Chapter 11

Topic 9: Cost of Capital

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Cost of Capital
◼ Firms need capital for short-term and long-term investments.
◼ The cost of capital is the rate of return that the suppliers of
capital—bondholders and owners—require as compensation for
their contributions of capital.
◼ Note that the return demanded by a firm’s investors is a cost to
the firm:
- “Required Rate of Return” = “Cost of Equity”
demanded by stock investors to the firm
- “Required Rate of Return” = “Cost of Debt”
demanded by bond investors to the firm
◼ As firms usually use both types of financing, a firm’s overall
cost of capital is calculated as a weighted average of the cost of
equity and the after-tax cost of debt, with the weights
representing the proportion of each source of financing used.
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Overview of the Cost of Capital
Capital

Preferred Common
Debt Stock Equity
Retained New Common
Earnings ** Stock

Main sources of capital use by firms

• Capital includes all items on the right hand side of the accounting equation, i.e.,
liabilities and stockholder’s (shareholders’) equity.
• Capital represents the funds used to finance a firm’s assets (short-term and long-term
investments) and operations.
• The two major sources (external) of capital are obtained through issuing equity and
debts (e.g. bonds).
• ** Retained Earnings (internal source): the accumulation of profits from the current
and previous periods not yet distributed to stockholders/owners of the entity in the form
of a dividend.

Topic 9 - Cost of Capital 2

Why is Cost of Capital So Important?

◼ Creating value requires investing in capital projects that

provide a return greater than the project’s cost of capital.
❑ When we view the firm as a whole, the firm creates value
when it provides a return greater than its cost of capital.

◼ All else the same, the reduction of financing cost implies

=> NPV increases
=> more projects end up with NPV > 0 and be accepted
=> more wealth be created to shareholders.

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 Company Cost of Capital and WACC
◼ If a firm’s only investors were common stockholders, then firm’s
cost of capital would be the required rate of return on equity.
◼ Most firms, however, use several types of capital, and, due to
differences in risk, these different securities have different required
rates of return on each capital component (called component cost).
◼ The cost of capital used to analyze capital budgeting decisions
should be a weighted average of the various components’ costs ---
weighted average cost of capital, or WACC.

 %  After - tax   % Preferred  Cost of   % Common  Cost of 

WACC =   +  +  
 Debt  Cost of Debt   Stock  Preferred Stock   Stock  Common Stock 
MV of asset i
= W .r (1 - T) + W .r + W .r where W =
MV of all assets
D d PS PS CS CS i

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To determine the firm’s WACC , we
need to know how to calculate the costs
of the individual sources of capital

(1) Cost of common equity (common stock)

(2) Cost of preferred stock
(3) Cost of debt

Topic 9 - Cost of Capital 5

 (1) Estimating Cost of CommonEquity

❖ There are two major methods for

determining the cost of equity
i. Topic 5: Dividend Growth Model, DGM (DDM - Dividend
Discount Model) – Model II, constant growth

D1 D1
P0 = R CS = +g
R CS − g P0
ii. Topic 6: CAPM

Required Return of a stock RCS = Rf + ( RM – Rf )  

Topic 9 - Cost of Capital 6

(2) Cost of Preferred Stock (rps)

◼ Topic 5: Dividend Discount Model (DDM) - Model I, zero growth

▪ Rps is the cost of preferred stock which is the rate of return investors
require on the firm’s preferred stock.
▪ Preferred stock generally pays a constant dividend each period forever.

▪ Preferred stock is a perpetuity, so we take the perpetuity formula,

rearrange and solve for Rps

D D
P0 = Rps =
R P0

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(3) Cost of Debt (rD)
◼ The cost of debt is the return demanded by investors on the
company’s debt.
◼ Topic 4 : Yield to Maturity

Bond C C C F
= + +  + +
Price (1 + r )1 (1 + r )2 (1 + r )t (1 + r )t
YTM implied
Current by the bond
bond price  1  price
1 −
 (1 + r) t   1 
= C  + F t 
 r   (1 + r) 
 

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 Cost of Debt: After-Tax Cost of Debt
◼ The firm’s TRUE cost of Income Statement Company A Company B
debt is LESS THAN the Debt +
return demanded by Equity Equity only tax deductible
Profit before interest and tax 300 300 and then
investors on the company’s reduce tax
debt , ie before tax cost of Less: Bond interest (100) - liability by $20
debts.
◼ The interest payments paid Profit before tax 200 300 Difference = 100
to bondholders are tax
deductible (可以扣税) for Less: Taxation @20% (40) (60) (20)
Company A paid less tax
the firm.
◼ So the interest expense on Net Income 160 240 Difference = 80
debt reduces the firm’s => tax saving $100x 20% =$20
taxable income and the Less: Dividend (100) (100)
firm’s tax liability.
Retained earnings $ 60 $ 140
◼ Firm’s true Cost of Debt
= After-tax cost of debt Effective bond interest = $100 - ($100 x 20%) (tax saving) = $80
=$ 100 (1 - tax rate)
= rD (before tax)  (1 – T) = $100 (20%)
80%

= $80

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Tax => Debt is cheapest*****
◼ Interest expenses reduce the tax liability of a firm (expense – help
company to generate revenue).
❖ Reduces the cost of debt

❖ After-tax cost of debt = rD (1 – tax rate)

◼ Dividends are NOT tax deductible, so there is no tax effect on the cost of
equity or cost of preferred stock (distribution of profit to stockholder, not
expense).

◼ Debt gets a tax advantage and Equity (common stock and preferred stock)
does not.

◼ **Debt is cheaper compared with preferred stock and common stock

because of tax deduction.

Topic 9 - Cost of Capital 10

 An Example
Suppose the Widget Company has a (target)* capital structure
composed of the following, in billions:
Debt €10
Common equity €40

If the before-tax cost of debt is 9%, the required rate of return on

equity is 15%, and the marginal tax rate is 30%, what is Widget’s
weighted average cost of capital?
Answer:
WACC = wdrd(1 − t) + wprp + were
WACC = [(10/50)(0.09)(1 – 0.30)] + [(40/50)(0.15)]
= 0.1325 (13.25%)
• The target capital structure of a company is the capital structure the company tries to
achieve. In other words, it’s the capital structure that is expected to optimize a company’s
stock price. 11
READING & EXERCISES

◼ Readings
❑ Chapter 11 (only read those sections related to
the lecture notes)

❑ Supplementary Exercices: Ex 9

Topic 9 - Cost of Capital 12

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