IFT Notes for Level I CFA^® Program

LM06 Cost of Capital-Foundational Topics

Part 1

1. Introduction

This reading defines what is cost of capital, methods to estimate the cost of capital, and why estimating the cost of capital accurately is important, both for decision-making by a company’s management and for valuation by investors. Estimating the cost of capital is a complex process which requires many assumptions.

This reading covers:

Introduction to the cost of capital and its basic computation
Methods for estimating the costs of the various sources of capital: debt, preferred stock, and common equity
Beta estimation for public and non-public companies
Correct treatment of floatation costs
Methods used in practice by companies

2. Cost of Capital

Cost of capital is the rate of return that the suppliers of capital require as compensation for their contribution of capital. Assume a company decides to build a steel plant and needs money or capital for it. Investors such as bondholders or equity holders will lend this capital to the company. Suppliers of capital will be motivated to part with their money for a certain period of time if the money invested can earn a greater return than it would earn elsewhere. In short, investors will invest if the return (IRR) is greater than the cost of capital.

A company has access to several sources of capital such as issuing equity, debt, or instruments that share characteristics of both debt and equity. Each source becomes a component of the company’s funding and has a specific cost associated with it called the component cost of capital.

The cost of capital is the rate of return expected by investors for average-risk investment in a company. Investors will demand a higher rate of return for higher-than-average-risk investments. Similarly, investors will demand a lower rate of return for lower-than-average-risk investments.

One way of calculating this cost is to determine the weighted average cost of capital (WACC), which is also called the marginal cost of capital. It is called marginal because it is the additional or incremental cost a company incurs to issue additional debt or equity.

Three common sources of capital are common shares, preferred shares, and debt. WACC is the cost of each component of capital in the proportion they are used in the company.

$\indent \ WACC = w_dr_d\ (1\ -\ t)\ +\ w_pr_p\ +\ w_er_e$

where
w_d = proportion of debt that the company uses when it raises new funds
r_d = before-tax marginal cost of debt
t = company’s marginal tax rate
w_p = proportion of preferred stock the company uses when it raises new funds
r_p = marginal cost of preferred stock
w_e = proportion of equity that the company uses when it raises new funds
r_e = the marginal cost of equity

The weights are the proportions of the various sources of capital that the company uses. The weights should represent the company’s target capital structure and not the current capital structure. For example, suppose that current capital structure of a company is 33.3% debt, 33.3% preferred stock and 33.3% common stock. To fund a new project, the company plans to issue more debt and its capital structure will change to 50% debt, 25% preferred stock, and 25% common stock. WACC calculations should be based on these new weights, i.e., the target weights.

Example

IFT has the following capital structure: 30 percent debt, 10 percent preferred stock, and 60 percent equity. IFT wants to maintain these weights as it raises additional capital. Interest expense is tax deductible. The before-tax cost of debt is 8 percent, cost of preferred stock is 10 percent, and cost of equity is 15 percent. If the marginal tax rate is 40 percent, what is the WACC?

Solution:

WACC = (0.3) (0.08) (1 – 0.4) + (0.1) (0.1) + (0.6) (0.15) = 11.44 percent

Note: Before-tax cost of debt is given. Do not forget to calculate the after-tax cost.

Example

Machiavelli Co. has an after-tax cost of debt capital of 4 percent, a cost of preferred stock of 8 percent, a cost of equity capital of 10 percent, and a weighted average cost of capital of 7 percent. Machiavelli Co. intends to maintain its current capital structure as it raises additional capital. In making its capital budgeting decisions for the average risk project, what is the relevant cost of capital?

Solution:

The relevant cost of capital is 7%. The WACC using weights derived from the current capital structure is the best estimate of the cost of capital for the average risk project of a company.

Taxes and the Cost of Capital

Notice that in the equation for WACC, we consider taxes only for debt. This is because payments to equity shareholders in the form of dividends are not tax-deductible. On the other hand, interest costs are tax-deductible in some jurisdictions; they pass through the income statement and provide a tax shield. If interest expense is not tax deductible then the tax rate applied is zero and effective marginal cost of debt is equal to cost of debt (r_d). Let us see the effect on net income in the example below.

A company pays 10% interest on capital raised. On the left-hand side of the table below, you see that the interest is tax deductible. On the right hand side, the interest is not tax deductible. So the tax expense on the LHS is 16, which is 4 less than that on the RHS. The savings on taxes consequently reflect in the net income as well. The actual cost of debt is 6% when it is tax-deductible instead of 10%.

Calculation of net income assuming interest is tax-deductible	Calculation of net income assuming interest is not tax-deductible
Revenue 100	Revenue 100
Operating Expenses 50	Operating Expenses 50
Interest 10	EBT 50
EBT 40	Tax expense (40%) 20
Tax Expense (40%) 16	Interest Expense 10
Net Income 24	Net Income 20