CHAPTER

THE COST OF CAPITAL

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 LEARNING OBJECTIVES
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• Explain the general concept of the opportunity cost of capital

• Distinguish between the project cost of capital and the firm’s
cost of capital
• Learn about the methods of calculating component cost of
capital and the weighted average cost of capital
• Recognize the need for calculating cost of capital for divisions
• Understand the methodology of determining the divisional beta
and divisional cost of capital
• Illustrate the cost of capital calculation for a real company
 INTRODUCTION
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• The project’s cost of capital is the minimum

required rate of return on funds committed to the
project, which depends on the riskiness of its cash
flows.
• The firm’s cost of capital will be the overall, or
average, required rate of return on the aggregate of
investment projects
 SIGNIFICANCE OF THE COST OF CAPITAL
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• Evaluating investment decisions

• Designing a firm’s debt policy

• Appraising the financial performance of top

management
 THE CONCEPT OF THE OPPORTUNITY COST OF
CAPITAL
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• The opportunity cost is the rate of return foregone

on the next best alternative investment opportunity
of comparable risk.

Risk-return relationships of various securities

 Shareholders’ Opportunities and
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Values
• The required rate of return (or the opportunity cost of capital)
is shareholders is market-determined.

• In an all-equity financed firm, the equity capital of ordinary

shareholders is the only source to finance investment projects,
the firm’s cost of capital is equal to the opportunity cost of
equity capital, which will depend only on the business risk of
the firm.
 Creditors’ Claims and Opportunities
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• Creditors have a priority claim over the firm’s assets and

cash flows.
• The firm is under a legal obligation to pay interest and
repay principal.
• There is a probability that it may default on its obligation
to pay interest and principal.
• Corporate bonds are riskier than government bonds since
it is very unlikely that the government will default in its
obligation to pay interest and principal.
 General Formula for the Opportunity Cost
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of Capital
• Opportunity cost of capital is given by the following formula:

• where Io is the capital supplied by investors in period 0 (it

represents a net cash inflow to the firm), Ct are returns
expected by investors (they represent cash outflows to the
firm) and k is the required rate of return or the cost of capital.
• The opportunity cost of retained earnings is the rate of return,
which the ordinary shareholders would have earned on these
funds if they had been distributed as dividends to them
 Cost of Capital
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• Viewed from all investors’ point of view, the firm’s

cost of capital is the rate of return required by them
for supplying capital for financing the firm’s
investment projects by purchasing various
securities.
• The rate of return required by all investors will be
an overall rate of return — a weighted rate of
return.
 Weighted Average Cost of Capital vs.
Specific Costs of Capital
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• The cost of capital of each source of capital is known as

component, or specific, cost of capital.
• The overall cost is also called the weighted average cost of
capital (WACC).
• Relevant cost in the investment decisions is the future cost or
the marginal cost.
• Marginal cost is the new or the incremental cost that the firm
incurs if it were to raise capital now, or in the near future.
• The historical cost that was incurred in the past in raising
capital is not relevant in financial decision-making.
 DETERMINING COMPONENT COSTS OF
CAPITAL
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• Generally, the component cost of a specific source

of capital is equal to the investors’ required rate of
return, and it can be determined by using

• But the investors’ required rate of return should be

adjusted for taxes in practice for calculating the
cost of a specific source of capital to the firm.
 COST OF DEBT
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• Debt Issued at Par

• Debt Issued at Discount or Premium

• Tax adjustment
 EXAMPLE
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Now,
 Cost of the Existing Debt
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• Sometimes a firm may like to compute the

“current” cost of its existing debt.

• In such a case, the cost of debt should be

approximated by the current market yield of the
debt.
 COST OF PREFERENCE CAPITAL
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• Irredeemable Preference Share

• Redeemable Preference Share

 Example
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 COST OF EQUITY CAPITAL
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• Is Equity Capital Free of Cost? No, it has an

opportunity cost.
• Cost of Internal Equity: The Dividend-Growth
Model
⇢ Normal growth

⇢ Supernormal growth

⇢ Zero-growth
 COST OF EQUITY CAPITAL
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• Cost of External Equity: The Dividend Growth

Model

• Earnings–Price Ratio and the Cost of Equity

 Example
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 Example: EPS
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• A firm is currently earning Rs 100,000 and its share is selling

at a market price of Rs 80. The firm has 10,000 shares
outstanding and has no debt. The earnings of the firm are
expected to remain stable, and it has a payout ratio of 100 per
cent. What is the cost of equity?
• We can use expected earnings-price ratio to compute the cost
of equity. Thus:
 THE CAPITAL ASSET PRICING MODEL
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(CAPM)
• As per the CAPM, the required rate of return on
equity is given by the following relationship:

• Equation requires the following three parameters

to estimate a firm’s cost of equity:
⇢ The risk-free rate (Rf)
⇢ The market risk premium (Rm – Rf)
⇢ The beta of the firm’s share (β)
 Example
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• Suppose in the year 2002 the risk-free rate is 6 per

cent, the market risk premium is 9 per cent and beta
of L&T’s share is 1.54. The cost of equity for L&T
is:
 COST OF EQUITY: CAPM VS.
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DIVIDEND–GROWTH MODEL
• The dividend-growth approach has limited
application in practice
⇢ It assumes that the dividend per share will grow at a
constant rate, g, forever.
⇢ The expected dividend growth rate, g, should be less than
the cost of equity, ke, to arrive at the simple growth
formula.
⇢ The dividend–growth approach also fails to deal with risk
directly.
 Cost of equity under CAPM
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 COST OF EQUITY: CAPM VS.
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DIVIDEND–GROWTH MODEL
• CAPM has a wider application although it is based on
restrictive assumptions.
⇢ The only condition for its use is that the company’s share is
quoted on the stock exchange.
⇢ All variables in the CAPM are market determined and
except the company specific share price data, they are
common to all companies.
⇢ The value of beta is determined in an objective manner by
using sound statistical methods. One practical problem with
the use of beta, however, is that it does not probably remain
stable over time .
 THE WEIGHTED AVERAGE COST OF CAPITAL
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• The following steps are involved for calculating the firm’s WACC:
⇢ Calculate the cost of specific sources of funds
⇢ Multiply the cost of each source by its proportion in the capital
structure.
⇢ Add the weighted component costs to get the WACC.

• WACC is in fact the weighted marginal cost of capital (WMCC);

that is, the weighted average cost of new capital given the firm’s
target capital structure.
 Book Value Versus Market Value
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Weights
• Market-value weights are theoretically superior
to book-value weights:
⇢ They reflect economic values and are not influenced by
accounting policies.
⇢ They are also consistent with the market-determined
component costs.
• The difficulty in using market-value weights:
⇢ The market prices of securities fluctuate widely and
frequently.
⇢ A market value based target capital structure means that the
amounts of debt and equity are continuously adjusted as the
value of the firm changes.
 The Cost of Capital for Projects
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• For example, projects may be classified as:

⇢ Low risk projects
discount rate < the firm’s WACC
⇢ Medium risk projects
discount rate = the firm’s WACC
⇢ High risk projects
discount rate > the firm’s WACC