CHAPTER THREE

COST OF CAPITAL

3.1 Meaning and Definition

Cost of capital of a firm is the rate of return the firm requires from investment in order to increase (or
maintain or leave unchanged) the value of the firm in the market.
It is the minimum rate of return expected by its investors. It is average cost of various source of
finance (debt, preference capital, retained earning and equity shares) used by a firm. A decision
to invest in particular project depends up on the cost of capital of the firm or the cut off rate
which is the minimum rate of return expected by investors. Hence, to achieve the objective of
wealth maximization, a firm must earn a rate of return more than its cost of capital.
If a firm’s actual rate of return exceeds its cost of capital and if this rate of return is earned without
increasing the firm’s risk characteristics, then the shareholders wealth will increase.
The cost of capital is critically important topic for three main reasons.
 To maximize a firm’s value, its management must minimize the cost of all inputs, including
capital, and to minimize the cost of capital they must be able to measure it.
 Financial managers require an estimate of the cost of capital to make correct capital budgeting
decisions.
 Many other types of decisions made by financial managers, including those related to leasing, to
bond refunding, and to working capital policy require estimates of the cost of capital.
The cost of capital is a dynamic concept affected by a variety of economic and firm factors. To
isolate the basic structure of the cost of capital, let’s make some key assumptions relative to risk
and taxes:
1. Business Risk: The risk to the firm of being unable to cover operating cost is assumed to
be unchanged. This means that acceptance of a given project by the firm leaves its
ability to meet operating cost unchanged.
2. Financial Risk: The risk to the firm of being unable to cover required financial
obligation (interest, lease payments, preferred stock dividends) is assumed to be
unchanged. This assumption means that the projects are financed in such a way that the
firm’s ability to meet required financial cost is unchanged.
 3. After-tax cost: are considered relevant. In other words, the cost of capital is measured
on after-tax basis. Note that this assumption is consistent with the framework used to
make capital budgeting decisions.
Cost of capital is a concept of vital importance in the financial decision-making. It is useful as a
standard for:

a) Evaluating investment
b) Designing a firm’s debt policy, and
c) Appraising financial performance.
Measuring the Specific Costs Of Capital
The cost of capital for any particular source of security issue is called the specific/component/ individual
cost of capital.
The higher the risk of a particular component, the higher the return required by investors & the higher the
cost to the firm.
Note that,
 Creditors have priority claim up on liquidation and first get interest before any dividend in paid to
owners.
 Specific cost of capital is computed on an after-tax basis and is expensed as an annual percentage.
Cost of debt must be adjusted for taxes since interest charges are tax deductible but the costs of the other
sources are paid form after-tax cash flows (they need no adjustment for income taxes). There are four
basic sources of long-term funds for the business firm: Long-term debt, preferred stock, common
stock, and retained earnings.
1. The cost debt: - is the minimum rate of return required by suppliers of debt. The relevant specific
cost of debt is the after-tax cost of new debt. Computing the new bond issue (debt) requires the
following steps.
i. Determine the net proceeds from the sale of each bond.
FORMULA , Where NPd = net proceeds from the sale sale of
NPd= Pd -F a Bond (debt)
Pd = the market price of the bond (debt)
F = Floatation costs
Flotation costs are any cost associated with selling new securities , which reduce the Net proceeds
of each bond sold & Increase the bond’s cost to the firm such as:
  Sales commission paid to those selling the securities, such as breakage.
 Cost of printing
 Advertising
 Registration with government agencies
 Under pricing or discounts offered to attached investors to buy the security.

ii. Compute the effective before-tax cost of the bond using the formula

Kd = I+(Pn - NPd)
Where, Kd = effective before tax cost of a
n
Pn + NPd New bond issue
2
I = Annual interest payment per Br.
Pn = Par or principal repayment
Required in n periods.
NPd = Net proceeds from the sale of the
bond
n = length of the holding period of
the bond in years.
Pn + Npd = Average amount borrowed
2
Pn – Npd = floatation cost & any premium/ discount
amortization

iii. Compute the after-tax cost of debt

Kdt = Kd (1 –T)
Where, Kdt = the firm’s after tax cost of debt
Kd = effective before-tax cost of a new bond
Issue
T = the firm’s marginal tax rate.
 Example: ABC company plans to issue 25 year bonds with a face value of
Br.4,000,000. Each bond has a par value of Br. 1000 and carries a coupon rate (the
interest rate paid on the bond’s par value) or 9.5% the firm’s marginal tax rate is 34%.
Assume the following conditions.
a) The bond is sold at par with no flotation costs.
b) The bond is expected to be sold for 98% or par value and flotation costs are
estimated to be approximately Br.26 per bond.
c) The bond is expected to be sold for Br. 104% of par value and flotation costs
are anticipated to be approximately Br.26 per bond.
Required: Under each of the above three assumptions calculate,
1) Net proceeds per bond.
2) The before tax cost of their bond issue.
3) The after-tax cost of this bond issue.
Solution:
Given :
Pn = Par value = Br. 1,000
I = Coupon rate = 9.5%
T = The firm's marginal tax = 34%
n = 25 years
Condition (a)
1) Net proceeds per bond NPd = Pd - F
o bond sold at par = Br.1000 - 0
o No flotation costs = Br. 1000 = pn

2) Before tax cost of the bond.

Solution: Kd = I + (Pn – NPd)
n
Pn + NPd
2
Kd =Br.95 + (Br.1,000 -Br. 1000), I = Rate x 1000
25_______ = (9.5%) (Br.1000) = Br. 95
 Br.1,000 + Br. 1,000
2
= 9.5% ( if there are no flotation costs Kd =I)
3) After- tax cost of the bond
Solution
Kdt = Kd (1-T)
= 9.5% (1 – 0.34)
= 9.5% (0.66)
= 6.27%
Interpretation: ABC is expected to earn at least 6.27% return on the proceeds of the bond issue
to provide the cost elements of the burden at the time they are due. In other words ABC is
expected to earn a minimum return of 6.27% on its invest to be financed by the proceeds from
the bond issue so as to maintain the market value of its shares.
Condition (b)
1. Net Proceeds per bond
 Bond expected to sell at 95% of par value
 Estimated flotation costs per bond is Br. 26
Or
Par value of bond Br. 1000 Pd = (0.98) (Br.1000)
Less discount (2%of Br.1000) 20 = Br. 980
Market value, Pd (98% of 1000) Br.980 NPd = Pd -F
Less flotation costs per bond (F) 26 = 980 -26
Net proceeds (Npd = Pd –F) Br.954 Br. 954
2. Before- tax cost of the bond
Solution
Kd = I + (Pn - Npd) = Br. 95 + (Br.1000 - Br. 954)
n 25
Pn + Npd Br.1000 + Br.954
2 2
= Br.95 +Br.1.84
Br. 977
 Br.96.84 = 9.91%
Br. 977
3. After - tax cost of the bond
Solution Kdt = Kd (1 - T)
9.91% (1 -0.34)
9.91% (0.66)
6.54%
Condition ( c)
1. Net proceeds per bond.
 Bonds expected to sell at 104% of per value
 Estimated flotation costs per bond is Br.26
Par value of the bond Br. 1000
Add premium (4% of Br.1000) 40
Market value (104% of Br.1000)=Pd Br. 1040
Less: flotation cost per bond (F) 26
Net proceeds (Npd = Pd -F) Br. 1014
2. Before-tax cost of the bond
Kd = I + (Pn - Npd) = Br.95 + (1000 - Br. 1014)
n __ = 25 = Br.95+(-14/25)
Pn + Npd Br.1000+Br.1014 1007
2 2
= Br.95 -0.56 = Br. 94.44 = Br. 9.38%
Br.1007 1007
3. After - tax cost of the bond
Kdt = Kd (1 -T)
= 9.38% (1 - 034)
= 9.38% (0.66)
= 6.19%
Why tax adjustment
The interest paid on debt is tax deductible. The higher the interest charges, the lower will be the
amount of tax payable of the firm. This implies that the government indirectly pays a part of the
lender’s required rate of return. As a result of the interest tax shield, the after-tax cost of debt to
the firm will be substantially less than the investor’s required rate of return. The before-tax of
debt, Kd, should, therefore, be adjusted for the tax effect as follows:
After-tax cost of debt = Kd (1-t),Where t is the tax rate of the firm.
It should be noted that the tax benefit of interest deductibility would be available only
when the firm is profitable and is paying taxes. An unprofitable firm is not required to pay any
taxes. It would not gain any tax benefit associated with the payment of interest, and its true cost
of debt is the before tax cost.

It is important to remember that in the calculation of average cost of capital, the after tax cost of
debt must be used, not the before tax cost of debt.
2.The cost of preferred stock: - is the minimum rate return required by preferred stock investors to
purchase a firm's preferred stock.

 When a corporation sells preferred stock, it expects to pay dividends to investors in

return for their money capital
 The dividend payments are the costs to the firm of the preferred stock
 Dividend payments on preferred stock are made:
o After interest payments on debt
o Before dividend payments on common stock.
Thus, both the risk ness of preferred stock to investors and the resulting cost issuing preferred stock
fall somewhere between debt and common stock.

Formula: Kp = Dp , where Kp= cost of new preferred stock

Npp Dp = Annual Dividend per share on p/s

Npp = Net proceeds from the sale of preferred
stock
Pp= the market price of the p/s
F = floatation cost
Example: -
ABC Company plans to sell preferred stock for its par value of Br.25 per share. The issue is expected
to pay quarterly dividends of Br.0.60 per share and to have flotation cost of 6% of the par value.
Required: Calculate the cost of the preferred stock to ABC Company.
 If the preferred stock is sold at:
 Par?
 95% of its par?
 102% of its par?

Given
- Stock is expected to sell at per = Br.25
- Flotation cost (6% x Br.25) = Br. 1.5
- Quarterly dividend = Br. 0.6/per share
Solution
NPp = Pp –F
= Br.25 - Br. 1.5
= Br. 23.5
Annual dividend = Dp = (Br.0.6) (4) = Br. 2.4

Kp = Br. 2.40 x 100 = 10.21 %

Br. 23.5
Interpretation: ABC company should earn at least 10.21% on the preferred stock financed
portion of the investment project in order to leave unchanged the market price of the shares
Note:
Unlike interest payments on bonds, preferred stock dividends are not a tax-deductible expense. Thus, no
tax adjustment is needed to adjust the cost of preferred stock downward because the before tax cost of p/s
are the same.
ii. Sold at 95% of par:
Pp= (Br.25) (95%) = Br. 23.75
NPp = Pp – F = Br. 23.75 - Br. 1.5
Br. 22.25
Kp = Dp = Br.2.4 = 10.78%
NPp 22.25
iii. Sold at 102% of par
Pp = (Br.25) (102) = 25.50
NPp = Br. 25.50 – 1.50 = Br. 24
Kp = Dp = Br.2.4 = 10%
NPp 24
 3. The cost of Common Stock:- is the minimum rate of return that the corporation must earn for its
common shareholders in order to leave unchanged /maintain the market value of the firm's equity.
A corporation does not make a definite or explicit commitment to pay dividends to common
stockholders but when common stock holders invest their funds in a corporation they expect returns
in the form of dividends. Therefore, common stocks implicitly involve a return in terms of the
dividends expected by the investors and, hence, they carry a cost.
Formula:

Ks = D1 + g
Nps

Where, Ks = the cost of new common stock

Nps = net proceed of the common stock issue &

Nps = Po -F

Po = Current market price of the firm's outstanding common stock

F = Flotation cost (resulting from selling new common stock below Po) under pricing & under
writing
D1 = dividends to be received during year one.

D1= Do (1+g)

Where, Do = Current dividend/ share

g = Annual Compound constant dividend growth rate
Example1.
An issue of common stock is sold to investors for Br.25 per share. The issuing corporation incurs a selling
expense of Br. 2 per share. The current dividend is Br.2 per share and expected to grow at 6% annual rate.
Compute the annual rate. Compute the specific cost of common stock.
Given Solution
Po = Br. 25/share Nps = Po – F and D1 = Do (1+g)
F = Br. 2/share = Br.25 - Br.2 D1 = Br.2(1+0.06)
Do = Br. 2/share = Br. 23 D1 = Br.2 (1.06)
g = 6% D1 = Br. 2.12
 Ks = D1 + g
Nps
= 2.12 + 0.06 = 15.21%
23
Example2:Dividend per share on a firm's common stock is expected to be Br.1 next year and is expected
to grow at 6% per year continuously. Assuming the market price per share is Br. 25 and no floatation
costs,
1. Calculate the cost of common stock to the firm
2. Compute the expected market value per share assuming the current dividend / share is Br.2. (Do
= Br.1)
 At the end of year 1
 At the end of year 2
 At the end of year 3
 At the end of year 6
Solution i) Given Required
D1= Br. 1 K? Ks = D1 +g
G = 0.06 Nps
Nps = Po -F 1+0.06 = 10%
= Br.25 - 0 = Br.25
1.Solution
Ks = D1 + g , but if there are no floatation costs Nps = po
Nps
Ks = D1 + g , let D1 = Dn for different years.
Po
Ks = Dn + g
Po
Ks - g = Dn
Po
Po (Ks - g)= Dn

Po = Dn
 Ks - g
- Po at the end of the year 1 Po at the end of year 3
D1 = Do (1 + g) D3 = D2 (1 +g)
= Br. 1 (1+0.06) = Br.1.124(1+0.06)
= Br. 1.06 = Br.1.191
Po = D1 = Br. 1.06 = Br.26.5 Po= D3 = Br. 1.191 = Br.29.7
Ks - g Ks - g 0.1 - 0.06
Po at the end of year 2 Po at the end of year 6
D2 = D1 (1 +g) D6 = Do (1+g)6
= Br.1.06 (1+0.06) = Br.1 (1+0.06)6
= Br.1.124 =
Po = D2 = Br. 1.124 Br.28.10 Po = D6 = Br. 1.42 1.42
=Br.35.46
Ks -g 0.1 - 0.06 Ks -g 0.1 - 0.06 0.04
4) Cost of Retained Earnings: - are internal sources (not external)
 Retain earnings are not securities like stocks and bonds and, therefore, they do not have market
prices that can be used to compute costs of capital.
 Retain earnings represent profits available to common stock holders that the corporation chooses to
reinvest in itself rather than payout as dividends. Thus,
a) The shareholders are made to reinvest part of their earnings in corporation.
b) In turn, the shareholders expect the corporation to earn rate of return on those funds at least
equal to the rate of earned on the outstanding common stock.
Therefore, the specific cost of capital of Retain earnings is equated with the specific cost of the common
stock.
 Retain earnings are not free form of financing
 There is an opportunity cost in retaining profits in the business
 These opportunity costs represent the minimum rate of return that the firm's stockholders could earn
on alternative investments of comparable risk.
There are several ways to measure the cost of retain earnings –one of them is:
 The Gordon constant growth model

Kr= D1 +g , Where Kr = cost of retain earnings

Po
D1 = dividends to be received during year
g = Annual constant growth rate
 Po = Current market price of the firms common stock
D1 = Do (1 +g)
Note; Po is considered b/c
 Retain earnings do not have market prices
 Retain earnings do not involve flotation costs
Example: An issue of common stock is sold to investors for Br. 40 per share. The issuing company
incurs costs of Br. 2 per share. The current dividend is Br. 2 per share. The current dividend
is Br. 2 share and expected to grow at 6% annual rate.
Compute the specific costs of capital of retained earnings? Ks?
Given :
Po = Br. 40 per share
F = Br. 2 (is ignored now)
Do= Br.2/per share of current dividend
G = 0.06
Solution:
D1 = Do (1+g) Ks?
= Br.2(1+0.06) Ks = D1 +g
= Br.2.12 Nps
NPd = Po -F
Kr = Br. 2.12 + 0.06 = 40 - 2
40 = 38
= 11.3% Ks = 2.12 + 0.06
38
Ks = 11.6%

Measuring the weighted average cost of capital (WACC )

- It is the rate of return that must be earned by a corporation in order to satisfy the requirements of the
individual specific cost of capital.
- It is the weighted cost of all long-term capital sources where by each specific cost of capital is
weighted by its relative importance in the firm's total capital.

Formula:
 n
Ka =  WiKi
i=1

Where Ka = weighted average cost of capital

Wi = percentage of total permanent capital represented by capital source i.
Ki = after tax cost of each new specific cost of capital
n = number of types of new capital.
There are two weighted approaches (plans) in computing the WACC: they are Historical & target
1) Historical weights: - are based on a firm's existing capital structure:
They are of two types: Book value & Market Value weights
a) Book Value Weights: - measure the actual proportion of each type of permanent capital in the
firm’s capital structure based on accounting values shown on the firm's balance sheet.
Example: ABC's existing capital structure and specific cost of new capital are shown below:
Source of capital Book value specific cost
Bonds (Br. 1000 par, 9.5% coupon) Br.15,000,000 6.6%
P/s (200,000 share at Br.25 par) 5,000,000 10.21%
Common stock (1,000,000 shares at Br.20 par) 20,000,000 13.33%
Retain earnings 10,000,000 13%
Br.50,000,000

Required: Compute the WACC for the company if it obtains new capital in book value proportions.
Solution
( a) (b) (a*b)
Source of capital B.V weights (proportion) Specific cost Weighted cost
Bonds 0.3 0.0660 0.0198
Preferred stock 0.1 0.1021 0.0102
Common stock 0.4 0.1333 0.0533
Retain earnings 0.2 0.1300 0.0260
1 WACC 0.1093
Ka = 10.93%
 b) Market value weights: - measure the actual proportion of each type of permanent capital in the
firm's capital structure at current market prices.
 The resulting cost of capital reflects the rates of return currently required by investors rather than
the historical rates embodied in the firm's balance sheet.
Example
Take the above example and the following market prices of the securities.
Bonds = 98% of par (i.e 98% x 1000)
Preferred stock = Br. 25 per share (i.e. 100% of par)
Common stock = Br. 45 per share (i.e. 125% of par)

Source of capital #of securities Market price Market value

Bonds 15,000 Br.980 Br.14,700,000
Preferred stock 200,000 25 5,000,000
Common stock 1,000,000 45 45,000,000
Total capital structure Br. 64,700,000

Note: - Retain earnings do not have a separate market value because their value is impounded into the
common stock
- Thus, to compute WACC, the common stock market value of Br. 45,000,000 is divided between
common stock & Retain earnings in proportion to the sum of their book values.
B/V Ratio
Common stock …………………………………20,000,000
Retain earnings ………………………… 10,000,000 2:1

Hence: 2/3 x Br.45,000,000 = Br. 30,000,000 for common stock

1/3 x 45,000,000 = 15,000,000 for Retain earnings
Source of capital Market values Market value weights Specific costs WAAC
Bonds Br.14,700,000 0.227 0.0660 0.0150
Retain earnings 5,000,000 0.077 0.1021 0.0079
Common stock 30,000,000 0.464 0.1333 0.0619
Retain earnings 15,000,000 0.232 0.1300 0.0302
Total Br.64,700,000 1 0.115
Ka= 11.5%
2. Target weight – based on the firm’s desired capital structure
- Firms, using this approach, establish these proportions on the basis of optional capital
structure they wish to achieve. Consequently, the firm raises additional funds so
as to remain constantly on target with its optional capital structure.
Example: In addition to the data provided above in the previous example, the company determined that
its optional capital structure is 40% bonds, 10% p/s, and 50% common equity (i.e. both common stock &
R/s)
 The firm wants to maintain this optimal capital structure in raising future long-term capital. It
expects to have sufficient retained earnings so that it can use the cost of retain earnings as
common equity cost component.
 If the company raises new capital in target proportions, what would be its WACC?
WACC = 0.4 (0.0660) + 0.10(0.1021) + 0.50(0.1300)
= 0.0264 + 0.0102 + 0.0650
= 0.1016
Ka = 10.16%
Significance of Risk in Capital Budgeting
Risk of capital budgeting
One of the most important consideration/factor influencing the capital budgeting /investment
decisions of a firm is the ‘risk’. In every day usage risk means the probability of loss or the
probability that a return will be lower than some target level. The ‘risk’ with reference to capital
budgeting is defined as the variability in actual returns emanating from an investment proposal in
future in relation to the estimated return as forecasted the time of initial decision. In short, the
risk ness of an investment proposal is defined as the variability of its possible returns. The firm
and its investment projects in particular are exposed to different degrees of risk. The investment
proposal themselves differ in risk. Risk exists because of inability of the decision-maker to make
perfect forecasts. Forecast cannot be made with perfection or certainty since the future events on
which they depend are uncertain. Thus, risk arises in investment evaluation because the
occurrence of the possible future events cannot be anticipated with certainty and consequently,
cannot make any correct prediction about the cash flow sequence.
The risk ness of an investment project is related to the variability of its returns, but the link
between risk and variability is subtle. If two projects have the same expected value, then the
project whose returns are more variable is riskier.
Cost of Capital in Capital Budgeting
The cost of capital is the most important concept in the finical decision-making. On one hand it
is used as a decision criterion in capital budgeting decision and on the other hand it is also
significant in designing the firm’s capital structure.
In the process of capital budgeting decision-making the cost of capital used as the discount rate
or the minimum rate or return to evaluate the desirability of the investment projects, while
adopting Net Present Value Method. In NPV method, a project will be accepted if it has a
positive net present value when the cash flows are discounted at the cost of capital. Here, the
cost of capital is the discount rate used in evaluating the desirability of investment projects. On
the other hand, in the internal rate of return method, the project will be accepted if it has a rate of
return greater than the cost of capital. In this sense, the cost capital is the minimum rate of return
required on investment project. It is the cut-off, or the target, or the hurdle rate. Whether under
NPV or IRR method It is supposed that the market value per share will be maximized. Thus, the
cost of capital is the minimum rate of return, which will maintain the market value per share at
its current level. If the firm earns more than the cost of capital, the market value per share is
expected to increase. Thus, the cost of capital represents a standard for allocating the firm’s
investible funds in the most optimum manner.
Capital Rationing
If the funds are sufficient, the firm can finance all profitable projects. On the other hand, if the
funds are insufficient, the firm will have to reject some of the profitable investment proposals.
This situation is described as ‘Capital Rationing.” It is a situation where the firm is constrained
for external or self-imposed, reasons to obtain necessary funds to invest in profitable investment
projects. Capital rationing occuRs anytime there is a budget ceiling, or constraint on the amount
of funds that can be invested during a specific period of time, say a year. Such constraints are
prevalent tin those firms that have a policy of financing all capital expenditures internally. It
also prevails where a division of a large company is allowed to make capital expenditure only up
to a specified budget ceiling, over which it does not have control. With a capital rationing
constraint, the firm attempts to select the combination of investment proposals that will provide
the greatest profitability.

Selection Process under Capital Rationing: The procedure of capital rationing involves two
steps: They are:
1) Ranking projects according to some measure of profitability: and
2) Selecting projects in the descending order of profitability until the funds are exhausted.
Although projects can be ranked by any one of the Discounted Cash-flow criteria, sometimes, the
internal rate of return method is preferred on the belief that it is easily understood. On the other
hand, it is advocated that Profitability Index is preferred to Net Present Value, and argued that
Net Present Value is the absolute measure