Chapter 11

Cost of Capital

© 2003 McGraw-Hill Ryerson Limited

Cost of Capital 2PPT 2-1

 The cost of capital represents the overall cost of future

financing to the firm
 The cost of capital is normally the relevant discount rate to

use in analyzing an investment

 It represents the minimal acceptable return from the investment
 If your cost of funds is 10%, you must earn at least 10% on your
investments to break even!
 The cost of capital is a weighted average of the various
sources of funds in the form of debt and equity
WACC = Weighted Average Cost of Capital

© 2003 McGraw-Hill Ryerson Limited

Cost of Debt 3PPT 2-1

 The cost of debt to the firm is the effective yield to maturity

(or interest rate) paid to its bondholders.
 Since interest is tax deductible to the firm, the actual cost of

debt is less than the yield to maturity because its true cost is
less than its stated cost as the government is picking up part
of the tab by allowing the firm to pay less taxes.

Kd (cost of debt) = yield/ interest rate * (1 - tax rate)

Example : CompanyX has decided to issue 10 percent coupon
bond to support its financing requirement. Now find out the after
tax cost of bond if corporate tax rate is 40 percent.

© 2003 McGraw-Hill Ryerson Limited

….continued 4PPT 2-1

 If the firm is preparing to issue new debt, the firm will compute
the yield on its currently outstanding debt. This is not the rate at
which the old debt was issued but the rate investors are
demanding today which is the yield to maturity.
 This yield to maturity indicates how much the corporation must

pay on a before tax basis.

 The interest payment on debt is a tax-deductible expense and

hence its true cost is less than its stated cost because the
government is picking up part of the tab by allowing firms to pay
less taxes.

© 2003 McGraw-Hill Ryerson Limited

 Cost of Preferred Stock 5PPT 2-1

Dp
Cost of preferred stock Kp 
Pp  F
Dp : Preferred Dividend
Pp: Price of Preferred Stock
Flotation costs: selling and distribution costs (such as sales commissions) for the
new securities
No tax treatment as it is not a tax-deductible expense

Example: Company Y plans to issue preferred stock that pays $10

dividend per share and sells for $100 per share in the market. If the
bank issued new shares of preferred stock, it would incur an
underwriting (or flotation) cost of 2.5 percent or 2.5 percent per
share. What will be the cost of preferred stock?

© 2003 McGraw-Hill Ryerson Limited

 Cost of Common Stock/Equity
PPT 2-1 6

D1
A. Cost of Common Equity/ Retained Earnings Ke  g
P0
D1 = First year common dividend
P0 = price of common stock
g = growth rate

Example: Suppose the market price (P0) of common stock is $50

per share. The firm expects to pay a dividend (D1) of $4 at the
end of the coming year, 1998. The dividend is expected to grow
at a rate of 5 percent a year over the foreseeable future. Calculate
the cost of common stock.

© 2003 McGraw-Hill Ryerson Limited

 Cost of Common Equity with 7PPT 2-1
new issue
D1
B. Cost of New Common Stock: Kn  g
P0  F
D1 = First year common dividend
P0 = price of common stock
g = growth rate
F = Flotation costs
Example: ABC Co. has decided to issue new common stock. The
current market price of the stock (P0) is $50, the expected dividend
(D1), $4, and the expected growth rate of dividend, (g) is 5%. It is
also found that, the company has to incur underwriting fee of $2.5
per share. Find out the cost of new issues of common stock?

© 2003 McGraw-Hill Ryerson Limited

Cost of Retained Earnings
8PPT 2-1

• Retained earning by law belong to the stockholders. If they

are not paid out to common stockholders as dividend, they
are retained for reinvestment.
• But they are not free and has an opportunity cost. It (RE)
could have been redeployed by stockholders in other
investments and the rate of return on these investments is
the opportunity cost.
• It is assumed that, on an equal risk basis, the stockholders
could earn at least an equal return to that provided by their
present investment in the firm.
• So, cost of RE is equal to the rate of return to the common
stock where P=P0

© 2003 McGraw-Hill Ryerson Limited

Optimum Capital Structure 9PPT 2-1

The optimum (best) situation is associated with the minimum

overall cost of capital:
 Optimum capital structure means the lowest WACC
 Usually occurs with 40-70% debt in a firm’s capital structure
 WACC is also referred to as the required rate of return or the
discount rate
 Based upon the market value rather than the book value of the firm’s
debt and equity

© 2003 McGraw-Hill Ryerson Limited

Weighted Average Cost of Capital,
WACC
 A weighted average of the component costs of debt,
preferred stock, and common equity
  Proportion   After - tax     Proportion   Cost of     Proportion   Cost of  
             
WACC   of 
  cost of 
   of preferred 
  preferred 
   of common 
  common 
  debt   debt     stock   stock     equity   equity  

 Wd  k dT  Wps  k ps  Ws  ks

Example: Suppose Goodwill Technologies has determined that in the future it

will raise new capital according to the following proportions: 40 percent debt,
15 percent preferred stock and 45 percent common equity (retained earnings
plus new common stock). In the preceding sections, it is found that it’s before
tax cost of debt, is 10 percent and the marginal tax rate is 40 percent; its cost of
preferred stock, is 10.5 percent; and it's cost of common equity, is 13 percent if
all of its equity financing comes from retained earnings. Calculate the Goodwill
Technologies weighted average cost of capital (WACC)?
© 2003 McGraw-Hill Ryerson Limited
 Table 11-7
Cost of components in the capital
structure
1. Cost of debt Kd = Yield (1-T) = 6.55% Yield = 10.74%
T = Corporate tax rate, 39%

2. Cost of preferred stock Dp Dp = Preferred dividend, $10.50

Kp  10.94%
Pp  F
Pp = Price of preferred stock,
$100
3. Cost of common equity F = Flotation costs, $4
D1
(retained earnings) Ke   g 12.0%
P0
D1 = First year common
dividend, $2
Pc = price of common stock, $40
D1 g = growth rate, 7%
4. Cost of new common stock Kn  g
P0  F
Same as above, with Pn =$36.00
F = Flotation costs, $4,
© 2003 McGraw-Hill Ryerson Limited
Summary and Conclusions 12PPT 2-1

The cost of debt is the effective

interest rate (yield to maturity)
the cost of preferred stock is the

dividend rate (yield) that must be

paid to investors
The cost of common shares is the

current dividend rate (yield) plus

The cost of capital represents the the anticipated future rate of
overall cost of future financing to the growth
firm The cost of capital from retained
It is a weighted average of the costs earnings is the required rate of
of the various source of funds return on the common stock
available
It represents the minimum
acceptable return from an investment
© 2003 McGraw-Hill Ryerson Limited