structure – Book Versus Market
Conceptually, calculating the cost of capital is simple: The book value of a firm’s capital accounts reflects the prices at which
the securities (that raised the firm’s capital) were originally sold,
embodied in the capital section of its balance sheet.
The market value reflects the current market prices of the same
Firm raise capital from Firm’s overall cost of capital is the
average of the costs of its separate
The separate sources are capital
components, and the proportions are the securities.
different sources that has percentages of each component in the
sources WEIGHTED by the
itsThe procedure has
own cost led to the term weighted average cost of capital firm’s capital structure.
proportion of each source used.
The value of capital can be stated based on either the book or market value
1
(WACC). It shares the same meaning as the simple “cost of capital”. (prices) of the underlying securities2

Example: Assume that Diplomat Corporation, a new firm, raises a $100,000  If Diplomat’s stock price increases to $12, while interest rates climb
in equity by selling 10,000 shares of common stock at $10 each. It also and drive the price of its bonds down to $850. These market
borrows $100,000 by selling 100 bonds at par value of $1,000.
1
Weighted Average Cost of Capital is for MIX of components. It is different from Cost of Capital for individual components.
2
Underlying asset is an investment term that refers to the real financial asset or security that a financial derivative is based on. Underlying assets include stocks, bonds, commodities, interest rates, market indexes, and currencies.
 adjustments do not change the capital entries on the company’s Market values are appropriate because new
books. projects are generally funded with newly raised
capital.

Capital structures based on book and market values are different because the Maintain the present by estimating the future.
WACC is used in techniques like the IRR 3and NPV 4 to evaluate newly
market values of securities change all the time and those changes are not
proposed projects. Old capital isn’t available to fund these undertakings
reflected in company books.
because it has already been spent. Firms will have to fund projects with new
 This means that the book value–based structure remains the same, capital they have YET to raise. This is why it is better to evaluate those new
while the market value-based structure changes significantly. projects against the likely cost of the new capital that will support them.
Market Value
Component Returns/ Costs – Book Versus Market This implies that it’s appropriate that WACC reflects current market
This relates to the current state of capital
markets. Using market values
Marketto= calculate
new/ currentthe conditions because those conditions are the best estimate of what capital will
Investor’s returns and the related component costs
WACC reflects an average of what capital cost during the coming period. Market values should be used throughout the
of capital can be thought of in either bookwould
or cost if it were raised
Booktoday.
= old/ original
WACC calculation.
market terms. Market values estimate the cost of capital to N re
be raised in the near future. The Customary Approach it assumes that in the future, the firm will either now
Example: A firm sells 10% bond at its face value. maintain its present capital structure based on market prices or will strive to
INITIALLY, an investor buying the bond earns 10% return, and the company achieve some target structure also based on market prices. [P
Ann
pays the same 10% interest on the borrowed money. Suppose the market
interest rate falls to 8%. Either of these structures is combined with market-based component costs of [P
capital to develop the WACC.
After the market rate changes, two returns can be associated with the bond:
1. The original investor still receiving 10% on his investment, and the
company still paying that original 10% borrowed amount. People are less concerned with the precision of the capital structure in the
2. The new investor buying the bond will pay a higher price and will calculation than with the accuracy of the component costs of capital. In
earn a return of only 8% practice, calculating the present structure at market prices is tedious and the
market-based structure is constantly changing. A reasonable target structure
Either the 8% market rate or 10% book rate can be associated with the debt. is often used for simplicity. The error implied is very small.
The Appropriate Perspective for the WACC Calculation. To determine CALCULATING THE WACC
which view (book or market) is appropriate for calculating WACC, it is
important to understand what the use of each implies in the context of capital 1. First, we develop a market value-based capital structure.
budgeting. 2. We adjust the market returns on the securities underlying the capital
components to reflect the company’s true component cost of capital.
3. Finally, we put these together to calculate the WACC.
Developing Market Value-Based Capital Structures

3
internal rate of return, is a metric used in financial analysis to estimate the profitability of potential investments. IRR is a discount rate that
makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis. IRR calculations rely on the same
formula as NPV does.
4
Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash
outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the profitability of a
projected investment or project.
 Developing a capital structure involves

stating the dollar amounts of

the capital components in use
by the firm.

A book value structure is easier to calculate because the book values of the
securities are readily available on the balance sheet because of its past or
history.
Debt:
Developing a market value-based structure is difficult because it requires that The returns paid to new investors are adjusted to
we compute the current market value of all the securities underlying each
2 is used because
semiannually. PB = PMT [PVFAk,n] + FV[PVFk,n]
arrive at effective costs to the company.
category of the balance sheet capital, and then develop a structure from those Multiply
values. PMT = [coupon rate x face value]/2

n = [originalCOSTS
term – term now] x2
Number of bonds
CALCULATING COMPONENT OF CAPITAL (outstanding)
k = [current market interest rate] x 2
We’ll start by considering the market return currently received by new
investors on the securities underlying the component.
FV = [face value] Bond formula multiplied to number of
Solution: The market value of each bonds will total to the market value of
Solving a Market Adjustments – The Effect of Financial Markets and debt. Taxes The returns
capital component is the market price
of Value-Based Capital the underlying security multiplied by received by investors and the costs
The tax deductibility of interest makes debt an even cheaper source of
Structure the number of those securities paid out by companies
capital than it is due to low risk.
same money, the
Preferred Stock: are the
amounts
outstanding.
effectively paid and Multiply received
P =D
adding them up and then restating each as a
percentage of the total.
D can be different because
p is preferred dividend p p
certain transaction costs associated with doing business in financial
of taxes and
Number of preferred
markets.

K is current market interest k (outstanding)

rate Preferred formula multiplied to number of

preferred stock will total to the market
value of preferred.

Taxes The tax 5effect

Common Equity: applies
only to debt because interest
[Market Price
payments are tax-deductible to thexpaying
numberfirm.of shares
This outstanding]
effectively makes debt

Market value-based weights:

5
The marginal federal income tax for most firms is 35%. However, most companies
[Total
are subject to state income tax, so the
40% components and pro-rata]
is a reasonable approximation f an average
total rate.
cheaper than it would be if interest weren’t deductible. Dividends are not tax Where f is in decimal form. Flotation costs lower the amount of money a
deductible. firm receives when it sells securities. They have the effect of making the cost
of the issue higher than the return received by investors.
Component cost of capital = investor’s return = k

The component cost of capital is higher than the investor’s return by the ratio
The cost of debt is the investor’s return adjusted for the tax
6
of 1(1-f) . Example, return on security
deductibility is 10%, payments.
of interest and the flotation cost 20%,
The dollar cost of paying an amount of interest I is
10% = 12.5%
I(1-T)
The Cost of Debt To calculate the component cost of debt based on market
Where T is tax rate. Same rule applies when interest is expressed as rate of returns, we take the return received by investors currently purchasing the
return. Paying interest at a rate kd the effective after-tax cost of paying that firm’s bonds and adjust it for the effects of taxes.
rate
Most debt isn’t initially sold to the general public, but it is privately placed
kd (1-T) with large investors. Therefore, flotation costs are minimal and we don’t need
to adjust them.
Example: interest rate 10% and tax rate of 40%, the cost of debt adjusted for
taxes would be
kd (1-T) = 10%(1-40%)= 6% The market return on business debt is known for the firm’s own securities or
for issues of similar risk. The return will be kd. The cost of debt would be
The return paid to investors on debt is the LOWEST of the three capital
components because
Total payments debt is
to investors arethe leastfor
higher risky (safest) investment.
the leveraged The tax effect
companies because Cost of debt = kd (1-T)
reduces
they canthe costinterest
deduct of debtfrom
eventaxable
further in relation
income and payto less
the tax.
cost of other
Where (1-T) adjusts for the fact that interest is tax deductible to the paying
components which makes it a bargain.
firm.
Flotation Costs are administrative fees and expenses incurred in the process
The Cost of Preferred Stock Preferred stock provides an
of issuing and selling (floating) securities. It is the commission paid to firms
investor with a constant dividend
(1-f) as long as the share
in the investment banking industry for services performed in raising capital.
remains outstanding. This arrangement is known as perpetuity.

The cost of preferred stock is the investor’s return

adjusted for flotation costs.
If flotation costs are f percent of the proceeds of a security issue that raises an
The price of preferred share is the present value of the perpetuity of the
amount P paid by investors, the amount received by the issuing company is
dividend stream
(1-.20)
P – fP = P(1 – f)
6
This relationship is strictly true ONLY when the investment expected to generate an
infinite stream of cash flows. If the stream is finite. As in a bond investment, it is an
approximation.
 The market return on new shares is the appropriate starting point for
estimating the cost of retained earnings.
Where Pp is the current price of a share, Dp is the preferred dividend, and Kp is
the return on the investment in preferred stock. The investor’s return yields
Kp =
Preferred dividends are not tax deductible to the issuing firm so no tax No
adjustments required. Flotation costs, however, must be incorporated by
multiplying it with 1(1-f) Required rate is the return that induces investors to
Cost of preferred stock = Dp = kp Adjustments
purchase aBetween
stock and Return and Cost
is generally for Retained
assumed to be a Earnings Since
retained earnings
function of theare the only
stock’s risk.internally generated capital source, they aren’t
The Cost of Common Equity The market return available on equity raised in financial markets, so they don’t incur flotation costs. They are also
investment isn’t as easy to come up as with the market return on debt or not tax deductible. No adjustments necessary to convert return to cost.
The cost of equity is imprecise because of the uncertainty of EXPECTED RATE OF
preferred stock. future cash flows. TheExpected
CAPM Approach – The
rate of return Required
is the return Rate of Return
investors expect in
The two aforementioned securities give an investor known streams of future the future
payments in return for the prices paid, which makes calculating the return Capital Asset given
Pricingthe knowledge
Model (CAPM) currently available
is a theory purporting to explain how
about a particular stock.
investors set required rates of return for a particular stock.
easy.
REQUIRED RATE OF
The anticipated return on stock investment depends on estimates of future
dividends and prices, much less certain than interest payments and preferred
dividends. This uncertainty results in the market return on equity investment
estimated.

A complication arises when equity comes from two sources (retained

earnings and the sale of new stock). These have to be treated separately
because they turn out to have different costs.
Under normal market conditions, market stock prices are more or less in
The Cost of Retained Earnings Retained earnings come from its own
equilibrium which means that expected and required rates of return are about
internal operations, but all earnings belong to the firm’s stockholders whether
equal. Hence, the market return on a particular stock can be approximated by
they’re paid out as dividends or retained. If the management retains earnings,
estimating either the required return or the expected return.
they reinvest shareholders’ money in the company for them. The cost of retained earnings is equal to the unadjusted return
The CAPM allows earned
estimation
by theofnew
required
buyersreturn. The CAPM’s
of the firm’s stock. expression for
Retained earnings (unreleased dividends) represent money stockholders
the required rate of return is the security market line (SML).
could have spent if it had been paid out in dividends. Those stockholders
deserve a return on the funds just as though the money had been paid out and
reinvested through a purchase of new shares.

(1-f)Pp (1-f)
It is also a direct estimate of the cost of equity acquired through retained Estimating the return on a firm’s equity by adding 3 – 5 percentage points to
earnings because no tax or market adjustments are necessary. the market on its debt, which is easy to get.
The Dividend Growth Approach – The Expected Rate of Return Expected
rate of return is used for pricing a stock that is expected to grow at a constant The cost of new common stock includes an adjustment for
Kd and Ke are the respective market returns on debt and equity, and rpe is the
rate into the indefinite future. This model is also called the Gordon Model. flotation costs.
additional risk premium on equity. The cost of retained earnings is equal to
the estimate of Ke.

The Cost of New Common Stock Firms often need to raise more equity
capital than is available from earnings and do so by selling new common
stock.
This gives us a direct estimate of
the cost of equity capital obtained through retained earnings.

Equity from new stock is like equity from retained earnings, with the
TheThe
Riskcost of retained
Premium earnings
Approach Any can be estimated
return usingoftheasCAPM,
can be thought the sum of a
exception that raising it involves incurring flotation costs.
basethe dividend
rate growthfor
and premiums (Gordon)
bearing model
risk. or a risk premium.

PUTTING THE WEIGHTS AND COST TOGETHER

Investment risk and associated risk premiums vary between kinds of
securities offered by a single company. The calculation for the weighted average is simple if we’ve calculated a
market value-based capital structure and a series of component costs based
Debt is the safest investment, while equity is riskier.
on market returns.
The MARGINAL
THE MCC is graphCOST
of the WACC showing(MCC)
OF CAPITAL abrupt increases
as larger amounts of capital are raised in a planning period.
A firm’s WACC is not independent of the amount of capital raised because it
tends to increase abruptly from time to time as funding requirements are
increased. Changes in WACC are
reflected in the marginal cost
of capital (MCC) schedule, a
graph showing how the WACC changes a firm raises more capital during a
The relations risk of debt and risk of equity is relatively constant among planning period.
companies. The increment in risk between debt and equity is about the same
for high-risk and low-risk firms. That increment commands an additional risk
premium of between 3% and 5%.
 that firms would pay higher interest rates to borrow more and accept a lower
price to sell additional stock.
The MCC schedule is a graph showing the values the WACC goes through as
larger amounts of money are raised. It is the graph of WACC. The term Combining MCC and the IOS A firm’s available capital budgeting projects
“marginal cost of capital” (MCC) means the cost of the next dollar of capital can be sorted into descending order of IRR and displayed on the same set of
to be raised. axes as the MCC.
The MCC breaks when retained earnings are exhausted, and the
WACCcost starts out at
of equity one level
increases dueand
tojumps to acosts.
flotation higher level as the total amount The pattern traced by the upper rightward boundary of the projects is known
of capital raised passes a certain point. as the investment opportunity schedule (IOS). The IOS is a plot of the
IRRs of available projects arranged in descending order.
Interpreting the MCC The MCC and IOS plotted together show which
THE BREAK IN MCC WHEN RETAINED EARNINGS RUN OUT
projects should be undertaken.
The first increase in MCC occurs when the firm runs out of retained earnings
The firm’s WACC for the planning period is at the intersection of the MCC
and starts raising external equity by selling stock. The WACC increases at
and the IOS.
that point because the cost of equity increases.
A POTENTIAL MISTAKE – HANDLING SEPARATELY FUNDED
PROJECTS
Find the MCC Break by dividing available RE by the It’s logical to ask whether the cost of capital used to evaluate the project
proportion
The difference with of
theequity
cost ofinretained
the capital structure.
earnings and cost of equity from new should be the cost of the bond issue and not the firm’s WACC because debt
stock is the flotation costs associated with selling new shares. tends to be the cheapest form of capital, this approach would make the
project accepted.
Firms use all the money available from retained earnings before selling new
stock so the cost of equity capital increases as the firm moves into externally A close matching of a source of funds with its use would be appropriate
raised money. If the cost of equity increases, the WACC must also increase at whenever possible, it’s a mistake in capital budgeting which has to be
the same point because equity is an element in the weighted average conducted within the context of the firm’s overall capital-raising capability.
calculation. Firms cannot continue to raise low-cost debt indefinitely without from time
to time raising higher cost of equity. This means that firms have limited debt
capacity that can be used up until a further infusion of equity is made.
All projects should be evaluated against the WACC including those with
Other Breaks in the MCC Schedule WACC is constant, aside from the dedicated funding.
break into external equity, as long as moderate levels of capital are raised.
Low-cost funds cannot be raised at or near the initial WACC without limit.
The internal workings of capital markets tend to put restrictions on the
amount of new money available to companies in any time period.
A large capital program is risk and investors would be likely to demand
higher returns for further investments in both debt and equity which means