Wollo University, Dep’t of Mgmt; Financial 2017 Eth.

c
Management Lecture Note

Chapter six: The Cost of Capital

Introduction: In the last two chapters, we discussed the values of and required rates of return on
stocks and bonds. When companies issue stocks or bonds, they are raising capital for investment in
various projects. Capital is a necessary factor of production, and like any other factor, and it has a
cost. This cost is equal to the marginal investor’s required return on the security in question. With this
in mind, we now consider the process of estimating the cost of capital. The firm’s primary objective
is to maximize shareholder value, and companies can increase shareholder value by investing in
projects that earn more than the cost of capital. For this reason, the cost of capital is sometimes
referred to as a hurdle rate of cut-off rate .For a project to be accepted, it must earn more than its
hurdle rate.
Although its most important use is in capital budgeting, the cost of capital is also used for at least
three other purposes: (1) it is a key input used to calculate a firm’s or division’s economic value
added (EVA). (2) Managers estimate and use the cost of capital when deciding if they should lease or
purchase assets. And (3), the cost of capital is important in the regulation of monopoly services
provided by electric, gas, and telephone companies. These firm’s are natural monopolies in the sense
that one firm can supply service at a lower cost than could two or more firms. Since it has a
monopoly, your electric or Telephone Company could, if it were unregulated, exploit you. Therefore,
regulators (1) determine the cost of the capital investors have provided to the utility and (2) then set
rates designed to permit the company to earn its cost of capital, no more and no less.
It should be noted that the cost of capital models and formulas used in this chapter are the same ones
we developed in Chapters 4 and 5, where we were concerned with the rates of return investors require
on different securities. The same factors that affect investors’ required rates of return also determine
the cost of capital to a firm’s, so investors and corporate treasurers often use exactly the same models.
Capital is obtained in three primary forms: debt, preferred stock, and common equity, with equity
coming from issuing new stock and by retaining earnings. The investors who provide that capital do
so expecting to earn at least their required rate of return on that capital, and the required return

represents the cost of capital to the firm. A variety of factors influence the cost of capital. Some
including interest rates, state and federal tax policies, and the regulatory environment are outside the
firm’s control. However, financing and investment policies, especially choices related to the types of

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capital the firm uses and the riskiness of the projects it undertakes have a profound effect on its cost
of capital.

Chapter objectives
Upon completion of this chapter, you should have a clear understanding of the following:
 Define cost of capital and identify its characteristics
 The calculation of cost of debt
 The calculation of the cost of preferred stock
 The calculation of the cost of common equity
 The calculation of the weighted average cost of capital
 Estimate the costs of different capital components—debt, preferred stock, retained earnings, and
common stock.
 Combine the different component costs to determine the firm’s WACC.
 Explain why the weighted average cost of capital (WACC) is used in capital budgeting.
6.1. An Overview of Cost of Capital
A few definitions on cost of capital are given below:
J.C.Van Horne, “Cost of capital is a cute- off rate for the allocation of capital to investments of
projects. It is the rate of return on a project that will leave unchanged the market price of the stock.”
Lawrence J.Gitman, “The cost of capital is the rate of return a firm must earn on its investments for
the market value of the firm to remain unchanged. It can also be thought of as the rate of return
required by the market suppliers of capital in order to attract needed financing at a reasonable
price.”
H.Kent Baker and Gray E.Powell, “The cost of capital is the rate that the firm has to pay, explicitly
or implicitly, to investors for their capital or the minimum rate of return required by the supplier of
capital, thus, ignoring taxes and flotation costs, the cost of capital represents two sides of the same
coin - the cost to issuers is the return to the investor.
I.M. Pandey, “The project’s cost of capital the minimum required rate of return on funds committed
to the project, which depends on the riskiness of its cash flows.”
Hampton, John J., “Cost of capital is the rate of return the firm requires from investment in order
to increase the value of the firm in the market place.”
From the above definitions, the following characteristics of the cost of capital may be drawn.
 Cost of capital is a rate of return, generally, expressed in percent value.

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 It is the minimum required rate of return to offset the effect of risk associated with business, and
to maintain profitability in order to maximize the wealth of shareholders
 It has a great role in maintaining market value of the firm. The value of a firm will decline if a
firm uses capital at a higher cost than its return on assets.
 Arranging source of finance at a rate of return, and allocating them in investment are the two
sides of same coin.
 Cost of capital involves implicit as well as explicit cost, therefore, it takes future risk and business
risk in to account.
The cost of capital is concerned with what a firm has to pay for the capital that is, the debt, preferred
stock, retained earnings, and common stock it uses to finance new investments. It can also be thought
of as the rate of return required by investors in the firm’s securities. As such, the firm’s cost of capital
is determined in the capital markets and is closely related to the degree of risk associated with new
investments, existing assets, and the firm’s capital structure. In general, the greater the risk of a firm
as perceived by investors, the greater the return investors will require and the greater will be the cost
of capital.
The cost of capital can also be thought of as the minimum rate of return required on new investments

undertaken by the firm. If a new investment earns an internal rate of return that is greater than the
cost of capital, the value of the firm increases. Correspondingly, if a new investment earns a return
less than the firm’s cost of capital, the firm’s value decreases.
The cost of capital is the return that must be provided for the use of an investor’s fund. If the funds
are borrowed, the cost is related to the interest that must be paid on the loan. That is, the cost of
capital is the cost associated with raising one more dollar of capital. If the funds are equity, the cost is
the return that investors expect, both from the stock’s price appreciation and dividends. From
investor’s point of view, the cost of capital is the same as the required rate of return. That is, the
return expected on one more dollar invested.

Cost of capital is the minimum rate of return expected by investors, the suppliers of capital. In other
words, it is a price for obtaining capital for a company. It is a compensation for time and risk for
investors. When we refer to the cost of capital for a firm, we are usually referring to the cost of
financing its asset. Thus, a firm’s cost of capital is the cost of its long term sources of funds: debt,
preferred stock, and common stock. And the cost of each source reflects the risk of the assets invested
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in. A firm that invests in assets having little risk will be able to bear lower cost of capital than a firm
that invests in assets having a high risk. Moreover, the cost of each source of funds reflects the
hierarchy of the risk associated with its seniority over the other sources.

For a given firm, the cost of funds raised through debt is less than the cost of funds from preferred
stock which, in turn, is less than the cost of funds from common stock. Why? Because creditors have
seniority over preferred shareholders, who have seniority over common shareholders. If there are
difficulties in meeting obligations, the creditors receive their promised interest and principal before
preferred shareholders who, in turn, receive their promised dividends before the common
shareholders. Thus, for a given firm, debt is less risky than preferred stock, which is less risky than
common stock. Therefore, preferred shareholders require a greater return than the creditors and
common shareholders require a greater return than preferred shareholders.
Assumption of Cost of Capital
Cost of capital is based on certain assumptions which are closely associated while calculating and
measuring the cost of capital. It is to be considered that there are three basic concepts:
] It is not a cost as such. It is merely a hurdle rate.
] It is the minimum rate of return.
] It consists of three important risks such as zero risk level, business risk and financial risk.
Classification of cost of capital
Cost of capital may be classified into the following types on the basis of nature and usage:
 Explicit and Implicit Cost.
 Average and Marginal Cost.
 Historical and Future Cost.
 Specific and Combined Cost.
Explicit and Implicit Cost
The cost of capital may be explicit or implicit cost on the basis of the computation of cost of capital.
Explicit cost is the rate that the firm pays to procure financing. Implicit cost is the rate of return
associated with the best investment opportunity for the firm and its shareholders that will be forgone
if the projects presently under consideration by the firm were accepted.
Average and Marginal Cost

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Average cost of capital is the weighted average cost of each component of capital employed by the
company. It considers weighted average cost of all kinds of financing such as equity, debt, retained
earnings etc. Marginal cost is the weighted average cost of new finance raised by the company. It is
the additional cost of capital when the company goes for further rising of finance.

Historical and Future Cost

Historical cost is the cost which has already been incurred for financing a particular project. It is
based on the actual cost incurred in the previous project. Future cost is the expected cost of financing

in the proposed project. Expected cost is calculated on the basis of previous experience.
Specific and Combine Cost
The cost of each sources of capital such as equity, debt, retained earnings and loans is called as
specific cost of capital. It is very useful to determine the each and every specific source of capital.
The composite or combined cost of capital is the combination of all sources of capital. It is also called
as overall cost of capital. It is used to understand the total cost associated with the total finance of the
firm.
6.2. The types of capital firms’ use

Debt is typically raised by issuing bonds or borrowing money from a financial institution such as a
bank. Some companies also finance with preferred stock. The third type of capital, common equity, is
provided by the company’s common stockholders, and it is raised in two ways: (1) by issuing new

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common stock and (2) by retaining earnings (that is, by not paying out all of their earnings as
dividends). Equity raised by selling newly issued stock is called external equity, while retained
earnings are called internal equity. As we will discuss later, all equity has a cost, whether it is raised
internally or externally, but the cost of newly issued shares exceeds the cost of retained earnings
because of fees that must be paid to investment bankers for helping sell the new shares.
A firm’s overall cost of capital is an average of the costs of the various types of funds it uses. The
target proportions of debt (wd), preferred stock (wps), and common equity (w s) along with the costs
of those components are used to calculate the firm’s weighted average cost of capital, WACC:

6.3. What Impacts the Cost of Capital?

] Riskiness of earnings.
] The debt to equity mix of the firm.
] Financial soundness of the firm.
] Interest rate levels in US/ global market place.
Note: - The cost capital becomes a guideline for measuring the profit abilities of different
investments. Another way to think of the cost of capital is as the opportunity cost of funds, since this
represents the opportunity cost for investing in assets with the same risk as the firm. When investors
are shopping for places in which to invest their funds, they have an opportunity cost. The firm, given
its riskiness, must strive to earn the investors opportunity cost. If the firm does not achieve the return
investors expect (i.e. the investors opportunity cost), investors will not invest in the firms debt and
equity. As a result, the firms value (both their debt & equity) will decline.

6.4. Significance or importance of Cost of Capital

Cost of capital is useful as a standard for:-

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 Evaluating investment decisions

 Designing a firms debt policy, and
 Appraising the financial performance of top management

6.5. Capital Structure

 It is the mixture of long term sources of funds used by affirm.

 The primary objective of capital structure decision is to mix the market value of long term
sources of bonds.
 The mix is called optimal capital structure which minimize the firms overall cost of capital.
6.6. Major Types of Cost of Capital (Sources of Capital) : The major sources capital is:-

 Specific cost of capital.

a) Cost of Debt (Kd).
b) Cost of Preferred Stock (Kp).
c) Cost of Common Stock (Ks).
d) Cost of Retrained Earnings (Kr).
 Weighted Average Cost of Capital (WACC)
 Marginal Cost of Capital (MCC)

6.6.1. The Specific Cost of Capital:

A firm’s capital is supplied by its creditors and owners. Firms raise capital by borrowing it (issuing
bonds to investors or promissory notes to banks) or by issuing preferred or common stock. The
overall cost of a firms capital depends on the return demanded by each of these suppliers is called the
specific cost of capital. In the following section, we estimate the cost of debt capital (rd), the cost of
capital raised though a preferred stock issue (rp), and the cost of equity capital supplied by common
stock holders, (rs) for internal equity and re for external equity
Basic definitions

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The items on the right side of a firm’s balance sheet- various types of debt, preferred stock, and
common equity are called capital components. Capital Component is one of the types of capital
used by firms to raise funds. Any increase in total assets must be financed by an increase in one or
more of these capital components. The cost of each component is called the component cost of that
particular type of capital. As we shall see in the chapter on capital structure, each firm has an optimal
capital structure, defined as the mix of debt, preferred, and common equity that causes its stock price
to be maximized.
Therefore, a value-maximizing firm will estimate its optimal capital structure, use it as a target,
and then raise new capital in a manner designed to keep the actual capital structure on target over
time. In this chapter, we assume that the firm has identified its optimal capital structure, that it uses
this optimum as the target, and that it finances so as to remain on target. The target proportions of
debt (wd), preferred stock (wp), and common equity (wc), along with the costs of those components,
are used to calculate the firm’s weighted average cost of capital, WACC.
We assume at this point that all new common equity is raised as retained earnings, as is true for most
companies; hence the cost of common equity is rs
Target (Optimal) Capital Structure is the percentages of debt, preferred stock, and common equity
that will maximize the firm’s stock price.
Weighted Average Cost of Capital (WACC) is a weighted average of the component costs of debt,
preferred stock, and common equity.

Now we define the key terms used in this chapter. Later we describe how to estimate the values of
these variables and how to combine them to form the weighted average cost of capital, but an early
overview is useful.

 rd = Interest rate on the firm’s new debt = before-tax component cost of debt. It can be found in
several ways, including calculating the yield to maturity on the firm’s currently outstanding bonds.

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 rd (1 -T) = After-tax component cost of debt, where T is the firm’s marginal tax rate. rd (1 - T) is the
debt cost used to calculate the weighted average cost of capital. As we shall see, the after-tax cost of
debt is lower than its before-tax cost because interest is tax deductible.

 rps = Component cost of preferred stock, found as the yield investors expect to earn on the preferred
stock. Preferred dividends are not tax deductible, so the before-tax and after-tax costs of preferred
are equal.
 rs= Component cost of common equity raised by retaining earnings, orinternal equity. It is the rs
developed in chapter 5, where it is defined as the rate of return that investors require on a firm’s
commonstock. Most firms, once they have become well established, obtain all of their new equity
as retained earnings.
 re = component cost of external equity, or common equity raised by issuing new stock. As we will
see, re is equal to rs plus a factor that reflects the cost of issuing new stock. Note, though, that
established firms rarely issue new stock; hence re is rarely a relevant consideration except for very
young, rapidly growing firms.
 w=wd, wps, ws, we = target weights of debt, preferred stock, internal equity (retained earnings) and
external equity (new issues of common stock). The weights are the percentages of the different
types of capital the firm plans to use when it raises capital in the future. Target weights may differ
from actual current weights.
 WACC = the firm’s weighted average, or overall /composite, cost of capital.
Self test1
1. Define cost of capital
2. List and explain cost of capital the basis of nature and usage
3. What are the three major capital components?
4. What is a component cost?
5. What is a target capital structure?
6. For a given firm, the cost of funds raised through debt is less than the cost of funds from preferred
stock which, in turn, is less than the cost of funds from common stock. Why?
6.6.1.1. The Cost Debt (rd)

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Cost of debt is the after tax cost of long-term funds through borrowing. Debt may be issued at par, at
premium or at discount and also it may be perpetual or redeemable. Cost of debt is the cost associated
with raising one more dollar by issuing debt. Before-Tax Cost of Debt, rd is the interest rate the firm
must pay on new debt. However, the after-tax cost of debt, r d (1 – T), should be used to calculate the
weighted average cost of capital. This is the interest rate on new debt, rd, less the tax savings that
result because interest is tax deductible. After-Tax Cost of Debt, rd (1 – T) is the relevant cost of new
debt, taking into account the tax deductibility of interest; used to calculate the WACC.
When a firm borrows money at a stated rate of interest, determining the cost of debt, rd, is relatively
straight forward. The lenders cost of capital is the required rate of return on either a company’s new
bonds or promissory note.

The firm’s cost of debt when it borrows money by issuing bonds is the interest rate demanded by the
bond investor. When borrowing money from an individual or financial institution, the interest rate on
the loan is the firm’s cost of debt. The cost of debt to the borrower: the firms cost of debt is the
investors required rate of return on debt adjusted for tax and flotation costs.

This is because interest on debt is a tax –deductible expenses; it reduces the firm's taxable income by
the amount of deductible interest. The interest deduction, therefore, reduces taxes by an amount equal
to the product of the deductible interest and the firm’s tax rate. Flotation costs which are costs
incurred in issuing debt securities – increases the cost of debt. Thus, the after tax cost of debt, rd, is
computed as follows:

Where: T = Corporate tax rate

rdat = rd * (1-T) F= Flotation cost as a percentage of value of debt

(1-F) rd = investor required rate of return before tax
rdat= after cost of debt

If there is no flotation costs, the rd can be computed using the formula

rdat = rd (1-T)

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Example 1:- Assume that MULU Co. is to issue long term notes, investors will pay Br, 1000 per
note when they are issued if the annual interest payment by the firm is Br 100.The firm’s tax rates is
45%, and flotation costs are 2%(birr20). Calculate the cost of this debt.

Given Required Solution

I = Br 100 rdat =? rdat= 100 / 980 (1-0.45) = 5.612%

M = Br 1000

T = 45%

In effect, the government pays part of the cost of debt because interest is tax deductible. Therefore, if
Mulu can borrow at an interest rate of 10% and its marginal federal-plus-state tax rate is 40%, but no
flotation cost, its after-tax cost of debt will be:
Given: rd= 10%, T= 40% required: rdat=?
Solution: rdat= rd (1-T) = 0.1(1-0.4) =0.06= 6%. Creditors require a return of 10% per year on the
funds they lend, but it only costs Mulu 6% per year.

 Now let us see the formulas that can be applied to find cost of debt before tax for perpetual
(irredeemable) debt, i.e., on which no date is given for repayment of the capital sum.
i) Cost of debt, issued at par, before tax effect
rd= I where: I =interest rd= cost of debt before tax
P P= principal amount/ face value of debt
ii) Cost of debt raised or issued at premium or discount.
In case of premium, principal amount will be increased by premium, in case of discount; principal
amount will be face value less discount amount.
rd = I
Np
Where Np= Net proceed on issue of debt. In case of debt issued at premium, NP= face value +
premium amount and in case of discount; NP= face value – Discount value.
iii) Cost of debt considering tax effect
rd= I *(1-T) or rd = I *(1-T)
P Np

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Illustration 1: A corporation issued 10% debentures of birr 500,000 at par. Compute the cost of debt
if the applicable tax rate on the company is a) 50% b) 40% c) 45%
Solution:
i) Tax rate =50%, T= 0.5
Cost of debt (rdat) = I *(1-T) = 50,000 *(1-0.5) = 5%
P 500,000
ii) Tat rate = 40%, T= 0.4
Cost of debt (rdat) = I *(1-T) = 50,000 *(1-0.4) = 6%
P 500,000
iii) Tax rate 45%, T= 0.45
Cost of debt (rdat) = I *(1-T) = 50,000 *(1-0.45) = 5.5%
P 500,000
Illustration 2: XYZ corporation issued 12% debenture of birr 200,000, face value of debenture is
birr 100. Compute cost of debenture if:
a) Issued at par, tax rate is 20%
b) Issued at 10% premium, tax rate is 30%
c) Issued at 10% discount, tax rate is 40%
Solution: in order to separate the tax adjustment, cost of debt is computed i) before tax ii) adjustment
and after tax adjustment
a) At par
Interest = 12%*200,000= 24,000
Before tax adjustment After tax adjustment
rd= I =24,000 =12% rdat= I *(1-T) =24,000 *(1-0.2) =9.6%
P 200,000 P 200,000
b) At premium
Np = Principal + premium= 200,000 + (200,000*0.1) = 220,000
Before tax, rd= I = 24,000 =10.91%
Np 220,000
After tax, rdat = I *(1-T) = 24,000 *(1-0.3) =7.64%
Np 220,000

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c) At discount
Np = Principal - Discount= 200,000 - (200,000*0.1) = 180,000
Before tax, rd= I = 24,000 =13.33%
Np 180, 00
After tax, rdat = I *(1-T) = 24,000 *(1-0.4) = 8%
Np 180,000
Thus, the cost of debt has tax advantage; it declines as the rate of tax increases.
Illustration 3: ABC corporation issues 9% bond of Birr 600,000, face value of the debenture is birr
100 at par value. It spent birr 20,000 as floating expense on issue of bond. Calculate cost of bond, if
tax rate is 40%.
Solution:
Interest =9% *600,000= 54,000
NP= principal amount – expense on issue (floating expense)
= 600,000 – 20,000 =580,000
rd at = I *(1-T) = 54,000*(1-0.4) = 5.58%
NP 580,000

Self test 2
1. A Ltd. issues Rs. 1000,000, 8% debentures at par. The tax rate applicable to the company is 50%.
Compute the cost of debt capital.
2. B Ltd. issues Rs. 100,000, 8% debentures at a premium of 10%. The tax rate applicable to the
company is 60%. Compute the cost of debt capital.
3. A Ltd. issues Rs. 100,000, 8% debentures at a discount of 5%. The tax rate is 60%, compute the cost
of debt capital.
4. B Ltd. issues Rs. 1000,000, 9% debentures at a premium of 10%. The costs of floatation are 2%.
The tax rate applicable is 50%. Compute the cost of debt-capital.

 Cost of Redeemable debt (short cut method)

When debts are issued for a predetermined period and have to redeem on maturity called redeemable
debt. The cost of redeemable debt (before tax effect) is measured as follows:
rd = I + 1/n (P-NP)
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(P +NP) / 2
Where, n= number of years in which debt is to be redeemed
P = principal amount
NP= Net proceeds
I = Interest amount
 Transaction costs: brokerage, underwriting, legal and flotation costs are incurred when a firm issues
stock or bond securities and these transaction costs are deducted from net proceed.
Illustration 1: Compute the cost capital of 12% debentures issued by Vikas P Ltd., face value of birr
100, amount of birr 200,000 in the following situations. The life of debenture is 7 years and tax rate is
20%
a) issued at par, redeemable at par
b) issued at10% premium
c) issued at 10% discount
Solution: a) At par I= 24,000, n=7 years, P = 200,000, NP= 200,000
rd = I + 1/n (P-NP) = 24,000 + 1/7(200,000- 200,000) = 12%
(P +NP) / 2 (200,000 +200,000)/ 2
rdat = rd (1-T) = 12 %(1-0.2)= 9.6%
b) At 10% premium
NP = 200,000 +0.1*200,000 = 220,000
rd = I + 1/n (P-NP) = 24,000 + (200,000- 220,000)/7 = 10.07%
(P +NP) / 2 (200,000 +220,000)/ 2
rdat = rd(1-T) = 10.07%(1-0.2)= 8.05%
c) At 10% discount
NP= 200,000 -0.1*200,000 = 180,000
rd = I + 1/n (P-NP) = 24,000 +(200,000- 180,000) / 7 = 14.14%
(P +NP) / 2 (200,000 + 180,000) / 2
rdat = rd (1-T) = 14.14 % (1-0.2)= 11.31%
Illustration 2: Birr 1,000 par value bond with market price of birr 970 and coupon interest rate 0f
10% while flotation cost for the issue is 5%. The bond matures in 10 years and the tax rate is
40% .Compute the cost of bond.

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Solution: Given P= 1000, NP = 970-(0.05*970) = birr 921.50, n=10 years, I =100 birr
rd = I + 1/n(P-NP) = 100 + (1,000- 921.5)/10 = 11.23%
(P +NP) / 2 (1,000 + 921.5) / 2
rdat = rd (1-T) = 11.23 %(1-0.4)= 6.74%
Short cut method has a limitation that this method gives only approximated result, it does not
consider the repayment and the annual compounding.
 We use the after-tax cost of debt in calculating the WACC because we are interested in maximizing
the value of the firm’s stock, and the stock price depends on after-tax cash flows. Because we are
concerned with after-tax cash flows, and because cash flows and rates of return should be calculated
on a comparable basis, we adjust the interest rate downward to take account of debt’s preferential tax
treatment.
] Note that the cost of debt is the interest rate on new debt, not that on already outstanding debt. We
are interested in the cost of new debt because our primary concern with the cost of capital is to use it
for capital budgeting decisions. For example, would a new machine earn a return greater than the
cost of the capital needed to acquire the machine? The rate at which the firm has borrowed in the
past is irrelevant when answering this question we need to know the cost of new capital.

Self test 3
1. Why is the after-tax cost of debt rather than the before-tax cost used to calculate the WACC?
2. Why is the relevant cost of debt the interest rate on new debt, not that on already outstanding, or old,
debt?
3. A company has outstanding long-term bonds with a face value of $1,000, an 11 percent coupon, and
an 8 percent yield to maturity. If the company were to issue new debt, what would be a reasonable
estimate of the interest rate on that debt? If the company’s tax rate is 40 percent, what would its after-
tax cost of debt be?
4. A company issues birr 2000,000, 10% redeemable debentures at a discount of 5%. The costs of
floatation amount to birr 50,000.The debentures are redeemable after 8 years. Calculate before tax
and after tax. Cost of debt assuring a tax rate of 55%.
5. A company issues 12% debenture for birr 100,000 and the tax rate of the company is 35%. Calculate
the cost of debt both before tax and after tax cost if the debentures are issued at

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i) At par
ii) At 7.5 % discount
iii) At 7.5% premium
5. A company has outstanding long-term bonds with a face value of $1,000, a 10% coupon rate, 25

years remaining until maturity, and a current market value of $1,214.82. If it pays interest

semiannually, what is the nominal annual pre-tax cost of debt? If the company’s tax rate is 40%,

what is the after-tax cost of debt?

6.6.1.2. Cost of Preferred Stock (rp)

Cost of Preferred Stock, rp The rate of return investors require on the firm’s preferred stock, rp is
calculated as the preferred dividend, DP, divided by the current price, Pp .The cost of preferred stock
(rp) is the rate of return investors require on a company’s new preferred stock plus the cost of issuing
the stock. For the company, the cost of preferred stock is the cost associated with raising one more
dollar of capital by issuing shares of preferred stock. Preferred stocks may or may not have maturity.
Preferred stocks without maturity date are called perpetual (irredeemable) preferred stocks; whereas,
those with maturity date are called redeemable.
Therefore, to calculate rp; a firm’s managers must estimate the rate of return that preferred stock
holders would demand and add in the cost of the stock issue. Because preferred stock investors
normally buy preferred stock to obtain the stream of constant preferred stock dividends associated
with the preferred stock issue, their return on investment can normally be measured by dividing the
amount of the firm’s expected preferred stock dividend by the price of the shares. The cost of issuing
the new securities known as flotation cost includes investment bankers’ fees and commissions, and
attorneys' fees. These costs must be deducted from the preferred stock price paid by investors to
obtain the net price received by the firm. There are two types of preference shares irredeemable and
redeemable.
I. Cost of irredeemable
Irredeemable preferred stocks are preferred stocks or shares without a stated maturity date, and
their cost is calculated with the help of the following formula:
rp = DP Or If flotation cost exists; rp = DP = DP
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PP PP - F PP (1- % of F)
Where:-
rp = the cost of the preferred stock issue; the expected return

Dp = the amount of the expected preferred stock dividend

Pp = the current price of the preferred stock or net proceed from sale

F = the flotation costs per share or as a percentage of proceeds

 No tax adjustments are made when calculating rp because preferred dividends, unlike interest on

debt, are not tax deductible. Therefore, no tax savings are associated with the use of preferred stock
because dividends are paid out of after tax profit. Moreover, the cost of preferred stock or share is
higher than the after tax cost of debt, rd because a company’s bond holders and bankers have a prior
claim on the earnings of the firm and its asset in the event of liquidation.

 A number of firms, use preferred stock as part of their permanent financing mix. Preferred dividends
are not tax deductible. Therefore, the company bears their full cost, and no tax adjustment is used
when calculating the cost of preferred stock. Note too that while some preferred stocks are issued
without a stated maturity date (irredeemable), today most have a sinking fund that effectively limits
their life. Finally, although it is not mandatory that preferred dividends be paid, firms generally have
every intention of doing so, because otherwise:
 They cannot pay dividends on their common stock,

 They will find it difficult to raise additional funds in the capital markets, and

 In some cases preferred stockholders can take control of the firm.

Example 1:- Suppose that Midrock Company has preferred stock that pays Br 13 dividend per share
and sells for Br 100 per share in the market. Compute the cost of preferred stock.

DP Br 13
rp = Pp = Br 100 = 13%

Example 2; - Suppose Ellis industries has issued preferred stock that has been paying annual
dividends of $ 2.50 and is expected to continue to do so indefinitely. The current price of Ellis

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preferred stock is $ 22 a share and the flotation cost is $ 2 per share. Compute the cost of the
preferred stock.
Given Required Solution
( DP ) $ 2 . 50
DP = $ 2.50 rp =? rp = ( Pp−F ) = $ 22−2 == 0.125 or 12.5%
Pp = $ 22 a share
F = $ 2 a share
Example 3: Assume that NCC has preferred stock that pays a $10 dividend per share and sells for
$100 per share. If NCC issued new shares of preferred, it would incur an underwriting (or flotation)
cost of 2.5%, or $2.50 per share, so it would net $97.50 per share. Therefore, NCC’s cost of preferred
stock is 10.3% calculated as follows:
Solution:
Given DP= $10, Pp = $100, F= 2.5%*100= 2.5
rp = DP = 2.5 = 10.3%
PP – F 100-2.5
Example 4: A company rises preferred share capital 100,000 by issuing 10% preference share of birr
1,000 each. Compute the cost of preference share when they are issued at i) 5 % premium ii) 5%
discount.
i) Solution:
PP =105,000,000 = (100,000 shares *1000) + 0.5*100,000,000
DP =10,000,000 = (100, 000, 000*0.10)
rp = DP = 10,000,000 = 9.5%
PP 105,000,000
ii) DP =10,000
PP =100,000,000 – (100,000,000 *0.5) =95,000,000
rp = DP = 10,000,000 =10.53%
PP 95,000,000
Self-test 4
1. Does the component cost of preferred stock include or exclude flotation costs? Explain.
2. Why is no tax adjustment made to the cost of preferred stock?

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3. A company’s preferred stock currently trades at $50 per share and pays a $3 annual dividend per
share. Flotation costs are equal to 3% of the proceeds. If the company issues preferred stock, what is
cost of the newly issued preferred stock?
4. A company’s preferred stock currently trades at $80 per share and pays a $6 annual dividend per
share. If the company were to sell a new preferred issue, what would the cost of that capital be?
Ignore flotation costs.
5. XYZ Ltd. issues 20,000, 8% preference shares of Rs. 100 each. Cost of issue is Rs. 2 per share.
Calculate cost of preference share capital if these shares are issued (a) at par, (b) at a premium of
10% and (c) of a discount of 6%.
II. Cost of redeemable preferred share/ stock
Redeemable preferred stocks/shares are preferred stocks with a stated maturity date. The cost of
redeemable preference share is the discount rate of return which equates the net proceeds of sales of
preference share with the present values of future dividends and repayment of principal. For preferred
stock with a stated maturity date, we use the following formulate to calculate its cost:
rp = DP + (RV– NP) / n
(RV +NP) / 2
Where, RV = Redemption value
rp= Cost of preference share n = Number of maturity period or
DP= Fixed preference share (annual) redeemable life.
NP= Net proceeds/earning = (face value +
premium) or (face value – discount-
floatation cost) of the preference share
Example 1: Ethiopian capital market authority issued 12% redeemable preference share capital of
Birr 500,000, face value of each share is birr1000. Calculate the cost of capital if shares are issued a)
at par, b) at 10% premium. Assuming that, the shares will be redeemed on 10th year at a premium of
10%.
Solution: a) Issue at par, redeemed at RV= 500,000 + 0.1*500,000 = birr 550,000
10% premium NP = 500,000 because it is at par.
DP= 60,000 Birr = 12% *500,000 n =10 years
rd = 60,000 + (550,000 -500,000) / 10 = 65,000 =12.38%

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(550, 000 +500,000) /2 525,000

b) Issue at premium (10%), Redemption at premium (10%)
DP= 60,000
RV =550, 0000 = (500,000 + 0.1*500,000)
NP = 550, 0000 = (500,000 + 0.1*500,000)
rd = 60,000 + (550,000 -550,000) / 10 = 60,000 =10.91%
(550, 000 +550,000) /2 550,000
Example 2: Kishore PLtd. issued 10% preference shares, face value of birr 1000 each, redeemable
after 8 years. Total numbers of shares issued are 5000. Preference shares are to redeem at 20%
premium. The cost of issue of such shares is 50 birr per share. Compute cost of capital of preference
shares.
DP= 5000 *1000 * 10% = Birr 500,000
RV = 5,000,000 + 0.2* 5000,000 = 6,000,000
NP= 5,000,000 – 50* 5000 = 4,750,000
n = 8 years
rd = 500,000 + (6,000,000 - 4,750,000) / 8 = 656,250 = 12.21%
(6,000,000 + 4,750,000) / 2 5,375,000
Example3: A company issues 10% redeemable preference share for Birr 100,000 at the end of the
10th year from the year of their issue. The underwriting cost is 5%. Calculate the effective cost of
preference share capital.
Solution: given DP= 100,000 *0.1 =10,000
NP = 100,000 – (0.05*100,000) = 95,000
rp = DP + (RV– NP) / n = 10,000 + (100,000 - 95,000) = 10.77%
(RV +NP) / 2 (100,000 +95,000)
Example 4: ABC Ltd. issues 20,000, 8% preference shares of Birr 100 each. Redeemable after 8
years at a premium of 10%. The cost of issue is Rs. 2 per share. Calculate the cost of preference share
capital.
Given: D= 20,000×100×8%=160,000
RV = 20, 00,000 + 200,000 =2,200,000
NP = 2,000,000 – 40,000 =1,960,000

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n = 8 years
rd = 160,000 + (2,200,000 – 1,960,00) / 8 = 190,000 = 9.13%

(2,200,000 + 1,960,000) / 2 2,080,000

Example 5: ABC Ltd. issues 20,000, 8% preference shares of Birr 100 each. Redeemable after 8
years at a discount of 10%. The cost of issue is Rs. 2 per share. Calculate the cost of preference share
capital.
Given: D= 20,000×100×8%=160,000
RV = 2,000,000 - 200,000 =1,800,000
NP = 2,000,000 – 40,000 =1,960,000
n = 8 years
rd = 160,000 + (1,800,000 – 1,960,00) / 8 = 140,000 = 7.4 %

(1,800,000 + 1,960,000) / 2 1,880,000

Cost of preference share in respect to market value

If investors or companies desire to find out the cost of preference shared capital on market value, i.e.,
yield of preference share then the above formula can be used for this purpose with minor changes as
given below:
rd = DP + (FV – MV) / n
(FV +MV) / 2
Where, D = dividend
N = Number of years of redemption
FV = Face value of the preference share
MV= Market value of the preference share

Self test 5
1. ABC Ltd. issues 20,000, 8% preference shares of birr1000 each at a premium of 5% redeemable after
8 years at par. The cost of issue is birr 20 per share. Calculate the cost of preference share capital.
2. Ethiopian capital market authority issued 15% redeemable preference share capital of Birr 100,000,
face value of each share is birr1000. Calculate the cost of capital if shares are issued a) at par, b) at

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12% premium, c) at 8 % discount. Assuming that, the shares will be redeemed on 10th year i) at
par, ii) at 15% premium, iii ) at 12 %discount
3. Kishore PLtd. issued 20 % preference shares, face value of birr 1000 each, redeemable after 10 years.
Total numbers of shares issued are 500,000. If Preference shares are to redeem at a) 15 %
premium, b) at 10% discount. The cost of issue of such shares is 100 birr per share. Compute cost
of capital of preference shares.

6.6.1.3. Cost of Common Stock

The costs of debt and preferred stock are based on the returns investors require on these securities.
Similarly, the cost of common equity is based on the rate of return investors require on the
company’s common stock. Note, though, that new common equity is raised in two ways: (1) by
retaining some of the current year’s earnings and (2) by issuing new common stock. Equity raised by
issuing stock has a somewhat higher cost than equity raised as retained earnings due to the flotation
costs involved with new stock issues. Therefore, once they get beyond the startup stage, firms
normally obtain all of their new equity by retaining earnings. We use the symbol rs to designate the
cost of retained earnings and re to designate the cost of new stock, or external equity.
The cost of common stock is the cost of raising one more dollar of common equity, either internally
from earnings retained in the firm or externally by issuing new share of common stock. There are
costs associated with both internally and externally generated capital. We might think that retained
earnings are “free” because they represent money that is “left over” after paying dividends. While it
is true that no direct costs are associated with capital raised as retained earnings, this capital still has a
cost. The reasoning here involves the opportunity cost principle. The firm’s after tax earnings belong
to its stockholders. Bondholders are compensated by interest payments and preferred stockholders by
preferred dividends. All earnings remaining after interest and preferred dividends belong to the
common stockholders, and these earnings serve to compensate stockholders for the use of their
capital.
Management can either pay out earnings in the form of dividends or retain earnings for reinvestment
in the business. If management decides to retain earnings, there is an opportunity cost involved—
stockholders could have received the earnings as dividends and invested this money in other stocks,
in bonds, in real estate, or in anything else. Thus, the firm needs to earn on its retained earnings at
least as much as the stockholders themselves could earn on alternative investments of comparable

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risk. Thus, retained funds are not a free source of capital. Therefore, the cost of internal equity funds
is the opportunity cost of funds of the firm’s shareholders. This opportunity cost is what shareholders
could earn on these funds for the same level of risk.
The only difference between costs of internally and externally generated funds is the cost of issuing
new common stock. As we have seen before, the cost of internally generated fund or capital is the
opportunity cost of those funds. But the cost of externally generated funds that is funds from selling
new shares of stock includes the sum of both the opportunity cost and cost of issuing the new stock.
Few mature firms issue new shares of common stock through public offerings. In fact, less than 2%
of all new corporate funds come from the external public equity market. There are three reasons for
this:

 Flotation costs can be quite high, as we show later in this chapter.

 Investors perceive issuing equity as a negative signal about the true value of the company’s stock.
Investors believe that managers have superior knowledge about companies’ future prospects, and
that managers are most likely to issue new stock when they think the current stock price is higher
than the true value. Therefore, if a mature company announces plans to issue additional shares,
this typically causes its stock price to decline.

 An increase in the supply of stock will put pressure on the stock’s price, forcing the company to
sell the new stock at a lower price than existed before the new issue was announced.
Therefore, we assume that the companies in the following examples do not plan to issue new shares.
We will address the impact of flotation costs on the cost of equity later in the chapter.
6.6.1.3.1. Cost of common stock equity, rs (cost of internal equity)
Cost of internal equity, rs is the rate of return required by stockholders on a firm’s common stock. The
cost of common stock equity (internal equity) is the rate at which investors discount the expected
dividends of the firm to determine its share value. The followings are the various methods to calculate the
cost of internal equity capital.

I. Constant growth(Gordon growth) model

Using the constant or Gordon growth model, the cost of internal equity of common stock, rs is
computed using the following formula, which is derived from the price of a stock for stock valuation

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PO = D1 = Do (1+g)  D1 = Po (rs-g)  D1 = rs-g  D1 + g = rs

rs –g rs-g Po Po

NB: We can get growth rate (g) if it is not known or given, by applying the following formula:

Most firms pay out some of their net income as dividends and reinvest, or retain, the rest. The payout
ratio is the percent of net income that the firm pays out as a dividend, defined as total dividends
divided by net income. The retention ratio is the complement of the payout ratio: Retention ratio =
(1 -Payout ratio). ROE is the return on equity, defined as net income available for common
stockholders divided by common equity issued.
Although we don’t prove it here, you should find it reasonable that the growth rate of a firm will
depend on the amount of net income that it retains and the rate it earns on the retentions. The
equation above produces a constant growth rate, but when we use it we are, by implication, making
four important assumptions: (1) We expect the payout rate, and thus the retention rate, to remain
constant; (2) we expect the return on equity on new investment to remain constant; (3) the firm is not
expected to issue new common stock, or, if it does, we expect this new stock to be sold at a price
equal to its book value; and (4) future projects are expected to have the same degree of risk as the
firm’s existing assets.
Example: NCC has had an average return on equity of about 14.5% over the past 15 years. In
addition, NCC’s dividend payout rate has averaged 0.52 over the past 15 years, so its retention rate
has averaged 1.0 - 0.52 = 0.48. Using the above equation, we estimate g to be 7% as follows:
g = 14.5% * 0.48 = 7%.
Example 2: To illustrate the constant growth model, suppose NCC’s stock sells for $32; its next
expected dividend is $2.40; and its expected growth rate is 7%. NCC’s expected and required rate of
return, hence its cost of common stock, would then be 14.5%:
Given: D1= 2.40, Po = 32, g = 7%
Solution: rs = D1 + g = 2.40 + 7% = 14.5%
Po 32

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Example 3: XYZ Ltd share quoted in stock exchange trading at birr 120 each. Next year’s dividend
is expected to be birr 30 per share and subsequent dividends are expected to grow at an annual rate of
5% of the previous year’s dividend. What is the cost of equity per share?
Solution: Given D1= 30, Po =120, g= 5%
rs = 30 + 5% = 30%
120
Example 4: ABC Corporation has just declared and paid dividends on the rate of 12% on equity
share equity share of birr 100 each. The expected growth rate in dividend s 10%. Calculate the cost of
capital of equity if the present market of share is birr150.
Solution: Given Po= 150, Do =12(0.12*100), g =10%,
rs= 12(1+0.12) + 10% = 18.8%
150
Self test 6:
1. Suppose that IBM industries common stock is selling for $ 40 a share. A next year's common
stock dividend is expected to be$4.20 and the dividend is expected to grow at a rate of 5% per year
indefinitely. Compute the expected rate of return on IBM’s common stock.
2. A company’s estimated growth rate in dividends is 6%. Its current stock price is $400 and its

expected annual dividend is $20. What is rs?

3. ABC co. Ltd, wants to issue 20,000 new shares of birr 1000 each at par. The company has paid
dividend of birr 150 in last years and expected to grow by 7%. Compute the cost of equity for
existing share holders assuming market price of share is birr 1600 per share.
II. Zero growth Dividend Method
This method is also knows as Dividend/price ratio method. According to this method, the cost of
equity capital is the discount rate that equates the present value of expected future dividend per share
with the current market price of a share. The basic assumptions of this method are:
] Investors give prime importance to dividend
] Risk of the firm remains unchanged
] There is no growth in future dividends
] It does not consider the retained earnings

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The formula used to compute cost of equity under this method is given below:
rs = D1 where: D1 is expected dividend
Po Po is market price per share
Example 1: A company has issued 1000 equity shares of birr 1,000 each. Company has been paying
dividends to equity shareholders at 25% of face value from last three years and expected to maintain
the same. The market value of the share is birr 1,800. Compute cost of equity?
Solution
Given: D1 = 0.25 *1000 =250, Po = 1800
rs = D1 = 250 = 13.89%
Po 1800
Example 2: Mohit surfactants Ltd. is currently earning birr 1000,000 and its share present market
value is birr 1750. The company has 10,000 shares out standings. The earning of the company is
expected to remain stable and its payout ratio is 100%. Calculate the cost of equity?
Solution D1 = 1000, 000 / 10,000 = 100 birr per share
Po =1750
rs = D1 = 100 = 5.71%
Po 1750

III. The Capital Asset Pricing Model (CAPM) Approach

The CAPM Approach is the most widely used approach to the cost of common equity is the Capital
Asset Pricing Model (CAPM) as developed in Chapter 8, following these steps:
Step 1: Estimate the risk-free rate, rRF. Many analysts use the 10-year Treasury bond rate as a
measure of the risk-free rate. Others use a short-term Treasury bill rate.
Step 2: Estimate the stock’s beta coefficient, bi, and use it as an index of the stock’s risk. The i
signifies the ith company’s beta.
Step 3: Estimate the expected market risk premium. Recall that the market risk premium is the
difference between the return that investors require to hold an average stock and the risk-free rate.
Step 4: Substitute the preceding values into the CAPM equation to estimate the required rate of
return on the stock in question:

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Where: rRf = risk free interest rate

rM= return from market or market risk

RPM= Market risk premium
bi = beta, a measure of systematic or non diversifiable risk the stock
Example 1: ABC’s company market return is 10% and the risk free rate is 8%. Its beta coefficient is
1.25. Calculate the cost of equity capital
Solution: rs = rRF +bi(rM- rRF) = 8% + 1.25(10%-8%) =10.5%
Example 2: Suppose BATU industries has a beta of 1.39, the risk free rate as measured by the rate
on short term U.S. Treasury bill is 3% and the expected rate of return on the overall stock market is
12%. Given those market conditions find the required rate of return for BATU’S common Stock.

Given Required Solution

B= 1.39 rs = rs = rRf + b (rM-rRf)

rRf = 3% = 3% + 1.39 (12%-3%)

rM= 12% = 3% + 1.39 (9%)

0.1551 or 15.5%
Although the CAPM appears to yield an accurate, precise estimate of rs, several potential problems
exist. . Further, even if the CAPM method is valid, it is hard to obtain accurate estimates of the
required inputs because (1) there is controversy about whether to use long-term or short-term
Treasury yields for rRF and it is difficult to estimate the market risk premium, (2) it is hard to estimate
the beta that investors expect the company to have in the future, and (3) it is difficult to estimate the
proper market risk premium. As we indicated earlier, the CAPM approach is used most often, but
because of the just-noted problems, analysts also estimate the cost of equity using other approaches.
Self test 7
1. A company’s beta is 1.4. The risk free rate 5%. If the market risk premium is 5.5%. What is a rs?
2. Identify the problems with the CAPM approach.

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3. Suppose you are an analyst with the following data: r RF =5.5%; rRf – rM=6%; beta=0.8; D1=
birr100; Po = birr 2500; g= 6%. What is the firm cost of equity using CAPM, Gordon model?
IV. Earning yield Method
This method is also known as earning /price ratio method and adheres the basic relationship between
earnings and market price of the security. According to this method, the cost of equity capital is the
discount rate that equates the present values of expected future earnings per share with the net
proceeds or current market value, presented below:
rs = Earnings per share (EPS) * 100
Market price per share (Po)
This method is adopted when the following conditions are satisfied:
 Earnings of the company are expected to remain constant in the future
 All expected profits would be distributed without leaving any profit for retention i.e., payout ratio
is 100% or retention ratio is zero
 New equity capital is expected to earn the same current rate of earnings and,
 Market price is likely to be influenced by only the earning per share
Example1: Rani Ltd’s shares are currently trading at a price of Birr 1050, with outstanding share of
500,000. The expected profit after tax for the coming year is birr 84,000,000. Calculate the cost of
equity capital based on price earning method.
Solution: EPS = 840,000,000 / 500,000 = 168
Market price= birr 1050
rs = EPS *100 = 168 * 100 = 16%
Po 1050
Example 2: Kapil Cop.Ltd, has proposal to expand its business operations for what it needs fresh
equity capital of Birr 2,000,000.On the basis of following information determine the cost of equity
capital for existing shareholders as well as new equity shareholders.
 Issue price of new share is $ 200 no issuing charges
 Number of existing equity shares, 200,000
 Market value of existing shares $300
 Net earnings 10,000,000

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Solution:
Cost of capital for existing shareholders
EPS = Net earnings = 10,000,000 = $50
Number of shares 200,000
rs = EPS = 50 *100 = 16.67%
MP 300
Cost of Capital for new share of capital
rs = EPS = 50 *100 = 25%
Net proceeds 200
V. Cost of capital based on net worth
This method is based on the average net worth and cost of capital is obtained by dividing dividend by
average net worth using the formula below:
rs = Dividend
Average net worth (equity)
Example1: For the year 2015- 2016 ABC Company had declared a dividend of 1,200,000 and it has a
net worth (equity) of 95,000,000 and 110,000,000 respectively. Calculate the cost of capital based on
net worth.
Dividend = 1,200,000
Average net worth = 95,000,000 + 110,000,000 /2 = 10,250,000
rs = 1,200,000 = 11.71%
10,250,000
6.6.1.3.2. Cost of new common stock, re
As explained earlier, most mature companies rarely issue new public equity. However, for those that
do, the cost of new common equity, re , or external equity, is higher than the cost of equity raised
internally by reinvesting earnings, rs ,because of flotation costs involved in issuing new common
stock. Notice that flotation costs are higher for equity than for debt, and that flotation costs (as a
percent of capital raised) fall as the amount of capital raised increases. If there are flotation costs, the
issuing company receives only a portion of the capital provided by investors, with the remainder
going to the underwriter.

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To provide investors with their required rate of return, given that less money is available to the
company than the amount the investors put up, then each dollar received must “work harder,” that is,
it must earn a higher rate of return than the investors required on the funds they put up.
What rate of return must be earned on funds raised by selling new stock to make issuing stock
worthwhile? To put it another way, what is the cost of new common stock? The answer for a constant
growth stock is found by applying this formula:

Here F is the percentage flotation cost required to sell the new stock, so Po (1 - F) is the net price per
share received by the company. Flotation Cost, F is the percentage cost of issuing new common
stock.
Example1: Suppose ABC’s stock sells for $23; its next expected dividend is $1.24; and its expected
growth rate is 8 percent. ABC’s expected and required rate of return, hence its cost of retained
earnings, would then be 13.4 percent but when flotation cost is added it takes different value.
Assuming that the has a flotation cost of 10 percent, its cost of new common equity, re , is computed
as follows:

Capital from existing stock holders is internal equity capital, i.e. the firm already has these funds. In
contrast, capital from issuing new stock is external equity capital. The firm is trying to raise new
funds from outside source. New stocks sometimes finance a capital budgeting project the cost of this
capital includes not only stockholders’ expected returns on their investment but also flotation costs
incurred to issue new securities. flotation costs makes the cost of using funds supplied by new stock
holders slightly higher than using retained earnings supplied by the existing stockholders .

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When Must External Equity Be Used?

Because of flotation costs, dollars raised by selling new stock must “work harder” than dollars raised
by retaining earnings. Moreover, because no flotation costs are involved, retained earnings (internal
equity) cost less than new stock (external equity). Therefore, firms should utilize retained earnings to
the extent possible. However, if a firm has more good investment opportunities than can be financed
with retained earnings plus debt supported by those retained earnings, it may need to issue new
common stock. The total amount of capital raised beyond which new stock must be issued is defined
as the retained earnings breakpoint, and it can be calculated as follows:

Retained Earnings Breakpoint is the amount of capital raised beyond which new common stock
must be issued.
Example 1: ABC Company’s addition to retained earnings in 2017 is expected to be $68 million, and
its target capital structure consists of 45 percent debt, 2 percent preferred, and 53 percent equity.
Therefore, its retained earnings breakpoint is:
Retained earnings breakpoint = $68 / 0.53 = $128 million
To prove that this is correct, note that a capital budget of $128 million could be financed as
0.45($128) = $57.6 million would be financed with debt, 0.02($128) = $2.6 million with preferred
stock, and 0.53($128) = $67.8 million with equity raised from retained earnings. However, if the
capital budget exceeded $128 million, the company would have to obtain equity by issuing new, high
cost common stock.
Self-test 8
1. What are flotation costs?
2. Are flotation costs higher for debt or equity?
3. A firm has common stock with D1= $3.00; P = $30; g = 5%; and F = 4%. If the firm must issue new
stock, what is its cost of external equity, re?
4. Suppose Firm A plans to retain $100 million of earnings for the year. It wants to finance using its
current target capital structure of 46% debt, 3% preferred, and 51% common equity. How large

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could its capital budget be before it must issue new common stock? ($196.08 million)
5. XYZ corporation want to retained earnings in 2017 is expected to be $66 million; and its target
capital structure consists of 45% debt, 2% preferred, and 53% equity. What will be its retained
earnings breakpoint for 2017? How much could be is its debt, preferred stock, and equity capital
financed? When the corporation is going to issue new common stock?

6.6.1.4. Cost of Retained Earnings (Kr)

The cost of equity is the opportunity cost of the foregone dividends to the existing equity shares. The
cost of retained earnings is the return foregone by the investors (existing shareholders) on the amount
of profit not distributed to them and kept in business. In other words, retained earnings have implicit
cost (the rate of return on dividends foregone by the equity share holders).
The cost of retained is closely related to the cost of equity share capital. If retained earnings are
viewed as a fully subscribed issue of additional equity share, the firm’s cost of retained earnings kr,
can be assumed to be equal to the cost of equity share as given in the following equation, rs = kr.
Further, in case the retained earnings are distributed as dividend and shareholders want to reinvest
amount so received after tax has to pay additional charges e.g., brokerage, commission, legal,
underwriting, etc to purchase securities in a new company. To make this adjustment kr is updated as
follows:
Kr = rs (1-T) (1-b)
Where, T = tax rate
b= brokerage, commission, legal, underwriting costs
rs = cost of common equity for internal equity.
Example1: A firm’s rs (return available to share holders) are 10%. The average tax rate of
shareholders is 50% and it is expected that brokerage cost that shareholders will have to pay while
investing dividends in alternative securities is 2%. What is the cost of retained earnings?
Solution: Kr = rs (1-T) (1-b) = 10(1-0.5)91-0.02) = 4.9%
6.6.2. Composite, or weighted average, cost of capital, WACC
A firm’s weighted average cost of capital (WACC) is a composite of the individual costs of
financing, weighted by the percentage of financing provided by each source. Therefore, a firm’s

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WACC is a function of (1) the individual costs of capital and (2) the makeup of the capital structure –
the percentage of funds provided by long term debt, preferred stock and common stock.

Thus, WACC is used to make decisions concerning capital budgeting or investment decisions. The
computation of the cost of capital requires three things.

 Compute the cost of capital for each and every source of financing used by the firm.

 Determine the weight percentage of each financing in the capital structure of the firm.

 Calculate the firm’s weighted average cost of capital (WACC) using the values in (1) & (2)

Two points should be noted. First, the WACC is the current weighted average cost the company
would face for a new, or marginal, dollar of capital -it is not the average cost of dollars raised in the
past. Thus, WACC also called weighted cost of capital (WCC) is a marginal cost- what it costs to
raise additional capital across the different sources of capital.
Second, the percentages of each capital component, called weights, should be based on
management’s target capital structure, which is presumably an estimate of the firm’s optimal capital
structure. The target proportions of debt, preferred stock, and common equity, along with the
component costs of capital, are used to calculate the firm’s WACC.
WACC = WD * rdat + WP * rP + Ws * rs + We * re + wr * kr, where

WACC= Weighted average cost of capital Wr= = percentage of capital supplied by

Wd = percentage of capital supplied by debt retained earnings
Wp = percentage of capital supplied by rdat = after tax cost of debt
preferred stock
rp =cost of preferred stock
Ws = percentage of capital supplied by common
rs= cost of internal equity
stock (internal equity)
We = percentage of capital supplied by new
re =cost of external equity (new common stock)
common stock kr = cost of retained earnings
Example1: A firm has the following capital structure and after-tax costs for the different sources of
funds used:
Source of fund Amount Proportio After tax
n cost
Debt 120,000 0.20 4
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Preferred share 150,000 0.25 8

Equity share 160,000 0.30 12
Retained 150,000 0.25 11
earnings
Total 600,000 1.00
Calculate the weighted average cost of capital.

Solution: WACC =0.2*4 +0.25*8 +0.30*12 +0.25*11 = 9.15%. Under these conditions,
every dollar of new capital that a firm raises would consist of 20 percent of debt with an
after-tax cost of 4 percent, 25percents of preferred stock with a cost of 8 percent, Equity share
with a cost of 12 percent, and 25 percents of retained earnings with a cost of 11 percent. The
average cost of each whole dollar, or the WACC, would be 9.15 percent.

Example 2: Assume that IBM industries finance its assets through a mixture of capital
sources, as shown on its balance sheet.

Source of capital Amount Cost of capital

(birr)
Equity share capital 25,000,000 11 %
Preference share 20,000,000 10 %
capital
Retained earnings 10,000,000 8%
Debenture (before tax) 20,0000 10 %
Tax rate is 50%. Calculate the overall cost of capital (WACC)

Solution
Source of capital Amount(b Weight Cost of Weighted
(1) irr /proportion capital cost
(2) (3) = 1/ Total (4) (5) = 3*4
value
Equity share 25,000,000 0.3333(33.33%) 11% 0.03667
Preferred share 20,000,000 0.2667(26.67%) 10% 0.02667
Retained earnings 10,000,000 0.1333(13.33%) 8% 0.01067

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Debenture after 20,000,000 0.2667(26.67%) 5% 0.01333

tax
Total 75,000,000 1 or 100% 0.08734
Therefore, WACC =0.08734 or 8.734%
Self-test 9
1. How is the weighted average cost of capital calculated? Write out the equation.
2. On what should the weights be based?
3. A firm has the following data: Target capital structure of 25% debt, 10% preferred stock, and 65%
common equity; Tax rate is 40%; rd= 7%; rp=7.5%; and rs= 11.5%. Assume the firm will not issue
new stock. What is this firm’s WACC?
4. Firm A has the following data: Target capital structure of 46% debt, 3% preferred stock, and 51% of
common equity; tax rate =40%; rd= 7%; rp=7.5%; rs=11.5%; and re= 12.5%. A) What is the firm
A’s WACC if it does not issue any new stock? B) What is the firm A’s WACC if it issue new common
stock
5. Firm A has 11 equally risky capital budgeting projects, each costing $19.608 million and each
having an expected rate of return 8.25%. Firm A’s retained earnings breakpoint is $196.08 million.
How much capital should Firm A raise and invest? Why?(hint: use your answer for question number
4 b as a base of your decision).
6. WACC Midwest Electric Company (MEC) uses only debt and common equity. It can borrow
unlimited amounts at an interest rate of rd=10% as long as it finances at its target capital structure,
which calls for 45 percent debt and 55 percent common equity. Its last dividend was $100, its
expected constant growth rate is 4 percent, and its common stock sells for $1050. MEC’s tax rate is
40 percent. Two projects are available: Project A has a rate of return of 14.5 percent, while Project
B’s return is 10.25 percent. These two projects are equally risky and also about as risky as the firm’s
existing assets.
a) What is its cost of common equity?
b) What is the WACC?
c) Which projects should Midwest accept? Why?

6.6.2.1. Factors that affect the WACC

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The cost of capital is affected by a number of factors. Some are beyond a firm’s control, but
others are influenced by its financing and investment decisions.
I. Factors the Firm Cannot Control
The three most important factors that are beyond a firm’s direct control are (1) the state of
financial markets, including stock prices in general and the level of interest rates; simplly, the
level of interest rates, (2) the market risk premium, and (3) tax rates.
] If interest rates in the economy rise, the
cost of debt increases because firms will have to pay bondholders a higher interest rate to obtain debt
capital. Also, recall from our discussion of the CAPM that higher interest rates increase the costs of
common and preferred equity.
] The perceived risk inherent in stocks and investors’ aversion
to risk determine the market risk premium. Individual firms have no control over this factor, but it
affects the cost of equity and, through a substitution effect, the cost of debt, and thus the WACC.
] Tax Rates: Tax rates, which are largely beyond the control of an individual firm (although firms do
lobby for more favorable tax treatment), have an important effect on the cost of capital. Tax rates are
used in the calculation of the cost of debt as used in the WACC, and there are other, less obvious
ways in which tax policy affects the cost of capital. For example, lowering the capital gains tax rate
relative to the rate on ordinary income would make stocks more attractive, which would reduce the
cost of equity relative to that of debt.
II. Factors the Firm Can Control
A firm can directly affect its cost of capital in three primary ways: (1) by changing its capital
structure, (2) by changing its dividend payout, and (3) by altering its capital budgeting
decision rules to accept projects with more or less risk than in the past.
 Capital Structure Policy: In this chapter, we assume that a firm has a given target capital structure
and we use weights based on that target structure to calculate the WACC. It is clear, though, that a
firm can change its capital structure, and such a change can affect its cost of capital. First, beta is a
function of financial leverage, so capital structure affects the cost of equity. Second, the after-tax cost
of debt is lower than the cost of equity. Therefore, if the firm decides to use more debt and less
common equity, this change in the weights in the WACC equation will tend to lower the WACC.

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However, an increase in the use of debt will increase the risk of both the debt and the equity, and
increases in component costs will tend to offset the effects of the change in the weights
 The percentage of earnings paid out in dividends may affect a
stock’s required rate of return, rs. Also, if a firm’s payout ratio is so high that it must issue new stock
to fund its capital budget, this will force it to incur flotation costs, and this too will affect its cost of
capital.
 capital budgeting When we estimate the cost of
capital, we use as the starting point the required rates of return on the firm’s outstanding stock and
bonds. Those rates reflect the risk of the firm’s existing assets. Therefore, we have implicitly been
assuming that new capital will be invested in assets with the same degree of risk as existing assets.
This assumption is generally correct, as most firms do invest in assets similar to those they currently
use. However, it would be incorrect if a firm dramatically changed its investment policy.
For example, if a firm invests in an entirely new line of business, its marginal cost of capital should
reflect the risk of that new business
Self-test 10
1. What three factors that affect the cost of capital are generally beyond the firm’s control?
2. What three policies under the firm’s control are likely to affect its cost of capital?
3. Explain how a change in interest rates in the economy would affect each component of the
weighted average cost of capital.
The Marginal Cost of Capital (MCC)
Because external equity capital has a higher cost than retained earnings due to flotation costs the
weighted cost of capital increases for each dollar of new financing. Therefore, lower cost of
capital sources is used first. In fact, the firms cost of capital is a function of the size of its total
investment. Thus, the marginal cost of capital (MCC) is the cost of obtaining additional new
capital. Technically speaking, the MCC is the weighted average cost of the last birr of new
capital obtained. A schedule or graph relating the firm’s costs of capital to the level of new
financing is called the weighted marginal cost of capital (WMCC). Such a schedule is used to
determine the discount rate to be used in the firm’s capital budgeting process. The steps to be
followed in calculating the firm’s marginal cost of capital are:

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1. Determine the cost and percentage of financing to be used for each source of capital (debt,
preferred stock, common stock equity).
2. Compute the break even points on the MCC curve where the weighted cost will in increase
Breakeven point = maximum amount of the lower cost source of capital
Percentage of financing provided by the source
3. Calculate the weighted cost of capital over the range of total financing between break
points.
4. Construct a MCC schedule or graph that shows the weighted costs of capital for each, level
of total new financing. This schedule will be used in conjunction with the firm’s available
investment opportunities (IOs) in order to select the investments. As long as a profit’s IRR is
greater than the marginal cost of new financing, the project should be accepted. Also the point
at which the IRR intersects the MCC gives the optimal capital budget.

Example: LULA Company is considering three investment Proposals whose initial costs
and internal rates of return are given below
Company Initial cost ($) Internal rate of Rerun (IRR) (% )
A 100,000 19
B 125,000 15
C 225,000 12
The company finances all expansion with 40% debt, and 60% equity capital. The after tax cost of
debt is 8% for the first $ 100,000 after which the cost will be 10 percent .Retained earnings in
the amount of $ 150,000 available, and the common stock holders’ required rate of rectum is
18% . If the new stock is issued, the cost will be 22%. Calculate
A) the dollar amounts at which break occur and
B) Calculate the weighted cost of capital in each of the intervals between the breaks.
C) Decide which projects should be selected and calculate the total amount of the optimal
capital budget.
Solution

a) Breaks (increase ) in the weighted marginal cost capital will occur as follow

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For debt = Total Debt = $100,000 = $250,000

Debt proportion 0.4
For common stock = Retain earning =$150,000 = $250,000
Equity proportion 0.6
The debt break is caused by exhausting the lower cost of debt, while the common stock break is
caused by using up retained earnings.

b) The weighted cost of capital in each intervals between the breaks is computed as follows
With $ 0-$ 250,000 total financing
Source of capital weight cost weighted cost
Debt 0.4 8% 3.2%
10 . 8 %
Common stock 0.6 18% 14 . 0 %
MCC =14%

With over $ 250, 000 total financing

Source of capital weight cost weighted cost
Debt 0.4 10% 4%
Common stock 0.6 22% 13.2%
MCC= 17.2%
c) Accepts projects A and B because there required rate of return (IRR) is higher than the cost
of capital (MCC =14%) for a total of $ 225,000, which is the optimal budget. Above the
optimal budget (> $225,000) none of the three projects is selected because MCC (17.2%) is
higher than their respective IRR.
Example 2: Example: The target capital structure of Shala Corporation and other pertinent data
are given below.
Long-term debt ------------------ 40% cost of preferred stock (rd) = 12.06%
Preferred stock -------------------10% cost of preferred stock (rp) = 14%
Common equity ----------------- 50% cost of common stock (rs) = 15%

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Shala Corporation has Br. 900,000 available retained earnings. But when the firm fully utilizes
its retained earnings, it must use the more expensive new common stock financing to meet its
equity needs at 18%. In addition, the firm expects that it can borrow up to Br. 1,200,000 of debt
at 7.3% after-tax costs. Additional debt will have an after-tax cost of 9.1%.
Required
1. What is the breaking point associated with the;
a. Exhausting of retained earnings?
b. Increment of debt between Br. 0 to Br. 1,200,000?
2. Determine the ranges of total new financing where the WACC will rise
3. Calculate the WACC for each range of finance.
Solutions
1) a. Breaking point (BP) common equity = Br. 900,000 = Br. 1,800,000
0.50
b. Breaking point (BP) long-term debt = Br. 1,200,000 = Br. 3,000,000

0.40

The breaking points computed above can be interpreted as:

Shala can meet its equity needs using retained earnings until its total finance need is Br.
1,800,000. But when total capital required is more than Br. 1,800,000, its equity needs should be
met with common stock at 18%. Similarly, until the firm‘s total finance need reaches Br.
3,000,000, shala can raise any debt at 7.3% cost. Any further finance need beyond Br. 3,000,000
will cause the cost of debt to rise to 9.1%.
2) There are three ranges of finance that could be identified on the basis of the breaking points:
1st: Range: Br. 0 to Br. 1,800,000,
2nd: Range: Br. 1,800,000 to Br. 3,000,000, and
3rd: Range: Br. 3,000,000 and above
3) WACC (1st range) = 0.40 (7.3%) + 0.10 (14%) + 0.50 (15%)
= 2.92% + 1.21% + 7.00%
= 11.82%
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WACC (2nd range) = 0.40 (7.3%) + 0.10 (14%) + 0.50 (18%)

= 2.92% + 1.21% + 7.50%
= 13.32%
WACC (3rd range) = 0.40 (9.1%) + 0.10 (14%) + 0.50 (15%)
= 3.64% + 1.21% + 7.50%
= 14.04%

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