9 COST OF CAPITAL

BMBS1024 ACCOUNTING AND FINANCE FOR MANAGERS

 Cost of Capital
• Is the minimum return an investor is looking
for in any long term capital investment.

• Is the cost of the funds that a company

raises and uses, and the return the investors
expect to be paid for putting the funds into
the company.

• Is the opportunity cost of finance. If

investors do not get this, they will transfer
their investments elsewhere.
 Relevance
• A bank offers to lend money to
a company , the interest rate it charges
( its return ) is the yield the bank wants
to receive from investing in /lending the
company.

• Shareholders invest in a company to

receive a return that must be sufficient
to persuade them not to sell their
investments with the company.
 Cost of Equity (Ke)
• The return that the equity investors
require on their common stock
investment in the firm.
• We can use the following two models to
measure the cost of common stock
equity capital:
• Gordon's Growth Model
• Capital Asset Pricing Model (CAPM)
 Cost of Equity (Ke)
Gordon’s Growth Model
• Cost of equity (ke) = [d1 / P0 - f ] + g
• Where
• d1 = expected dividend for next year
• P0 = current price of stock
• g = growth rate
• f = flotation costs
 Cost of Equity (Ke)
Gordon’s Growth Model
• Cost of equity (ke) = [d1 / P0 - f ] + g
• Where
• d1 = expected dividend for next year
• P0 = current price of stock
• g = growth rate
• f = flotation costs
Or Ke = d0(1+g) + g
P0 - f
 Cost of Equity (Ke)
Example
Firm A just paid a dividend of $1.85. The dividend is
expected to grow at a constant rate of 3% per year. The
stock price is currently selling for $12.50. New stocks can
be sold at this price subject to a flotation costs of 15%.
Calculate the cost of equity.

Ke = $1.85 (1 + 0.03) + 0.03

---------------------
$12.50 - 1.875

Ke = 20.93%
 Capital Asset Pricing Model
(CAPM)
CAPM is a model that describes the relationship between
risk and expected return and is used in the pricing of
risky securities.

Investors are compensated in two ways - time value of

money and risk. The time value of money is represented
by the risk free rate and compensates the investor for
investing money over a point of time. The other half of
the formula represents risk and calculates the amount of
compensation the investors need for taking on additional
risk. Beta is a measure of systematic risk.
 Capital Asset Pricing Model
(CAPM)
Expected return on stock (ke) = rf + ( expected market
risk premium ) β

Where
ke = cost of equity
rf = risk free rate
market risk premium = market return minus risk free
rate
β = beta factor
 Capital Asset Pricing Model
(CAPM)
Example:
Firm B has a beta of 1.2 . The market risk premium is
9% and the risk free rate is 5%. Calculate the cost of
equity using the CAPM model.

Ke = 5% + (9%) 1.2

Ke = 15.8 %
 Cost of Debt (Kd)
• The return that lenders of money require on
the firm’s debt borrowings.
• Cost of debt (kd) = I + ( M – { V – f } / n
----------------------------
(M + V) / 2
Where
I = coupon payment
M = face value
V = current market price
n = number of years to maturity
f = flotation costs
 Cost of Debt (Kd)
Example
Firm A issued $1,000 face value bond that pays 9%
interest annually. Investors are expected to pay $918
for the 10 year bond. It will have to pay $33 per bond in
flotation costs . What is the after - tax cost of debt if the
company is in the 34% tax bracket

Cost of debt (kd) = 90 + ($1,000 – {$918 – $33} / 10

----------------------------------
($1,000 + $885) / 2

= 10.77%
kd after tax = 10.77 (1 – tax) = 10.77 (1-0.34) = 7.11 %
 Cost of Preferred Stocks (Kp)
The return that the equity investors require on their
preferred stock investment in the firm.

Cost of preferred stocks (kp) = d / P0 - f

Where
d = dividend
P0 = current price
f = flotation costs
 Cost of Preferred Stocks (Kp)
Example

Firm A is currently selling for $36 and pays a perpetual

annual dividend of $2.60 per share. The underwriters of
a new issue charges $6 per share in flotation costs.
Calculate the cost of the new preferred stocks.

Cost of preferred stocks (kp) = $2.60

-----------
$36 - $6

= 8.67%
 Weighted Average Cost of
Capital (WACC)
• When a firm has a combination of financing, a
combined rate is used. This rate is the weighted
average cost of capital (WACC).
• WACC assumes that when a company raises
finance, the cash raised is added into a pool of
funds.
• An investment project is assumed to be financed
from this pool rather than from any specific fund.
• The discount rate or required return in appraising the
project will therefore be the cost of this pool of funds.
The WACC is therefore measured as the weighted
average of the individual specific cost of capital.
 Weighted Average Cost of
Capital (WACC)
WACC (kw) = Wd (kd) + We (ke) + Wp (kp)

Where
Wd = weightage of debt
We = weightage of equity
Wp = weightage of preferred stock
Ke = cost of equity
Kp = cost of preferred stock
Kd = cost of debt after tax
Weighted Average Cost of
Capital (WACC)
QUESTION & ANSWER