Financial management course

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Cost of Capital
Financial management and control systems (Lecture 2)
Dr. Mahmoud Otaify
Assistant Professor of Finance
2
LO1 Understand the basic concept of cost
of capital
LO2 Determine a firm’s cost of equity
capital.
LO3 Determine the cost of long-term debt
LO4 Calculate the weighted average cost
of capital (WACC)
Dr. Mahmoud Otaify - FMCS: Cost of Capital
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Weight
Amount $
Source
E/V=600,000/1000,000=0.6
600,000
Common Stocks (E)
P/V=150,000/1000,000=0.15
150,000
Preferred Stock (P)
D/V=250,000/1000,000=0.25
250,000
Bonds (D)
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1,000,000
Total value of capital
structure (V=E+P+D)
How Much? %
Symbol
Cost of Capital
SML
RE
Cost of Equity
DDM
RP
Cost of Preferred
YTM
RD
Pre-tax cost of
Debt
Dr. Mahmoud Otaify - FMCS: Cost of Capital
Owners
+
Creditors
Require
rate of
return
Company
Use funds
to receive
more than
cost of
funds
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Debt
Financing
• If you want to finance project from banks
and bank requires 10% as interest (return),
the cost of debt capital is 10%
• Firm must earn at least 10% to pay the
interest payment.
Equity
Financing
• If you want to finance project from capital
market and investors require 8% return, the
cost of equity capital is 8%.
• Firm must earn at least 8% to compensate
investors for the use of the capital needed
to finance the project.
Cost of Debt Capital
• The return that lenders
require on the firm's debt.
Cost of Equity Capital
• The return that equity
investors require on their
investment in the firm.
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Dr. Mahmoud Otaify - FMCS: Cost of Capital
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Expected return on the market –
risk-free rate of return
Dr. Mahmoud Otaify - FMCS: Cost of Capital 7
E(RM) = 17% RF=12%
Beta =
1.2
RE=?
RE = 12%+ (17% - 12%) =
17%
RE = 12%+ 1.2*(17% - 12%) =
18%
E(RM) – RF
= 17 – 12 = 5%
CAPM
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Cost of
Common Stock
(SML)
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Compute cost of equity using the
SML
Risk-free rate, Rf
Market risk premium, E(RM) – Rf
Systematic risk of asset, 
)
)
(
( f
M
E
f
E R
R
E
R
R 

 
Example:
Company’s equity beta = 1.2
Current risk-free rate = 7%
Expected market risk premium = 6%
What is the cost of equity capital?
%
2
.
14
)
6
(
2
.
1
7
RE 


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Cost of
Preferred
Stocks (Rp)
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 Reminders
 Preference shares generally pay a
constant dividend every period.
 Dividends are expected to be paid
every period forever.
 Preference share valuation is an
annuity, so we take the annuity
formula, rearrange and solve for RP.
 RP = D/P0
 Example
 Your company has preference shares that
have an annual dividend of $3. If the current
price is $25, what is the cost of a preference
share?
RP = 3 / 25 = 12%
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Risk-
free
rate
Credit
Risk
Premiu
m
Required
Return by
Bondholders
A bond’s rating is used
to indicate its relative
probability of default
Yield on
Treasury
Securities
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The cost of debt = the required
return on a company’s debt.
Compute the yield to maturity on
existing Bond
𝒀𝑻𝑴 =
𝑪𝒐𝒖𝒑𝒐𝒏 +
𝑭𝑽 − 𝑩𝑽
𝑴𝒂𝒕𝒖𝒓𝒊𝒕𝒚
𝑭𝑽 + 𝑩𝑽
𝟐
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Cost of
Debt
(Example)
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Suppose we have a bond issue currently outstanding that has
25 years left to maturity. The coupon rate is 9% and coupons.
The bond is currently selling for $908.72 per $1000 bond.
What is the cost of debt? Tax rate = 40%
 Coupon = 1000*0.09 = 90
 Semiannual coupon = 90/2 = 45
 𝒀𝑻𝑴 =
𝟏𝟎𝟎
𝟏𝟎𝟎𝟎 𝟗𝟎𝟖.𝟕𝟐
𝟐𝟓
𝟏𝟎𝟎𝟎 𝟗𝟎𝟖.𝟕𝟐
𝟐
= 10%
 Annual pretax cost = 5*2 = 10%
 After-tax cost of Debt = RD (1- TC) = 10 x
(1 – 0.4 ) = 6%
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Source Amount Weight Cost
Equity (E) 600,000 60% 14.2%
Preferred
(P)
150,000 15% 12%
Debt (D) 250,000 25% 10%
Capital (V) 1,000,000
Tax Rate 40%
WACC WACC= E/V*RE + P/V*RP + D/V*RD(-
TC)
=0.6*14.2 + 0.15*12 + 0.25*10(1-0.4)
=
17
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