Cost of CapitalCost of Capital

Cost of CapitalCost of Capital

For InvestorsFor Investors the rate of return on a the rate of return on a security is a benefit of investing.security is a benefit of investing.

For Financial ManagersFor Financial Managers that same that same rate of return is a cost of raising rate of return is a cost of raising funds that are needed to operate the funds that are needed to operate the firm.firm.

In other words, the cost of raising In other words, the cost of raising funds is the firm’s funds is the firm’s cost of capitalcost of capital..

How can the firm raise How can the firm raise capital?capital?

Debentures Debentures Preference sharesPreference shares Equity sharesEquity shares Each of these offers a Each of these offers a rate of returnrate of return to to

investors.investors. This return is a This return is a costcost to the firm. to the firm.

The Weighted Cost of CapitalThe Weighted Cost of Capital

To calculate the firm’s weighted To calculate the firm’s weighted cost of capital, we must first cost of capital, we must first calculate the costs of the individual calculate the costs of the individual financing sources:financing sources:

Cost of DebtCost of Debt Cost of Cost of Preference sharesPreference shares Cost of Cost of Equity sharesEquity shares

Cost of DebtCost of Debt

For the issuing firm, the For the issuing firm, the cost of debtcost of debt is: is: the the rate of returnrate of return required by required by

investors,investors, adjusted for adjusted for taxes.taxes.

Cost of DebtCost of Debt Recall:Recall:

kd = = kd = = IntIntPoPo

InterestInterest PricePrice

Component Cost of DebtComponent Cost of Debt

Interest is tax deductible, soInterest is tax deductible, so

kkd ATd AT = k= kd BTd BT(1 - T)(1 - T)

= 10%(1 - 0.40) = = 10%(1 - 0.40) = 6%.6%.

Cost of Preferred StockCost of Preferred Stock Recall:Recall:

kp = = kp = = DDPoPo

DividendDividend PricePrice

Example: Cost of PreferredExample: Cost of Preferred

If Reliance Corporation issues If Reliance Corporation issues Preference sharesPreference shares, it will pay a , it will pay a dividend of dividend of Rs 8Rs 8 per year and should per year and should be valued at be valued at Rs 75Rs 75 per share. per share.

what is the cost of what is the cost of Preference sharesPreference shares for Reliance?for Reliance?

Cost of Cost of Equity sharesEquity shares

There are 2 sources of Equity:There are 2 sources of Equity:

1) 1) InternalInternal equity (retained earnings), equity (retained earnings), and and

2) 2) External External equity (new equity (new Equity sharesEquity shares issue)issue)

Cost of Internal EquityCost of Internal Equity

Since the stockholders own the firm’s Since the stockholders own the firm’s retained earnings, the cost is simply the retained earnings, the cost is simply the stockholders’ required rate of return.stockholders’ required rate of return.

Why?Why? If managers are investing stockholders’ If managers are investing stockholders’

funds, stockholders will expect to earn funds, stockholders will expect to earn an acceptable rate of return.an acceptable rate of return.

Cost of Internal EquityCost of Internal Equity

1) 1) Dividend Growth ModelDividend Growth Model

Ke = + gKe = + gDD11PoPo

Weighted Cost of CapitalWeighted Cost of Capital

The weighted cost of capital is just The weighted cost of capital is just the weighted average cost of all of the weighted average cost of all of the financing sources.the financing sources.

Weighted Cost of CapitalWeighted Cost of Capital

CapitalCapital Source Cost Structure Source Cost Structure

debt 6% 20%debt 6% 20%preferred 10% 10%preferred 10% 10%equity 16% 70%equity 16% 70%

Weighted cost of capital =Weighted cost of capital = .20 (6%) + .10 (10%) + .70 (16).20 (6%) + .10 (10%) + .70 (16)= ?= ?

Weighted Cost of CapitalWeighted Cost of Capital(20% debt, 10% preferred, 70% equity)(20% debt, 10% preferred, 70% equity)

What factors influence a company’s What factors influence a company’s WACC?WACC?

Market conditions, especially interest rates Market conditions, especially interest rates and tax rates.and tax rates.

The firm’s capital structure and dividend The firm’s capital structure and dividend policy.policy.

The firm’s investment policy. Firms with The firm’s investment policy. Firms with riskier projects generally have a higher riskier projects generally have a higher WACC.WACC.