Cost of capital

Izaskun Larrieta
 Learning objectives

1. Calculate the cost of capital of the different sources

of financing
2. Calculate the cost of capital of external resources
(cost of debt)
3. Calculate the capital cost of own resources
1. Cost of shares (capital increases)
2. Costs of retained earnings
4. Calculate the weighted average cost of capital
(WACC) of the company

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 Content Index

1. Concept
2. The cost of debts
3. The cost of shares
4. The cost of retained earnings
5. The weighted average cost of
capital (WACC)

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 Concept

• The companies use to finance their assets

different financial sources like credits,
bonds, capital increases, reserves etc.
• Financial resources have a cost
• The cost of each financial source and
• the average cost of the different sources of
financing of the company, which is what is
usually called Cost of Capital

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 Concept

• A business firm must strive to earn at least as much

as the cost of the funds that it uses.

• Usually a firm has several sources of funds and

each source may have a different cost.

• The overall cost of the funds employed is a

proportionate average of the various sources.

• The firm's required rate of return that will satisfy all

suppliers of capital is called its cost of capital.

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 Concept

• Financing has a cost, but the company aims to

minimize it
• The company tries to find the minimum cost of
capital through several mixtures of its sources of
financing
• It should be provided with those funds that are
cheaper
• Company must adopt an optimal financial
structure, understanding the way in which the
capital is distributed according to its origin, time and
cost
• The cost of capital is an opportunity cost, since
when using it, other possible uses of funds are
waived
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 Concept

There are several steps in measuring a

firm's cost of capital.

1. Compute the cost of each source of capital.

2. Assign weights to each source.
3. Compute the weighted average of the
component costs.

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 Concept

• The profitability of the investments undertaken by

the company must not be lower than the cost of
capital of the resources used to finance it
• The cost of capital equals the Minimum Rate of
Return, MRR, necessary to justify the use of the
funds.
• In order to economically evaluate an investment, it
will be necessary to compare its rate of return with
the cost of the average capital of the company

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 Content

• The cost of capital is the minimum

return that an investment must offer to
make it worthwhile from the point of
view of the company
• It is the price that the company must
pay for the resources employed in
order to satisfy the remuneration to the
capital providers

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 Decisions to be taken

1. THE SELECTION OF INVESTMENTS since the

return provided by the investments can never be
less than the cost of capital of the resources that
have been used in its financing (R> i) (Controller)

2. DESIGN THE OPTIMIZED FINANCIAL

STRUCTURE, which will be the one that suits the
different means of financing so that the cost of
capital is minimal (Treasurer)

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 The costs of debts

• The cost of a financing source is defined as the

discount rate that equals the net present value of
the funds obtained with the net present value of the
payments made

• Id: the cost of the debt or effective discount rate

• M: amount of debt actually received
• S: annual payments or disbursements
• N: number of years of debt

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 Costs of Debts

DESEMBOLSOS DISTINTOS PARA CADA UNO DE LOS AÑOS: S1 ≠ S2 ≠ … ≠ Sn

M S1 S2 … Sj … Sn

0 1 2 … j … n

… ACTUALIZACIÓN
UPDATING

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 Costs of debts

• If it is understood as a debt of unlimited duration, it

is a perpetual income. Then, the cost of the debts is
obtained by dividing the annual disbursements
between the amount of the debt

Id = S / M

• Since interest is tax deductible, the actual cost of

debt to the firm is less than the yield to maturity
The after-tax cost of debt is:
Id’ = Id (1-T)
Where:
T = The firm’s effective tax rate 13
 EXERCISE 45

• A company purchases raw materials

that it has to pay in 120 days.
However, if the company chooses to
pay in 30 days, the supplier offers a
discount of 2%.

• What is the cost of the capital of the

loan granted?

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 EXERCISE 51

• A company requests a loan from the bank to

buy a machine for € 10,000. The repayment
of the loan is 50% in each of the two years
(end of the period). The interest rate applied
by the bank is 3%.
• CHECK that if there are no expenses
inherent in the operation, the cost of the
debt is the one provided by the bank.

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 EXERCISE 52

• A company wants to expand its production capacity

so that it needs to acquire a new equipment that it
will finance by issuing a 10,000 bonds at a nominal
value is 30 € / bond. The issue is made at 96%. The
repayment will be made at the end of the second
year, which is the duration of the debt. The bank
responsible for placing the bonds among its clients,
charges a commission of € 20,000 for advertising,
commissions ... The annual interest rate is 5% and
corporation tax is 30%.
• It is required, the actual cost of the loan.

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 EXERCISE 53

The GOING company needs € 50,000 to finance an

investment. A bank offers these two investment
options:
A) loan of € 50,000, two years at an effective interest
rate of 4%
B) loan of € 50,000, two years with a 3.75% effective
interest and a 2 per thousand opening commission.
Knowing that the loan will be returned by the end of
the second year, INDICATE the best of the options

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 The Cost of Internal Finance Resources

• Internal financing is available through the

retention of earnings belonging to present
stockholders or by issuing new common
stock/share.
• Sources of capital for common stock equity
• Purchaser of new shares – external source
• Retained earnings – internal source

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 The Cost of Share Capital: the shares

• Shares are long-term financial funds belonging to

and owned by the company and are remunerated
through profit sharing
• The cost of share capital or shares is defined as the
return that the shareholder expects to obtain from
having invested his funds in the company
• The cost of shares is the discount rate that equals
the current price of a share with the current price of
the dividend stream that the shareholder expects to
obtain

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The Cost of Share Capital: the shares

• Po: the current value of the share: theoretical value

or quoted value
• D: dividend per share at the end of each year
• IA: rate of updating or cost of capital

As the actions are permanent financial resources

and the purpose of the company is their continuity,
the expression above would be transformed as
follows (n ∞):
iA= D / PO
• The cost of the share capital or of the shares is
equal to the split dividend of the present value of
the share (if the dividends are constant and
indefinite) 20
 Corporate dividend policy

The companies follow a behavior that we can call

Dividend Policy
 Partial allocation of annual benefits
 Apply a constant current dividend
 Distribution of annual dividends constant, adjusted
or supplemented according to the situation of the
company
 Variable dividends depending on the financial
needs of the company derived from the available
investments

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 The Cost of Share Capital: the shares

• The cost of financing through capital increases with

shares that accrue or distribute dividends at a
constant growth rate is equal to the current value of
the expected return on shares for shareholders
• g = constant growth rate of dividends

Po = D / (iA – g) iA = D / Po + g

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 The Cost of Share Capital: the shares

• Note: The stock dividend is not a tax deductible

expense and therefore there is no fiscal adjustment
• Banks charge commissions for placing capital
increases and these commissions increase the cost
of financing

Po – c*P0 = D / iA iA = D / Po (1- c)

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 Corporate dividend policy

• Self-financing needs of companies must be compatible with

the expectations of profitability of the shareholders
• If all the benefit is distributed, it means that business growth
will be financed with external resources, i.e. through capital
increase or loans
• If profits are not distributed and the growth has to be financed
with internal resources, discouragement in the shareholders
can be generated and in the next capital increases they will
not go to the subscription
• The company must find a balance between the policy of
distributing dividends to guarantee the expectations of the
shareholders combined with a policy of self-financing that
does not make the growth of the company depend only on
external resources

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 EXERCISE 54

The shares of the LARREA company have a

nominal value of € 30 and are listed at 120%.
Knowing that the policy of the company is to
distribute constant dividends of € 4, CALCULATE:
i. The capital cost of each share
ii. The capital cost of each share if the bank
applies a commission of 2 per thousand for
placing it
iii. The cost of capital of each share if dividends
grow by 3%

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 EXERCISE 55

• A company wants to finance a new investment to

expand its production capacity by issuing shares.
The company applies a constant dividend policy of
€ 3 per share. The nominal value of each of them is
20 € and its quotes of 150%. DETERMINE:
• The cost of the share capital
• What would be the cost if the bank charged a
commission for the placement of 3% shares?
• If the dividends distributed by the company increase
by 4%, what would be the new cost of the shares?

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 The Cost of Retained Earnings

• The benefits retained by the company constitute a form of

financing that does not have to be remunerated, since they
are resources generated by the company itself.
• Represent present and past earnings of firm minus previously
distributed dividends
• Belong to current stockholders – paid as dividends or
reinvested in firm
• Reinvestments represent source of equity capital supplied by
current stockholders
• The fact that it does not have an explicit cost, that is, that
nothing is to be paid for its use, does not mean that it is a
gratuitous source, but must be given an opportunity cost

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 The Cost of Retained Earnings

• Retained earnings could be paid to current

shareholders in the form of dividends and these
could then be redirected to other shares, bonds,
real estate ...
• What is the expected return on these alternative
investments? What is their opportunity cost?
• Shareholders, at least, could earn a return
equivalent to that provided by their current
investment in the company (at equal risk)
• In the stock markets there are thousands of
investments to choose from, so it is not unlikely to
assume that the shareholders could take the
dividend payments and reinvest them for a
comparable return

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 The Cost of Retained Earnings

• Therefore, the cost of retained earnings is

calculated from the dividend that the shareholder
no longer receives as a result of the retention of
profits
• The cost of retained earnings is equivalent to the
rate of return on the firm's common stock. This is
the opportunity cost.
• That cost of opportunity is the cost of the share
capital, since if the company, instead of holding
them, distributes all its benefits, in order to have the
same funding as if it had retained them and if it
wants to maintain the same debt ratio, should have
to make a capital increase for the same amount
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 The Cost of Retained Earnings

• Therefore, the cost of retaining benefits can be

estimated approximately as the realization of the
capital increase or the cost of capital, except for the
differential of:
– The different tax treatment since dividends are taxed on
capital income and profits are not
– The existence of share issuance expenses
• Retained earnings are a slightly cheaper financial
source than share capital, although it is usually
assimilated to it

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 The cost capital of depreciations

• With amortization funds, it is the same.

• They do not have an explicit cost, but
they have to be assigned an
opportunity cost that, in this case,
would be similar to the cost of the
medium- and long-term financing, also
rectified downwards

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 Optimal Capital Structure

• Having established the techniques for computing

the financing cost of the different financial sources
of the company's financial structure, we must know
discuss methods for assigning weights to these
cost.
• We will attempt to weight capital components in
accordance with our desire to achieve a minimum
overall cost of capital.
• This would represent the optimal capital structure of
the company
• The firm should seek to minimize its cost of capital
by employing the optimal mix of capital financing.

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 Example

Weighted Average Cost of Capital (WACC) can be

calculated by the summation of the product of each
element of capital multiplied by its relative weight or
mix.
Financing Cost (after tax) Weights Weighted Cost
source
Debt 7,05% 30% 2.12%
Preferred stock 10,94% 10% 1.09%
Retained 12% 60% 7.20%
earnings
(common stock)
Weighted average cost of capital (WACC) 10.41%

The company is financed at a weighted average cost of 10.41%

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 Weighted average cost of capital

• The weighted average cost of capital (WACC) is

made by weighting the cost of each source
according to its proportion in the total capital

• Im = id Liabilities + iA Own resources

Total Resources Total Resources

• The minimum return on investment made by the

company must exceed the cost of all the financial
resources used by the company, i.e. it has to be
higher than the cost of capital

• Profitability of investments> Weighted average cost of capital of

the company

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WACC

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 EXERCISE 56

• The financial structure of a company consists of three

sources of financing whose costs, before taxes, and
amounts are shown in the following table (€):
FINANCING SOURCES COST
Credits 40,000 12%
Bonds 50,000 13%
Share Capital 110,000 14%

DETERMINE the weighted average cost of capital

knowing that corporation tax is 35% and that the
interest on loans and bonds are tax deductible.

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 EXERCISE 57

• The financial structure of a company consists of

three sources of financing whose costs, before
taxes, and amounts are shown in the following table
(€):
FINANCING SOURCES COST
Loans 149.000 7%
Bonds 135.000 8%
Share Capital 585.000 5.5%
Reserves 36.000 5%
DETERMINE the weighted average cost of capital
knowing that corporation tax is 35% and that the
interest on loans and bonds are tax deductible.

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 EXERCISE 58

Assume the following capital structure for Bilbao Corp.:

Long Term Loan 35%
Preferred shares 15%
Retained earnings (reserves) 50%
The following facts are also provided:
Loan interest rate 9%
Corporate tax rate 35%
Dividend per preferred share € 8.50
Nominal value preferred share € 100
Price (current value) preferred share 98%
Dividend per ordinary share 1,20 €
Price (current value) ordinary share € 30
Growth rate, ordinary share 9%
COMPUTE the weighted average cost of capital
Preferred shares: entitles the holder to a fixed dividend, whose
payment takes priority over that of ordinary share dividends. 38
 FINAL IDEAS

Financing Cost (after tax) Weights Weighted Cost

source
Debt 7,05% 30% 2.12%
Preferred stock 10,94% 10% 1.09%
Retained 12% 60% 7.20%
earnings
(common stock)
Weighted average cost of capital (WACC) 10.41%

The company is financed at a weighted average cost of 10.41%

Debts are the most economical financing source (7.05% <10.94%), why not use more debt?

External financing should only be used within reasonable limits as increased funding
from outside sources increases financial risk

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 FINAL IDEAS

• In determining the appropriate capital

mix, the firm generally begins with its
present capital structure and
ascertains whether its current position
is optimal
• If not, subsequent financing should
carry the firm toward a mix that is
deemed more desirable.

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 FINAL IDEAS

• From a financial perspective, the company wants to

get all its necessary financing at the lowest possible
cost
• The corporate finance officer (CFO) should know
how interest rates move during the business cycle,
as well as when to use short-term debt and when
the long term
• The company has to find a balance between own
resources and others to achieve the minimum
capital cost

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 FINAL IDEAS

• From the economic point of view, the capital

cost of each financial source is important
when making investment decisions
• The economic value added (EVA) is a
concept that refers to decision making
• The EVA indicates that investment decisions
should only be made or projects accepted if
the net operating profit after tax (NOPAT)
exceeds the capital costs necessary to
finance the investment

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 Final Insights Unit 8-Cost of capital

1. The cost of capital represents the weighted average cost of all of the
sources of financing to the firm.

2. The cost of capital is normally the discount rate to use in analyzing an

investment.

3. A firm attempts to find a minimum cost of capital through varying the

mix of its sources of financing.

4. The cost of capital may eventually increase as larger amounts of

financing are utilized.

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 Final Insights

• In March 2010, Elkano Relievers bought a massage

machine that provided a return of 8%. It was
financed by debt costing 7%. In August 2010, Mr.
Elkano came up with a heating compound that
would have a return of 14%.
The Chief Financial Officer, Mrs. Sarriko, told him it
was impractical because it would require the
issuance of common shares at a cost of 16% to
finance the purchase.
Is the company following a logical approach to
using its cost of capital?

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 Final Insights

• No.
• Each individual project should not be measured
against the specific means of financing that project,
but rather against the weighted average cost of
financing all projects for the firm.
• This principle recognizes that the availability of one
source of financing is dependent on other sources.
• Once a common overall cost is determined, the
“heating compound” yielding 14% is much more
likely to be accepted than the “massage machine”
only yielding 8%.

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 Final Insights

• Sarriko Systems can buy a piece of equipment that

is anticipated to provide an 11%return and can be
financed at 6 % with debt. Later in the year, the firm
turns down an opportunity to buy a new machine
that would yield a 9% return but would cost 15% to
finance through common equity. Assume debt and
common equity each represent 50% of the firm’s
capital structure.
• a. Compute the weighted average cost of capital.
• b. Which project(s) should be accepted?

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 Final Insights

Costs Weights Weighted Cost

Debt 6% 50% 3%
Common equity 15% 50% 7,5%
Weighted average cost of capital (WACC) 10,5%

Only the piece of equipment with a return of 11%.

The return exceeds the weighted average cost of capital of 10.5%

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 Final Insights

• Calculate the after-tax cost of debt under each of

the following conditions.
Interest Corporate (1-T) Weighted
Tax Rate Cost
8% 18% (1-0,18) 6,56%
12% 34% (1-0,34) 7,92%
10,6% 15% (1-0,15) 9,01%

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 Final Insights

Elkano Technology has the following capital structure.

Debt 40%
Common equity 60%
The after-tax cost of debt is 6 %; and the cost of common equity (in
the form of retained earnings) is 13 %.

a) What is the firm’s weighted average cost of capital?

b) An outside consultant has suggested that because debt is cheaper
than equity, the firm should switch to a capital structure that is 50 %
debt and 50 % equity. Under this new and more debt-oriented
arrangement, the after-tax cost of debt is 7 %, and the cost of
common equity (in the form of retained earnings) is 15 %.
Recalculate the firm’s weighted average cost of capital.
c) Which plan is optimal in terms of minimizing the weighted average
cost of capital (WACC)?

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 Final Insights

Finance Source Cost Weights Weighted Cost

after
tax
Debt 6% 40% 2,40%
Common equity 13% 60% 7,80%
(retained earnings)
Weighted average cost of capital (WACC) 10,20%

Finance Source Cost Weights Weighted Cost

after
tax
Debt 7% 50% 3,50%
Common equity 15% 50% 7,50%
(retained earnings)
Weighted average cost of capital (WACC) 11,0%
The plan presented in part a is the better alternative. Even though
the second plan has more relatively cheap debt, the increased
costs of all forms of financing more than offset this factor.
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 THANK YOU
ESKERRIK ASKO
GRACIAS