1. Chapter 7 Cost of Capital
Ms. Faith M. Simwami

2. After studying THIS Chapter , you should be able to understand:
Introduction to Cost of Capital
Why is Cost of Capital Important?
Cost of Capital Components
Debt
Preferred
Common Equity
WACC
Introduction to Cost of Capital
The cost of capital reflects the average cost of funds for the firm. In other words it is the return required by investors in the firm.
Cost of capital depends mostly on the assets (use of funds), not the financing (source of funds).
1 - 2

3. Importance of Cost of Capital
For 12%, we are saying:
The firm can only have a positive NPV on a project if return exceeds 12%
The firm must earn 12% just to compensate investors for the use of their capital in a project
The use of capital in a project must earn 12% or more, not that it will necessarily cost 12% to borrow funds for the project
Thus cost of capital depends primarily on the USE of funds, not the SOURCE of funds
Importance of Cost of Capital
Capital Budgeting Decisions
Designing the Corporate Financial Structure
Deciding about the method of financing
Performance of top management
Other areas – e.g., dividend policy, working capital 1 1

4. What sources of long-term capital do firms use?
The value of the firm can be thought of as a pie.
The goal of the manager is to increase the size of the pie.
The Capital Structure decision can be viewed as how best to slice up a the pie.
If how you slice the pie affects the size of the pie, then the capital structure decision matters.
25% Debt
75% Equity
70% Debt
30% Equity
Capital structure
50% Debt
The form of capital that a firm uses in financing its business makes what is known as its Capital structure. A company may use only one type of capital say Common stock or it can use a combination of different capital.
50% Equity
Long-Term Capital
Long-Term Debt
Preferred Stock
Common Stock
Retained Earnings
New Common Stock
What sources of long-term capital do firms use?

5. Example 1 Cost of Debt After Tax cost of debt = Kd(1-T)
Debt is borrowed Capital (Loan) provided by a lender (creditor) in exchange for interest payment. The interest paid on a debt at a given rate is the cost of debt capital. Since interest expense is deductable under tax rules this creates a saving for the company due to what is called the Tax Shield (1-Tax%).The tax shield lowers the overall cost of debt, which is a benefit to the company. The cost of debt is kd (before tax). When we take into account the tax shield this changes.
Therefore ,
After Tax cost of debt = Kd(1-T)
Where T is the tax rate.
Kd is the before tax cost of debt
Example 1
Debt cost is 10% and the tax rate is 40% for company tax, what is the after tax cost of Debt?
Kd x (1-T) = 10 x (1-0.4) = 6%
The cost has been reduced from 10% to 6% and this is the major advantage of using debt for financing.

6. Cost of Preferred Stock
Preference Shares - The dividend paid is fixed and is a percentage of the share price. e.g. 10% preference shares meaning your dividend is 10% of the price you paid for the share.
Kp=Dp/Price of Share
Example 2
A preferred stock pays a dividend of K11.70
and sells for K Find the Cost of the preferred equity?
Kp=Dp/Price of Share = K11.70/ K = 11.7%

7. Cost of Equity
Equity is the capital supplied by ordinary share holders. These are the owners of the company. Despite them being the owners they too require a return for the amount they have invested, otherwise there is no reason to invest. Share holders expected to gain from their investment in two ways, through share price increase (Capital gains) and dividends paid by the company.
The two components form the cost of equity, which can be computed using the following.
Ke= Rf + (ERm-Rf) x β.
This cost of equity using the CAPM model.
2) Ke= D1/Po +g.
This is cost of equity using the Dividend Growth model

8. Example 3
Suppose for a Stock the risk free rate is Rf=8%, expected market return ERm=14% and the stock β 0.7.
Find the Cost of this stock.
Ke= Rf + (ERm-Rf) x β.
Ke= 8% + (14-8) % x 0.7
= 12.2%
Example 4
A stocks expected dividend D1 = K1.43 and it has a growth rate g of 6.6%. The stock sells for K25.54.What is the cost of equity using the Gordon’s model.
Ke= D1/P0 + g
= 1.43/ = 12.2%
Ensure that you multiply with 100% the first computation of the equation to convert the decimal to percentage.

9. Weighted Average Cost of Capital (WACC)
Cost of Retained Earnings
The retained earnings equally belong to share holders and are supposed to be paid out as dividends. The cost to the shareholders is the opportunity cost of forgoing dividends and this represents the cost of retained earnings.
The cost of retained earnings is the same as the cost of equity.
Weighted Average Cost of Capital (WACC)
Weighted average cost of capital (WACC)is the average rate of return a company expects to compensate all its different investors.
When a company with a given target capital structure uses different forms of capital in its capital structure, an average cost of the capitals will be computed. This is called the weighted average cost of capital or WACC in short.
WACC- FORMULA
WACC= We(ke) + Wps(kps) + Wd(kd)(1-T)
W = weight of each form of capital used in the capital structure of the firm.

10. Determining the Weights for the WACC
Example 5
Capital Structure for Company Z extracted from the Balance Sheet.
The weights are the percentages of the firm that will be financed by each component.
If possible, always use the target weights for the percentages of the firm that will be financed with the various types of capital.
The weights are the fraction of each financing source in the company's target capital structure.
Capital Structure
(K)
Weight
LT Debt
3,000,000
30%
Preferred Stock
1,000,000
10%
Common Stock
6,000,000
60%
Total
10,000,000
100%
Suppose a company has the following costs for each form of Capital.
Kd=10%; Kps=12%; Tax=40% and Ke=12.2%.
Find the WACC for the company using the above capital structure?
WACC= We(ke) + Wps(kps) + Wd(kd)(1-T)
WACC= 0.6(12.2)+0.1(12)+0.3(10)(1-0.4)= 10.32%

11. What factors influence a company’s WACC?
Advantages and Limitations of Weighted Average Cost of Capital as the Hurdle Rate for Project Evaluation
The main advantage of using WACC for evaluation of projects is its simplicity.
The main limitation of using WACC is that it does not take into consideration the floatation cost of raising the marginal capital for new projects. Another problem with WACC is that it is based on an impractical assumption of same capital mix which is very difficult to maintain.
What factors influence a company’s WACC?
Market conditions, especially interest rates and tax rates.
The firm’s capital structure and dividend policy.
The firm’s investment policy.
Firms with riskier projects generally have a higher WACC.

12. Flotation costs and WACC
While raising new capital, a company incurs cost, which is paid as a fee to the investment bankers. This fee is referred to as the flotation cost. The investment banker provides a number of services for the firm, including:
Setting the price of the issue(Bonds, Stocks)
Selling the issue to the public
Printing the certificates
Paying the underwriters (underwriting means: To guarantee, as to guarantee the issuer of securities a specified price by entering into a purchase and sale agreement To bring securities to market)
Government fees, and other associated costs
Flotation costs and WACC
Flotation costs depend on the firm’s risk and the type of capital being raised. Flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small.
We frequently ignore flotation costs when calculating the WACC.

13. Conclusion on WACC
Since the WACC is the weighted average of cost of equity + cost of debt, we can vary the WACC by changing the mix of debt + equity
If cost of debt < cost of equity, we can reduce WACC by increasing the % of debt in the mix and vice versa
The value of the firm (its earning’s potential) is maximized when its WACC is minimized. A firm with a lower cost of capital can more easily return profits to its owners
The optimal, or target capital structure is the structure with the lowest possible WACC
The Interest Tax Shield (deductibility of corp. interest) is critical here, because it effectively lowers the cost of debt.
Therefore for many firms, the use of financial leverage (debt financing) can lower WACC and increase profitability

14. WACC Estimates for Some Large U. S. Corporations
Company WACC
General Electric (GE) 12.5
Coca-Cola (KO) 12.3
Intel (INTC) 12.2
Motorola (MOT) 11.7
Wal-Mart (WMT) 11.0
Walt Disney (DIS) 9.3
AT&T (T) 9.2
Exxon Mobil (XOM) 8.2
H.J. Heinz (HNZ) 7.8
BellSouth (BLS) 7.4