Cost of Capital

Professor Ronald Miolla

Agenda

• 1) What is Cost of Capital?• 2) How to compute Cost of Capital.• 3) Cost of debt.• 4) Cost of equity.

A Company’s Cost of Capital

• The overall cost of getting financing• A=L+OE• Computation (next slide) gives you a % cost for

the average $ that is financed• Called a WACC, weighted average cost of

capital• Can be used to determine a discount rate for

the firm

Example

Finance Item Cost Weight Weighted CostDebt (bonds) 7.05% * .30 = 2.12%Pref. Stock 10.94%* .10 = 1.09Retained Earn 12.00%* .60 = 7.2

WACC 10.41%Interest on debt reduces taxesOptimal structure is not all debt as financial risk

increases with debt in the financing structure.

After Tax Cost of Debt

• After tax cost % = cost%(1-tax rate)• Example:– Tax rate is 35%– After tax % = 10.84%(1-.35) = 7.05%

The Capital Asset Pricing Model (CAPM)

• Required return stock = risk free return + B(market return – risk free)

B is the beta of a stock: a measure of how risky it is compared to the overall market. Over 1 is more risky. Less than 1 is less risky.

Example: ? = 3% + 1.5(11-3) = 15%

Summary

• Cost of Capital is the % cost of funding.• Based on the cost of liabilities and equity.• Investments/projects must yield returns

higher than the Cost of Capital.