CHAPTER FIVE: THE COST OF CAPITAL

Learning Objective:
After completing this unit, students should be able to understand:
 The meaning of cost of capita
 The implications of the cost of capital on the value of a firm,
 Four major sources of capital to a firm and their cost,
 That the weighted average cost of capital is used in investment decisions,
 That the marginal cost of capital increases with raising of more and more capital during
a given period,
 The point where the costs of debt, preferred share, ordinary share, or retained earnings
increases.

3.1 INTRODUCTION
As you well understand, two parties are involved in a financial asset under normal
circumstances. One is the party issuing the financial asset. Another is the one that buys or invests
on the financial asset. When we discusses about valuation, we emphasized on the investor. That
is, how much is the maximum price the investor would pay for the financial asset? To decide on
this, the investor would discount the expected future cash flows. The discounting is done based
on the investor’s required rate of return.
The rate of return required by the investor should definitely be provided by some other party.
The party which should provide the investor its required rate of return is the issuing party. For
example, if the required rate of return by an investor on a given bond is 10%, the issuing
company should provide this 10% to the investor. This required rate of return that should be met
by the issuing company becomes its cost. This is a cost on the capital the issuing company wants
to raise.
Therefore, the required rate of return on investments in financial assets by the investor is the cost
of capital for the company issued the financial assets. But, generally, the cost of capital for the
issuing company is higher than the required rate of return by the investor. This is because when
the issuing company issues a financial asset, it must incur some costs. These costs incurred by
the issuer in relation to issuance of financial assets are called flotation costs. Examples include
advertising costs, commissions paid to those selling the financial assets, cost of printing
documents, costs of registration with government agencies, discounts to encourage the sale of
securities, and so on.

3.2 MEANING OF THE COST OF CAPITAL

The cost of capital is the minimum rate of return that a firm must earn in order to satisfy the
overall rate of return required by its investors. It is also the minimum rate of return a firm must
earn on its invested capital to maintain the value of the firm unchanged. The second definition
considers the cost of capital as a break even rate.
If a firm’s actual rate of return exceeds its cost of capital, the value of the firm would increase. If
on the other hand, the cost of capital is not earned, the firm’s market value will decrease. So, the
cost of capital is the rate of return that is just sufficient to leave the price of the firm’s ordinary
share unchanged.

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The cost of capital serves as a discount rate when a firm evaluates an investment proposal.
Suppose a firm is considering investment on a plant. The finance required for this investment is
to be raised by selling an ordinary share (a common stock) issue. Now, after raising capital, the
firm is expected to provide required rate of return to those who invest on the ordinary share. This
in effect is the firm’s cost of capital. So to decide to invest on the plant, the minimum rate of
return from the investment at least should be equal to the required rate of return by the ordinary
shareholders. If the required rate of return by the firm’s ordinary shareholders is 13%, then the
firm should earn a minimum of 13% on its investment on the plant. The 13% minimum rate of
return that should be earned by the firm is, therefore, its cost of capital.

3.3 MEASURING THE SPECIFIC COST OF CAPITAL

The cost of capital for any particular capital source or security issue is called the specific cost of
capital. It is also called individual cost of capital or component cost of capital. Each type of
capital contained the capital structure of a firm include:
1. Debt
2. Preference share(Preferred stock)
3. Ordinary share(Common stock)
4. Retained earnings
Two important points you should bear in mind about the specific cost of capital. One is that it is
computed on an after-tax basis.basis. Meaning, if there would be any tax implication on the
individual source of capital, it should be considered. In almost all circumstances, the tax
implication is only on debt sources of finance. The second point is that the specific cost of capital
is expressed as an annual percentage or rate like 6%, 9%, or 10%. The cost of capital is not stated
in terms of birrs.

3.3.1 The cost of debt

This 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. Generally, debt is the cheapest source of finance to a firm
and, hence, the cost of debt is the lowest specific cost of capital. There are two basic
explanations for this. First, debt suppliers, generally, assume the lowest risk among all suppliers
of capital. They receive interest payments before preference and ordinary dividends are paid.
Since they assume the smallest risk, their return is the lowest. Their lowest return would be the
lowest cost of capital to the firm. Second, raising capital through debt sources entails interest
expense. The interest expense in turn reduces the firm’s income which ultimately would cause
tax payment to be reduced. So raising money in the form of debt results in the smallest tax
burden, and finally, the firm’s cost of debt would be the lowest.
Debt sources of finance may take several forms like bonds, promissory notes, bank loans. Here,
for our convenience we consider bond issue to illustrate the cost of debt.
Computing the cost of new bond issue involves three steps:
i) Determine the net proceeds from the sale of each bond
NPd = Pd – f
Where:
NPd = the net proceeds from the sale of each bond
Pd = the market price of the bond
f = Flotation costs
ii) Compute the effective before tax cost of the bond using the following approximation formula:

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 Pn − NPd
I+
n
Pn+NPd
Kd = 2
Where:
Kd = The effective before tax cost of debt
I = Annual interest payment
Pn = the par value of the bond
n = Length of the holding period of the bond in years.
iii) Compute the after-tax cost of debt
Kdt = Kd (1 – t)
Where:
Kdt = the after-tax cost of debt
t = the marginal tax rate

Example: Currently, Abyssinia Industrial Group is planning to sell 15-year, Br. 1,000 par-value
bonds that carry a 12% annual coupon interest rate. As a result of lower current interest rates,
Abyssinia bonds can be sold for Br. 1,010 each. Flotation costs of Br. 30 per bond will be
incurred in the process of issuing the bonds. The firm’s marginal tax rate is 40%.
Required: Calculate the after tax cost of Abyssinia’s new bond issue:
Solution:
Given: Pn = Br. 1,000; I = Br. 120 (Br. 1,000 x 12%); n = 15; Pd = Br. 1,010; f = Br. 30;
t = 40%; Kdt = ?
Then apply the three steps:
i) NPd = Br. 1,010 – Br. 30 = Br. 980
Br .1 , 000−Br . 980
Br .120 +
15
= 12. 26 %
Br .1 , 000+Br . 980
ii) Kd = 2
iii) Kdt = 12.26% (1 – 40%) = 7.36%
Therefore, the after – tax cost of Abyssinia’s new bond issue is 7.36%. That is, Abyssinia should
be able to earn a minimum of 7.36% to satisfy bondholders. Otherwise, the firm’s value will
decline.

8.3.2 The cost of preference share

The cost of preference share is the minimum rate of return a firm must earn in order to satisfy
the required rate of return of the firm’s preference share investors. It is also the minimum rate of
return a firm’s preference share investors require if they are to purchase the firm’s preference
share.
When a firm raises capital by issuing new preference share, it is expected to pay fixed amount of
dividends to the preference shareholders. So, it is the dividend payment that is the cost of the
preference share to the firm stated as an annual rate. The cost of a new preferred stock issue can
be computed by following two steps:
i) Determine the net proceeds from the sale of each preference share.
NPpf = Ppf – f
Where:
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 NPpf = Net proceeds from the sale of each preference share
Ppf = Market price of the preference share
f = Flotation costs
ii) Compute the cost of preference share issue
Kps = Dps__
NPpf
Where:
Kps = the cost of preference share
DPs = the per share annual dividend on the preference share
Example: Sefa Computer Systems Company has just issued preference share. The share has
12% annual dividend and Br. 100 par value and was sold at 102% of the par value. I nddition,
flotation costs of Br. 2.50 per share must be paid. Calculate the cost of the preference share
Solution:
Given: Pps = Br. 102 (Br. 100 x 102%); Dps = Br. 12 (Br 100 x 12%); f = Br. 2.50;
Kps =?
Then apply the two steps:
i) NPpf = Br. 102 – Br. 2.50 = Br. 99.50
ii) Kps = Br. 12 =12.06%
=12.06%
Br. 99.50
Therefore, Sefa Company should be able to earn a minimum of 12.06% on any investment
financed by the new preference share issue. Otherwise, the firm’s value will decrease.

3.3.3 The cost of ordinary share

The cost of ordinary share is the minimum rate of return that a firm must earn for its ordinary
shareholders in order to maintain the value of the firm. A firm does not make explicit
commitment to pay dividends to ordinary shareholders. However, when ordinary
shareholders invest their money in a corporation, they expect returns in the form of dividends.
Therefore, ordinary share implicitly involve a return in terms of the dividends expected by
investors and hence, they carry cost.

Generally, ordinary share dividends are paid after interest and preference dividends are paid.
As a result, ordinary share investors assume the maximum risk in corporate investment. They
compensate the maximum risk by requiring the highest return. This highest return expected by
ordinary shareholders make ordinary share the most expensive source of capital. The cost of
ordinary share can be computed using the constant growth valuation model.
Ks = D1 + g
NPo.
Where:
Ks = the cost of new ordinary share issue
D1 = the expected dividend payment at the end of next year
NPo = Net proceeds from the sale of each ordinary share
g = the expected annual dividends growth rate

The net proceeds from the sale of each ordinary share (NPo) is computed as follows:
NPo = Po – f

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 Where:
Po = the current market price of the ordinary share
f = flotation costs

Example: An issue of ordinary share is sold to investors for Br. 20 per share. The issuing
corporation incurs a selling expense of Br. 1 per share. The current dividend is Br. 1.50 per share
and it is expected to grow at 6% annual rate. Compute the specific cost of this ordinary share
issue.
Solution
Given: Po = Br. 20; Do = Br. 1.50; g = 6%; f = Br. 1; Ks = ?
Then apply the two steps:
i) NPo = Br. 20 – Br. 1 = Br. 19
ii) Ks = D1 + g = Br. 1.50 (1.06) + 6% = 14.37%
Npo Br. 19
Therefore, the firm should be able to earn a minimum return of 14.37% on investments that are
financed by the new ordinary share issue.

3.3.4 The cost of Retained Earnings

Retained earnings represent profits available for ordinary shareholders that the corporation
chooses to reinvest in itself rather than payout as dividends. Retained earnings are not securities
like stocks and bonds and hence do not have market price that can be used to compute costs of
capital.
The cost of retained earnings is the rate of return a corporation’s ordinary shareholders expect
the corporation to earn on their reinvested earnings, at least equal to the rate earned on the
outstanding ordinary share. Therefore, the specific cost of capital of retained earnings is equated
with the specific cost of ordinary share. However, flotation costs are not involved in the case of
retained earnings.
Computing the cost of retained earnings involves just a single procedure of applying the
following formula:

Kr = D1 + g
Po
Where:
Kr = the cost of retained earnings
D1 = the expected dividends payment at the end of next year
Po = the current market price of the firm’s ordinary share
g = the expected annual dividend growth rate.
Example: Zeila Auto Spare Parts Manufacturing Company expects to pay an ordinary share
dividend of Br. 2.50 per share during the next 12 months. The firm’s current ordinary share price
is Br. 50 per share and the expected dividend growth rate is 7%. A flotation cost of Br. 3 is
involved to sale a share of ordinary share.
Required: Compute the cost of retained earnings
Solution
Given: Po = Br. 50; D1 = Br. 2.50; g = 7%; Kr = ?
Then apply the formula:

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 Kr = D1+ g = Br. 2.50 + 7% = 12%
Po Br. 50

3.4 WEIGHTED AVERAGE COST OF CAPITAL (WACC)

In the previous section we have seen how to compute the cost of capital for each individual
source of capital. The specific cost of capital is used in evaluating an investment proposal to be
financed by a particular capital source. Practically, however, investments are financed by two or
more sources of capital. In such a situation, we cannot make use of the individual cost of capital.
Rather we should use the average cost of capital employed by the firm.
The firm’s capital structure is composed of debt, preference share, ordinary share, and retained
earnings. Each capital source accounts to some portion of the total finance. But the percentage
contribution of one source is usually different from another. So we must compute the weighted
average cost of capital rather than the simple average.
The weighted average cost of capital (WACC) is the weighted average of the individual costs of
debt, preference share and ordinary equity (ordinary share and retained earnings). It is also called
the composite cost of capital.
If the weights of the component capital sources are all given, the weighted average cost of capital
can be computed as:
WACC = WdKdt + WpsKps + WceKs
Where:
WACC = the weighted average cost of capital
Wd = the weight of debt
Wps = the weight of preference share
Wce = the weight of ordinary equity
Kdt = the after – tax cost of debt
Kps = the cost of preference share
Ks = the cost of ordinary equity
The WACC is found by weighting the cost of each specific type of capital by its proportion in
the firm’s capital structure. Weights of the individual capital sources can be calculated based on
their book value or market value.
To illustrate the computation of the WACC, look at the following example.
Muna Tools Manufacturing Company’s financial manager wants to compute the firm’s weighted
average cost of capital. The book and market values of the amounts as well as specific after-tax
costs are shown in the following table for each source of capital.
Source of capital Book value Market value Specific cost
Debt Br. 1,050,000 Br. 1,000,000 5.3%
Preference share 84,000 125,000 12.0
Ordinary equity 966,000 1,375,000 16.0
Total Br. 2,100,000 Br. 2,500,000
Required: Calculate the firm’s weighted average cost of capital using:
1) book value weights
2) market value weights
Solution:
1) Total book value = Br. 2,100,000
Wd = Br. 1,050,000 = 0.5; Wps = Br. 84,000__ = 0.04; Wce = Br. 966,000 = 0.46
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 Br. 2,100,000 Br. 2,100,000 Br. 2,100,000
WACC = WdKdt + WpsKps + WceKs
= 0.5 (5.3%) + 0.04 (12.0%) + 0.46 (16.0%)
= 2.65% + 0.48% + 7.36%
= 10.49%
The minimum rate of return on all projects should be 10.49%. Meaning, Muna should accept all
projects so long as they earn a return greater than or equal to 10.49%
2) Total Market value = Br. 2,500,000
Wd = Br. 1,000,000 = 0.4; Wps = Br. 125,000 = 0.05; Wce = Br. 1,375,000 = 0.55
Br. 2,500,000 Br. 2,500,000 Br. 2,500,000
WACC = 0.4 (5.3%) + 0.05 (12.0%) + 0.55 (16.0%)
= 2.12% + 0.60% + 8.80%
= 11.52%
If the market value weights are used, Muna should accept all projects with a minimum rate of
return of 11.52%

3.5 MARGINAL COST OF CAPITAL (MCC)

As a firm tries to have more new capital, the cost of each birr will rise at some point. Thus, the
marginal cost of capital (MCC) is the cost of obtaining additional new capital. Technically
speaking, the MCC is the weighted average cost of the last birr of new capital obtained. So, the
concept of marginal cost of capital is discussed in the context of the weighted average cost of
capital.
As a firm raises larger and larger amounts of capital, the weighted average cost of capital also
rises. But the question would be at what point the firm’s costs of debt, preference share, and
ordinary equity as well as WACC increase?
The first point, therefore, in computing the MCC is to determine the breaking points where the
cost of capital will increase. The technical aspects of the MCC can be better understood using an
example.
Example: The target capital structure of Shala Corporation and other pertinent data are given
below.
Long-term debt ------------------ 40%; cost of preference share (Kps) = 12.06%
Preference share -------------------10% cost of retained earnings (Kr) = 14%
Ordinary equity ----------------- 50% cost of ordinary share (Ks) = 15%
Shala Corporation has Br. 900,000 available retained earnings. But when the firm fully utilizes
its retained earnings, it must use the more expensive new ordinary share financing to meet its
equity needs. In addition, the firm expects that it can borrow up to Br. 1,200,000 of debt at 7.3%
after-tax costs. Additional debt will have an after-tax cost of 9.1%.
Required
1) What is the breaking point associated with the
a. Exhausting of retained earnings?
b. Increment of debt between Br. 0 to Br. 1,200,000?
2) Determine the ranges of total new financing where the WACC will rise
3) Calculate the WACC for each range of finance.
Solutions
1) a. Breaking point (BP) ordinary equity = Br. 900,000 = Br. 1,800,000

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 50%
b. Breaking point (BP) long-term debt = Br. 1,200,000 = Br. 3,000,000
40%
The breaking points computed above can be interpreted as:
Shala can meet its equity needs using retained earnings until its total finance need is Br.
1,800,000. But when total capital required is more than Br. 1,800,000, its equity needs should be
met with ordinary equity. Similarly, until the firm’s total finance need reaches Br. 3,000,000,
shala can raise any debt at 7.3% cost. Any further finance need beyond Br. 3,000,000 will cause
the cost of debt to rise to 9.1%.
2) There are three ranges of finance that could be identified on the basis of the breaking points:
1st Range : Br. 0 to Br. 1,800,000,
2nd Range : Br. 1,800,000 to Br. 3,000,000, and
3rd Range : Br. 3,000,000 and above
3) WACC (1st range) = 0.40 (7.3%) + 0.10 (12.06%) + 0.50 (14%)
= 2.92% + 1.21% + 7.00%
= 11.13%
WACC (2nd range) = 0.40 (7.3%) + 0.10 (12.06%) + 0.50 (15%)
= 2.92% + 1.21% + 7.50%
= 11.63%
WACC (3rd range) = 0.40 (9.1%) + 0.10 (12.06%) + 0.50 (15%)
= 3.64% + 1.21% + 7.50%
= 12.35%

Exercises
1. Ayenew Company’s financing plans for next year include the sale of long-term bonds with a
10% coupon. The company believes it can sell the bonds at a price that will provide a yield to
maturity of 12% to investors. If its marginal tax rate is 35%, what is Ayenew’s after-tax cost
of debt?
2. Sattelite Share Company plans to sale preference share with par value of Br. 50 per share.
The issue is expected to pay quarterly dividends of Br. 1.25 per share and to have flotation
costs of 6% of the par value. The preferred share sells at 95% of its par.
Required: Calculate the cost of preference share to Satellite Share Company.
3. Repentance Corporation’s ordinary share is currently selling at Br. 75. The firm’s projected
dividend per share during the next year is Br. 3.38 and the expected dividend growth rate is
8%. Because of competitive nature of the market a Br. 3 per share underpricing is necessary.
In addition, the sale of new ordinary share involves underwriting fee of Br. 0.60 per share
and other flotation costs of Br. 0.90 per share.
Required: Calculate the cost of ordinary share for Repentance Corporation.
4. Zequala Textiles Share Company wishes to measure its cost of retained earnings. The firm’s
stock is currently selling for Br. 57.50. The firm expects to pay Br. 3.40 dividend at the end
of the year. The expected dividend growth rate is 8%.
Required: Determine the cost of retained earnings.
5. On January 1, 2002, the total assets of Ziway Share Company were Br. 54 million. There was
no short-term debt. The firm’s optimal capital structure is given below.
Long-term debt Br. 27,000,000
Ordinary equity 27,000,000
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 Total liabilities and equity Br. 54,000,000
New bonds will have a 10% coupon rate and will be sold at Par. Ordinary share currently has a
market price of Br. 60 and can be sold with a flotation cost of Br. 6 per share. Dividend yield is
estimated to be 4% and the expected dividend growth rate is 8%
Required: Calculate:
1) the cost of debt assuming s 40% marginal corporate tax rate
2) the cost of ordinary equity (50% common stock and 50% retained earnings)
3) the weighted average cost of capital

6. In the example above why have we used 14% for cost of common equity in the 1 st range and
15% in the 2nd and 3rd ranges respectively?

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