Module 5

Cost
Cost of
of Capital
Capital
 Overall Cost of Capital
of the Firm
Cost of Capital is the required rate
of return on the various types of
financing. The overall cost of
capital is a weighted average of the
individual required rates of return
(costs).
 Market Value of
Long-Term Financing
Type of Financing Mkt Val Weight
Long-Term Debt $ 35M 35%
Preferred Stock $ 15M 15%
Common Stock Equity $ 50M 50%
$ 100M 100%
 Cost of Debt

Cost of Debt is the required rate

of return on investment of the
lenders of a company.
n I j + Pj
P0 =  (1 + k ) j
j=1 d

ki = kd ( 1 – T )
 Determination of
the Cost of Debt
1. Assume that BW Ltd. has Rs1,000 par
value zero-coupon bonds outstanding.
BW bonds are currently trading at Rs
385.54 with 10 years to maturity. BW tax
bracket is 40%.
0 + 1,000
385.54 =
(1 + kd)10
Determination of
the Cost of Debt
(1 + kd)10 = $1,000 / $385.54
= 2.5938
(1 + kd) = (2.5938) (1/10)
= 1.1
kd = 0.1 or 10%

ki = 10% ( 1 – .40 )

ki = 6%
2. A company has 10 per cent perpetual debt of Rs 1,00,000. The
tax rate is 35 per cent. Determine the cost of capital (before tax as
well as after tax) assuming the debt is issued at (i) par, (ii) 10 per
cent discount, and (iii) 10 per cent premium.

(i)10%, 6.5%

(ii)11.11%, 7.22%

(iii)9.09%, 5.91%
 Shortcut Method

I1  t   f  d  pr  pi /Nm
k  (7)
d RV  SV /2

where I = Annual interest payment

RV = Redeemable value of debentures/debt
SV = Net sales proceeds from the issue of debenture/debt
(face value of debt minus issue expenses)
Nm = Term of debt
f = Flotation cost
d = Discount on issue of debentures
pi = Premium on issue of debentures
pr = Premium on redemption of debentures
t = Tax rate
3. A company issues a new 10 per cent debentures of Rs 1,000
face value to be redeemed after 10 years The debenture is
expected to be sold at 5 per cent discount. It will also involve
floatation costs of 5 per cent of face value. The company’s tax
rate is 35 per cent. What would the cost of debt be? Illustrate
the computations using (1) trial and error approach and (2)
shortcut method.

8%

7.9%
 Cost of Preferred Stock

Cost of Preferred Stock is the

required rate of return on
investment of the preferred
shareholders of the company.

kP = D P / P 0
 Determination of the
Cost of Preferred Stock
Assume that BW Ltd. has preferred
stock outstanding with par value of
Rs 100, dividend per share of Rs 6.30,
and a current market value of Rs 70
per share.

kP = $6.30 / $70
kP = 9%
 Cost of Equity
Approaches
• Dividend Discount Model
• Capital-Asset Pricing Model
• Before-Tax Cost of Debt plus
Risk Premium
 Dividend
Dividend Discount
Discount Model
Model

The cost of equity capital,

capital ke, is
the discount rate that equates the
present value of all expected
future dividends with the current
market price of the stock.
D1 D2 D
P0 = + +...+
(1 + ke)1 (1 + ke)2 (1 + ke)
 Constant
Constant Growth
Growth Model
Model

The constant dividend growth

assumption reduces the model to:

ke = ( D 1 / P 0 ) + g

Assumes that dividends will grow

at the constant rate “g” forever.
 Determination of the
Cost of Equity Capital
Assume that BW Ltd. has common stock
outstanding with a current market value of
Rs64.80 per share, current dividend of Rs3
per share, and a dividend growth rate of 8%
forever.
ke = ( D 1 / P0 ) + g
ke = (3(1.08) / 64.80) + 0.08
ke = 0.05 + 0.08 = 0.13 or 13%
 Growth
Growth Phases
Phases Model
Model

The growth phases assumption

leads to the following formula
(assume 3 growth phases):
a D0(1 + g1)t b Da(1 + g2)t–a
P0 =  (1 + ke)t

(1 + ke)t
+
t=1 t=a+1
 Db(1 + g3)t–b

t=b+1 (1 + ke)t
 Capital
Capital Asset
Asset
Pricing
Pricing Model
Model
The cost of equity capital, ke, is
equated to the required rate of
return in market equilibrium. The
risk-return relationship is described
by the Security Market Line (SML).

ke = Rj = Rf + (Rm – Rf)j
 Determination of the
Cost of Equity (CAPM)
Assume that BW Ltd. has a company beta
of 1.25. Research by Julie Miller suggests
that the risk-free rate is 4% and the
expected return on the market is 11.4%
ke = Rf + (Rm – Rf)j
= 4% + (11.4% – 4%)1.25
ke = 4% + 9.25% = 13.25%
 Before-Tax
Before-Tax Cost
Cost of
of Debt
Debt
Plus
Plus Risk
Risk Premium
Premium
The cost of equity capital, ke, is the
sum of the before-tax cost of debt
and a risk premium in expected
return for common stock over debt.
ke = kd + Risk Premium*

* Risk premium is not the same as CAPM risk

premium
 Determination of the
Cost of Equity (kd + R.P.)
Assume that BW Ltd. typically adds a
2.75% premium to the before-tax cost of
debt.
ke = kd + Risk Premium
= 10% + 2.75%
ke = 12.75%
 Comparison of the
Cost of Equity Methods
Constant Growth Model 13.00%
Capital Asset Pricing Model 13.25%
Cost of Debt + Risk Premium 12.75%
Generally, the three methods will not agree.
We must decide how to weight –
we will use an average of these three.
 Weighted Average
Cost of Capital (WACC)
n
Cost of Capital = 
kx(Wx)
x=1

WACC = 0.35(6%) + 0.15(9%) +

0.50(13%)
WACC = 0.021 + 0.0135 + 0.065
= 0.0995 or 9.95%
 Weighted marginal cost of capital (WMCC)
Marginal cost is the new or the incremental cost of new capital
(equity and debt) issued by the firm. We assume that new funds
are raised at new costs according to the firm’s target capital
structure. Hence, what is commonly known as the WACC is in
fact the weighted marginal cost of capital (WMCC); that is, the
weighted average cost of new capital given the firm’s target
capital structure.
 Limitations of the WACC

1. Weighting System
• Marginal Capital Costs
• Capital Raised in Different
Proportions than WACC
 Limitations of the WACC

2. Flotation Costs are the costs

associated with issuing securities
such as underwriting, legal, listing,
and printing fees.
a. Adjustment to Initial
Outlay
b. Adjustment to Discount
Rate
 Determining Project-Specific
Required Rate of Return

1. Calculate the required return

for Project k (all-equity financed).
Rk = Rf + (Rm – Rf)k

2. Adjust for capital structure of the

firm (financing weights).
Weighted Average Required Return = [ki]
[% of Debt] + [Rk][% of Equity]
 Project-Specific Required
Rate of Return Example

Assume a computer networking project is

being considered with an IRR of 19%.
Examination of firms in the networking
industry allows us to estimate an all-equity
beta of 1.5. Our firm is financed with 70%
Equity and 30% Debt at ki=6%.
The expected return on the market is 11.2%
and the risk-free rate is 4%.
 Do You Accept the Project?
ke = Rf + (Rm – Rf)j
= 4% + (11.2% – 4%)1.5
ke = 4% + 10.8% = 14.8%

WACC = 0.30(6%) + 0.70(14.8%)

= 1.8% + 10.36% = 12.16%
IRR = 19% > WACC = 12.16%
 Determining Group-Specific
Required Rates of Return
Use of CAPM in Project Selection:
• Initially assume all-equity financing.
• Determine group beta.
• Calculate the expected return.
• Adjust for capital structure of group.
• Compare cost to IRR of group
project.
Comparing Group-Specific
Required Rates of Return
Expected Rate of Return

Company Cost
of Capital

Group-Specific
Required Returns

Systematic Risk (Beta)

 Qualifications to Using
Group-Specific Rates
• Amount of non-equity financing
relative to the proxy firm. Adjust
project beta if necessary.
• Standard problems in the use of
CAPM. Potential insolvency is a
total-risk problem rather than just
systematic risk (CAPM).
 Project Evaluation
Based on Total Risk

Probability Distribution
Approach
Acceptance of a single project
with a positive NPV depends on
the dispersion of NPVs and the
utility preferences of
management.
 Adjusting Beta for
Financial Leverage
j = ju [ 1 + (B/S)(1 – TC) ]
 j: Beta of a levered firm.
ju: Beta of an unlevered firm
(an all-equity financed firm).
B/S: Debt-to-Equity ratio in
Market Value terms.
TC : The corporate tax rate.
1. Calculate the Cost of Equity Capital in the following cases:
(i) A company is expected to disburse a dividend of Rs.30 on each
equity shares of Rs.10 each. The current market price of shares is
Rs.80. Calculate the cost of Equity capital as per dividend yield
method.
(ii) A company has its equity shares of Rs.10 each quoted in a
stock exchange has market price of Rs.56. A constant expected
annual growth rate of 6% and a dividend of Rs.3.60 per share was
paid for the current year. Calculate cost of capital.

37.5%
12.814%
2. Suppose you estimate that eBay’s stock has a beta of 1.45.
for UPS beta is 0.79. If the risk-free interest rate is 3% and
you estimate the market’s expected return to be 8%,
calculate the equity cost of capital for eBay and UPS.
Which company has a higher cost of equity capital?

10.25%, 6.95%
3. Valence Industries wants to know its cost of equity. Its
chief financial officer (CFO) believes the risk-free rate is 5
percent, equity risk premium is 7 percent, and Valence’s
equity beta is 1.5. What is Valence’s cost of equity using the
CAPM approach?

15.5%
4. Here are stock market and Treasury bill returns (in %) between Year 1 and Year 5:
Year Index T-Bill
Return Return
(Rm) (Rf)

1 1.31 3.9

2 37.43 5.6

3 23.07 5.21

4 33.36 5.26

5 28.58 4.86

What is the average risk premium?

19.784%
5. Dexter ltd is planning to raise money from the capital
markets. Sensex is expected to give a 10% return in the last one
year. The 10 year government yield going rate is 8%. The
Covariance of the Rm and Company’s returns is 0.12 and their
market variance is 0.9. Calculate the cost of equity based on
CAPM model.

8.2667%
6. Suppose that the beta of a publicly traded company’s stock is
1.3 and that the market value of equity and debt are, respectively,
C$540 million and C$720 million. If the marginal tax rate of this
company is 40 percent, what is the asset beta of this company?

Beta (unlevered) 0.72

7. Suppose we want to find the beta of an unlisted company with debt and equity in a ratio of
0.4:1. The comparable company operating in the same line of business has a beta of 1.2 and a
debt - to - equity ratio of 0.125 the project. The marginal tax rate is 35 percent. Calculate the
beta for the unlisted company.

Beta (unlevered) 1.1098

Beta (levered) 1.3983
8. Cyclone Software Co. is trying to estimate its optimal capital structure. Cyclone’s current
capital structure consists of 25 percent debt and 75 percent equity; however, management
believes the firm should use more debt. The risk-free rate is 5 percent, the market risk premium,
is 6 percent, and the firm’s tax rate is 40 percent. Currently, Cyclone’s cost of equity is 14
percent, which is determined on the basis of the CAPM. What would be Cyclone’s estimated
cost of equity if it were to change its capital structure from its present capital structure to 50
percent debt and 50 percent equity?

17%
9. Berta ltd, issues 11% irredeemable preference shares of the face value of Rs. 100 each.
Floatation costs are estimated at 5% of the expected sale price. What is the Cost of Preference
Shares, if preference shares are issued at (i) par value, (ii) 10% premium and (iii) 5% discount?

11.58%
10.53%
12.19%
12.68%
11. Max ltd has 10% perpetual debt of Rs. 1,00,000. The tax rate is 35%. Determine the cost of
capital (before tax as well as after tax) assuming the debt is issued at (i) par, (ii) 10% discount,
and (iii) 10% premium

10%, 6.5%
11.1%, 7.22%
9.09%, 5.91%
12. Calculate the explicit cost of debt (after tax) for Annie Lenox limited in each of the following
situations:
a) Debentures are sold at par and floatation costs are 5%
b) Debentures are sold at premium of 10% and floatation costs are 5% of issue price
c) Debentures are sold at discount of 5% and floatation costs are 5% of issue price.
Assume Interest rate on debentures is 10%, face value is Rs. 100 maturity period is 10 years
and tax rate is 35%

7.18%
5.92%
7.86%
13. Acme Industries issues a bond to finance a new project. It offers a 5-year, 5 percent coupon
bond. Upon issue, the bond sells at $1,025. What is Acme’s before tax cost of debt? If Acme’s
marginal tax rate is 35 percent, what is Acme’s after-tax cost of debt? Use YTM to calculate cost
of debt. Face Value of the Bond is $ 1,000 and Redemption Value is also the same $ 1000.

4.43%
2.709%
14. Calculate the cost of debt for the below listed companies if tax rate is 40% and the risk free
rate is 3.5%.

Company EBIT Interest Category

Disney 6819 821 > $ 5 billion

Aracruz 574 155 < $ 5 billion

Tata chemicals 6263 1215 < $ 5 billion

Bookscape 3575 575 < $ 5 billion
3.15%
4.65%
3.9%
3.6%
15. Star Cements ltd has given you the following capital structure, Calculate WACC based on
book values and market values.
1.Cost of capital is before of tax.
2. Assume tax is 40%.
S ou rces M a rk et B ook B efo re tax
C ost
V alu es V alu es (% )
(R s C r) (R s C r)
E quity 80 120 18
P reference 30 20 15
D eb entures 40 40 14

16.33%
16.78%
16. Alpha limited is considering raising of funds of about Rs. 100 lakhs by one of the two
alternative methods viz., 14% institutional term loan and 13% non-convertible debentures. The
term loan option would attract no major incidental cost. The debentures would have to be
issued at a discount of 2.5% and would involve a cost of issue of Rs. 1 lakh. You are to advise
the company as to the better option based on the effective cost of capital in each case. Assume
a tax rate of 50%.
7%
6.74%
Option 2 is better
17. Aries limited wishes to raise additional finance of Rs. 10 lakhs for meeting its investment
plans. It has Rs. 210,000 in the form of retained earnings available for investment purposes.
The following are the further details:
Debt-equity mix 30:70
Cost of debt up to 180,000, 10 percent (before tax); beyond 180,000, 12 percent (before tax)
EPS = Rs. 4 per share
Dividend payout, 50 percent of earnings
Expected growth rate in dividend, 10 per cent
CMP = Rs. 44 (on BSE).
Tax rate = 35%
You are required to
• Determine the pattern for raising the additional finance, assuming the firm intends to
maintain debt-equity mix 30:70
• to determine post –tax average cost of additional debt
• to determine cost of retained earnings and cost of equity
• compute overall cost of capital after tax of additional finance.

(ii) 7.02% (iii) 15% (iv) 12.606%

(a) 1.8 (b) 15%, 8% (c) 11.764%
20:80 best ratio
a)7.5%, b) 8.57%
i)13.454%, ii) 14.86%
i)10.28%, ii) 11.85%
(i) 8.5% (ii) 3.5% (iii) 4.36% (iv) 10.6% (v) 16.1% (vi) 13%