Presented by:-

Yash gupta
What is the Cost of Capital?
When we talk about the cost of capital, we are
talking about the required rate of return on
invested funds

It is also referred to as a hurdle rate because this
is the minimum acceptable rate of return

Any investment which does not cover the firms
cost of funds will reduce shareholder wealth (just
as if you borrowed money at 10% to make an
investment which earned 7% would reduce your
wealth)
An Example
The managers of Rocky Mountain Motors are considering
the purchase of a new tract of land which will be held for one
year. The purchase price of the land is $10,000. RMMs
capital structure is currently made up of 40% debt, 10%
preferred stock, and 50% common equity. This capital
structure is considered to be optimal, so any new funds will
need to be raised in the same proportions.

Before making the decision, RMMs managers must
determine the appropriate require rate of return. What
minimum rate of return will simultaneously satisfy all of the
firms capital providers?
Example (cont.)
Source of
Funds
Amount Dollar
Cost
After-tax
Cost
Debt $4,000 $280 7%
Preferred $1,000 $100 10%
Common $5,000 $600 12%
Total $10,000 $980 9.8%
Because the current capital structure is optimal, the
firm will raise funds as follows:
(Cont.)
Rate of Return 8% 9.8% 11%
Total Funds Available $10,800 $10,980 $11,100
Less: Debt Costs $4,280 $4,280 $4,280
Less: Preferred Costs $1,100 $1,100 $1,100
= Remainder to Common $5,420 $5,600 $5,720
The following table shows three possible scenarios:
Obviously, the firm must earn at least 9.8%. Any less,
and the common shareholders will not be satisfied.
The Weighted Average Cost of Capital
We now need a general way to determine the minimum
required return

Recall that 40% of funds were from debt. Therefore, 40% of
the required return must go to satisfy the debtholders.
Similarly, 10% should go to preferred shareholders, and 50%
to common shareholders

This is a weighted-average, which can be calculated as:
WACC w k w k w k
d d p p cs cs
= + +
Calculating WACC
Using the numbers from the RMM example, we
can calculate RMMs Weighted-Average Cost of
Capital (WACC) as follows:
Note that this is the same as we found earlier
WACC = + + = 040 007 010 010 050 012 0098 . ( . ) . ( . ) . ( . ) .
Finding the Weights
The weights that we use to calculate the WACC
will obviously affect the result

Therefore, the obvious question is: where do the
weights come from?

There are two possibilities:
Book-value weights
Market-value weights
Book-value Weights

One potential source of these weights is the firms
balance sheet, since it lists the total amount of
long-term debt, preferred equity, and common
equity

We can calculate the weights by simply
determining the proportion that each source of
capital is of the total capital
Book-value Weights (cont.)
Source Total Book Value % of Total
Long-term Debt $400,000 40%
Preferred Equity $100,000 10%
Common Equity $500,000 50%
Grand Totals $1,000,000 100%
The following table shows the calculation of the
book-value weights for RMM:
Market-value Weights
The problem with book-value weights is that the book values
are historical, not current, values

The market recalculates the values of each type of capital on
a continuous basis. Therefore, market values are more
appropriate

Calculation of market-value weights is very similar to the
calculation of the book-value weights

The main difference is that we need to first calculate the total
market value (price times quantity) of each type of capital
Calculating the Market-value Weights
Source Price per
Unit
Units Total Market
Value
% of
Total
Debt $ 905 400 $362,000 31.15%
Preferred $ 100 1,000 $100,000 8.61%
Common $ 70 10,000 $700,000 60.24%
Totals $1,162,000 100.00%
The following table shows the current market prices:
( ) ( ) ( )
WACC = + + = = 0 3115 0 07 0 0861 010 0 6024 012 01027 10 27% . . . . . . . .
Market vs Book Values
It is important to note that market-values is always
preferred over book-value
The reason is that book-values represent the
historical amount of securities sold, whereas
market-values represent the current amount of
securities outstanding
For some companies, the difference can be much
more dramatic than for RMM
Finally, note that RMM should use the 10.27
WACC in its decision making process
The Costs of Capital
As we have seen, a given firm may have more
than one provider of capital, each with its own
required return

In addition to determining the weights in the
calculation of the WACC, we must determine the
individual costs of capital

To do this, we simply solve the valuation
equations for the required rates of return
The Cost of Debt
Recall that the formula for valuing
bonds is:
( )
( )
V Pmt
k
k
FV
k
B
d
N
d
d
N
=

+

(
(
(
(
+
+
1
1
1
1
We cannot solve this equation directly for k
d
, so we
must use an iterative trial and error procedure (or,
use a calculator)
Note that k
d
is not the appropriate cost of debt to use
in calculating the WACC, instead we should use the
after-tax cost of debt
The After-tax Cost of Debt
Recall that interest expense is tax deductible

Therefore, when a company pays interest, the
actual cost is less than the expense

As an example, consider a company in the 34%
marginal tax bracket that pays $100 in interest

The companys after-tax cost is only $66. The
formula is:
( )
After tax k Before tax k t
d d
= 1
The Cost of Preferred Equity
As with debt, we calculate the cost of
preferred equity by solving the
valuation equation for k
P
:
k
D
V
P
P
=
Note that preferred dividends are not tax-deductible,
so there is no tax adjustment for the cost of preferred
equity
The Cost of Common Equity
Again, to find the cost of common
equity we simply solve the valuation
equation for k
CS
:
( )
k
D g
V
g
D
V
g
CS
CS CS
=
+
+ = +
0
1
1
Note that common dividends are not tax-deductible,
so there is no tax adjustment for the cost of common
equity
Flotation Costs
When a company sells securities to the public, it must use the
services of an investment banker
The investment banker provides a number of services for the
firm, including:
Setting the price of the issue, and
Selling the issue to the public
The cost of these services are referred to as flotation costs,
and they must be accounted for in the WACC
Generally, we do this by reducing the proceeds from the issue
by the amount of the flotation costs, and recalculating the cost of
capital
The Cost of Debt with Flotation Costs
Simply subtract the flotation costs (F)
from the price of the bonds, and
calculate the cost of debt as usual:
( )
( )
( )
V F Pmt
k
k
FV
k
B
d
N
d
d
N
=

+

(
(
(
(
+
+
1
1
1
1
Note that we still must adjust this calculation for
taxes
The Cost of Preferred with Flotation Costs

Simply subtract the flotation costs (F)
from the price of preferred, and
calculate the cost of preferred as
usual:

( )
k
D
V F
P
P
=

The Cost of Common Equity with Flotation Costs

+ =

+
0
1
1
A Note on Flotation Costs
The amount of flotation costs are generally quite
low for debt and preferred stock (often 1% or less
of the face value)

For common stock, flotation costs can be as high
as 25% for small issues, for larger issue they will
be much lower

Note that flotation costs will always be given, but
they may be given as a dollar amount, or as a
percentage of the selling price
The Cost of Retained Earnings
The firm may choose to finance new projects
using only internally generated funds (retained
earnings)
These funds are not free because they belong to
the common shareholders (i.e., there is an
opportunity cost)
Therefore, the cost of retained earnings is exactly
the same as the cost of new common equity,
except that there are no flotation costs:
( )
k
D g
V
g
D
V
g
RE
CS CS
=
+
+ = +
0
1
1