Chapter 4
Cost of Capital
Introduction
Basic Definitions
o Capital—refers to the long-term funds used by a firm to finance its assets.
o Capital components—the types of capital used by a firm. Generally, we
include various kinds of debt, such as bonds, and equity, both preferred
and common, in the capital of the firm.
o Cost of capital—the cost associated with the various types of capital used
by the firm. Each type of capital—that is, each component—has a cost,
which, as we will see, is based on the rate of return required by the
investors who provide the funds to the firm.
o Weighted average cost of capital, WACC—the average percentage cost,
based on the proportion each component of the total capital, of all the
funds used by the firm to finance its assets.
Cost of capital
• The cost of capital is the return that must be
provided for the use of an investor’s funds. If
the funds are borrowed, the cost is related to
the interest that must be paid on the loan. If the
funds are equity, the cost is the return that
investors expect, both from the stock’s price
appreciation and dividends. From the investor’s
point of view, the cost of capital is the same as
the required rate of return.
Cont’d
• The required rate of return on an investment
and its value are intertwined.
• If you buy a bond, you expect to receive interest
and the repayment of the principal in the
future. The price you pay reflects your required
rate of return. What determines your required
rate? Your opportunity cost—the return you
could have received on an investment with
similar risk.
Cont’d
• Suppose that after you buy this bond, market
interest rates increase. Your own required rate
of return also rises.
• When your required rate of return increases,
the value of your bond’s future interest and
principal fall since the discount rate—the rate
you use to translate future cash flows into
today’s value—increases. The discount rate
increases because its is a reflection of market
interest rates.
Cont’d
• The cost of capital and the required rate of
return are marginal concepts.
• That is, the cost of capital is the cost associated
with raising one more dollar of capital, whereas
the required rate of return is the return
expected on one more dollar invested.
• For example, suppose I have already borrowed
$10,000, promising to pay 5% interest per year.
Cont’d
• And suppose that if I need to borrow any more,
I would have to pay 6% per year of the amount I
borrow above $10,000. Six percent is the
marginal cost.
• The cost of what we have already borrowed is
history, sort of. How much we have already
borrowed and what we committed ourselves to
pay will influence what we will have to pay to
borrow further.
Cont’d
o That’s because the more you are already
paying for your borrowings, the greater the
rate lenders will require to lend you more.
o That’s why when we analyze the cost of a new
investment, we should be thinking about the
marginal costs of capital.
Cont’d
• To make investment decisions of any kind, we
need to know the cost of capital.
• In economics, you learned that a firm should
produce goods to the point where the firm’s
marginal benefit from producing them equals
the marginal cost to produce them. At that
level of production,profit is maximized.
Cont’d
• It’s the same in investment and financing
decisions: Invest in a project until the marginal
cost of funds to invest is equal to the marginal
benefit the project provides.
• The benefit from an investment is its return,
which we refer to as its internal rate of return
(from the investor’s perspective)or the
marginal efficiency of capital (from the firm’s
perspective).
Cont’d
• This means that managers keep on raising funds
to invest in projects until the marginal cost of
these funds is equal to the marginal benefit
(which decreases as we take on more and more
projects).
• Therefore, you need to know the marginal cost
of funds before you can determine how much to
invest in projects in your attempt to maximize
shareholder wealth.
Cont’d
• A firm’s cost of capital is the cost of its long-
term sources of funds: debt, preferred stock,
and common stock.
• And the cost of each source reflects the risk of
the assets the firm invests in.
• A firm that invests in assets having little risk
will be able to bear lower costs of capital than
a firm that invests in assets having a high risk.
DETERMINING THE COSTS OF EACH CAPITAL
COMPONENT
Cost of Debt, rd(1 T)
The required return to debt holders, rd, is not
equal to the company’s cost of debt because,
since interest payments are deductible, the
government in effect pays part of the total
cost. As a result, the cost of debt to the firm is
less than the rate of return required by debt
holders
Cont’d
• The after-tax cost of debt, rd(1 T), is used to
calculate the weighted average cost of capital,
and it is the interest rate on debt, rd, less the tax
savings that result because interest is deductible.
• This is the same as rd multiplied by (1 T), where T
is the firm’s marginal tax rate:
• After-tax component cost of debt = Interest rate -
Tax savings.
= rd – rdT
= rd(1-T)
Cont’d
• Therefore, if NCC can borrow at an interest rate
of 11 percent, and if it has a marginal federal-
plus-state tax rate of 40 percent, then its after-
tax cost of debt is 6.6 percent:
rd(1 T) = 11%(1.0 0.4)
= 11%(0.6)
= 6.6%.
Flotation costs are usually fairly small for most
debt issues, and so most analysts ignore them
when estimating the cost of debt.
Cost of Preferred Stock, rps
• The component cost of preferred stock used to
calculate the weighted average cost of capital,
rps, is the preferred dividend, Dps, divided by the
net issuing price, Pn, which is the price the firm
receives after deducting flotation costs:
Component cost prefered stock = rps = Dps/Pn
• Flotation costs are higher for preferred stock
than for debt, hence they are incorporated into
the formula for preferred stocks’ costs.
Cont’d
• To illustrate the calculation, assume that NCC
has preferred stock that pays a $10 dividend
per share and sells for $100 per share.
• If NCC issued new shares of preferred, it
would incur an underwriting (or flotation) cost
of 2.5 percent, or $2.50 per share, so it would
net $97.50 per share. Therefore, NCC’s cost of
preferred stock is 10.3 percent:
rps = $10/$97.50 = 10.3%.
Cost of Common Stock, rs
Three methods typically are used:
(1) the Capital Asset Pricing Model (CAPM),
(2) the discounted cash flow (DCF) method, and
(3) the bond-yield-plus risk- premium approach.
These methods are not mutually exclusive—no
method dominates the others, and all are
subject to error when used in practice
The CAPM Approach
• To estimate the cost of common stock using the Capital Asset
Pricing Model (CAPM), we proceed as follows:
Step 1. Estimate the risk-free rate, rRF.
Step 2. Estimate the current expected market risk
premium, RPM = rm -rRF
Step 3. Estimate the stock’s beta coefficient, bi, and use
it as an index of the stock’s risk. The i signifies
the ith company’s beta.
Step 4. Substitute the preceding values into the CAPM
equation to estimate the required rate of return
on the stock in question:
rs = rRF + (RPM)bi.
Cont’d
• To illustrate the CAPM approach for NCC, assume that rRF
8%, RPM 6%, and bi 1.1, indicating that NCC is somewhat
riskier than average. Therefore, NCC’s cost of equity is 14.6
percent:
rs = 8% + (6%)(1.1) = 8% + 6.6% = 14.6%
• It should be noted that although the CAPM approach
appears to yield an accurate, precise estimate of rs, it is hard
to know the correct estimates of the inputs required to make
it operational because (1) it is hard to estimate the beta that
investors expect the company to have in the future, and (2) it
is difficult to estimate the market risk premium. Despite
these difficulties, surveys indicate that CAPM is the preferred
choice for the vast majority of companies.
Cont’d
• It should be noted that although the CAPM
approach appears to yield an accurate, precise
estimate of rs, it is hard to know the correct
estimates of the inputs required to make it
operational because (1) it is hard to estimate
the beta that investors expect the company to
have in the future, and (2) it is difficult to
estimate the market risk premium.
• Despite these difficulties, surveys indicate that
CAPM is the preferred choice for the vast
majority of companies.
Dividend-Yield-plus-Growth-Rate, or
Discounted Cash Flow (DCF), Approach
• If dividends are expected to grow at a constant rate,
and the current price of the stock is given, then, the
expected rate of return is:
rs = D1 + Expected g
Po
• Here P0 is the current price of the stock; D1 is the
dividend expected to be paid at the end of Year 1 and rs
is the required rate of return.
• Thus, investors expect to receive a dividend yield, D1/P0,
plus a capital gain, g, for a total expected return of rs.
Cont’d
• To illustrate the DCF approach, suppose NCC’s
stock sells for $32; its next expected dividend
is $2.40; and its expected growth rate is 7
percent. NCC’s expected and required rate of
return, hence its cost of common stock, would
then be 14.5 percent.
rs = $2.40 + 7.0%
$32.00
= 7.5% + 7.0% = 14.5%
Bond-Yield-plus-Risk-Premium Approach
• Some analysts use a subjective, ad hoc
procedure to estimate a firm’s cost of common
equity: they simply add a judgmental risk
premium of 3 to 5 percentage points to the
interest rate on the firm’s own long-term debt.
It is logical to think that firms with risky, low-
rated, and consequently high-interest-rate debt
will also have risky, high cost equity, and the
procedure of basing the cost of equity on a
readily observable debt cost utilizes this logic
Cont’d
• For example, if an extremely strong firm such as BellSouth had
bonds which yielded 8 percent, its cost of equity might be
estimated as follows:
rs = Bond yield + Risk premium = 8% + 4% = 12%.
• The bonds of NCC, a riskier company, have a yield of 10.4
percent, making its estimated cost of equity 14.4 percent:
rs = 11% + 4% = 15%.
• Because the 4 percent risk premium is a judgmental estimate,
the estimated value of rs is also judgmental. Empirical work
suggests that the risk premium over a firm’s own bond yield
has generally ranged from 3 to 5 percentage points, so this
method is not likely to produce a precise cost of equity.
However, it can get us “into the right ballpark.”
Composite, or Weighted Average, Cost of
Capital, WACC
• Each firm has an optimal capital structure,
defined as that mix of debt, preferred, and
common equity that causes its stock price to
be maximized.
• Therefore, a value-maximizing firm will
establish a target (optimal) capital structure
and then raise new capital in a manner that
will keep the actual capital structure on target
over time
Cont’d
• we assume that the firm has identified its
optimal capital structure, that it uses this
optimum as the target, and that it finances so
as to remain constantly on target.
• The target proportions of debt, preferred
stock, and common equity, along with the
component costs of capital, are used to
calculate the firm’s WACC.
. . . Cont’d
• To illustrate, suppose NCC has a target capital
structure calling for 30 percent debt, 10 percent
preferred stock, and 60 percent common equity.
Its before-tax cost of debt, rd, is 11 percent; its
after-tax cost of debt is rd(1 - T) = 11%(0.6) =
6.6%; its cost of preferred stock, rps, is 10.3
percent; its cost of common equity, rs, is 14.5
percent; its marginal tax rate is 40 percent; and
all of its new equity will come from retained
earnings. We can calculate NCC’s weighted
average cost of capital, WACC, as follows:
. . . Cont’d
WACC = wdrd(1 - T) + wpsrps + wcers
= 0.3(11.0%)(0.6) + 0.1(10.3%) + 0.6(14.5%)
= 11.7%.
• Here wd, wps, and wce are the weights used for debt, preferred,
and common equity,respectively.
• Here wd, wps, and wce are the weights used for debt, preferred,
and common equity, respectively.
• Every dollar of new capital that NCC obtains will on average
consist of 30 cents of debt with an after-tax cost of 6.6 percent,
10 cents of preferred stock with a cost of 10.3 percent, and 60
cents of common equity with a cost of 14.5 percent. The
average cost of each whole dollar, the WACC, is 11.7 percent.
Factors That Affect the Weighted Average
Cost of Capit
• The cost of capital is affected by a number of
factors. Some are beyond the firm’s control, but
others are influenced by its financing and
investment policies.
• Factors the Firm Cannot Control
• The three most important factors that are beyond a
firm’s direct control are
(1) the level of interest rates,
(2) the market risk premium, and
(3) tax rates.
Cont’d
• Factors the Firm Can Control
• A firm can affect its cost of capital through
(1) its capital structure policy,
(2) its dividend policy, and
(3) its investment (capital budgeting) policy.