Lesson 5.

1
The Cost of Capital

An Overview of Weighted Average Cost of Capital (WACC)

To understand the concept of cost of capital in financial management, we need to understand first what is
capital component.

Capital Component is one of the types of capital used by firms to raise funds. The investor-supplied items-debt,
preferred stock, and common equity-are called capital components. Increases in assets must be financed by
increases in these capital components. The cost of each component is called its component cost; for example,
XYZ company can borrow money at 10%*, so its component cost of debt is 10%. These costs are then combined
to form a weighted average cost of capital, which is used in the capital budgeting process.

*bare in mind that there is a before-tax and an after-tax cost of debt; for now, it is sufficient to know that 10% is
the before-tax component cost of debt. Also, for simplicity, let’s assume that long- and short-term debt have the
same cost; hence, we deal with just one type of debt.

The following symbols identify the cost and weight of each:

rd interest rate on the firm’s new debt = before-tax component cost of debt. It can be
found in several ways, including calculating the yield to maturity on the firm’s
currently outstanding bonds.
rd (1-T) After-tax component cost of debt, where T is the firm’s marginal tax rate. r d (1-T) is the
debt cost used to calculate the weighted average cost of capital.
rp Component cost of preferred stock, found as the yield investors expect to earn on the
preferred stock. Preferred dividends are not tax-deductible; hence, the before-and
after-tax costs of preferred are equal.
rs Component cost of common equity raised by retaining earnings, or internal equity.
Most firms once they have become well established, obtain all of their new equity as
retained earnings; hence, rs is their cost of all new equity.
re Compenent of external equity, or common equity raised by issuing new stock. As we
will see, re is equal to rs plus a factor that reflects the cost of issuing new stock.
Wd, Wp, Target weights of debt, preferred stock, retained earnings (internal equity), and new
Ws. We common stock (external equity). The weights are the percentages of the different
types of capital the firm plans to use when it raises capital in the future. Target weights
may differ from actual current weights.
WACC The firm’s weighted average, or overall, cost of capital.

The target proportions of debt (Wd), preferred stock (Wp), and common equity (Wc), along with the costs of
those components, are used to calculate the firm’s weighted average cost of capital, WACC.

Weighted Average Cost of Capital is a weighted average of the component costs of debt, preferred stock, and
common equity. Following is the equity of WACC:

WACC = (% of debt x after tax cost of cost of debt) + (% of preferred stock x cost of preferred stock) + (%
of common equity x cost of common equity)
= Wd rd (1-T) + Wp rp + Wc rs
Note that only debt has a tax adjustment factor, (1-T), this is because interest on debt is tax-deductible but
preferred dividends and the returns on common stock (dividends and capital gains) are not.

Self Test
1. What are the three major components of capital structure and give their respective component cost and
weight symbols.
2. Why might there be two different component costs of common equity? Which one is generally relevant,
and for what type of firm is the second one likely to be relevant?
 3. If a firm now has a debt ratio of 50% but plans to fiannce with only 40% debt in the future, what should
I use as Wd when it calculates its WACC?

Cost of Debt, rd (1-T)

Before-Tax Cost of Debt, rd – the interest rate the firm must pay on new debt.

After-Tax Cost of Debt, rd (1-T) – the relevant cost of new debt, taking into account the tax deductibility of
interest; used to calculate the WACC.

After-tax cost of debt = interest rate on new debt – Tax savings

= rd - rdT
= rd (1-T)

For example: XYZ company can borrow at an interest rate of 10% and its tax rate is 40%, its after-tax
cost
of debt will be 6%. Computed as follows:

After-tax cost of debt = rd (1-T)

= 10% (1.0 – 0.4)
= 10% (0.6)
= 6.0%
Self Test:
1. Why is the after-tax cost of debt rather than the before-tax cost used to calculate the WACC?
2. Why is the relevant cos tof debt the interest rate on new debt, not that on already outstanding, or old,
debt?
3. How can the yield to maturity on firm’s outstanding debt to used to estimate its before-tax cost of debt?
4. A company has outstanding 20-year non-collable bonds with a face value of P1,000, an 11% annual
coupon, and a market price of P1,294.54. if the company was to issue new debt, what would be a
reasonable estimate of the interest rate on that debt? If the company’s tax rate is 40%, what is its after-
tax cost of debt?

Cost of Preferred Stock, rp

Cost of Preferred Stock, rp – the rate of return investors require on the firm’s preferred stock. r p is calculated as
the preferred dividend, Dp’ divided by the current price, Pp.

Component cost of preferred stock = rp = Dp/Pp

For example, the stock of XYZ company would have a P10.00 dividend per share, and it would be priced
at P97.50 a share. Therefore, XYZ’s cost of preferred stock would be 10.3%.

rp = P10.00/97.50 = 10.3%

The Cost of Retained Earnings

The costs of debt and preferred stock are based on the returns that investors require on these securities.
Similarly, the cost of common equity is based on the rate of return that investors require on the company’s
common stock. Note, though, that new common equity is raised in two ways: (1) by retaining some of the
current year’s earnings and (2) by issuing new common stock.

The cost of retained earnings is the rate of return required by stockholders on a firm’s common stock.
The cost of new common stock, re is the cost of external equity based on the cost of retained earnings but
increased for flotation costs.

Some argued that retained earnings should be “free” because they represent money that is “left over” after
dividends are paid. While it is true that no direct costs are associated with retained earnings, this capital still
has a cost, an opportunity cost. The firm’s after-tax earnings belong to its stockholders. Bondholders are
compensated by interest payments; preferred stockholders, preferred dividends. But the net earnings
remaining after interest and preferred dividends belong to the common stockholders, and these earnings serve
to compensate them for the use of their capital. The managers, who work for the stockholders, can either pa out
earnings in the form of dividends or retained earnings for reinvestment in the business. when managers make
this decision, they should recognize that there is an opportunity cost involved-stockholders could have received
the earnings as dividends and invested this money in other stocks, bonds, in real estate, or in anything else.
Therefore, the firm needs to earn at least as much on any earnings retained as the stockholders could earn on
alternative investments of comparable risk.

Whereas debt and preferred stocks are contractual obligations whos costs are clearly stated on the contracts,
stocks have no comparable stated cost. The required return is equal to a risk-free rate, r RF, plus a risk premium,
RP, whereas the expected return on the stock is its dividend yield, D1/P0, plus its expected growth rate, g. thus,
we can write the following equation and estimate rs using the left term, the right term, or both terms:

Required rate of return = expected rate of return

rs = rRF + RP = D1/P0 + g = ŕs

rs is the Capital Asset Pricing Model (CAPM).

The CAPM Approach

The most widely used method for estimating the cost of common equity is the Capital Asset Pricing Model
(CAPM). Here are the steps used to find rs:

Step 1: Estimate the risk-free rate, rRF. Generally use the 10-year Treasury bond rate as the measure of the risk-
free rate, but some analysts use the short-term Treasury bill rate.

Step 2: Estimate the stock’s beta coefficient, bi, and use it as an index of the stock’s risk. The i signifies the ith
company’s beta.

Step 3: Estimate the expected market risk premium. Recall that the market risk premium is the difference
between the return that investors require on an average stock and the risk-free rate.

Step 4: Substitute the preceding values in the CAPM equation to estimate the required rate of return on the
stock
question:

rs = rRF + (RPM)bi
= rRF + (rM - rRF) bi

The CAPM estimate of rs is equal to the risk-free rate, rRF, plus a risk premium that equal to the risk
premium on an average stock, (r M - rRF), scaled up or down to reflect the articular stock’s risk as measured by its
beta coefficient.

Assume that in today’s market, rRF = 5.6%, the market risk premium is RPM = 5.0%, and XYZ’s beta is
1.48. Using the CAPM approach, XYZ’s cost of equity is estimated to be 13.0%:

rs = 5.6% + (5.0%)(1.48)
= 13.0%

Bond-Yield-plus-Risk-Premium Approach
In situation where reliable inputs for the CAPM approach are not available, as would be true for a closely held
company, analysts oftern use a somewhat subjective procedure to estimate the cost of equity. Empirical studies
suggest that the risk premium on a firm’s stock over its own bonds generally ranges from 3 to 5 percentage
points. Based on this evidence, one might simply add a judgmental risk premium of 3% to 5% to the interest
rate on the firm’s own long-term, and consequrently high-interest-rate debt also have risky, high-cost equity;
and the procedure of basing the cost of equity on the firm’s own readily observable debt cost utilizes this logic.
For example, given that XYZ’s bonds yield 10%, its cost of equity might be estimated as follows:

rs = Bond yield + Risk premium = 10.0% + 4.0% = 14%

The bonds of a riskier company might have a higher yield, 12% in which case the estimated cost of equity would
16%:
rs = 12.0% + 4.0% = 16%

because the 4% risk premium is a judgmental estimate, the estimated value of r s is also judgmental. Therefore,
one might use a rang e of 3% to 5% for the risk premium and obtain a range of 13% to 15% for XYZ. While this
method does not produce a precise cost of equity, it should “get us the right ballpark”

Dividend-Yield-plus-Growth-Rate, or Discounted Cash Flow (DCF), Approach

For companies that are expected to remain in business indefinitely, the cash flows are the dividends; on the
other hand, if investors expect the firm to be acquired by some other company or to be liquidated, the cash
flows will be dividends for some number of years plus a terminal price when the firm is expected to be acquired
or liquidated. Like most firms, XYZ is expected to continue indefinitely, in which case the following equation
applies:

P0 = D1 / rs – g

We can solve rs to obtain the required rate of return on common equity, which for the marginal investors is also
equal to the expected rate of return:

rs = ŕs = D1/P0 + Expected g

Thus, an investors expect to receive a dividend yield, D 1/P0, plus a capital gain, g, for a total expected return of
ŕs; and in equilibrium, this expected return is also equal tot the required return, r s. this method of estimating the
cost of equity is called the discounted cash flow, or DCF, method.

For example, Value line, which is available in most libraries, provides growth rate forecasts for 1,700
companies; and Merrill Lynch, Citi Smith Barney, and other organizations make similar forecasts. Averages of
this forecasts re available on Yahoo Finance and other web sites. Therefore, someone estimating a firms cost of
equity can obtain analysts’ forecasts and use them as a proxy for the growth expectations of investors in
general. Then they can combine this g with the current dividend yield to estimate ŕs :

ŕs = D1/P0 + Growth rate as projected by security analysts

to illustrate the DCF approach, XYZ’s stock sells for P23.06, its next expected dividends is P1.25, and analysts
expect its growth rate to be 8.3%. thus, XYZ’s expected and required rates of return are estimated to be 13.7%:

ŕs = rs = (1.25/23/06) + 8.3%
= 5.4% + 8.3%
= 13.7%

Based on the DCF method, 13.7% is the minimum rate of return that should be earned on retained earnings to
justify plowing earnings back into the business rather than paying them out as dividends. Put another way,
since investors are thought to have an opportunity to earn 13.7% if earnings are paid out as dividends, the
opportunity cost of equity from retained earnings is 13.7%.