Explain the general concept of opportunity cost of capital. Distinguish between the project cost of capital and the firm’s cost of capital. Learn about the methods of calculating component cost of capital and the weighted average cost of capital. Understand the concept and calculation of the marginal cost of capital. Recognise the need for calculating cost of capital for divisions. Understand the methodology of determining the divisional beta and divisional cost of capital. Illustrate the cost of capital calculation for a real company.

1. Chapter - 9
The Cost of Capital

2. 2Financial Management, Ninth
Chapter Objectives
 Explain the general concept of opportunity cost of
capital.
 Distinguish between the project cost of capital and the
firm’s cost of capital.
 Learn about the methods of calculating component
cost of capital and the weighted average cost of
capital.
 Understand the concept and calculation of the
marginal cost of capital.
 Recognise the need for calculating cost of capital for
divisions.
 Understand the methodology of determining the
divisional beta and divisional cost of capital.
 Illustrate the cost of capital calculation for a real
company.

3. 3Financial Management, Ninth
Introduction
 The project’s cost of capital is the minimum
required rate of return on funds committed to
the project, which depends on the riskiness of
its cash flows.
 The firm’s cost of capital will be the overall,
or average, required rate of return on the
aggregate of investment projects.

4. 4Financial Management, Ninth
Significance of the Cost of Capital
 Evaluating investment decisions,
 Designing a firm’s debt policy, and
 Appraising the financial performance of top
management.

5. 5Financial Management, Ninth
The Concept of the Opportunity
Cost of Capital
 The opportunity cost is the rate of return
foregone on the next best alternative
investment opportunity of comparable risk.
OCC
.Equity shares
Risk
.Preference shares
.Corporate bonds
.Government bonds
.Risk-free security

6. 6Financial Management, Ninth
General Formula for the Opportunity
Cost of Capital
 Opportunity cost of capital is given by the following
formula:
where Io is the capital supplied by investors in period
0 (it represents a net cash inflow to the firm), Ct are
returns expected by investors (they represent cash
outflows to the firm) and k is the required rate of
return or the cost of capital.
 The opportunity cost of retained earnings is the rate
of return, which the ordinary shareholders would
have earned on these funds if they had been
distributed as dividends to them.
1 2
0 2
(1 ) (1 ) (1 )
n
n
CC C
I
k k k
= + + +
+ + +
L

7. 7Financial Management, Ninth
Weighted Average Cost of Capital
Vs. Specific Costs of Capital
 The cost of capital of each source of capital is known
as component, or specific, cost of capital.
 The overall cost is also called the weighted average
cost of capital (WACC).
 Relevant cost in the investment decisions is the
future cost or the marginal cost.
 Marginal cost is the new or the incremental cost that
the firm incurs if it were to raise capital now, or in the
near future.
 The historical cost that was incurred in the past in
raising capital is not relevant in financial decision-
making.

8. 8Financial Management, Ninth
Cost of Debt
 Debt Issued at Par
 Debt Issued at Discount or Premium
 Tax adjustment
0
INT
dk i
B
= =
0
1
INT
(1 ) (1 )
n
t n
t n
t
d d
B
B
k k=
= ∑ +
+ +
After-tax cost of debt (1 )dk T= −

9. 9Financial Management, Ninth
Cost of Preference Capital
 Irredeemable Preference Share
 Redeemable Preference Share
0
PDIV
pk
P
=
0
1
PDIV
= +
(1 ) (1 )
n
t n
t n
t
p p
P
P
k k=
∑
+ +

10. 10Financial Management, Ninth
Cost of Equity Capital
 Is Equity Capital Free of Cost? No, it has
an opportunity cost.
 Cost of Internal Equity: The Dividend—
Growth Model
 Normal growth
 Supernormal growth
 Zero-growth
1
0
DIV
( )e
P
k g
=
−
10
0
= 1
DIVDIV (1 ) 1
(1 ) (1 )
ns
t e e
tn
t n
n e
g
P
k k g k
++
= + ×
+ − +
∑
1 1
0 0
DIV EPS
(since 0)ek g
P P
= = =

11. 11Financial Management, Ninth
Cost of Equity Capital
 Cost of External Equity: The Dividend—
Growth Model
 Earnings–Price Ratio and the Cost of
Equity
1
0
DIV
ek g
P
= +
1
0
1
0
EPS (1 )
( )
EPS
( 0)
e
b
k br g br
P
b
P
−
= + =
= =

12. 12Financial Management, Ninth
The Capital Asset Pricing Model
(CAPM)
 As per the CAPM, the required rate of return
on equity is given by the following
relationship:
 Equation requires the following three
parameters to estimate a firm’s cost of equity:
 The risk-free rate (Rf)
 The market risk premium (Rm – Rf)
 The beta of the firm’s share (β)
( )e f m f jk R R R β= + −

13. 13Financial Management, Ninth
Cost of Equity: CAPM Vs.
Dividend—Growth Model
 The dividend-growth approach has limited
application in practice
 It assumes that the dividend per share will grow at
a constant rate, g, forever.
 The expected dividend growth rate, g, should be
less than the cost of equity, ke, to arrive at the
simple growth formula.
 The dividend–growth approach also fails to deal
with risk directly.

14. 14Financial Management, Ninth
Cost of Equity: CAPM Vs.
Dividend—Growth Model
 CAPM has a wider application although it is
based on restrictive assumptions:
 The only condition for its use is that the company’s
share is quoted on the stock exchange.
 All variables in the CAPM are market determined
and except the company specific share price data,
they are common to all companies.
 The value of beta is determined in an objective
manner by using sound statistical methods. One
practical problem with the use of beta, however, is
that it does not probably remain stable over time.

15. 15Financial Management, Ninth
The Weighted Average Cost of Capital
 The following steps are involved for calculating
the firm’s WACC:
 Calculate the cost of specific sources of funds
 Multiply the cost of each source by its proportion in the
capital structure.
 Add the weighted component costs to get the WACC.
 WACC is in fact the weighted marginal cost of
capital (WMCC); that is, the weighted average
cost of new capital given the firm’s target capital
structure.
(1 )
(1 )
o d d d e
o d e
k k T w k w
D E
k k T k
D E D E
= − +
= − +
+ +

16. 16Financial Management, Ninth
Book Value Versus Market Value
Weights
 Managers prefer the book value weights for
calculating WACC:
 Firms in practice set their target capital structure in
terms of book values.
 The book value information can be easily derived
from the published sources.
 The book value debt—equity ratios are analysed by
investors to evaluate the risk of the firms in practice.

17. 17Financial Management, Ninth
Book Value Versus Market Value
Weights
 The use of the book-value weights can be
seriously questioned on theoretical grounds:
 First, the component costs are opportunity rates
and are determined in the capital markets. The
weights should also be market-determined.
 Second, the book-value weights are based on
arbitrary accounting policies that are used to
calculate retained earnings and value of assets.
Thus, they do not reflect economic values.

18. 18Financial Management, Ninth
Book Value Versus Market Value
Weights
 Market-value weights are theoretically
superior to book-value weights:
 They reflect economic values and are not
influenced by accounting policies.
 They are also consistent with the market-
determined component costs.
 The difficulty in using market-value weights:
 The market prices of securities fluctuate widely
and frequently.
 A market value based target capital structure
means that the amounts of debt and equity are
continuously adjusted as the value of the firm
changes.

19. 19Financial Management, Ninth
Flotation Costs, Cost of Capital and
Investment Analysis
 A new issue of debt or shares will invariably involve
flotation costs in the form of legal fees, administrative
expenses, brokerage or underwriting commission.
 One approach is to adjust the flotation costs in the
calculation of the cost of capital. This is not a correct
procedure. Flotation costs are not annual costs; they
are one-time costs incurred when the investment
project is undertaken and financed. If the cost of capital
is adjusted for the flotation costs and used as the
discount rate, the effect of the flotation costs will be
compounded over the life of the project.
 The correct procedure is to adjust the investment
project’s cash flows for the flotation costs and use the
weighted average cost of capital, unadjusted for the
flotation costs, as the discount rate.

20. 20Financial Management, Ninth
Divisional and Project Cost of Capital
 A most commonly suggested method for
calculating the required rate of return for a
division (or project) is the pure-play
technique.
 The basic idea is to use the beta of the
comparable firms, called pure-play firms, in
the same industry or line of business as a
proxy for the beta of the division or the
project.

21. 21Financial Management, Ninth
Divisional and Project Cost of Capital
 The pure-play approach for calculating the
divisional cost of capital involves the following
steps:
 Identify comparable firms.
 Estimate equity betas for comparable firms.
 Estimate asset betas for comparable firms.
 Calculate the division’s beta.
 Calculate the division’s all-equity cost of capital.
 Calculate the division’s equity cost of capital.
 Calculate the division’s cost of capital.

22. 22Financial Management, Ninth
The Cost of Capital for Projects
 A simple practical approach to incorporate
risk differences in projects is to adjust the
firm’s WACC (upwards or downwards), and
use the adjusted WACC to evaluate the
investment project.
 Companies in practice may develop policy
guidelines for incorporating the project risk
differences. One approach is to divide
projects into broad risk classes, and use
different discount rates based on the
decision-maker’s experience.

23. 23Financial Management, Ninth
The Cost of Capital for Projects
 For example, projects may be classified as:
 Low risk projects
discount rate < the firm’s WACC
 Medium risk projects
discount rate = the firm’s WACC
 High risk projects
discount rate > the firm’s WACC