Financial Management I

(ACFN 3041)

Chapter V
Cost of Capital

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Cost of Capital /Financing/
◼ Cost of capital: is defined as the rate of return that is
necessary to maintain the market value of the firm (or price of
the firm’s stock).
◼ The cost associated with borrowing money depends on the
particular form of capital borrowed.
◼ These can be:
❑ Cost of Debt

❑ Cost of Equity

◼ Cost of Debt: is the cost of debt financing, or the interest paid

on the money borrowed.
◼ Cost of Equity: is the dividends paid to shareholders plus any
estimate of the equity’s capital growth. Equity could include:
❑ Preferred shares , Common shares and Retained earnings
Cost of Capital
◼ The cost of capital is computed for individual financial assets or
as a weighted average of the various capital components, such
as debt, preferred stock, common stock, and retained earnings.

◼ Managers must know the cost of capital, often called the

minimum required rate of return in:
❑ making capital budgeting decisions;

❑ helping to establish the optimal capital structure; and

❑ making decisions such as leasing, bond refunding, and

working capital management.

Please read more on this!!!

 Individual (specific) Cost of Capital

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Computing individual /specific/cost of capital
◼ COST OF DEBT
◼ Is the minimum rate of return required by suppliers of debt.
◼ Generally, it is the cheapest source of finance.
◼ Debt source may take several forms (such as bonds, promissory
notes, bank loans, etc)
◼ Steps to calculate the cost of new bond issue:
❑ Determine net proceeds from the sale of each bond (V)
❑ V= market price of the bond (Mp)– floatation costs (f)
❑ Compute the before tax cost of bond using the following formula:
 M −V 
◼ Ki= I + 
 n  Where: Ki = Before tax cost debt
 M +V  I= annual interest payment

 2 
 M = Par value of the bond
V = Net proceeds from sale of
❑ Compute the after tax cost of bond using the bond
❑ K K (1 – tax rate)
d= i
N=time to maturity in years

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Cost of Debt
◼ Example:
◼ ABC Industrial Group [our case company here after] 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, ABC bonds can be sold for
Br. 1,010 each. If flotation costs of 3.0% of the par value
per bond will be incurred in the process of issuing the
bonds, compute the after tax cost of the bond at 40% tax
rate.

◼ 7.35%

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Cost of Preferred stock
◼ Formula: Where:
Kp = cost of preferred stock
dp dp = annual preferred stock dividend per share
❑ Kp = Pn= the net proceeds that could be obtained from a
Pn sale of a new preferred share

◼ E.g. ABC Industrial group has just issued preferred stock which pays
a quarterly dividends of Br. 26 per share at a flotation cost of 6% of
the par value. If the preferred stock sells at 95% of its par where the
par value is Br. 1000, compute the cost of preferred stock.

◼ Answer: 11.69%

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Cost of common stock
◼ Is the minimum rate of return that a firm must earn for its
common stockholders in order to maintain the value of
the firm.
◼ The firm doesn’t make explicit commitment to pay
dividends to common stock but the investors expect
dividends, hence, such stocks carry cost.
◼ If bond holders and preferred stockholders exist, the
common stockholders will assume the maximum risk in
corporate investments.
◼ The cost of common stock can be computed using:
❑ The Constant Growth Valuation Model (CGVM)
❑ The Capital Asset Pricing Model (CAPM)

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Cost of Common Stock
◼ The Constant Growth Valuation Model (CGVM)
◼ Formula:
D1
❑ Ks = P + g
n

where : D1 = exp ected dividend per share next year

Pn = Net proceeds from sale of common stock
◼ E.g. g = exp ected annual dividendsgrowth rate
◼ ABC Industrial Group has issued common stock to investors at
selling price of Br. 1500 per share where the par value was Br.
100. Where selling expense was 5% of the par value per share.
The current dividend is Br. 150 per share and it is expected to
grow at 4% annual rate. What is the cost of issuing this
common stock?
◼ Answer = 14.43
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Cost of Common stock
◼ Capital Asset Pricing Model (CAPM)
◼ Formula:
R f + ( K m − R f ) i
◼ Ks = where : R f = the risk free rate of return
K m = the market rate of return on common stock
i = rate of return on the firm' s common stock relativeto the market return
◼ E.g.
◼ Assume an electronic company uses CAPM to estimate
its cost of common equity. The current interest yield on
TB is 9.2% and the market rate of return is 14%. If beta
is 1.3, compute the cost of common stock.
◼ Answer = 15.44%

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Cost of Retained Earnings [REs]
◼ REs 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 REs is the rate of return a corporation’s common
stockholders expect the corporation to earn on their
reinvested earnings, at least equal to the rate earned on the
outstanding common stock.
◼ Therefore, the specific cost of capital of REs is equated with
the specific cost of common stock. However, flotation costs
are not involved in the case of REs.
◼ E.g. Compute the cost of retained earnings to ABC industrial
group.
◼ Answer= 14.44%

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 Weighted Average Cost of Capital

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Weighted Average Cost of Capital (WACC)
◼ The specific cost of capital is used in evaluating an
investment proposal to be financed by a particular capital
source.
◼ Practically, however, investment 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, preferred
stock, common stock, 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.

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WACC
◼ Formula:

◼ WACC = Wd * Kd + WPs * K p + Ws * Ks + WRE * K RE

Where:
Wd = the weight of debt
Wps= weight of Preferred stock
Ws = weight of common stock
WRE= weight of Retained earnings

◼ Weights of the individual source of finance can be

computed based on Book value and market value.

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WACC
◼ Assume the following data for ABC Industrial Group. As per the
current balance sheet of the firm, the book values of the sources of
financing is given below.
❑ Bond (20 bonds) ETB 20,000
❑ Preferred Stock (5 shares @ Br. 1000) 5,000
❑ Common Stock (600 shares @ Br. 100 Par) 60,000
❑ Retained Earnings 90,000
◼ From our previous examples, it is to be recalled that the specific costs
of capital of ABC Industrial group were computed as follows:
❑ Cost of Bond 7.35%
❑ Cost of Preferred Stock 11.69%
❑ Cost of Common Stock 14.43%
❑ Cost of Retained Earnings 14.44%
◼ Compute the WACC
◼ Ans.= 13.6381%

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WACC
◼ If the market values of the sources of financing is given below.
❑ Bond ETB 20,200
❑ Preferred Stock 4,750
❑ Common Stock
900,000*
❑ Retained Earnings

◼ Compute WACC based on market value

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WACC
◼

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WACC
◼ Givens: Based on market value, ABC Co’s
data is presented below
❑ Debt financing = Br. 1,000,000
❑ Equity financing = Br. 4,000,000
❑ Tax Rate = 30%
❑ Cost of debt = 9.5%
❑ Cost of equity = 12.6%
◼ Compute WACC

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 End of Chapter Five

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