CORPORATE FINANCE

COST OF CAPITAL
Reading - 37

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Popularity of Capital Budgeting Methods
• Location – European companies follow payback period as
decision making criteria.

• Size – Bigger companies more likely to use NPV as selection

criteria.

• Public v/s Private Companies – Private companies more likely

to use payback period.

• Management – Educated managers more likely to use NPV

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Cost of Capital
• It is the rate that suppliers of capital – bondholders and
owners – require as compensation for their contribution of
capital.
• It is the minimum rate of return that a company must earn on
its investment, returns are required to satisfy various
stakeholders .
• Failing on returns generation will result in the loss of the
investors faith on the company and he may be compelled to
pull his money out.
• As we use cost of capital in evaluation of investment
opportunities we are dealing with a marginal cost – what it
would cost to raise additional funds for potential investment
projects.

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Components of Cost of Capital
• All the costs put together
help us compute the Cost of Term
Weighted Average Cost of Loan
Capital (WACC)
Cost of
– Cost of Term Loan Debenture
– Cost of Debt WACC
Cost of
– Cost of Preference Share Preference Share
– Cost of Equity
Cost of Equity

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WACC Calculation
• WACC = wdrd(1 – t) + wprp + were
– Where,
• wd – weightage of debt in overall capital
• rd – cost of debt
• t – Company’s tax rate
• wp – weightage of preference shares
• rp – cost of preference shares
• we – weightage of equity
• re – cost off equity

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Taxes and Cost of Capital
Company I Company II Remarks

Method I
Equity (10% dividend) 1000 0 Capital raised in form of equity
Debt (10% Interest Rate) 0 1000 Capital raised in form of debt
Total Capital 1000 1000 Total Capital raised

Operating Profit (EBIT) 250 250

Interest incurred @ 10% on the debt by
Interest 0 100
Company II
PBT 250 150
Savings of 30 in Tax due to Debt funding.
Hence benefits wil be available only if
Tax @ 30% 75 45
debt is a part of the capital. Thus it
reduces the cost of debt funding
PAT 175 105
Dividend 100 0
Net difference of 30 as interest on debt is
Retained Earnings 75 105
tax deductible

Method II
EBIT 250 250
T 75 75
NOPAT 175 175
After Tax cost of debt 0 70 kd = I * (1-T)
After tax cost of equity 100 0
Cash Flow 75 105

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Weights of WACC
• Target capital structure is the capital structure a company is
striving to achieve
• Arrive at target capital structure
– Take it as current capital structure
– Examine trends in capital structure and look at management
guidance
– Use averages of comparable companies target capital structure

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WACC
Example
• An analyst is estimating the cost of company Duke Ltd. The
following information is provided
– Duke Ltd
• Market Value of debt = $ 30 million
• Market Value of equity = $ 40 million
– Competitor data:
Competitor MV of Debt MV of equity
A $ 34 $ 56
B $ 123 $ 170
C $ 50 $ 70

1. Current Capital Structure ?

2. Competitor Capital Structure ?
3. Calculate the weights if Duke Ltd. Announces their target D/E ratio of
0.6 ?
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WACC
Solution:
1.) Current Capital Sturcture
wd 30
= = 0.4286
(30 + 40)

we = 40 = 0.5714
(30 + 40)

2.) Competitor Capital Structure

[34/(34+56)] + [123/(123+170)] + [50/(50+70)]
wd = = 0.4047
3
[56/(34+56)] + [170/(123+170)] + [70/(50+70)]
we = = 0.5953
3

3.) D/E = 0.6

0.6
wd = = 0.3750
(0.6 + 1)
we = 1 - wd = 0.6250
These would have been the preffered weights for the target D/E ratio.
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Optimal Capital Budget
• MCC (Marginal Cost of
Capital)
– A firm’s MCC is the cost
of an additional dollar of
capital raised
– A firm’s MCC increases
as the firm increases the
amount of capital it
raises during a given
period
– MCC curve slopes
upward
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• IOS (Investment
opportunity schedule)
– We can order the
opportunities for
investment from highest
to lowest IRR
– When we plot them we
obtain the IOS
– Intersection of IOS and
MCC identifies the
optimal capital budget
10
Optimal Capital Budget…
Investment Marginal Cost
80
Opportunity Of Capital
Project IRR
70
Schedule
Cost of60
Capital (%)
50

40

30

20

10
New Capital
0
Raised (%)
1 2 Optimal
3 Capital
4 Budget
5 6 7

• The WACC is the appropriate discount rate for projects that

have same level of risk as that of the firm’s existing projects.
• For projects with greater (lesser) risk use a discount rate
greater (lesser) than the firm’s existing WACC.

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Cost of Debt
Method I : Yield to Maturity Approach
• YTM is the annual return that an investor earns on a bond if
the investor purchases the bond today and holds it until
maturity.
PMT1 PMT2 PMT3 PMTn FV
P0 = + + + …… + +
(1 + kd)1 (1 + kd)2 (1 + kd)3 (1 + kd)n (1 + kd)n

t=n PMTt FV
= ∑ +
t=1 (1 + kd)t (1 + kd)n

– Where,
• P0 = Current value of Bond
• PMT = Interest Payment for a given period
• kd = Cost of debt
• FV = Future value of the bond
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Cost of Debt
Method II : Debt-Rating Approach
• When market price of debt is not available, debt rating
approach is used.
• Based on company’s debt rating – estimate the before tax cost
of debt by using the yield on a similarly rated bond for
maturities that closely match with that of the company
• After Tax Cost of Debt = kd * ( 1 – Tax Rate)

Example
Market price of debentures of company ABC is Rs.70. Debentures pay an
interest rate of 7% and have a maturity of 5 years. Face value of the
debentures is Rs.100 and the applicable tax rate for the company is 30%
Solution
PV = -70, FV = 100, N = 5, PMT = 7% * 100 * (1-30%)  CPT I/Y = 13.54%
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Cost of Preferred Stock
• Cost committed to the preferred stock holders while issuing preferred
stock
• For nonconvertible, noncallable preferred stock that has a fixed dividend
rate
– Pp = Dp / rp
• Pp = Price of preferred stock
• Dp = Dividend to preferred stock holder
• rp = cost of preferred stock
– rp = Dp / Pp

Example
ABC Corp has preferred stock outstanding, $5 cumulative preferred
stock. The current price of this stock is $87. What is the cost of preferred
equity?
Solution: Cost of Preferred Equity = $5 / $ 87 = 5.75%
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Cost of equity
• There are various measures by which cost of equity can be
calculated. They are:
– Capital Asset Pricing Model (CAPM)
– Dividend forecast approach
– Bond yield plus risk premium

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CAPM
Ke = Rf + β (Rm – Rf) To Remember
– Where,
 Cost of equity as per
• Ke = Cost of Equity
the CAPM model is
• Rf = risk free rate of return
given as
• Rm = market return
Ke = Rf + β (Rm – Rf)
• β = beta of the stock
• (Rm – Rf) = Also called as Risk Premium

Example
ABC Corp wants to know the cost of equity? Its finance department
believes the risk free rate is 5%, equity risk premium is 8% and beta is 2.
Find the cost of equity?
Solution:
Cost of Equity = Rf + β (Rm – Rf) = 5% + 2*(8%) = 21%.
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Dividend forecast approach
Ke = D1 + g
P0
– Where,
• Ke = cost of equity
• D1 = expected dividend at the end of year 1
• P0 = price per equity share
• g = growth rate
• g = Retention Ratio * Return on Equity
• g = b * ROE

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Bond Yield plus risk premium
Ke = bond market yield + risk premium
• Assumes
– Investors require higher return on a firm’s equity than on its
debt
– Risk premium normally ranges from 3% to 5%
– It is judgment based and hence imprecise

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Estimating Beta and Project Beta
• Pure-Play Method (4 Steps)
1. Select a comparable company
2. Estimate the beta of the comparable company
3. Unlever the comparable’s beta
4. Lever the beta for the project’s financial risk
• Asset (Project) Unlevered Beta

βLevered = βUnlevered * [ 1 + ( 1 - T ) D / E]
βUnlevered = βLevered
[1+(1-T)D]
E
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Estimating Beta and Project Beta
Example
• Estimate the WACC for the following details of XYZ Corp
– Nominal Risk Free Rate for 10-year government bond is 4%
– Average risk premium is 6%
– Corporate tax rate is 35%
– Target D/E = 0.6
– Cost of Debt for XYZ Corp is at 275 bps premium to the government
bond
• Following are the details of a comparable company
Comparable MV of
Tax Rate Mcap D/E Beta
Company Debt
ABC 40% 5,600 3,400 0.61 1.25
PQR 33% 13,000 15,600 1.20 0.7
STU 38% 2,300 3,200 1.39 1.05

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Estimating Beta and Project Beta
Solution:
WACC = wdrd(1 – t) + were
D/E 0.6 Following the 4 Steps of the Pure Play Method
wd = = = 0.3750 Unlever the beta of the given comparable companies
(D/E + 1) (0.6 + 1)
Comparable Unlevered
we = 1 = 1 = 0.6250 βUnlevered = βLevered Company Beta
(D/E + 1) (0.6 + 1) [1+(1-T)D]
ABC 0.9162
E PQR 0.3880
kd = I * (1 - t) = 4% + 2.75% = 6.75% STU 0.5637
βUnlevered = Average 0.6227
ke = Rf + β (Rm – Rf) βLevered = βUnlevered * [ 1 + ( 1 - T ) D / E]

ke = Rf + β (Rm – Rf) = 4% + 0.8655 * 6% βL = 0.6227 * [ 1 + (1 - 0.35) * 0.6)]

= 9.19% βL = 0.8655

WACC = wdrd(1 – t) + were

WACC = 8.28%

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Country Risk Premium
• Use of CAPm becomes difficult for developing
countries.
• Hence a country risk premium needs to be added
while calculating Ke with this method
• The country spread is referred to as a country equity
premium
Ke = Rf + β *[ (Rm – Rf) + Country Risk Premium]
Annualized Standard Deviation of equity
Index
Country Risk Soverign yield
= * Annualized Standard Deviation of the
Premium spread
soverign bond market in terms of the
developed market currency

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Country Risk Premium…
Example
• Given the following details regarding a project:
– Indian 10-yr sovereign bond yield = 7.7%
– 10-yr US Treasury Bond yield = 3.2%
– Annualized std. dev. Of Sensex = 23%
– Annualized std. dev. Of 10-yr USD denominated Indian sovereign
bond = 12%
– Beta of project = 1.5
– Expected Market Return = 11%
– Risk Free Rate = 5%
• Compute Cost of Equity

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Country Risk Premium
Solution:
Market Risk Premium = 11% - 5% = 6%
Annualized Standard Deviation of equity
Index
Country Risk Soverign yield
= * Annualized Standard Deviation of the
Premium spread
soverign bond market in terms of the
developed market currency

Country Risk Premium = (7.7% - 3.2%) * (23% / 12%) = 8.625%

Cost of Equity
Ke = Rf + β *[ (Rm – Rf) + Country Risk Premium]
Ke = 5% + 1.5 * [ 6% + 8.625%]
Ke = 26.9375%

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Marginal Cost of Capital
• MCC (Marginal Cost of Capital)
– A firm’s MCC is the cost of an additional dollar of capital
raised
– A firm’s MCC increases as the firm increases the amount of
capital it raises during a given period
– MCC curve slopes upward
• Breakpoint: The amount of new capital investment for which
WACC increases because the cost of one of the component
costs of capital increases is termed as breakpoint.
Amount of capital at which the sourc's cost of
capital changes
Break Point =
Proportion of new capital raised from the
source

E.g. cost of debt increases past $2 million. Raised debt is 40% of the
target capital structure,
Breakpoint = 2 /.4 = $5 million
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Floatation Costs
• Fees charged by the investment banker when a company
raises external equity capital is called as Floatation Cost
• These fees range between 2% to 7%
• Incorrect Method: Adjust cost of equity
– Formula
D1
ke = + g
P0 * (1 - f)
– Where, f is the floatation cost as a percent of issue price
– However cost gets incorrectly carried through the life of the
project in this method
• Preferred Method: Adjust the initial cash outflow while
computing NPV
– Correctly shows floatation cost as a cash outflow at inception of
project.

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