CHAPTER THREE

THE COST OF CAPITAL

3.1 INTRODUCTION
• 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.
• 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.
• 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.
• If a firm’s actual rate of return exceeds its cost of
capital, the value of the firm would increase.
• So the cost of capital is the rate of return that is
just sufficient to leave the price of the firm’s
common stock unchanged.
 Suppose a firm is considering investment on
a plant.
 The finance required for this investment is
to be raised by selling a common stock
issue.
 Now, after raising capital, the firm is
expected to provide required rate of return
to those who invest on the common stock.
 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
common stockholders.
• If the required rate of return by the firm’s
common stockholders 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.Preferred stock
3.Common stock
4.Retained earnings
• Two important points you should bear in mind about the
specific cost of capital.

1. One is that it is computed on an after-tax 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.

2. 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 birr.
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 preferred and common
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/needs 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:

Kd

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, ABC 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, ABC 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 ABC’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
ii) Kd =

iii) Kdt = 12.26% (1 – 40%) = 7.56%

• Therefore, the after – tax cost of ABC’s new bond issue
is 7.56%.
• That is, ABC should be able to earn a minimum of
7.56% to satisfy bondholders.
• Otherwise, the firm’s value will decline.
3.3.2 The cost of preferred stock
• The cost of preferred stock is the minimum rate
of return a firm must earn in order to satisfy the
required rate of return of the firm’s preferred
stock investors.
• It is also the minimum rate of return a firm’s
preferred stock investors require if they are to
purchase the firm’s preferred stock.
• When a firm raises capital by issuing new
preferred stock, it is expected to pay fixed
amount of dividends to the preferred stockholders.
• So it is the dividend payment that is the cost of
the preferred stock 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
preferred stock.
NPpf = Pps – f
Where:
NPpf = Net proceeds from the sale of each
preferred stock
Pps = Market price of the preferred stock
f = Flotation costs
ii) Compute the cost of preferred stock issue

Kps =

Where:
Kps = The cost of preferred stock

DPs = The per share annual dividend on the

preferred stock
• Example: Sefa Computer Systems Company has just issued
preferred stock. The stock has 12% annual dividend and Br.
100 par value and was sold at 102% of the par value. In
addition, flotation costs of Br. 2.50 per share must be paid.
Calculate the cost of the preferred stock.
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%

Br. 99.50
• Therefore, Sefa Company should be able to earn
a minimum of 12.06% on any investment
financed by the new preferred stock issue.
Otherwise, the firm’s value will decrease.
3.3.3 The cost of common stock
• The 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.
• A firm does not make explicit commitment to pay dividends to
common stockholders.
• However, when common stockholders invest their money 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 investors and hence, they carry cost.
• Generally, common stock dividends are paid after
interest and preferred dividends are paid.
• As a result, common stock investors assume the
maximum risk in corporate investment.
• They compensate the maximum risk by requiring the
highest return.
• This highest return expected by common stockholders
make common stock the most expensive source of
capital.
• The cost of common stock can be computed using
the constant growth valuation model.
Ks = + g
Where
Ks = The cost of new common stock issue
D1 = The expected dividend payment at the end of next year
NPo = Net proceeds from the sale of each common stock
g = The expected annual dividends growth rate
The net proceed from the sale of each common stock (NPo) is
computed as follows:
NPo = Po – f
Where:
Po = The current market price of the common stock
f = flotation costs
Example: An issue of common stock 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 common stock
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 (0.06) +0.06 = 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
common stock issue.
3.3.4 The cost of Retained Earnings
• Retained earnings represent profits available for
common stockholders 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 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
retained earnings is equated with the specific
cost of common stock.
• However, floatation 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 = + g
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 common stock
g = The expected annual dividend growth rate.
• Example: ZK Auto Spare Parts Manufacturing
Company expects to pay a common stock
dividend of Br. 2.50 per share during the next 12
months. The firm’s current common stock price
is Br. 50 per share and the expected dividend
growth rate is 7%. A floatation cost of Br. 3 is
involved to sale a share of common stock.
• Required: Compute the cost of retained earnings
Given: Po = Br. 50; D1 = Br. 2.50; g = 7%;
Kr = ?
Then apply the formula:
Kr = + g
Kr = + 7%= 12%
 3.4 WEIGHTED AVERAGE COST OF
CAPITAL (WACC)
• 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 weighted average cost of capital
(WACC) is the weighted average of the
individual costs of debt, preferred stock and
common equity (common stock 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 preferred stock

• Wce = The weight of common equity

• Kdt = The after – tax cost of debt

• Kps = The cost of preferred stock
• Ks = The cost of common 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%
Preferred stock 84,000 125,000 12.0%
Common 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==0.04,
Wce == 0.46
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==0.05,

Wce == 0.55
WACC = WdKdt + WpsKps + WceKs

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, preferred stock, and common 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.
• Example: The target capital structure of Shala
Corporation and other pertinent data are given
below.
 Long-term debt=40%;

 cost of preferred stock (Kps)= 12.06%

 Preferred stock=10%

 cost of retained earnings (Kr) = 14%

 Common equity=50%

 cost of common stock (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
common stock 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) common equity = = Br. 1,800,000

b. Breaking point (BP) long-term debt = = Br. 3,000,000

• 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
common stock.
• 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, 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%
END OF CHAPTER
3
THANK YOU!