BBC406 Fundamentals of

Finance
Week 7 The Cost of Capital

Learning Objectives
At the end of this chapter, you
should be able to:
Explain the breakdown and composition of a firms
cost of capital
Determine a firms cost of debt capital
Determine a firms cost of equity capital
Understand the impact of beta in determining the
firms cost of equity capital
Determine the firms overall cost of capital

Introduction
Investors required rate of return is the firms
cost of capital.
Cost of capital is the required rate of return
that a firm must achieve to cover the cost of
generating funds in the marketplace.

Understanding Concepts of
Cost of Capital

Factors that impact the cost of capital:

The Cost of Capital: A

Starting Point
3 broad sources of financing available or
raising capital: debt, common stock
(equity), and preferred stock (hybrid
equity).
Each has its own risk and return profile and
therefore its own rate of return required by
investors to provide funds to the firm.

Weighted Average Cost of

Capital
The firms WACCCost of capital for the firms mixture of debt
and stock (preferred and common stocks)
Firms are usually geared/leveraged using a mixture of debt
and equity.

WACC
The weighted average cost of capital (WACC) is
estimated by multiplying each component
weight by the component cost and summing
up the products.
The WACC is essentially the minimum
acceptable rate of return that the firm should
earn on its investments of average risk, in
order to be profitable.
WACC discount rate for computing NPV
IRR > WACC for acceptance of project.

Computation of WACC

See the illustration below:

WACC Components
Cost of Debt (Kd)the level of return that must
be provided for by a firm to meet the required
return of debt holders.
Cost of Preferred Stock (Kps)has higher return
than bonds, but is less costly than common
stock.
Cost of Equity (i.e. Common Stock & Retained
Earnings)the rate of return that investors
require to make an equity investment in a firm

Cost of Debt
An example is given
below:

Cost of Debt
Calculating the cost of debt
Kelloggs wants to raise an additional $3,000,000 of debt as
part of the capital that would be needed to expand their
operations into the Morning Foods sector.
They were informed by their investment banking consultant that
they would have to pay a commission of 3.5% of the selling price
on new issues.
Their CFO is in the process of estimating the corporations cost
of debt for inclusion into the WACC equation.
The company currently has an 8%, AA-rated, non-callable bond
issue outstanding, which pays interest semi-annually, will mature
in 17 years, has a $1000 face value, and is currently trading at
$1075.

Calculate the appropriate cost of debt for the firm.

Cost of Debt
Answer:
First determine the net proceeds on each bond
= Selling price Commission
=$1075-(.035*1075) = $1037.38
Using a financial calculator we enter:
P/Y = C/Y = 2
Input 34

? -1037.38

Key N I/Y
Output

PV

PMT

40 1000
FV

7.60%

The appropriate cost of debt for Kelloggs is

7.6%

Cost of Preferred Share

Cost of Preferred Share

Cost of Preferred Stock

Kelloggs will also be issuing new preferred

stock worth $1 million. They will pay a dividend
of $4 per share which has a market price of
$40. The floatation cost on preferred will
amount to $2 per share. What is their cost of
preferred stock?

Cost of Common Shares

Cost of Common Shares

Calculating Cost of Equity with the SML equation

Well, to reach their desired capital structure their CEO has

decided to utilize all of their expected retained earnings in the
coming quarter. Kelloggs beta is estimated at 0.65 by Value
Line. The risk-free rate is currently 4%, and the expected
return on the market is 15%. How much should the CEO put
down as one estimate of the companys cost of equity?

Cost of Common Shares

Applying the Dividend Growth Model to
calculate Re
Kelloggs common stock is trading at $45.57
and its dividends are expected to grow at a
constant rate of 6%.
The company paid a dividend last year of
$2.27.
If the company issues stock they will have to
pay a floatation cost per share equal to 5% of
selling price. Calculate Kelloggs cost of equity
with and without floatation costs.

Cost of Common Shares

Cost of equity without floatation cost:

Re = (Div0*(1+g)/Po) + g
($2.27*(1.06)/$45.57)+.06 = 11.28%
Cost of equity with floatation cost:

Re = [$2.27*(1.06)/(45.57*(1-.05)]+.06 =
11.56%

Cost of Common Share

Depending on the availability of data, either of
the two models, or both, can be used to estimate
Re .
With two values, the average can be used as the
cost of equity.
For example, in Kelloggs case we have
(11.15%+11.28%)/2=11.22% (without floatation
costs)
or (11.15%+11.56%) /2=11.36%(with floatation
costs)

Calculating WACC

Adjusted WACC
Calculating Adjusted WACC
Using the market value weights and the component
costs determined earlier, calculate Kelloggs
adjusted WACC.
Capital
Debt

Weight
38%

Preferred Stock 14%

Common Stock 48%
The firm pays a corporate tax rate of 30%

Recap
Computing WACC: Assume New Idea Inc maintains a mix of 36.15% of
Debt, 9.89% of Preferred Stock, and 53.96% of Common Stock. Based
on the information below, calculate the WACC assuming New Idea is
subject to 35% corporate tax rate.
The cost of debt is 6.18%
The firm also has an issue of 1 million preferred shares outstanding
with a market price of $11.00. The preferred shares offer an annual
dividend of $1.20.
New Ideas Inc. also has 2 million shares of common stock
outstanding with a price of $30.00 per share. The firm is expected
to pay a$3.20 common dividend one year from today, and that
dividend is expected to increase by 7 percent per year forever.

WACC Breakpoints

Business Risk and Financial Risk

Firms business risk is attributed to a firm business and
investment decisions.
Evaluating business riskvariability of EBIT
Financial risk is a direct result of the firms financing decision
selection of financing mix of debt and equity

Types of Leverage

See the illustration below:

Operating Leverage

Financial Leverage

Total Leverage

Implications of Financial
Leverage