Contemporary Engineering Economics, 4 th edition, © 2007 Cost of Capital Lecture No. 61 Chapter 15 Contemporary Engineering Economics Copyright © 2006

Contemporary Engineering Economics, 4 th edition, © 2007 Cost of Capital (k) Cost of Equity (i e ) – Opportunity cost associated with using shareholders’ capital Cost of Debt (i d ) – Cost associated with borrowing capital from creditors Cost of Capital (k) – Weighted average of i e and i d Cost of Equity Cost of Debt Cost of Capital

Contemporary Engineering Economics, 4 th edition, © 2007 Cost of Equity (i e ) Cost of Retained Earnings (k r ) Cost of issuing New Common Stock(k e ) Cost of Preferred Stock (k p ) Cost of equity: weighted average of k r k e, and k p

Contemporary Engineering Economics, 4 th edition, © 2007 Where C r = amount of equity financed from retained earnings, C c = amount of equity financed from issuing new stock, C p = amount of equity financed from issuing preferred stock, and C e = C r + C c + C p Calculating the Cost of Equity based on Financing Sources

Contemporary Engineering Economics, 4 th edition, © 2007 Calculating the Cost of Equity Issuing New Common Stock Cost of Preferred Stock Cost of Equity Cost of Retained Earnings Where c r = amount of equity financed from retained earnings, c c = amount of equity financed from issuing new stock, c p = amount of equity financed from issuing preferred stock, and c e = c r + c c + c p

Contemporary Engineering Economics, 4 th edition, © 2007 Example 15.4 Determining the Cost of Equity – Alpha Corporation SourceAmountFraction of Total Equity Retained earnings $1 million0.167 New common stock $4 million0.666 Preferred stock $1 million0.167

Contemporary Engineering Economics, 4 th edition, © 2007  Cost of retained earnings: With D 1 = $5, g = 8%, and P 0 = $40  Cost of new common stock: With D 1 = $5, g = 8%, and f c = 12.4%  Cost of preferred stock: With D*= $9, P*= 95, and f c = 0.06  Cost of equity: Solution:

Contemporary Engineering Economics, 4 th edition, © 2007 Cost of Debt (i d )

Contemporary Engineering Economics, 4 th edition, © 2007 Example 15.6 Determining the Cost of Debt Given: Sources of debt financing, tax rate = 38% Find: A/T cost of debt SourceAmountFractionInterest Rate Flotation Cost Term loan$1.33 million % per year Bonds$2.67 million % per year 6%

Contemporary Engineering Economics, 4 th edition, © 2007 Solution A/T Cost of Issuing Bond (k b ): A/T Cost of Debt:

Contemporary Engineering Economics, 4 th edition, © 2007 The Weighted A/T Cost of Capital c d = Total debt capital(such as bonds) in dollars, c e =Total equity capital in dollars, V = c d + c e, i e = Average equity interest rate per period considering all equity sources, i d = After-tax average borrowing interest rate per period considering all debt sources, and k = Tax-adjusted weighted-average cost of capital.

Contemporary Engineering Economics, 4 th edition, © 2007 Process of Calculating the Cost of Capital

Contemporary Engineering Economics, 4 th edition, © 2007 Marginal Cost of Capital Given: C d = $4 million, C e = $6 million, V= $10 millions, i d = 6.92%, i e =19.96% Find: k Comments: This 14.74% would be the marginal cost of capital that a company with this financial structure would expect to pay to raise $10 million.

Contemporary Engineering Economics, 4 th edition, © 2007 Summary Methods of financing: 1. Equity financing uses retained earnings or funds raised from an issuance of stock to finance a capital investment. 2. Debt financing uses money raised through loans or by an issuance of bonds to finance a capital investment. Companies do not simply borrow all funds to finance projects. Well-managed firms usually establish a target capital structure and strive to maintain the debt ratio when individual projects are financed.

Contemporary Engineering Economics, 4 th edition, © 2007 The cost of the capital formula is a composite index reflecting the cost of funds raised from different sources. The formula is The marginal cost of capital is defined as the cost of obtaining another dollar of new capital. The marginal cost rises as more and more capital is raised during a given period.