Required Returns and

The Cost of Capital

For any business or project, the main objective is:

“maximise shareholders wealth by keeping the cost of capital as low

as possible, and by maximising returns on its investments ”

How?

Cost of Capital

Funds of Creditors Funds of owners

 Cost of Capital of the Firm

 A firm is consisting of number of projects

 It is possible to finance a firm entirely with common equity
 However firms have several types of capital called capital
components which include

1) Common stock
2) Preferred stock
3) Debt

 All capital components have investors who provide the funds

and expect to receive a return on their investment.

 Required rate of return on equity (for shareholders only)

 When firms use different types of capital, due to differences in risk,
capital components have different required rate of return

 The required rate of return on each capital component is called its

component cost (cost of capital)

 This cost of capital should be a weighted average of the various

component costs.

 We call this weighted average just, the Weighted Average Cost of

Capital or WACC

 A target capital structure requires firms to set target percentages

for the different financing sources. Such as 30/10/60 debt, preferred
and common percentages as given.
Cost of Debt
 It is the return that lenders require on the firm’s current debt
 Therefore, it measures the cost of borrowing funds to finance projects
 It is generally determined by the following variables:
o Current level of interest rates
o Default risk of the firm
o Tax advantage associated with debt
After-tax component cost of debt =
Interest – (Tax savings on Interest)
= Int – (Int × 50%)
Replacing Int with Cost of Debt Kd and 50% with tax ‘T’

= Kd – (KdT)

= Kd (1-T)
Cost of Preferred Stock

 A number of firms use preferred stock as part of their permanent

financing mix.
 Preferred dividends are not tax deductible
 The Component cost of preferred stock is used to calculate

the weighted average cost of capital Kps

D ps
Component cost of preferred stock  K ps 
Pn
Cost of Common Equity

 It is the return that equity investors require on their investment

in the firm
 We may use two approaches to determine the cost of equity
o Dividend growth model approach
o Security Market Line (SML) approach
Dividend Growth Model
Easiest way to estimate the cost of equity capital is to use the Dividend
Growth Model as we discussed in the lecture ‘Stock Valuation’

D1
Ks  g
P0
Merits De-merits
 simple to understand and use.  applicable to companies that pay
constant growing dividends.
 Cost of equity is sensitive
to growth rate ‘g’.
The SML Approach
The Security Market Line (SML) gives us expected
return on a risky investment depending on three
things:
a)The risk free rate Rf
b) The market premium
c) The systematic risk of the asset relative to average
securities in the market

RE  R f  ( RM  R f )  
Risk-free Risk premium
Systematic
Rate risk
Composite, or Weighted Average Cost of Capital, WACC

A firm having an optimal capital structure, defined as that mix of debt,

preferred and common equity that results in its stock price to be
maximized.
Therefore, a value-maximizing firm will establish a target (optimal)
Capital structure and then raise new capital .

WACC  wd k d (1  T )  w ps k ps  ws k s
 The Capital Structure Weights
If we use symbol
V for the combined market value of debt and equity
E for market value of the firm’s Equity and
D for market value of the firm’s debt

Then,

V=E+D
Dividing both sides by V, we get

E D
1 
V V
E D
OR 100%  
V V
 Questions

1) RM Motors has a target capital structure of 40% debt and 60%

equity. The yield to maturity on the company’s outstanding bonds is
9%, and the company’s tax rate is 40%. It has been calculated that
company’s WACC is 9.96%. What is the company’s cost of equity
capital?

2) Tunney Industries can issue perpetual preferred stock at a price of $50

a share. The issue is expected to pay a constant annual dividend of $3.80
a share. The flotation cost on the issue is estimated to be 5%. What is the
company’s cost of preferred stock, kps?
3) The B.B. Lea Co, has 1.4 million shares of stock outstanding. The stock currently
sells for $20 per share. The firm’s debt is publicly traded and was recently quoted
at 93 percent of face value. It has a total face value of $5 million, and it is currently
priced to yield 11%. The risk-free rate is 8% and the market risk premium is 7%.
You have estimated that Lean has a beta of 0.74. If the corporate tax rate is 34%,
what is the WACC of Lean Co.?
4) On January 1, the total market value of Tyseland Company was $60
million. During the year, the company plans to raise and invest $30 million
in new projects. The firm’s present market value capital structure, shown
below, is considered to be optimal. Assume that there is no short-term
debt
Debt $30 million
Common equity $30 million
Total capital $60 million
New bonds will have a 8% coupon rate, and they will be sold at par. Common
Stock currently sell at $30 a share. Stockholder’s required rate of return is
estimated to be 12%, consisting of a dividend yield of 4% and expected constant
growth rate of 8% (the next expected dividend is $1.2) . The marginal corporate tax
rate is 40%.
Required:
(a)To maintain the present capital structure, how much of the new investment must be
financed by common equity?
(b)Assume that Tyseland can maintain its target capital structure without issuing
additional shares of equity. What is the WACC?