The cost of Capital

1. 1
The Cost
of Capital

2. Learning Goals
1. Define cost of capital.
2. Bring out the important of cost of capital.
3. Explain how to design an ideal capital structure.
4. Compute Weighted Average Cost of Capital.
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3. 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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4. The cost of debenture is the discount rate
which equates the net proceeds from issue of
debenture to the expected cash outflow –
interest and principal repayments.
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Cost of Debenture

5. Where Kd is post tax cost of debenture capital,
I is the annual interest payment per unit of
debenture,
T is the corporate tax rate,
F is the redemption price per debenture,
P is the net amount realized per debenture,
n is maturity period.
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1. Compute Cost of Debenture

6. EXAMPLE
• Falinkuta Enterprise wants to have an issue of
non-convertible debenture for GMD10 Cr.
Each debenture is of par value of GMD100
having an interest rate of 15%. Interest is
payable annually and they are redeemable
after 8 years at a premium of 5%. The
company is planning to issue the NCD at a
discount of 3% to help in quick subscription. If
the corporate tax rate is 50% what is the cost
of debenture to the company?
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7. SOLUTION
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8. COST OF TERM LOAN
Term loans are loans taken from banks or
financial institution for a specified number of
years at a pre-determined interest rate. The cost
of term loans is equal to the interest rate
multiplied by 1-tax rate. The interest is multiple
by 1-tax rate as interest on term loans is also
taxed.
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9. FORMULA
Kt = I(1 - T)
Where
I is interest,
T is tax rate.
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10. EXAMPLE
Nyanfora Ltd: has taken a loan of GMD5,000,000
from Guaranty Trust Bank at 9% interest. What
is the cost of term loan?
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11. SOLUTION
Kt = I(1- T) = 9(1 – 0.4) = 5.4%
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12. • Cost to raise a dollar of preferred stock.
12
11.90%
$5.00
$42.00
kp = =
The cost of preferred stock:
Example: You can issue preferred stock for a net
price of $42 and the preferred stock pays a
$5 dividend.
Dividend (Dp)
Market Price (PP) - F
Required rate kp =
2. Compute Cost Preferred Stock

13. • 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

14. • 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

15. • Cost of Internal Common Stock Equity
– Dividend Growth Model
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D1
P0
kS = + g
3. Compute Cost of Common Equity

16. • Cost of Internal Common Stock Equity
– Dividend Growth Model
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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%.
3. Compute Cost of Common Equity
D1
P0
kS = + g

17. • Cost of Internal Common Stock Equity
– Dividend Growth Model
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3(1+0.10)
60
kS = + .10 =.155 = 15.5%
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%.
3. Compute Cost of Common Equity
D1
P0
kS = + g

18. • Cost of Internal Common Stock Equity
– Capital Asset Pricing Model (Chapter 7)
18
kS = kRF + (kM – kRF)
3. Compute Cost of Common Equity

19. • Cost of Internal Common Stock Equity
– Capital Asset Pricing Model (Chapter 7)
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Example:
The estimated Beta of a stock is 1.2. The risk-free rate
is 5% and the expected market return is 13%.
3. Compute Cost of Common Equity
kS = kRF + (kM – kRF)

20. • Cost of Internal Common Stock Equity
– Capital Asset Pricing Model (Chapter 7)
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kS = 5% + 1.2(13% – 5%) 14.6%
3. Compute Cost of Common Equity
=
Example:
The estimated Beta of a stock is 1.2. The risk-free rate
is 5% and the expected market return is 13%.
kS = kRF + (kM – kRF)

21. • Cost of New Common Stock
– Must adjust the Dividend Growth Model equation for
floatation costs of the new common shares.
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3. Compute Cost of Common Equity
D1
P0 - F
kn = + g

22. • Cost of New Common Stock
– Must adjust the Dividend Growth Model equation
for floatation costs of the new common shares.
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3. Compute Cost of Common Equity
Example:
If additional shares are issued floatation costs
will be 12%. D0 = $3.00 and estimated growth
is 10%, Price is $60 as before.
D1
P0 - F
kn = + g

23. • Cost of New Common Stock
– Must adjust the Dividend Growth Model equation for
floatation costs of the new common shares.
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3. Compute Cost of Common Equity
3(1+0.10)
52.80
kn = + .10 = .1625 =
D1
P0 - F
kn = + g
16.25%
Example:
If additional shares are issued floatation costs will
be 12%. D0 = $3.00 and estimated growth is 10%,
Price is $60 as before.

24. 24
Weighted Average Cost of Capital
Gallagher Corporation estimates the following
costs for each component in its capital structure:
Gallagher’s tax rate is 40%
Source of Capital Cost
Bonds kd = 10%
Preferred Stock kp = 11.9%
Common Stock
Retained Earnings ks = 15%
New Shares kn = 16.25%

25. 25
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)

26. 26
If using retained earnings to finance the
common stock portion the capital structure:
Weighted Average Cost of Capital
 Assume that Gallagher’s desired capital
structure is 40% debt, 10% preferred and
50% common equity.
WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

27. 27
Weighted Average Cost of Capital
WACC = .40 x 10% (1-.4) + .10 x 11.9%
+ .50 x 15% = 11.09%
WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)
If using retained earnings to finance the
common stock portion the capital structure:
 Assume that Gallagher’s desired capital
structure is 40% debt, 10% preferred and
50% common equity.

28. 28
If using a new equity issue to finance the
common stock portion the capital structure:
Weighted Average Cost of Capital
WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

29. 29
Weighted Average Cost of Capital
WACC = .40 x 10% (1-.4) + .10 x 11.9%
+ .50 x 16.25% = 11.72%
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)