Cost of Capital

n For Investors the rate of return on a security is a benefit of investing. n For Financial Managers that same rate of return is a cost of raising funds that are needed to operate the firm. n In other words, the cost of raising funds is the firm’s cost of capital.

How can the firm raise capital? n Debentures n Preference shares n Equity shares n Each of these offers a rate of return to investors. n This return is a cost to the firm.

The Weighted Cost of Capital n To calculate the firm’s weighted cost of capital, we must first calculate the costs of the individual financing sources: n Cost of Debt n Cost of Preference shares n Cost of Equity shares

Cost of Debt For the issuing firm, the cost of debt is: n the rate of return required by investors, n adjusted for taxes.

Cost of Debt n Recall: kd = = kd = = IntPo Interest Price Price

Component Cost of Debt n Interest is tax deductible, so k d AT = k d BT (1 - T) k d AT = k d BT (1 - T) = 10%( ) = 6%.

Cost of Preferred Stock n Recall: kp = = kp = = DPo Dividend Price Price

Example: Cost of Preferred n If Reliance Corporation issues Preference shares, it will pay a dividend of Rs 8 per year and should be valued at Rs 75 per share. n what is the cost of Preference shares for Reliance?

Cost of Equity shares n There are 2 sources of Equity: 1) Internal equity (retained earnings), and 2) External equity (new Equity shares issue)

Cost of Internal Equity n Since the stockholders own the firm’s retained earnings, the cost is simply the stockholders’ required rate of return. n Why? n If managers are investing stockholders’ funds, stockholders will expect to earn an acceptable rate of return.

Cost of Internal Equity 1) Dividend Growth Model Ke = + g Ke = + g D 1 Po

Weighted Cost of Capital n The weighted cost of capital is just the weighted average cost of all of the financing sources.

Weighted Cost of Capital Capital Capital Source Cost Structure debt 6% 20% preferred 10% 10% equity 16% 70%

n Weighted cost of capital =.20 (6%) +.10 (10%) +.70 (16).20 (6%) +.10 (10%) +.70 (16) = ? Weighted Cost of Capital (20% debt, 10% preferred, 70% equity)

What factors influence a company’s WACC? n Market conditions, especially interest rates and tax rates. n The firm’s capital structure and dividend policy. n The firm’s investment policy. Firms with riskier projects generally have a higher WACC.