The Cost

of Capital

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 Learning Goals
• Sources of capital
• Cost of each type of funding
• Calculation of the weighted average cost of capital
(WACC)
• Construction and use of the marginal cost of capital
schedule (MCC)

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 Factors Affecting the Cost of Capital
• General Economic Conditions
– Affect interest rates
• Market Conditions
– Affect risk premiums
• Operating Decisions
– Affect business risk
• Financial Decisions
– Affect financial risk
• Amount of Financing
– Affect flotation costs and market price of security

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 Weighted Cost of Capital Model
• Compute the cost of each source of capital
• Determine percentage of each source of
capital in the optimal capital structure
• Calculate Weighted Average Cost of Capital
(WACC)

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1. Compute Cost of Debt
• Required rate of return for creditors
• Yield to maturity on bonds (kd).
• Since interest payments are tax deductible, the
true cost of the debt is the after tax cost.
• If the company’s tax rate is 40%, the after tax
cost of debt is kd (1-t).

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 2. Compute Cost Preferred Stock
• Cost to raise a dollar of preferred stock.

Dividend (Dp)
Required rate kp =

Market Price (PP) - F

 Example: You can issue preferred stock for a net

price of $42 and the preferred stock pays a

$5 dividend.

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• The cost of preferred stock:

$5.00
kp = = 11.90%
$42.00
 3. Compute Cost of Common
Equity
• Two Types of Common Equity Financing
– Retained Earnings (internal common equity)
– Issuing new shares of common stock (external
common equity)

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3. Compute Cost of Common Equity
• Cost of Internal Common Equity
– Management should retain earnings only
if they earn as much as stockholder’s
next best investment opportunity of the
same risk.
– Cost of Internal Equity = opportunity
cost of common stockholders’ funds.
– Two methods to determine
• Dividend Growth Model
• Capital Asset Pricing Model
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3. Compute Cost of Common Equity
• Cost of Internal Common Stock Equity
– Dividend Growth Model

D1
kS = + g
P0

Example:
The market price of a share of common stock is
$60. The dividend just paid is $3, and the expected
growth rate is 10%.

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3. Compute Cost of Common Equity
• Solution

kS = 3(1+0.10) + .10 =.155 = 15.5%

60

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3. Compute Cost of Common Equity

• Cost of Internal Common Stock Equity

– Capital Asset Pricing Model

kS = kRF + (kM – kRF)

Example:
The estimated Beta of a stock is 1.2. The risk-free rate
is 5% and the expected market return is 13%.

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3. Compute Cost of Common Equity
• Solution

kS = 5% + 1.2(13% – 5%) = 14.6%

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3. Compute Cost of Common Equity
• Cost of New Common Stock
– Must adjust the Dividend Growth Model equation
for floatation costs of the new common shares.

D1
kn = +g
P0 - F
Example:
If additional shares are issued floatation costs
will be 12%. D0 = $3.00 and estimated growth
is 10%, Price is $60 as before.
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3. Compute Cost of Common Equity
• Solution

kn = 3(1+0.10) + .10 = .1625 = 16.25%

52.80

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Weighted Average Cost of Capital
XYZ Corporation estimates the following costs for
each component in its capital structure:

Source of Capital Cost

Bonds kd = 10%
Preferred Stock kp = 11.9%
Common Stock
Retained Earnings ks = 15%
New Shares kn = 16.25%

XYZ’s tax rate is 40% 16

Weighted Average Cost of Capital
 If using retained earnings to finance the
common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

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Weighted Average Cost of Capital
 If using retained earnings to finance the
common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

 Assume that XYZ’s desired capital

structure is 40% debt, 10% preferred and
50% common equity.

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Weighted Average Cost of Capital

 If using retained earnings to finance the

common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

 Assume that XYZ’s desired capital

structure is 40% debt, 10% preferred and
50% common equity.
WACC = .40 x 10% (1-.4) + .10 x 11.9%
+ .50 x 15% = 11.09% 19
Weighted Average Cost of Capital

 If using a new equity issue to finance the

common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

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Weighted Average Cost of Capital

 If using a new equity issue to finance the

common stock portion the capital structure:

WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

WACC = .40 x 10% (1-.4) + .10 x 11.9%

+ .50 x 16.25% = 11.72%

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 Marginal Cost of Capital
• Weighted average cost will change if one component
cost of capital changes.
• This may occur when a firm raises a particularly large
amount of capital such that investors think that the
firm is riskier.
• The WACC of the next dollar of capital raised is called
the marginal cost of capital (MCC).

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 Contd…
• Assume now that XYZ Corporation has $100,000
in retained earnings with which to finance its
capital budget.
• We can calculate the point at which they will need
to issue new equity since we know that
Gallagher’s desired capital structure calls for 50%
common equity.

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 Contd…

Breakpoint = Available Retained Earnings

Percentage of Total

Breakpoint = ($100,000)/.5 = $200,000

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 Balance Sheet
Assets Liabilities
Cash 5,000 LT Debt 3,000
Equipment 5,000 Pref. Stock 1,000
Stock 6,000
Tot. Assets 10,000 Tot. Debt & Eq. 10,000

Kd = 10%;
Kp = 8%
Ke = 12%
Tax rate = 40%
Calculate WACC?
 Country risk premium
• The additional risk associated with investing in an
international company rather than the domestic market. 
• Macroeconomic factors such as political instability,
volatile exchange rates and economic turmoil causes
investors to be wary of overseas investment
opportunities and thus require a premium for investing.
• The country risk premium (CRP) is higher for developing
markets than for developed nations.
 How to estimate CRP?
• Using debt 1
• CAPM:
• Ri = Rf + Bi (Rm – Rf) + Crp
• Crp = {Avg. Bond Yield in Developing country -
Avg. Bond Yield in Developed country}
• Ri = Rf + Bi (Rm – Rf) + (ABYdev_c – ABYd_c)
• Using debt 2
• CAPM:
• Ri = Rf + Bi (Rm – Rf) + Crp
– Crp = {Avg. Bond Yield in Developing country - Avg. Bond
Yield in Developed country} * {Annualized standard
deviation of Equity index / Annualized standard deviation
of Bond index
• Ri = Rf + Bi (Rm – Rf) + (ABYdev_c –
ABYd_c)*(ASD_ei/ASD_bi)
Thank you