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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL

TABLE OF CONTENTS

Fundamentals of financial management, Eugene F. Brigham, Joel F. Houston....16


Investment decision making in the private and public sectors, Henri L.
Beenhakke........................................................................................................... 16

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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL

I. The cost of capital of a firm/ project and its major components

1. Definition of the Cost of Capital

The cost of capital is a decisive factor in financial decision-making. The


concept of it, therefore, is a recent development and has relevance in almost every
financial matter. The progressive management always has to take notice of the cost of
capital while taking a financial decision.
Cost of capital is the rate of return a firm must earn on its projects or
investments to maintain the market value of its stock. It is a composite cost of the
individual sources of funds, including common stock, debt, preferred stock. The
overall cost of capital depends on the cost of each source and the proportion that
source represents of all capital used by the firm. The goal of an individual or business
is to limit investment to assets that provide a return that is higher than the cost of the
capital that was used to finance those assets, which is also called average cost of
capital.
A company's cost of capital is exactly as its name implies. When a company
raises capital from its lenders and owners, both types of investors require a return on
their investment. Lenders expect to be paid interest on their loans, while owners
expect a return, too.
A stable, predictable company will have a low cost of capital, while a risky
company with unpredictable cash flows will have a higher cost of capital. It means
that the riskier company's future cash flows are worth less in present value terms,
which is why stocks of stable companies often look more expensive on the surface.
2. Major components of the Cost of Capital
A firm can finance new projects by borrowing, issuing common stocks or
issuing preferred stocks. Financing new projects only by borrowing is normally not
recommended since, at some point, the firm will find it necessary to use one of the
other forms of financing to prevent the debt ratio from becoming too large.
Alternatively, financing new projects by issuing too many preferred stocks is not
desirable since it is riskier to guarantee a given dividend to many people. A firm

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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL

should, therefore, be considered as an on going concern, about what is the most


reasonable way to raise their capital.
The following are major components of cost of capital:
2.1. Cost of debt
The cost of debt is the effective rate that a company pays on its current loans,
bonds and various other forms of debt. The measure provides an idea as to the overall
rate being paid by the company to use debt financing. The higher the cost of debt, the
riskier the company is.
2.2. Cost of equity
The cost of equity is the rate of return on required by the company's ordinary
shareholders. The return consists both of dividend and capital gains. The returns are
expected future returns, not historical returns. Returns on equity are often expressed as
the anticipated dividends on the shares every year in perpetuity. The cost of equity is
then the cost of capital, which will equate the current market price of the share with
the discounted value of all future dividends. The cost of equity reflects the effective
opportunity cost of investment for shareholders.
2.3. Cost of preferred stock
Preferred Stock has a higher return than bonds, but is less costly than common
stock. In case of default, preferred stockholders get paid before common stock
holders. However, in the case of bankruptcy, the holders of preferred stock get paid
only after short and long-term debt holder claims are satisfied.
Preferred stock holders receive a fixed dividend and usually cannot vote on the firm’s
affairs.
For investors, the cost of preferred stock, once it has been issued, will vary like
any other stock price. That means it will be subject to supply and demand in the
market. In theory at least, preferred stock may be seen as more valuable than common
stock as it has a greater likelihood of paying a dividend and offers a greater deal of
security if the company folds.

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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL

II. Motivations and calculations of Cost of Debt, Cost of Equity and


WACC
The firm must always decide how to raise the capital to fund its business or
finance its growth. Most firms employ several types of capital, called capital
components, with common stock equity (retained earnings plus common stock) and
preferred stock, along with debt, being the three most frequently used types. Any
increase in a firm’s total assets will have to be financed through an increase in at least
one of these capital components. All capital components have one feature in common:
The investors who provided the funds expect to receive a return on their investment.
The cost of each of these components is called the component cost of capital and the
minimum overall cost of capital will maximize the value of the firm (share price).
If a firm’s only investors are common stockholders, then the cost of capital will
be the required rate of return equity. If the capital structure of company only consists
of debt, the cost of capital will be required rate of return debt. However, most firms
employ different types of capital, and due to differences in risk, these different
securities have different required rates of return. The required rate of return on each
capital component is called its component cost, and the cost of capital used to analyze
capital budgeting decisions should be a weighted average of the various components’
costs. We call this weighted average just that, the weighted average cost of capital, or
WACC (rhymes with “quack”).
Indeed, the company cost of capital is usually calculated as a weighted average
of the after-tax interest cost of debt financing and the “cost of equity,” that is, the
expected rate of return on the firm’s common stock. The weights are the fractions of
debt and equity in the firm’s capital structure. Managers need to use the weighted-
average cost of capital to evaluate average-risk capital investment projects. “Average
risk” means that the project’s risk matches the risk of the firm’s existing assets and
operations.
The following sections discuss each of the component costs in more detail, then
we show how the weighted average cost of capital is calculated in practice and when

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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL

the weighted-average cost of capital is or is not the appropriate rate at which the cash
flows associated with a capital budgeting project is discounted.

1. Cost of debt

We assume that funds of the firm are raised through the issuance and sale of
bonds and the bonds pay annual interest. The first step in estimating the cost of long –
term debt (bonds) is to determine the rate of return debt holders require, or kd. So the
cost of debt is referred as to the market interest rate demanded by bondholders. In
other words, it is the rate that the company would pay on new debt issued to finance
its investment projects. The cost of debt can be measured as either before-tax or after-
tax returns.

• The before – tax cost of debt kd is the rate at which the firm can issue new
debt. This is the yield to maturity (YTM) on existing debt. The before – tax cost of
debt can be obtained by using the IRR method. However, because the interest
expense is tax deductible, the after-tax cost is seen more often than the before – tax
cost of debt.

• The after – tax cost of debt, kd (1-t), is the interest rate on debt, kd, less the tax
savings from the tax deductibility of interest, kd(t), which is the same as before-
tax cost of debt multiplied by (1 – t), where t is the firm’s marginal tax rate.

After – tax cost of debt = interest rate – tax savings = kd – kd(t) = kd(1 – t)

We use the after-tax cost of debt in calculating the WACC because we are
interested in maximizing the value of the firm’s stock, and the sotock price depends on
after-tax cash flows.

Example:

Dexter, Inc., is planning to issue new debt at an interest rate of 8%. Dexter has
a 40% marginal federal-plus-state tax rate. What is Dexter’s cost of debt capital?

Answer:

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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL

kd(1 – t) = 8% (1 – 0.4) = 4.8%

2. Cost of equity
2.1. Cost of preferred stock (kps).
Preferred stock dividends are usually a stated dollar amount. Alternatively,
preferred stock dividends may be stated as an annual percentage rate, e.g., 7%.
Preferred stockholders often receive a stated dividend prior to the distribution of
earnings to common stockholders.
The cost of preferred (kps) is just the preferred dividend divided by the market
price of a preferred share, or the net issuing price (not “book value” of preferred
stock).
kps = Dps/P
where Dps = annual dollar dividend per share; P = market price of preferred stock.
Example:
Suppose Dexter has preferred stock that pays an $16 dividend per share and
sells for $100 per share. What is Dexter’s cost of preferred stock?
Answer:
kps = Dps/P = $16/ $100 = 0.16 = 16%

2.2. Cost of common (stock) equity


The cost of common equity kce is the rate at which investors discount expected
dividends to determine the share value of the firm. The cost of common equity can be
estimated by using the following capital asset pricing model approach (CAMP).

The capital asset pricing model approach (CAMP)


Step 1: Estimate the risk-free rate, RFR. The short-term treasury bill (T-bill) rate is
usually used, but some analyst feel the long-term Treasury rate should be used.
Step 2: Estimate the stock’s beta, β. This is the stock’s reisk measure.
Step 3: Estimate the expected rate of return on the market, E(Rm).
Step 4: use the capital asset pricing model (CAMP) equation to estimate the required
rate of return:

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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL

kce = RFR + β[E(Rm) - RFR]


Example: Using CAMP to estimate cost of equity
Suppose RFR = 6%, Rm = 11%, and Dexter has a beta of 1.1. Estimate
Dexter’s cost of equity.
Answer:
The required rate of return for Dexter’s stock is:
kce = 6% + 1.1(11% - 6%) = 11.5%

There are two forms of common stock including retained earnings and new
issues of common stock. The rationale here is that the firm could avoid part of the cost
of common stock outstanding by using retained earnings to buy back shares of its own
stock.

2.2.1. Cost of retained earnings (kr)


The cost of retained earnings is the rate of return stockholders require on equity
capital the firm obtains by retained earnings, or that part of current earnings not paid
out in dividends and, hence available for reinvestment. The cost of retained earnings is
essentially the same as the cost of common stock equity. Retained earnings increase
the stockholders’ equity in the same way as a new issue of common stock.
Stockholders accept the firm’s retention of earnings as long as they expect those
earnings to return to them a rate equal to their required return on the reinvested funds.
Thus, the cost of retained earnings kr is equal to ks and CAMP can be used to
determine it.

2.2.2. Cost of a newly issued common stock (kn)

Cost of a new stock issue (kn) is the cost of expernal equity, and it is based on
the cost of retained earnings increased for flotation costs (cost of issuing common
stock). For a constant-growth company, this can be calculated as follows:
ks = D1/ P0(1-F) + g

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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL

where:
Ds: dividend price per share
P0(1-F): the net price per share received by the company
F: the percentage flotation cost required to sell the new stock, or (current stock price –
funds going to company)/ current stock price
(Flotation costs are the total costs incurred by the firm in issuing and selling a
security).
g: Growth rate as projected by security analysts
(g = (retention rate) x (ROE) = (1.0 – payout rate) x (ROE))

Example:
Suppose Dextex’s stock is selling for $40, its expected ROE is 10%, next year’s
dividend is $2 and the company expects to pay out 30% of its earnings. Additionally,
assume the company has a flotation costs of 5%. What is Dextex’s cost of new equity?
Answer:
ks = 2/ 40(1-0.05) + 0.07 = 0.123, or 12.3%

3. Weighted average cost of capital (WACC)

The weighted average cost of capital (WACC) is the expected rate of


return on a portfolio of all the firm’s securities, adjusted for tax savings due to interest
payments. WACC is calculated using weights based on the market values of each
component of a firm's capital structure and is the correct discount rate to use discount
the cash flows of project with risk equal to the average risk of a firm’s project.
Calculating a Company's Weighted-Average Cost of Capital

The WACC is given by:

WACC = wdkd(1 - t) + wcekce

where:

wd = the percentage of debt in the capital structure (weight debt)

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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL

wce =the percentage of common stock in the capital structure (weight common
equity)

kd(1 - t) the after – tax cost of debt.

kce The cost of common equity.

This WACC formula is usually written assuming the firm’s capital structure
includes just two classes of securities, debt and equity. If there is another class, say
preferred stock, the formula expands to include it :

WACC = wdkd(1 - t) + wpskps + wcekce,

Where: wps is the percentage of preferred stock in the capital structure(weight


preferred stock) and kps is the cost of preferred stock.

In other words, we would estimate kps, the rate of return demanded by preferred
stockholders, determine wps, the fraction of market value accounted for by preferred,
and add kps × wps to the equation. Of course the weights in the WACC formula always
add up to 1.0. In this case wd + wps + wce = 1.0

Example: Computing WACC

Suppose Dextex Company seeks a target capital structure of 45% long-term


debt, 5% preferred stock, and 50% common stock equity. Assuming that Dextex can
obtain long-term debt financing at the before-tax cost of 8% for debt, its cost of equity
is 12%, its cost of preferred stock is 8,4%, and its marginal tax rate is 40%. Calculate
Dexter's WACC.

Answer:

We have: wd = 0,45; wps = 0,05; wce = 0,50; kps = 0,84; kce = 0,12

After-tax cost of debt = kd (1-t) = 0,08 x (1-0,4) = 0,08 x 0,6 = 0,048

WACC = wdkd(1 - t) + wpskps + wcekce

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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL

WACC = 0,45 x 0,048 + 0,05 x 0,084 + 0,50 x 0,12 = 0,0858 or 8,6%

How a company raises capital and how they budget or invest it are considered
independently. Most companies have separate departments for the two tasks. The
financing department is responsible for keeping costs low and using a balance of
funding sources: common equity, preferred stock, and debt. Generally, it is necessary
to raise each type of capital in large sums. The large sums may temporarily
overweight the most recently issued capital, but in the long run, the firm will adhere to
target weights. Because of these and other financing considerations, each investment
decision must be made assuming a WACC which includes each of the different
sources of capital and is based on the long-run target weights. A company creates
value by producing a return on assets that is higher than the required rate rerum on the
capital needed to fund those assets.

The WACC as we have described it is the cost of financing firm assets. We can
view this cost as an opportunity cost. Consider how a company could reduce its costs
if it found a way to produce its output using fewer assets, say less working capital. If
we need less working capital, we can use the funds freed up to buy back our debt and
equity securities in a mix that just matches our target capital structure. Our after-tax
savings would be the WACC based on our target capital structure, times the total
value of the securities that are no longer outstanding.

For these reasons, any time we are considering a project that requires
expenditures, comparing the return on those expenditures to the WACC is the
appropriate way to determine whether undertaking that project will increase the value
of the firm. This is the essence of the capital budgeting decision. Since a firm's
WACC reflects the average risk of the projects that make up the firm, it is not
appropriate for evaluating all new projects. It should be adjusted upward for projects
with greater-than-average risk and downward for projects with less-than-average risk.

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III. Usefulness and applications of WACC

1. Project evaluation

Business and organizations are established to make profits. Before investment


decisions that will yield profits are made, organizations are expected to fully analyze
such investments to ensure that they comply with expectations. The first significant
usefulness of WACC therefore, is to evaluate capital projects of the company.

Example:

ATL limited is having an expansion project which will generate a rate of return
at 8%. Should this project be run? Given the following information:

ATL has a long term bond with:


1. A face value of $1,000

2. Time to maturity of 15 years


3. An annual coupon rate of 8%
4. An annual current market yield of 6%
5. 500,000 bonds are currently issued

ATL has ordinary shares with:


1. A cost of equity of 10%
2. A long term sustainable growth of 3%
3. The next dividend will be $3
4. There are twenty million shares outstanding

The tax rate is 35%

Assume that this project would cost all ATL’s capital.

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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL

A note here is that the cost of capital must be based on what investors are
actually willing to pay for the company’s outstanding securities—that is, based on
the securities’ market values.

Therefore, let’s start with evaluating the market values of bond and share.

(1 + k ) n −1 ParV
PVbond = PVA + PV = CF0 +
k (1 + k ) n
(1 + k ) n

(1 + 0.06 )15 −1 1000


= 80 + = $1,194.24498
0.06 (1 + 0.06 ) 15
(1 + 0.06 )15

Value of debt = 1,194.24 x 5,000,000 = $597,122,489.9

Rd = 6% (given)

D 3
PVshare = r − g = = $42.8571
e 0.1 −0.03

Value of equity = 42.8571 x 20,000,000 = $857,142,857.1

Re = 10% (given)

 D   E 
WACC =  × (1 − Tc ) × Rd  +  × Re 
 V   V 

 597 ,122 ,489 ,9   857 ,142 ,857 .1 


597 ,122 ,489 .9 +857 ,142 ,857 .1 ×(1 − 0.35 ) ×0.06  + 597 ,122 ,489 .9 +857 ,142 ,857 .1 ×0.1
   

= 0.0749 ≈ 7.5% (< 8%)

Conclusion: The expansion project is supposed to generate net value for


ATL and its stockholders and looks like a good idea

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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL

2. Choosing the most appropriate investment

The second usefulness of WACC that worth-mentioning is its value in


budgeting purposes. It helps organizations seek out sources of cheaper finance
among potential investments. A similar example with the above one can be easily
taken. Now keep the equity unchanged. Let assume that the company has two
options: to issued bond as the above example or to borrow from bank. With the same
way of calculation, you can easily have two WACCs and then simply make a
comparison. The cheaper is usually the chosen one (of course its WACCs must be
lower than project’s rate of return).

3. EVA Determination

Another thing that draws our attention is that WACC plays an irreplaceable
role in calculating Economic Value Added (EVA). Let’s have a look at the below
chart for EVA’s formula

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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL

An EVA ratio is greater than zero suggests that the after-tax economic cash-
generating ability of a company exceeds its cost of capital. The reverse holds true for a
negative value generation. If EVA is equal to zero, the project’s cash flows are just
sufficient to give debt-holders and shareholders the returns they require.

This is likely to resemble our first point but here we’d like to emphasize on the
importance of value added. Capital or other sources of funds have cost. The cost for a
project is the rate or return its owners are seeking, with special consideration on the
risks inherent in the project. Projects or investments need to earn returns greater than
its cost of capital and value added for the investors to be satisfied. Any investment
which weighted average cost of capital does not cover its cost reduces investors funds
as the funds may be better invested elsewhere, even if it produces profitability.

One of the methods for calculating this is the Weighted Average Cost of
Capital (WACC). Simply put, this is the calculation of a firm’s cost of capital in

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which each category of investment is proportionately weighted. This is because; there


are different sources of funds for investment available for a firm to choose from.
Common stocks, bonds, debentures, and others can be used, and each of them has to
be analyzed for its WACC to determine if it passes the firms expectations or
requirements.

The company's WACC is a very important number, both to the stock market
for stock valuation purposes and to the company's management for capital budgeting
purposes. In an analysis of a potential investment by the company, investment projects
that have an expected return that is greater than the company's WACC will generate
additional free cash flow and will create positive net present value for stock owners.
These corporate investments should result in an increase in stock prices. These
projects are good things! Investments that earn less than the firm's WACC will result
in a decrease in stockholder value and should be avoided by the company.

Weighted average cost of capital is used to assess a company’s financial health.


It provides insight into the cost of finance used by an organization. It is useful in
investment decisions. With it, company can seek out other sources of cheaper finance.

Capital or other sources of funds have cost. The cost for a project is the rate or
return its owners are seeking, with special consideration on the risks inherent in the
project. Projects or investments need to earn returns greater than its cost of capital and
value added for the investors to be satisfied. Any investment which weighted average
cost of capital does not cover its cost reduces investors funds as the funds may be
better invested elsewhere, even if it produces profitability.

----------------------------------***---------------------------------
This also brings us to the end of our assignment. We have tried
our best to deliver the meaning as well as the importance of “Cost
of capital”. We do hope that this document is a valuable report as it
contains our strict researches.

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REFERENCE

Fundamentals of financial management, Eugene F. Brigham, Joel F. Houston.

Investment decision making in the private and public sectors, Henri L. Beenhakke.
1. Level 1 Book 4: Corporate finance, portfolio management, and equity

investments, 2008 Kaplan Schweser.

4. http://lexicon.ft.com

5. http://news.morningstar.com

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