Cost of capital

1. Required Returns
and the Cost of
Capital
15-1

2. Required Returns and the
Cost of Capital
● Creation of Value
● Overall Cost of Capital of the
Firm
● Project-Specific Required Rates
● Group-Specific Required Rates
● Total Risk Evaluation
15-2

3. 15-3
Key Sources of
Value Creation
Growth
phase of
product
cycle
Barriers to
competitive
entry
Other --
e.g., patents,
temporary
monopoly
power,
oligopoly
pricing
Cost
Marketing
and
price
Perceived
quality
Superior
organizational
capability
Industry Attractiveness
Competitive Advantage

4. Overall Cost of
Capital of the Firm
15-4
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).

5. Cost of Capital
15-5
● Purpose to study Competitive Advantage
● Cost & its Classifications
● Explicit Cost
● Implicit Cost (Opportunity Cost)
● Absolute Cost
● Relative Cost
● Floatation cost
● Specific Cost
● Multiple Cost / WACC

6. Source of Capital or
Financing
15-6
Debt Financing
● Debt Certificate (Interest / Discount or Premium)
●Loan (Interest / Processing or other
charges) Equity Financing
● Ordinary Shares Financing (Dividend/Disc. or Prem.)
●Retained Earning (Dividend/Disc. or Prem.)
Hybrid Financing
● Preferred Stock (Dividend / Disc. or Prem.)
● Convertibles

7. Overall Cost of
Capital of the Firm
15-7
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).

8. Mkt Val
$ 35M
Weight
35%
Type of Financing
Long-Term Debt
Preferred Stock
$ 15M 15%
Common Stock Equity $ 50M50%
$ 100M 100%
Market Value of
Long-Term Financing
15-8

9. Cost of Debt
Cost of Debt is the rate of return demanded
by investors for their investment in Bonds /
Debentures / Long term Debts.
Int = Annual interest to be paid
t = Company’s effective tax rate
RV = Redemption value per Debenture
N = Number of years to maturity
SV = issue price per debenture minus floatation cost
15-9

10. Calculate the cost of capital in the following cases:
i) X Ltd. issues 12% Debentures of face value Rs. 100
each and realizes Rs. 95 per Debenture.
The Debentures are redeemable after 10 years at a
premium of 10%.
Note: Both companies are paying income tax at 50%.
Determination of the Cost of Debt
15-10
Data:
Int = Annual interest to be paid i.e. Rs. 12
t = Company’s effective tax rate i.e. 50% or 0.50
RV = Redemption value per Debenture i.e. Rs. 110
N = Number of years to maturity = 10 years
SV = issue price per debenture minus floatation cost i.e. Rs. 95

11. [12 + (110 - 95) / 10] (1 - 0.5) = [12 + 1.5] x 0.5 = 6.75
(110 + 95) / 2 = 102.5
(kd) = 6.75 / 102.5 = 0.0659 or 6.59%
15-11
Determination of
the Cost of Debt
kd = [12 + (110 – 95) / 10] (1 – .5)
(110 + 95) / 2

12. Cost of Preferred Stock
15-12
Cost of Preferred Stock is the required rate of return on investment
of the preferred shareholders of the company.
kP = DP / P0

13. Determination of the Cost of
Preferred Stock
15-13
Assume that Basket Wonders (BW) has
preferred stock outstanding with par value
of $100, dividend per share of $6.30, and a
current market value of
$70 per share.
k = $6.30 / $70
P
kP = 9%

14. Determination of the Cost of
Preferred Stock
15-14
A company raised preference share capital of Rs. 1,00,000 by the issue of 10%
preference share of Rs. 10 each. Find out the cost of preference share capital when
it is issued at (i) 10% premium, and (ii) 10% discount
Cost of 10% preference share capital
(i) When share issued at 10% premium
Kp = D / P0
= 1 / 11 = 9.09%
(ii) When share issued at 10% discount
Kp = D / P0
= 1 / 9 = 11.11%

15. ● Dividend Discount Model
● Capital-Asset
Pricing Model
● Before-Tax Cost of Debt
plus Risk Premium
15-15
Cost of Equity Approaches

16. Dividend Discount Model
The cost of equity 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
e )2
e
0
15-16
P =
(1+ k )1 +(1
. +k
∞
∞ (1+k )
D
e

17. Constant Growth Model
The constant dividend growth
assumption reduces the model to:
15-17
ke = ( D1 / P0 ) + g
Assumes that dividends will
grow at the constant rate “g”
forever.

18. Assume that Basket Wonders (BW) has common
stock outstanding with a current market value of
$64.80 per share, current dividend of $3 per share,
and a dividend growth rate of 8% forever.
ke = ( D1 / P0 ) + g
ke = ($3(1.08) / $64.80) + .08
ke = .05 + .08 = .13 or 13%
Determination of the Cost of Equity
Capital

19. Growth Phases Model
15-18

20. Capital Asset Pricing Model
15-19
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)βj

21. Assume that Basket Wonders (BW) 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 11.2%
ke = Rf + (Rm - Rf)βj
= 4% + (11.2% - 4%)1.25
k = 4% + 9% = 13%
Determination of the Cost of
Equity (CAPM)
15-20

22. Before-Tax Cost of Debt Plus
Risk 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.
15-22
ke = kd + Risk Premium*
* Risk premium is not the same as CAPM
risk premium

23. Assume that Basket Wonders (BW)
typically adds a 3% premium to the
before-tax cost of debt.
ke = kd + Risk Premium
= 10% + 3%
ke = 13%
15-23
Determination of the Cost
of Equity (kd+ R.P.)

24. Comparison of the Cost of
Equity Methods
Constant Growth Model 13%
Capital Asset Pricing Model 13%
Cost of Debt + Risk Premium 13%
Generally, the three methods
will not agree.
15-24

25. Weighted Average costof
capital
15-25
WACC = .35(6%) + .15(9%) +
.50(13%)
WACC = .021 + .0135 + .065
= .0995 or 9.95%

26. 1. Weighting System
● Marginal Capital Costs
● Capital Raised in Different
Proportions than WACC
15-26
Limitations of the WACC

27. 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
15-27
Limitations of the WACC

28. Subtract Flotation Costs from the
proceeds (price) of the security
and recalculate yield figures.
Impact: Increases the cost for any
capital component with flotation costs.
Result: Increases the WACC,
which
Adjustment to
Discount Rate (ADR)
15-27

29. Use of CAPM in Project Selection:
● Initially assume all-equity financing.
● Determine project beta.
● Calculate the expected return.
● Adjust for capital structure of firm.
● Compare cost to IRR of project.
15-29
Project-Specific Required
Rates of Return

30. Difficulty in Determining the
Expected Return
Determining the SML:
● Locate a proxy for the project
(much easier if asset is traded).
● Plot the Characteristic Line
relationship between the market
portfolio and theproxy asset
excess returns.
● Estimate beta and create the SML.
15-30

31. Project Acceptance and/or
Rejection
SML
X
X
X
X
X
X
O
X
O
O O
O
SYSTEMATIC RISK (Beta)
EXPECTED
RATE
OF
RETURN
Rf
Accept
O Reject
O
15-31

32. 1. Calculate the required return
for Project k (all-equity financed).
Rk = Rf + (Rm - Rf)βk
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
15-32

33. 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
Project-Specific Required
Rate of Return Example
15-32

34. ke = Rf + (Rm - Rf)βj
= 4% + (11.2% - 4%)1.5
ke = 4% + 10.8% = 14.8%
WACC = .30(6%) + .70(14.8%)
= 1.8% + 10.36% = 12.16%
IRR = 19% > WACC = 12.16%
Do You Accept the Project?
15-34

35. 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.
15-35