9-1
Institute of Human Resource Advancement
University of Colombo
• Lecturer: Dr. A. A. Azeez
• Program: MBM
• Subject : MBM 14-Financial Management
• Topic : Cost of capital
• Date :18. 04.2015

9-2
Cost of Capital
Firms raise funds from both equity investors and
lenders to fund investments.
Cost of Equity is the rate of return investors
require on an equity investment in a firm.
Cost of Capital is the required rate of return on
the various types of financing. It is a weighted
average of the individual required rates of return.

9-3
Why Cost of Capital Is
Important
• We know that the return earned on assets
depends on the risk of those assets
• The return to an investor is the same as
the cost to the company
• Our cost of capital provides us with an
indication of how the market views the risk
of our assets
• Knowing our cost of capital can also help
us determine our required return for
capital budgeting projects
14-3

9-4
Required Return
• The required return is the same as the
appropriate discount rate and is based on the
risk of the cash flows
• We need to know the required return for an
investment before we can compute the NPV and
make a decision about whether or not to take the
investment
• We need to earn at least the required return to
compensate our investors for the financing they
have provided
14-4

9-5
Cost of Equity
• The cost of equity is the return required by
equity investors given the risk of the cash flows
from the firm
– Business risk
– Financial risk
• There are two major methods for determining
the cost of equity
– Dividend growth model/ discounted cash flow
approach
– SML, or CAPM
14-5

9-6
The CAPM Approach
• From the firm’s perspective, the
expected return is the Cost of Equity
Capital: )( FMiF RRβRke 
• To estimate a firm’s cost of equity capital, we
need to know three things:
1. The risk-free rate, RF
FM RR 2. The market risk premium,
2
,
)(
),(
M
Mi
M
Mi
i
σ
σ
RVar
RRCov
β 3. The company beta,

9-7
Example
• Suppose the stock of Stansfield Enterprises, a
publisher of PowerPoint presentations, has a
beta of 2.5. The firm is 100% equity financed.
• Assume a risk-free rate of 5% and a market
risk premium of 10%.
• What is the appropriate discount rate for an
expansion of this firm?
)( FMiF RRβRKe 
%105.2%5 ke
%30ke

9-8
Example
Suppose Stansfield Enterprises is evaluating the
following independent projects. Each costs $100 and
lasts one year.
Project Project b Project’s
Estimated Cash
Flows Next
Year
IRR NPV at
30%
A 2.5 $150 50% $15.38
B 2.5 $130 30% $0
C 2.5 $110 10% -$15.38

9-9
Using the SML
An all-equity firm should accept projects whose IRRs
exceed the cost of equity capital and reject projects
whose IRRs fall short of the cost of capital.
Project
IRR
Firm’s risk (beta)
SML
5%
Good
project
Bad project
30%
2.5
A
B
C

9-10
Advantages and Disadvantages
of SML
• Advantages
– Explicitly adjusts for systematic risk
– Applicable to all companies, as long as we can
estimate beta
• Disadvantages
– Have to estimate the expected market risk premium,
which does vary over time
– Have to estimate beta, which also varies over time
– We are using the past to predict the future, which is
not always reliable
14-10

9-11
The Discounted Cash flow
Approach
• Three inputs are required to use the DCF
Approach: the current stock price, the
current dividend, and the expected growth
in dividends.
• ke = D1 + g
P0
• Of these inputs , the growth rate is the
most difficult to estimate. To estimate this
Retention growth model is used.

9-12
The Discounted Cash flow
Approach
• Retention Growth Model:
g = ROE * Retention ratio
• Retention Ratio= (1- payout ratio)
• ROE is the return on equity defined as net
income available for stockholders divided
by equity.

9-13
The Discounted Cash flow
Approach
• A firm has been earning 14% on equity (ROE = 14%) and retaining 35% of
its earnings (dividend payout = 65%). This situation is expected to
continue. If D0 = Rs. 4.19, and P0 = Rs.50, what’s the cost of equity based
upon the DCF approach?
g = ( 1 – Payout ) (ROE) D1 = D0 (1+g)
= (0.35) (14%) D1 = Rs. 4.19 (1 + .049)
= 4.9% D1 = Rs. 4.395
ke = D1 / P0 + g
= Rs.4.395 / Rs.50 + 0.049
= 13.7%

9-14
Advantages and Disadvantages of
Discounted cash flow approach
• Advantage – easy to understand and use
• Disadvantages
– Only applicable to companies currently paying
dividends
– Not applicable if dividends aren’t growing at a
reasonably constant rate
– Extremely sensitive to the estimated growth rate
– an increase in g of 1% increases the cost of
equity by 1%
– Does not explicitly consider risk
14-14

9-15
Why is there a cost for
retained earnings?
• Earnings can be reinvested or paid out as
dividends.
• Investors could buy other securities, earn a
return.
• If earnings are retained, there is an
opportunity cost (the return that stockholders
could earn on alternative investments of
equal risk).
– Investors could buy similar stocks and earn ke.
– Firm could repurchase its own stock and earn
ke.
– Therefore, ke is the cost of retained earnings.

9-16
Why is the cost of retained earnings
cheaper than the cost of issuing new
common stock?
• When a company issues new common stock
they also have to pay flotation costs to the
underwriter.
• Issuing new common stock may send a negative
signal to the capital markets, which may depress
the stock price.

9-17
Flotation costs
• Flotation costs depend on the risk of the
firm and the type of capital being raised.
• The flotation costs are highest for common
equity. However, since most firms issue
equity infrequently, the per-project cost is
fairly small.
• We will frequently ignore flotation costs
when calculating the WACC.

9-18
If issuing new common stock incurs a
flotation cost of 15% of the proceeds, and
D0 = Rs. 4.19, P0 = Rs.50, and g = 5%, what
is ke?
15.4%
5.0%
Rs.42.50
4.3995Rs.
5.0%
0.15)-Rs.50(1
05)Rs.4.19(1.
g
F)-(1P
g)(1D
k
0
0
e







9-19
The Firm versus the Project
• Any project’s cost of capital depends
on the use to which the capital is
being put—not the source.
• Therefore, it depends on the risk of
the project and not the risk of the
company.

9-20
Capital Budgeting & Project
Risk
A firm that uses one discount rate for all projects may over
time increase the risk of the firm while decreasing its value.
ProjectIRR
Firm’s risk (beta)
SML
rf
bFIRM
Incorrectly rejected
positive NPV projects
Incorrectly accepted
negative NPV projects
Hurdle
rate
)( FMFIRMF RRβR 
The SML can tell us why:

9-21
Suppose the Conglomerate Company has a cost of capital,
based on the CAPM, of 17%. The risk-free rate is 4%, the
market risk premium is 10%, and the firm’s beta is 1.3.
17% = 4% + 1.3 × 10%
This is a breakdown of the company’s investment projects:
1/3 Automotive Retailer b = 2.0
1/3 Computer Hard Drive Manufacturer b = 1.3
1/3 Electric Utility b = 0.6
average b of assets = 1.3
When evaluating a new electrical generation investment,
which cost of capital should be used?
Capital Budgeting & Project Risk

9-22
Capital Budgeting & Project
Risk
ProjectIRR
Project’s risk (b)
17%
1.3 2.00.6
Ke = 4% + 0.6×(14% – 4% ) = 10%
10% reflects the opportunity cost of capital on an investment
in electrical generation, given the unique risk of the project.
10%
24% Investments in hard
drives or auto retailing
should have higher
discount rates.
SML

9-23
What is debt?
Debt generally has the following
characteristics:
• Commitment to make fixed payments in
the future
• The fixed payments are tax deductible
• Failure to make the payments can lead to
either default or loss of control of the firm
to the party to whom payments are due.

9-24
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
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9-25
The Cost of Capital with Debt
• The Weighted Average Cost of Capital is given
by:
• Because interest expense is tax-deductible, we
multiply the last term by (1 – TC).
rWACC =
Equity + Debt
Equity
× KEquity +
Equity + Debt
Debt
× KDebt ×(1 – T
rWACC =
S + B
S
× ke +
S + B
B
× Kd ×(1 – TC)

9-26
Example: International Paper
• First, we estimate the cost of equity
and the cost of debt.
–We estimate an equity beta to estimate
the cost of equity.
–We can often estimate the cost of debt
by observing the YTM of the firm’s debt.
• Second, we determine the WACC by
weighting these two costs
appropriately.

9-27
Example: International Paper
• The industry average beta is 0.82, the
risk free rate is 3%, and the market
risk premium is 8.4%.
• Thus, the cost of equity capital is:
Ke = RF + bi × ( RM – RF)
= 3% + 0.82×8.4%
= 9.89%

9-28
Example: International Paper
• The yield on the company’s debt is 8%,
and the firm has a 37% marginal tax rate.
• The debt to value ratio is 32%
8.34% is International’s cost of capital. It should be used to
discount any project where one believes that the project’s risk
is equal to the risk of the firm as a whole and the project has
the same leverage as the firm as a whole.
= 0.68 × 9.89% + 0.32 × 8% × (1 – 0.37)
= 8.34%
rWACC =
S + B
S
× Ke +
S + B
B
× Kd ×(1 – TC)

9-29
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
• kP = D / P0
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9-30
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?
• KP = 3 / 25 = 12%
14-30

9-31
Is preferred stock more or less
risky to investors than debt?
• More risky; company not required to pay
preferred dividend.
• However, firms try to pay preferred
dividend. Otherwise, (1) cannot pay
common dividend, (2) difficult to raise
additional funds, (3) preferred
stockholders may gain control of firm.

9-32
Calculating the weighted
average cost of capital
WACC = wdkd(1-T) + wpkp + weke
• The w’s refer to the firm’s capital
structure weights.
• The k’s refer to the cost of each
component.

9-33
How are the weights
determined?
WACC = wdkd(1-T) + wpkp + weke
• Use accounting numbers or market value
(book vs. market weights)?
• Use actual numbers or target capital
structure?
• The target capital structure is one which the
firm intends to maintain in the long run given
its operating conditions and attitude towards
risk.