Financing

Decisions &
Understanding
Cost of Capital
Shiv Kothari
EDI
Introduction to Cost of Capital
• The cost of capital is the cost of company’s funds (both equity and
debt)or, from an investor’s point of view, “the expected return of
portfolio of all the company’s existing securities”
• It is used to evaluate new projects of a company as it is the minimum
return that investors expect for providing capital to the company, thus
setting benchmark that a new project has to meet
• In simple terms, it means “the rate of return that capital could be
expected to earn in an alternative investment of equivalent risk
 Optimal Investment Decision
Marginal cost of capital Investment opportunity schedule

Cost
or
Return

Optimal
Capital
Budget

Amount of New Capital

3
 Business

Capital Structure Funds

Raised

Various
Sources

Shareholders
Borrowings
Funds

Equity Share Pref Share Reserve &

Debentures Bonds Bank Loans
Capital Capital Surplus
 Introduction to Cost of Capital

Funds
Minimum Returns in
Cost Owners Cost of Equity
invested elsewhere
Outsider

Borrowing Cost Interest Cost Tax effect

Cost of Capital, Capital Structure & Capital
Budgeting
Replacement
Capital Expansion
Budget
Modernisation
Decision

Diversification

Funds
Risk
Debt Equity mix
Capital Structure Decision Value
Payout Policy
of
Existing Capital Structure Return firm
 Cost of Capital

PV of Cash Acceptance of
Discount Rate Decide
Flow Project

Minimum
Cost of Capital Earn Maintain Market Value
Rate of Return

Opportunity Return that Same Risk

Cost can be earned Level
Types of Cost of Capital
1. Cost of Debt (Kd)
2. Cost of Equity (Ke)
3. Cost of Preference Share (Kp)
4. Cost of Retained Earning (Kr)
 The cost of Debt
Alternative approaches
1. Yield-to-maturity approach: Calculate the yield to maturity on the company’s
current debt.
2. Debt-rating approach: Use yields on comparably rated bonds with maturities
similar to what the company has outstanding.

Copyright © 2013 CFA Institute 9

 Example: Cost of debt
Debt-Rating Approach
Yield-to-Maturity Approach

Consider a company that has $100 million of Consider a company that has nontraded $100 million
of debt outstanding that has a debt-rating of AA. The
debt outstanding that has a coupon rate of 5%,
yield on AA debt is currently 6.2%. What is the after-
10 years to maturity, and is quoted at $98. What
tax cost of debt if the marginal tax rate is 40%?
is the after-tax cost of debt if the marginal tax
rate is 40%? Assume semi-annual interest.

Solution:
Solution: Kd = 0.062 (1 – 0.4) = 3.72%
Kd = 0.0526 (1 – 0.4) = 3.156% The cost of debt capital is 3.72%
The cost of debt capital is 3.156%

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 Issues in estimating the cost of debt
• The cost of floating-rate debt is difficult because the cost depends not only on current
rates but also on future rates.
• Possible approach: Use current term structure to estimate future rates.
• Option-like features affect the cost of debt.
• If the company already has debt with embedded options similar to what it may issue, then we can
use the yield on current debt.
• If the company is expected to alter the embedded options, then we would need to estimate the yield
on the debt with embedded options.

• Nonrated debt makes it difficult to determine the yield on similarly yielding debt if the
company’s debt is not traded.
• Possible remedy: Estimate rating by using financial ratios.

• Leases are a form of debt, but there is no yield to maturity.

• Estimate by using the yield on other debt of the company.

Copyright © 2013 CFA Institute 11

 The Cost of Preferred Stock
The cost of preferred stock that is noncallable and nonconvertible is based on the
perpetuity formula:
𝐷𝑝 𝐷𝑝
Kp = 𝑟𝑝
→ 𝐾𝑝 = 𝑃𝑝

Problem
Suppose a company has preferred stock outstanding that has a dividend of Rs.1.25 per share and a
price of Rs 20. What is the company’s cost of preferred equity?

Solution
1.25
rp = = 0.0625, or 6.25%
20

Copyright © 2013 CFA Institute 12

Cost of Equity Capital
Methods of estimating the cost of equity:
1. Capital asset pricing model
2. Dividend discount model
3. Bond yield plus risk premium
 Using the CAPM to estimate the
Cost of Equity
The capital asset pricing model (CAPM) states that the expected return on equity, E(Ri) ,
is the sum of the risk-free rate of interest, RF, and a premium for bearing market risk, bi
[E(RM) – RF]:

E(Ri) = RF + bi [E(RM) – RF]

where
bi is the return sensitivity of stock i to changes in the market return
E(RM) is the expected return on the market
E(RM) – RF is the expected market risk premium or equity risk premium (ERP)

Problem:
If the risk-free rate is 3%, the expected market risk premium is 5%, and the company’s stock beta is
1.2, what is the company’s cost of equity?

Solution:
Cost of equity = 0.03 + (1.2 × 0.05) = 0.03 + 0.06 = 0.09, or 9%
Cost of Equity – Dividend Discount Method
• With Growth
• D1/Po or Expected Return/Current Market Value

• Without Growth
• D1/Po + g or (Expected Return/CMV) + growth rate
 Using the Dividend Valuation Model to Estimate
the Cost of Equity
• The dividend discount model (DDM) assumes that the value of a stock today is the present value of
all future dividends, discounted at the required rate of return.
• Assuming a constant growth in dividends:
𝐷1
𝑃0 =
𝑟𝑒 −𝑔
which we can rearrange to solve for the required rate of return:
𝐷1
𝑟𝑒 = 𝑃0
+𝑔

• We can estimate the growth rate, g, by using third-party estimates of the company’s dividend growth
or estimating the company’s sustainable growth.
• The sustainable growth is the product
𝐷
of the return on equity (ROE) and the retention rate (1 minus
the dividend payout ratio, or 1 − 𝐸𝑃𝑆 ):
𝐷
𝑔 = 1− ROE
𝐸𝑃𝑆
 Using the DDM to estimate the
cost of Equity
Problem
Suppose the Gadget Company has a current dividend of £2 per share. The current price of a share of
Gadget Company stock is £40. The Gadget Company has a dividend payout of 20% and an expected
return on equity of 12%. What is the cost of Gadget common equity?

Solution
Using the dividend payout and the return on equity, we calculate g:
𝑔 = 1 − 0.2 × 0.12 = 0.96, or 9.6%
Then we insert g into the required rate of return formula:
£2 (1 + 0.096)
𝑟𝑒 = + 0.096 = 0.0548 + 0.096 = 0.1508, or 15.08%
£40
If Gadget raises new common equity capital, its cost is 15.08%.
Using the bond yield plus risk premium approach
to estimating the cost of equity
• The bond yield plus risk premium approach requires adding a
premium to a company’s yield on its debt:
re = rd + Risk premium
• This approach is based on the idea that the equity of the company is riskier than its
debt, but the cost of these sources move in tandem.
Cost of Retained Earning
• Equity Share Holder are investors in Retained Earning
• Book Value Approach
• Same as cost of Equity

• Market Value Approach

• Not considered as Market value absorbs the value of equity
Thank You