Cost of Capital Lecture Notes

Overview

• Cost of capital: Minimum return expected by an investor or company on their investment to compensate for the risk involved. Expressed as a percentage.
• Key components: Cost of debt and cost of equity.
• Used in capital budgeting: Determines if a project/investment is profitable.

Types of Cost of Capital

1. Debt Cost of Capital

• Definition: Cost of borrowing money (interest rates, fees on loans/bonds).
• Interest Rate: Rate paid on outstanding debt.
• Example: Company issues $1M in bonds at 5% interest, cost of debt capital = 5%.
• Creditworthiness Impact: Good rating = lower interest rate; poor rating = higher interest rate.
• Tax Deductible: Interest on debt can reduce tax liability (e.g., 20% tax bracket, $50K interest, reduces tax by $10K).

2. Equity Cost of Capital

• Definition: Cost of using equity financing to raise capital (expected returns by investors on stock).
• Higher than Debt Capital: No guaranteed return for equity investors.
• Example: Company issues stock at $50/share; expected return = 10%, cost of equity capital = 10%.
• Factors Affecting: Financial performance, industry trends, market conditions.

Cost of Capital Formula

• WACC (Weighted Average Cost of Capital): Average cost of capital for a company.

  Formula:

  [ WACC = \left( E \over V \right) \star Re + \left( D \over V \right) \star Rd \star (1 - Tc) ]

  • E: Market value of equity
  • D: Market value of debt
  • V: Total market value (E + D)
  • Re: Cost of equity
  • Rd: Cost of debt
  • Tc: Corporate tax rate

Components of Cost of Capital

• Weighted Average Cost of Capital (WACC): Discussed earlier.
• Cost of Preferred Stock: Fixed dividend-paying stock with priority over common stock.
• Marginal Cost of Capital: Cost of raising an additional dollar of capital beyond existing levels.
• Opportunity Cost of Capital: Cost of next best foregone investment opportunity.

Importance of Cost of Capital

1. Investment Decisions: Evaluates profitability of investment opportunities.
2. Financing Decisions: Determines cost-effective ways to raise capital (debt vs. equity).
3. Dividend Policy: High cost of capital may lead to retaining earnings instead of paying dividends.
4. Capital Structure: Balance between debt and equity to minimize cost and maximize value.
5. Performance Evaluation: Compare actual return on investment with cost of capital for resource utilization assessment.

Conclusion

• Understanding cost of capital is crucial for informed financial decisions and maximizing shareholder value.
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