CHAPTER 6

COST OF CAPITAL
The financing of a company has several possible combinations according
to the origin of the funds used. You can fully fund the company with
shareholder funds, or funds from third parties (banks or investors) or with
parts of each, the proportion involved depends on the financial policy of
the firm. The cost of these resources is known as Cost of Capital of the
company.

6.1.- CONCEPTUAL DEFINITION

The cost of operating is an approximate way to define the concept of cost
of capital and obtain operating assets for the proper functioning of the
organizational structure without losing its value.
Since all economic and financial evaluation of any investment requires a
rough idea of the costs of the different sources of funding used to
undertake their projects, the knowledge of the cost of capital of the firm
is very important. There is another large number of decisions such as
growth strategies, financing possibilities, leasing, and working capital
policies, which require the knowledge of the cost of capital of the
company, so that the results obtained with those decisions are consistent
with the goals and objectives established by the organization.
There are several definitions of this concept, including: The interest rate
that investors both creditors and owners, want you to be paid to preserve
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Chapter 6 Cost of Capital

and increase their investment in the company; Weighted Average of

different sources of financing; the interest rate that equates the present
value of net flows received by the company, with the present value of
expected disbursements; minimum rate of return that a project must be
held to justify the use of capital to adopt it. All these definitions are
equivalent and somehow reflect a benchmark that the entrepreneur seeks
for successful management of his business.
To calculate the cost of capital it is necessary to establish the cost of each
component to determine it, depending on the proportion of each, the
weighted cost of capital, i.e., the average cost of funds used by the firm
to finance the investment.
Since the cost of capital is equivalent to a rate of return that the capital
invested should gain in order to keep the real value of the company
(shares) is maintained, if you get lower returns than its cost of capital, the
Company shall not be sufficient to cover its obligations or will be forced
to cut their dividends. As an example, we cannot (or should not) receive
loans of 10%, and reinvest them at 7%, expecting to stay in business for
long.
From the point of view of the investor, the cost of capital of the company
represents the minimum acceptable rate of return (MARR) which is the
minimum rate of return an investor would expect to receive from an
investment.
In the evaluation of investment projects, the performance of different
proposed projects is compared with the cost of capital of the firm,
assumed as MARR. Some investors prefer to compare these yields with
inflation to make a decision, or the average rate charged by banks
(similar to the cost of debt). The final decision is taken by the
entrepreneur.
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Chapter 6 Cost of Capital

There are three sources from which a company can obtain funds: By
borrowing from third parties; using their share capital and, through funds
generated by business operations (utilities).
6.2.-

COST OF DEBT

This refers to the interest rate that the firm pays to the bank or lender, or
holder of the Companys obligations. Calling d = borrowed capital, i =
interest or annuity paid, the cost of debt Cd is given by:
Cd

i
d

(1)

If the company issues bonds for $ 180,000 with an annual yield of $

9,000 the cost of that debt is 9,000 / 180.000 = 5%
The performance achieved by the company by investing the $ 180,000
must be greater than 5% to justify the indebtedness.
When there are several creditors, Cd is the weighted average of the cost
of debt.
Thus, a company with a indebtedness as shown in the table, has a cost of
debt: Cd = 9.05%

Debts

Value

Rate

Annual Interest

Obligations Issued

180,000

5%

9,000

Mortgage

200,000

9%

18,000

Loan Signing

250,000

12%

30,000

630,000

57,000

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Eng. Gustavo Guerrero Macas

In Ecuador, the interest paid on productive indebtedness is deductible of

the income tax, where the cost of debt decreases after deducting taxes
paid.
If taxes have been paid,
Cdi = Cd (1 t)

(2)

Where t = rate of income tax according to profits of the firm.

For a 25% tax on profits (example above), the cost of debt is C di = 0.0905
x 0.75 = 6.79%
6.3.-

COST OF COMMON SHARES

The companys capital is usually composed of shares classified as:

ordinary or common and preferred. The investor who acquires ordinary
shares seeks profits as dividends to increase the value of the investment.
Therefore, by measure the performance of common capital, is common to
add the dividend per share plus the estimated annual average increase.
This sum represents the expected return for the investor, who will be
encouraged to buy shares of the firm only if they equal or exceeds the
minimum return required by it to invest.
The performance of the ordinary shares of a company Cao is then given
by:
C ao

D
p

Where;
D = Annual cash dividend
p = Shares Market Value
g = Expected annual growth rate of the dividend,
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(3)

Chapter 6 Cost of Capital

that is, the cost of the ordinary shares of the firm is equal to the yield of
each ordinary share plus the expected increase of it.
Thus, a company that pays a dividend of $ 15 per share whose market
price is $ 1,000 and whose future annual dividend is expected to increase
by 3%, has a cost of ordinary shares of 4.50%
Dividends on common equity, as well as preferred stock, are taken from
the profits after tax (not deductible as expenses).
Another method to estimate Cao, presupposes the sum of the performance
of a risk-free investment plus arbitrary adjustment factors to compensate
business and financial risks. For example, if a risk-free investment (in
Government Bonds) yield 5%, the investor may decide to invest in a
particular project which requires an additional 3% to offset business risks
and 1% extra to exposure to financial risk. The cost of ordinary shares for
the project in question would then 9%.
In symbolic form the above is expressed as:

Cao

(4)

Where,
= Performance of a risk-free investment, eg. government bonds

= Additional yield to compensate project risks

= Additional yield to compensate financial risks.
and

are requirements and its determination is subjective and

depends on the discretion of the investor.
6.4.-

COST OF PREFERRED STOCK

Investment Projects

Eng. Gustavo Guerrero Macas

Preferred shares differ from ordinary shares, because the first ones have
basically a guaranteed fixed dividend D. The cost of preferred stock Cap
is obtained by dividing the fixed value D to the net value received by the
firm and place those shares (p - c). Usually the value received is less than
the paid p by the investor, because of Discounts in placement fees c, paid
to brokers.
D
Cap
pc
(5)
If ABC Company sold preferred shares a p=$1,000 each, which have a
guaranteed dividend annual D = $ 60 and received p-c=$960 per share,
the cost of issuance of these preferred shares was (60/960 = 0.0625) C ap =
6.25%
The discount was $ 40, calculated at a rate of 4% on the value of the
stock (1,000 x 0.04 = 40).
For the case where a firm perform several issues is necessary to
determine the cost of each, and take the weighted average whose value
will be used to determine the cost of capital.
Investment in preferred shares is similar to debt, because in case of
liquidation, it takes priority over common stock. An investment in
preferred stock is less risky than ordinary shares, but riskier than a third
in bonds (debt).
As indicated above, the preferred dividends are not deductible from the
income tax and therefore the cost of the preferred shares is calculated
after tax values. Its cost is greater than the debt, considering the same
interest.
6.5.-

COST OF RETAINED EARNINGS

Profits can be distributed to their owners or be retained by the firm for

reinvestment. As shareholders dividends are taxed and also pay
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Chapter 6 Cost of Capital

brokerage commissions to reinvest in another activity, the investor might

prefer not to receive dividends and instead reinvest them in the same
company.

If the shareholder decides to invest in another activity Cao, the cost of

investment would be Cao(1 t)(1 c), where t is the tax that investors
pay to invest in another company and c, the percentage paid to the broker
for investment management.
Reinvest in the same company does not pay taxes or commissions values,
so this may be a preferred alternative to the withdrawal of dividends.
The cost of retained earnings to reinvest in the same company is:
Cu = Cao(1 t)(1 c)

(6)

For a company with Cao = 4.5%, and generally t = 25% and c = 4%, the
cost of retained earnings is:
Cu = 0.045(1 0.25)(1 0.04) = 0.0324 = 3.24%

6.6.-

WEIGHTED AVERAGE COST OF CAPITAL (WACC)

The cost of capital, often used as a comparison rate for investment

appraisal, is the weighted average (WACC) of the cost of shares
(common and preferred), debt and retained earnings distributed
proportionally according to the composition of financing.
For a firm financed with debt by x%; ordinary shares by y%; preferred
shares by z%, and its retained earnings by w%, the weighted average cost
capital (WACC) is expressed by the relation:
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Eng. Gustavo Guerrero Macas

CPPC = xCdi + yCao + zCap + wCu

Where:

(7)

x+y+z+w=1

Example 1:
Suppose the prior years relate to the same company, and that its funding
is given in a 20% debt, 30% common shares, 35% preferred shares and
15% for reinvestment of profits, then the weighted average cost capital
will be:
x = 0.20
y = 0.30
z = 0.35
w = 0.15
1.00

*
*
*
*

Cdi = 0.0679
Cao = 0.045
Cap = 0.0625
Cu = 0.0324

0.013580
0.013500
0.021875
0.004860
0.053815

WACC = 5.4 %
The capital cost may vary if the company decides to change its financial
structure. The resulting value of WACC represents the minimum cost that
the firm must meet to avoid losing market value and therefore the
minimum return that the firm expects to receive from any investment you
make without losing value as a company. In certain cases, however,
depending on the risk involved, may be necessary to ask a higher
performance as safety margin. The "optimal mix" of capital (equity, debt,
retained earnings) is the ratio that minimizes the cost of capital of the
company or equivalently, maximizes its market value.
Example 2:
Suppose the case of the company ACME S.A. whose shares have a
market value of $ 400 each, which last year earned profits for
shareholders $ 15 per share. It is expected to grow 5% per share in
dividends to be distributed next year. The company plans to invest in a
project that, according to developers, will yield at least 18%. As part of
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Chapter 6 Cost of Capital

its financing, the company will hire a long-term credit through the Bank
Atlantic for $ 90,000 at 12%. Should ACME take part in the new
business? The company bases its financing by 49.9% debt, to 50.1% with
common shares. The policy is distributed to shareholders without
reinvesting.
Solution:
The Bank loan represents an initial annual charge of $ 10,800 (90,000 x
0.12) that, in relation to the capital received ($ 90,000), it represents a
cost of (Eq. 2)
Cdi =10,800/90,000*(1 0.25) = 0.09
That means, the cost of debt is 9.00%
On the other hand, using equation (3) to find the cost of common stock,
Cao= D/P + p, we have:
15

Cao = 400

0.05

= 0.0875

Where D (= 15) is the dividend paid per share last year, P (= 400) is the
market value of each share, and g (= 5% ) the expected growth rate of
dividends for the new year.
Therefore, the cost of of the ordinary shares is 8.75%
The company has no other components in their cost of capital, so by
applying the percentages that each component involved in the funding we
have:
WACC= 0.09 x 0.499 + 0.0875 x 0.501 = 0.0887
The capital cost is then 8.87% and any new investment should have a
higher return in order to be considered. According to the promoters, the
proposed investment will pay to the company at least 18%, which is
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Eng. Gustavo Guerrero Macas

higher than its cost of capital. Therefore, ACME must undertake the new
project.
Normally the cost of capital is calculated based on historical figures. In
situations of interest rates that change rapidly is necessary to be aware of
changing trends and other economic factors and use them in calculating
values based on those trends.
-o-

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