Cost of Capital
Birendra Bista
Chapter-5
BBA-IV
15-1
Why Cost of Capital Is Important
• Knowing our cost of capital can also help
us determine our required return for capital
budgeting projects.
15-2
Definition of cost of capital
• It is the minimum required rate of return
necessary to operate a company.
• Cost of capital includes the cost of debt,
cost of equity and cost of preferred stock.
15-3
Cost of Equity
• The cost of equity is the return required by
equity investors given the risk of the cash
flows from the firm
• There are two major methods for
determining the cost of equity
• Dividend growth model
• SML or CAPM
15-4
The Dividend Growth Model
Approach
• Start with the dividend growth model
formula and rearrange to solve for RE
D1
P0
RE g
D1
RE g
P0
15-5
Dividend Growth Model Example
• Suppose that your company is expected to
pay a dividend of $1.50 per share next
year. There has been a steady growth in
dividends of 5.1% per year and the market
expects that to continue. The current price
is $25. What is the cost of equity?
1.50
RE .051 .111 11 .1%
25
15-6
The SML Approach
• Use the following information to compute
our cost of equity
• Risk-free rate, Rf
• Market risk premium, E(RM) – Rf
• Systematic risk of asset,
RE R f E ( E ( RM ) R f )
15-7
Example - SML
• Suppose your company has an equity beta
of .58 and the current risk-free rate is
6.1%. If the expected market risk premium
is 8.6%, what is your cost of equity capital?
• RE = 6.1 + .58(8.6) = 11.1%
• Since we came up with similar numbers
using both the dividend growth model and
the SML approach, we should feel pretty
good about our estimate
15-8
Example – Cost of Equity
• Suppose our company has a beta of 1.5. The
market risk premium is expected to be 9% and the
current risk-free rate is 6%. We have used analysts’
estimates to determine that the market believes our
dividends will grow at 6% per year and our last
dividend was $2. Our stock is currently selling for
$15.65. What is our cost of equity?
• Using SML: RE = 6% + 1.5(9%) = 19.5%
• Using DGM: RE = [2(1.06) / 15.65] + .06 =
19.55%
15-9
• The ABC Company earns Rs 5 per share, the expected
year-end dividend is Rs 1.60, and price per share is Rs
40. Iverson’s earnings, dividends and stock price have
been growing at 8% per share year, and this growth rate
is expected to continue indefinitely. New common stock
can be sold to net Rs 38.
• What is Inversion’s percentage of flotation cost, FC%?
• What is Inversion’s cost of retained earnings Ks?
• What is Inversion’s cost of new common stock, Ke?
15-10
Cost of Debt
• The cost of debt is the required return on our
company’s debt
• We usually focus on the cost of long-term debt or
bonds
• The required return is best estimated by computing
the yield-to-maturity on the existing debt
• We may also use estimates of current rates based
on the bond rating we expect when we issue new
debt
• The cost of debt is NOT the coupon rate
15-11
Example: Cost of Debt
• Suppose we have a bond issue currently
outstanding that has 25 years left to
maturity. The coupon rate is 9% and
coupons are paid semiannually. The bond
is currently selling for $908.72 per $1000
bond. What is the cost of debt?
• N = 50; PMT = 45; FV = 1000; PV = -908.75;
CPT I/Y = 5%; YTM = 5(2) = 10%
15-12
Cost of Preferred Stock
• Reminders
• Preferred stock generally pays a constant
dividend each period
• Dividends are expected to be paid every
period forever
• Preferred stock is a perpetuity, so we take
the perpetuity formula, rearrange and solve
for RP
• RP = D / P0
15-13
Example: Cost of Preferred
Stock
• Your company has preferred stock that has
an annual dividend of $3. If the current
price is $25, what is the cost of preferred
stock?
• RP = 3 / 25 = 12%
15-14
The Weighted Average Cost of
Capital
• Recall that 40% of funds were from debt.
Therefore, 40% of the required return must
go to satisfy the debtholders. Similarly,
10% should go to preferred shareholders,
and 50% to common shareholders
• This is a weighted-average, which can be
calculated as:
15-15
Flotation Costs
• The required return depends on the risk,
not how the money is raised
• However, the cost of issuing new securities
should not just be ignored either
15-16
• Weighted average cost of capital, its use
and limitations.
• Measuring capital structure, calculating
required return.
15-17
Marginal Cost of Capital (MCC)
• The term marginal refers to an additional
unit of an item. Similarly, marginal capital
is an additional rupee of new capital which
is also termed as incremental in cost of
capital.
15-18
Quick Quiz
• What are the two approaches for computing the cost
of equity?
• How do you compute the cost of debt and the after-
tax cost of debt?
• How do you compute the capital structure weights
required for the WACC?
• What is the WACC?
15-19
