CHAPTER THREE

3. COST OF CAPITAL
3.1 THE CONCEPT OF COST OF CAPITAL
The concept of cost of capital has its roots in the items on the right-hand-side of the balance
sheet, which includes various types of debt, preferred stock, common stock, and retained
earnings. These items are called the capital components. An increase in total asset must be
financed by an increase in one or more of these capital components.

Capital is one of the necessary components of production/operation of a business firm, and like
any other factor it has a cost of its own. The cost of each component of capital is called
component/specific cost of that particular capital.

Every profit-making/seeking business firm has its own risk-return characteristics. Each group of
investors in the business firm such as bondholders, preferred stockholders, and common
stockholders requires a minimum rate of return that commensurate with the risks the group
accepts as a result of investing in the firm. From the stand point of the firm, these groups
provide the capital (financial resources) needed to finance the firm’s investments in its total
assets. The minimum rate of return that the business firm must earn in order to satisfy the overall
rate of return required by its financers is called the firm’s cost of capital.
Definition of cost of capital and its implications
The most important implication of the definition of cost-of-capital can be stated as follows:
If the actual rate of return that the business firm earns exceeds its cost-of-capital, and if this rate
of return is earned without increasing the risk characteristics of the firm, than the shareholders’
wealth is increased, which further implies the achievement of the basic goal of the business firm
(i.e. the maximization of shareholders wealth).

The reasoning behind this implication is that when the rate of return of the firm exceeds its cost
of-capital, the bondholders and preferred stock holders will basically receive their fixed rate of
return. Then, the remaining portion of the firm’s rate of return that is available to common
stockholders will definitely exceed their required rate of return. The excess earnings, then, may
be treated in several ways of which some are:
 The business firm may distribute these excess earnings to common stockholders in the
form of increased dividends, or
 The business firm may retain and reinvest these excess earnings to further increase it
subsequent rate of return, or
 The business firm may divide the excess earnings between the increased dividends and
retained earnings (i.e. part of the excess earnings may be distributed to common
stockholders in the form of increased dividends, and other portion of the earnings may be
retained for further expansion of firm’s operation.)
As the consequence of the decision made in relation to the excess earnings, the common shares
will become more demanded in the stock market and the increased demand for common share
ownership will increase the resale prices of common shares. In such a way, shareholders; wealth
will be maximized, thus meeting the basic goal of the business firm.
An alternative definition of cost-of-capital considers cost-of-capital as the minimum rate of
return that the firm must earn on its invested capital if the market value of the firm is to remain
unchanged.

1
This definition, as you can understand, assumes cost-of-capital as a “break-even” rate.
According to this definition, cost-of-capital is the rate that maintains the current market value of
the firm. If this cost of capital (rate of return) is not earned, the market value of the firm will
decline.
3.2 Measuring component of Cost-of-capital
As it was indicated at the beginning, the capital structure of the business firm contains debts
(bonds), preferred stocks, common stocks, and retained earnings and has its own minimum
required rate of return, and consequently its own cost-of-capital (the average cost-of capital).
The cost-of-capital has to be computed for each capital source and security issue. The cost-of-
each capital source or component is called the specific cost-of-capital, or the component cost of
that particular type of capital.
3.2.1 Cost of Debt
Since most long-term debts of the firm are in the form of bonds, computation of the cost of debt
capital is based on the characteristics of bonds and the interest charges the bonds impose on the
firm. Estimating this specific (component) cost of debts (bonds) requires computing the
effective cost of debt to the firm and stating this effective cost of debt to the firm and stating this
effective cost of debt as an annual compounding rate.
The computation of the specific (component) cost of debts (bonds) involves three steps:
If the Ethiopian Government (NBE) sells the bonds at a net proceed of 1000Birr per bond which
is equal to the principal (par value) of the bond, the sum of the present values of the series
payments and the present value of the principal payment at maturity of the bond is equal to the
proceed at time zero at the discounting rate that is equal to the bond’s coupon rate, that is 12
percent. Hence, the specific (component) cost of capital of debt bond) is 12 percent. Since the
net present value at a discount (interest rate of 12 percent, is 0, the specific cost of capital of debt
(bond) before-tax (Kd) is 12 percent. As a general rule, when the proceeds from the sales of
bonds are equal to the par values of the bonds, the specific cost-of-capital of debts (bonds)
before-tax is equal to the coupon rate attached to the bonds.
After-tax specific cost of debt (bond) of capital = Kd-KdT
= 12% - (12%)(0.40)
= 12% -4.8%
=7.2%
Therefore, the Ethiopian Government (NBE) is required to pay an effective cost of capital of
debt (bond) after-tax of 7.2 percent if it sells its bonds for a net proceed of 1000 Birr per bond.
The reason for using after-tax cost of debt capital is as follows. The value of firm’s capital stock,
which the financial manager wants to maximize, depends on the after-tax cash flows. As interest
on debts or bonds is a tax deductible expense, it produces tax savings which reduce the net cost
of debt, making the after-tax cost of debt less than the before-tax cost of debt.
3.2.2 Cost of preferred stock
When a business firm sells preferred stock, it expects to pay fixed dividends to investors
(preferred stock holders) in the return for their money capital. The dividend payments are
basically the cost of the firm preferred stock. In order to express these dividends as yearly rated,
the firm uses the net proceeds it receives after deducting whatever costs incurred in selling
(floating cost per share) the issue. If, for example the firm sells the preferred stock for 40 Birr
per share and pays a 2 Birr selling (flotation costs per share), the firm has to use 38 Birr (40-2)
net proceeds per share in computing the specific (component) cost of capital of preferred stock.

2
The specific cost of capital of preferred stock, Kps, is the preferred dividends/Dps, divided by
the net proceeds from the issuance of the share Pn, or the price of the share that the firm accepts
after deducting the flotation costs.
D ps
In general, specific cost of Preferred share = Kps = P. n
For example, suppose that Bontu Share Company has preferred stock that pays a 10 Birr
dividend per share and sells for 100 Birr per share in the market. If Bontu share company issues
new shares of preferred stock, it will incur an underwriting or flotation) cost of 2.5 percent of the
selling price, or 2.50 Birr per share, so it will net 97.50 Birr per share. Therefore, the specific
cost of capital of preferred stock for Bontu Share Company would be: Specific cost of capital of
preferred stock = Kps =Dps/Pn = 10/97.50 = 10.26%
No tax adjustments are made when calculating the specific cost of capital for preferred stock
(Kps) because preferred dividend unlike interest expenses on debt, are non-tax deductable, hence
there are not tax saving associated with use of preferred stock as a source of capital.
3.2.3 Cost of common stock/Equity
The specific (component) cost of capital of common stock is the minimum rate of return that the
business firm must earn for its common shareholders in order to maintain the market value of the
firm’s equity. When the firm sells its common stock issue and nets for Pn Birr amount per share,
it can set the net proceeds equal to the stocks’ intrinsic value because investors have been willing
to acquire the security at the price that nets the firm on amount of Pn Birr. The intrinsic value of
common stock is estimate by using an equation:

Ke = Do (1+g) + g
Pn
Where Ke is specific cost of common stock
Do = Current dividend per share
g = Compound dividend growth rate each year
Pn = Net proceeds per share = Pn = Selling price – Flotation cost
This is the equation that is used most frequently to measure the specific cost of capital of
common stock. However, it is based on the assumption of the dividend stream that increases
indefinitely at a given compound rate of ‘g’. This compound rate, ‘g’, is the compound rate of
growth of common stock dividend that might be determined from the records in the past related
to dividend growth. Therefore, the use of this equation is limited to those business firms whose
expected future dividend stream at least approximates this assumption.
For instance, assume that Nib international Bank (N/B) sells an issue of common stock to
potential investors in the country. The selling price per the common share of the bank is 20 Birr.
The bank incurs a selling (flotation) cost of 2.50 Birr per share. The current dividend of the
bank’s common share is 2.00 Birr per year and it is expected to grow at 5 percent annual
compound rate. Compute the specific cost of capital of common stock of Nib International
Bank.
The net proceeds per share = Pn = Selling price – Flotation cost
= 20-2.50 = 17.50 Birr per share
Annual dividend = Do = 2.00 Birr per share.
Dividend growth rate per year = g = 5%, or 0.05
Therefore,
Ke = Do (1+g) + g = (2.00)(1+0.05) + 0.05
3
 Pn 17.50
= (2.00)(1.05) + 0.05
17.50
= 2.10 + 0.05
17.50
= 0.12 + 0.05 = 0.17 or 17%
There is no need to make income tax adjustment to the computed specific cost of capital of
common stock of 17 percent because common stock dividends, unlike interest on debts (bonds),
are not tax deductible, hence there is no tax-savings associated with the use of common stock
financing.
3.3 Weighted Average Cost-of-Capital
Once the specific/component/ costs of capital for each firm’s long term financing source has
been measured, it is possible to measure the firm’s overall cost-of-capital. It has been defined as
a rate of return that must be earned by the firm in order to satisfy the requirements of the
individual specific (component) costs of capital. The overall cost of capital (weighted average
cost of capital) that is computed form the firm’s existing capital structure allows the firm to
obtain a measure of a minimum rate of return that must be earned on its entire investments. The
overall cost of capital (weighted average cost of capital) of the firm can be of help in identifying
the discount rate to be used in evaluating the capital-budgeting decisions.
The overall cost of capital (weight average cost of capital) is obtained as follows:
1. Multiply the specific cost of capital of each source by its percentage composition in the
capital structure of the firm
2. Add the products you have computed under (1) above. The resulting sum is called the
firm’s weighted average cost of capital.
The percentage compositions (weights) that is used under (1) above can be based either on the
book values of the sources of capital or on their market values. The use of both values to
determine the percentage composition of each capital source of the capital structure has both
advantages and limitations.
3.3.1 Book Value Weights
The first approach to measuring firm’s weighted average cost of capital is to use the balance
sheet book values of the individual source of long term and permanent capital. These book
values reflect the amount of capital the firm has raised by selling securities as well as the amount
of capital that has been generated by reinvesting earnings that were not paid out as common
stock dividends Since each source of capital has its own cost of capital, the following three steps
are needed to compute the overall, weighted average, cost of capital on the basis of book value
weights:

1. Find the percentage of long-term capital provided by each financing source. The Birr
values for each capital sources are taken from the firm’s balance sheet.
2. Multiply each capital percentage by its specific (component) cost of capital.
3. Add the products you have computed under step 2.

To illustrate the use of book values of sources of capital as the basis of determining the overall
cost of capital (weighted average cost of capital), assume Lemlem company whose capital
structure contains the following book values and specific costs of capital of its capital sources.

4
Lemlem Company
Book values and specific cost of capital for a Given Capital Structure
Source of capital Book value Specific cost of capital
9% bonds, 1000 Birr par 15,000,000 Birr 5.4%, or 0.054

50,000 Shares, 8 Birr preferred Stock 5,000,000 Bir 8.0%, or 0.080

Common stock, 400,000 shares Outstanding 20,000,000 Birr 11.0%, or 0.110

Retained earnings 10,000,000 Birr 10.5%, or 0.105

The specific costs of capital given for Lemlem Company are assumed to have been computed

using the equations for each type of specific costs of capital indicated earlier. The book value

weights are obtained by dividing the book value of each financing source by the total book

values of all financing sources (i.e. 50,000,000 Birr in the case of this example). The book value

weight is then multiplied by the corresponding specific cost of capital to give the weighted costs.

The sum of these weighted costs equals 8.92 percent. This sum of the weighted costs of the

company is what we call the weighted average cost of capital (WACC). The computation of the

WACC on the basis of the book value weights is shown below.

Lemlem Company
Computation of weighted Average cost of capital
Book value Specific cost Weighted
Source of capital Weights of capital costs
9% bond, 1000Birr par……. 0.30 ……… 0.054 ……………. 0.0162
50,000 shares, 8 Birr
Preferred Stock -------------- 0.10 -------- 0.080 ---------------- 0.0080
Common Stock, 400,000
Outstanding shares ---------- 0.40 -------- 0.110 ---------------- 0.0440
Retained earnings ----------- 0.20 -------- 0.105 ---------------- 0.0210
Total 0.0892
The total (sum) of weighted costs is equal to 0.0892 which means 8.92 percent. This is to mean
that Lemlem company is required to earn a minimum of 8.92 percent on its total funds obtained
from all long-term sources, if the company is to satisfy the minimum requirements of its
financers (such as bondholders, preferred stockholders, and common stockholders).
The advantages of using book-value weights in computing a company’s weighted average cost of
capital are as follows:
1. The weighted average cost of capital (WACC) computation is so simple since book
values are available in the balance sheet of the company.

5
 2. The computed weighted average cost of capital (WACC) using book value weights is
generally stable overtime because book value weights are not dependent on market value
which is highly volatile.
3. The market values/prices of firm’s securities are being influenced by external factors like
inflation. Book Value weights may provide the only usable estimates of the firm’s
weighted average cost of capital.
There are two principal limitations in using the book value weights for the computation of
weighted average cost of capital (WACC) are:
1. Book values provide a historical (based on past data) weighted average cost of capital
that may not yield a cost-of-capital value that is useful for evaluating current strategies.
2. Their use is not consistent with the concept contained in the definition of the overall cost
of capital of the business firm. That definition, as we have touched upon, speaks of a
minimum rate of return needed to maintain the firm’s market value, but the book value
weights ignore market values. As a result, the weighted average cost of capital of the
firm that is determined on the basis of book value weights can be used only to provide a
quick estimate of the rate of return that investors require form their firm. Otherwise, the
weighted average cost of capital calculated by using book value weights can’t reflect
what is going on in the market at present accurately.
3.3.2 Market value weights
A second approach of measuring weighted average cost of capital is to use the market values of
the firm’s securities as weights in the computational process. The resulting cost of capital from
this process reflects the rate of return currently required by investors rather than the historical
rate embodied in the firm’s balance sheet.
The computation of the weighted average cost of capital of a firm using the market value weights
requires you to go through the following four steps:
1. Find the market value of each financing sources, using the current market prices of the
securities.
2. Divide each of the market values by the total market values of all capital sources in order
to obtain the market value weight.
3. Multiply the specific costs of capital (already determined by their corresponding market
value a weight for example, the specific cost of capital of debts (bonds) is multiplied by
the market value weight of debts (bond). The resulting products are the weighted costs.
4. Add the products (weighted costs) you have computed under step 3 above. The sum of
the products is what is called the weighted average cost, of capital (overall costs of
capital) (based on market values).
To illustrate, the computation of weighted average cost of capital of the firm using the market
values of the financing sources, assume the same information provided for Lemelem company
with the necessary market values for each sources which are observed to be the following: Bond
prices are 95 percent of their par values, preferred stocks are 100 Birr per share, and common
stocks sell for 75 Birr per share.
The first step is to determine the market value for each financing sources. The market values for
bonds, preferred stocks, and common stocks are available in the market at any point in time since
these are securities that are exchanged in the stock exchange markets. But in countries, like ours,
the market value for these securities are hardly available because there is no a formally organized
stock exchange market that sets prices for these securities. Even if there is existed stock
exchange market for these securities, the market value is not available for retained earnings

6
which are not securities but sources of firm’s funds. As you remember from our previous
discussions, the specific cost of capital of retained earnings was estimated on the basis of the
specific cost of capital of common stock. In the same way, the market value of retained earnings
is derived from the market value of common stock. The Market value of common stock is
divided between common stock and retained earnings in the same proportion of their book
values.
The market values of each financing sources are:
(0.95) (15,000,000) = 14,250,000 for the bonds
(100) (50,000 shares) = 5,000,000 for the preferred stock
(75) (400,000 shares) = 30,000,000 for the common stock & 49,250,000 for the total
capital structure.
Then, as stated above, the market value of common stock of 30,000,000 Birr is divided between
common stock and retained earnings on the bases of their book values in the balance sheet.
Their book values are 20,000,000 Birr for common stock and 10,000,000 Birr for retained
earnings and 30,000,000 in total for both.

Thus, 20,000,000 x 30,000,000 = 20,000,000 Birr (the market value of common

10,000,000 x 30,000,000 = 10,000,000 Birr (the market value of

Lemlem Company
Market values and their weights for the company’s capital structure
Source of capital Market value Market value weight
9% bond, 1000 Birr par ---------- 14,250,000 ---------------- 0.289
50,000 shares, 8 Birr preferred
Stock ------------------------------- 5,000,000 ----------------- 0.102
Common stock, 400,000 shares
Outstanding -------------------- 20,000,000 ---------------- 0.406
Retained earnings ------------ 10,000,000 ---------------- 0,203
Total 49,250,000 1,000
The market value weight for bonds of 0.289 is determined by dividing the market value of bonds
(i.e. 14,250,000) by the total market values (i.e. 49,250,000). The other market value weights are
determined in the same manner.
Next to the determination of market value weights, these weights are multiplied by the
corresponding specific cost of capital of the financing sources and the resulting products are
added. The sum of 0.0898 or 8.98 percent which represents the company’s weighted average
cost of capital, computed by using market value weights as shown below.
Lemlem company
Weighted Average cost of capital using market value weights
Source of capital Market value weight x specific cost = weighted
Cost

7
9% bonds, 1000 Birr par 0.289 0.054 0.0156
50,000 shares, 8 Birr Preferred stock 0.102 0.080 0.0082
Common Stock, 400,000
Shares outstanding 0.406 0.110 0.0447
Retained earnings 0.203 0.105 0.0213
Total 0.0898
Therefore, the average cost of capital that reflects the current conditions in the market is 8.98 percent
for Lemlem Company.
The advantages of using the market value weights in computing a company’s weighted average cost of
capital are:
1. The use of market value weights is consistent with the concept of maintaining market
values in the cost-of-capital definition.
2. They provide current estimates of financers (investors) required rate of return, which are
more relevant than historical book value weights in evaluating current capital budgeting
alternatives.
3. To the extent that business firm has attained its targeted or desired capital structure,
market value weights will yield good estimate of cost of capital that would be incurred in
case the firm needs additional financing.
The limitations of using market value weights in computing cost-of-capital are:
1. Market value weights are more difficult to use in computing the overall cost of capital of
the firm than the book value weights which are readily available. It is difficult not only
to obtain the market value of the financing sources but also to allocate the market value
of the common stock between common stock and retained earnings when the specific
cost of capital of retained earnings is the selling costs (floatation costs) of common shares
are insignificant and to be ignored, the specific costs-of-capital of common stock and
retained earnings are the same and there is no need to allocate the market values of
common stock between the two.
2. Since the market values/ prices of the firm’s securities change daily, the market value of
the firm and its corresponding cost daily, the market value of value weights also change
daily of capital using market value weights also change daily and highly instable to make
use of them.
3. Market value weight can seriously distort the overall cost of capital of the business firm
when the prices of its securities are significantly influenced by external factors/forces
such as inflation. Inflation can depress bond prices severely for a period of time. This
been. If market value weights are to relied upon the computed weighted average cost of
capital may have to be adjusted subjectively for what have been thought to be distortions
by external forces.
3.4 Marginal Cost of Capital (MCC)
In the previous section, it was tried to analyze cost-of-capital when the firm’s total financing
remained constant. In reality, the desire of the firm to finance new investment proposals using
internal and/or external funds requires that the firm has to increase its total capital base. When
this happens the cost of capital of the additional financing is called Marginal Cost of Capital
(MCC). Thus, the marginal cost of capital, MCC, is defined as the cost of the last Birr of new
capital the firm raises, and this cost (i.e. MCC) rises as more and more capital is raised during a
given period. If the additional financing uses more than one type of funds, such as a

8
combination of retained earnings and debts, the weighted average cost of capital of the new
financing is called the weighted marginal cost of capital.
3.4.1 Calculating the Marginal Cost of Capital (MCC)
The firm’s marginal cost of capital (MCC) is a function of several variables. Because of this,
calculating the marginal cost of capital is often a difficult task that yields only approximations of
true values. The four variables that impact on MCC do so by influencing the specific cost of
capital of the new financing sources. These variables are:
1. Investors may perceive that the firm’s business risk will increase as a result of new
investment decisions that require additional financing.
2. If new financing changes the percentage composition of the financing sources (composition
of capital structure), its financial risk may increase. Increases in financial and business risks
will be reflected in higher MCC.
3. The investment alternatives that are available and desirable to the firm may require a large
amount of financing relative to its existing total capital. In this case, the size of the desired
financing may increase the firm’s MCC and thus may reduce the importance of some of the
investment alternatives.
4. External forces such as inflation may increase the firm’s MCC to the point where it delays
raising long-term external capital and forcing the firm to finance its new investment
proposals with funds from retained earnings source.
The Marginal Cost of Capital (MCC) calculation procedures followed in this material are based
on the following assumptions.
1. The new financing decision has a minimum impact on the existing capital structure of the
firm. This assumption implies that the percentage composition of new financing is
specified by the financial managers of the firms.
2. The second assumption is that the firm can reasonably forecast the specific costs of capital
of the new financing which are the same as the specific cost of capital of the existing
capital structure or totally different. This implies the need for some ability to estimate the
impact of some added business risk and the external variables on the specific cost of
capital.
3. Market value weights are used based on the realizations that new capital is obtained by
paying the cost-of –capital which is a good estimate of the current market price of capital.
That market value weight based MCC is more relevant than the MCC that is computed on
the basis of book values of the existing capital structure.

9
10