Chapter # 15

Required returns and

Cost of capital

Cost of capital:
The cost of funds used for financing a business. Cost of
capital depends on the mode of financing used it
refers to the cost of equity if the business is financed
solely through equity or to the cost of debt if it is
financed solely through debt. Many companies use a
combination of debt and equity to finance their
businesses, and for such companies, their overall cost
of capital is derived from a weighted average of all
capital sources, widely known as the weighted average
cost of capital (WACC). Cost of capital is extensively
used in the capital budgeting process to determine
whether the company should proceed with a project.
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We know, there are three basic sources of

long-term funds for the business firms.
These are as under:
1. Long-term debt
2. Preferred stock
3. Common Equity

1. Long-term debt

The following types of debt instruments may

be used for financing by the firm:
i). Bond
ii). Banks loan.

i). Bond
Bond is a long-term promissory note that promises to
pay bondholder a predetermined, fixed amount of
interest each year, based on coupon rate until
maturity and at maturity date, the principal/par value
will be paid to the bondholder.
Types of Bonds
The Bonds are two types:
(i).Perpetual Bond-The Bond that never matures
(ii).Redeemable Bond-The Bond which will mature
after some period of time.
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Cost of Bond
Cost of perpetual Bond before tax can be
calculated by the following formula:
We know, V0 = I
Thus, r =
I
.

r
Vo
Where as, V0 = Current market price,
I =Interest coupon rate amount, r = Cost of
bond

Cost of Redeemable Bond before tax can be

calculated from the following formula
Valuation=V0= I
(1+r)n 1
+ PV
r (1+r)n
(1+r)n
.

Where as, V0 = Current market price, I =Interest coupon

rate amount, r = Cost of bond, PV= Par value,
n= Remaining life (in years) for the maturity of bond

 Hint to calculate the cost:

If the current Market price of the Bond is less
than its face value, then it means that the
Bond is selling at discount. Thus the cost of
Bond (r) will be higher than its coupon rate (I).
If the current Market price of the Bond is more
than its face value, then it means that the
Bond is selling at premium. Thus the cost of
Bond (r) will be less than its coupon rate (I).

Cost of Banks loan.

Unlike a bond, a bank loan is not traded in the
secondary market. Thus cost of a bank loan is
simply the current interest rate the bank
would charge if the firm takes a loan from
them.

Cost of Bond and Banks loan (after tax)

Since the interest payments on Bond or banks
loan are tax deductible, therefore, the net cost
of these will always be taken after tax. It will
be calculated as under:
Cost of bond or banks loan (After tax) =
Cost of Bond/banks loan before tax (1-tax
rate)

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2. Preferred stock
Shareholders of preferred stock receive fixed,
regular dividend payments for a specified period of
time, unlike the variable dividend payments offered
to common stockholders. Preferred stockholders
generally do not have voting rights, as common
stockholders do, but they have a greater claim to
the companys assets at the time of liquidation.
Preferred stock may also be callable, which
means that the company can purchase shares back
from the shareholders at any time for any reason,
although usually at a favorable price.
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Cost of Preferred stock

The required rate of return on investment by
the preferred stock holders of a company.
We use the following formula to calculate the
cost of preference stock
We know, Vo = Dp/r
Thus, r = Cost of Preferred stock= Dp /Vo
Where as, Dp = fixed dividend amount on
preferred stock, and ,Vo = current market
price
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3. Common stock
Common stock is the most common type of stock
that is issued by companies. It entitles
shareholders to share in the companys profits
through dividends and/or capital appreciation.
Common stockholders are usually given voting
rights, with the number of votes directly related
to the number of shares owned. Of course, the
companys board of directors can decide
whether or not to pay dividends, as well as how
much is paid.
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Cost of common equity

The required rate of return on investment by
the common stock holders of a company.
There are commonly two methods available
for measuring the cost of common stock.
However, the method to use in finding out
the cost of capital is dependant on the type
of given data available. These methods are
as under:
(i).Dividend Discount model approach
(ii).Capital Asset pricing model approach
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(i).Dividend Discount model approach

A procedure for valuing the price of a stock by using
predicted dividends and discounting them back to
present value. The idea is that if the value obtained
from the DDM is higher than what the shares are
currently trading at, then the stock is undervalued.

We know from the valuation of common stock that

there are four sub dividend models fall under
dividend
discount model. These are as under:
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Model -1: General valuation model :

Assumption:[When share is purchased for a finite
period. i.e. for next few years and further yearly
expected dividends]
Example: Next n years dividends are given discount
rate is r
Valuation=V0= D1
+
D2
+ . . Dn
(1+r)
(1+r)2
(1+r)n
Now r can be calculated by the trial & error
procedure, i.e. IRR technique.
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Model 2: Zero growth Model

Assumption: [share is purchased for an infinite period and
companys dividends are not growing, but the company
is paying out same amount of dividend every year i.e.Rs5
per share for each year [say]. That is, Do=D1=D2Dn]
Thus the value of the common stock would be like the PV of
perpetuity.
The formula for zero growth will be:
Valuation= Vo= D where as, D1 = D0,
r
Therefore, Cost of common equity =r = D1
Vo
.

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Model -3: Constant growth model

Assumption: [Share is purchased for an infinite period
and company is paying with a constant dividend
payout ratio or constant growth rate of g percent]
The formula for constant growth will be:
Valuation= V0 =
D1
(r-g)
Where as, D1= Do (1 + g), g= Growth rate in dividend.
Therefore, Cost of common equity (r)

= D1

+ g
V0
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Model 4: Multiple (variable)

growth model
Assumption: [share is purchased for an infinite
period and growths in dividend are in multiple
and ending in constant growth or Zero growth]
For example, Y1 to y3 =Super normal growth, Y4 to y4
= above normal growth
Y5= Constant growth or Zero growth.
The valuation of multiple growth stocks will be
calculated by the following procedure:
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Sum of the present values of future dividends

during the multiple growth periods plus the present
value of the estimated stocks price at the end of
multiple growth periods.
Example: Multiple growths are up to 4 years (say)
and in fifth year constant or zero growth, then the
formula for multiple/rapid growths will be:
Valuation=V0=

D1
(1+r)

D2
(1+r)2

D3

(1+r)3

+ D4
(1+r)4

P4

(1+r)4

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Where as, Do=Present dividend per share,

D1 =Do(1+g), D2=D1(1+g), D3=D2(1+g),
D4=D3(1+g), D5=D4(1+g) [In case of
constant growth from fifth year] or
D5=D4 [In case of zero growth in fifth year]
P4=
D5
(r g)
[In case of constant growth from sixth year i.e.,
at the end of multiple growth period]
Or,
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P4=

D5
r
[In case of zero growth from sixth year i.e. at
the end of multiple growth period].
Now r can be calculated from the above
example formula by trial & error procedure,
.i.e. IRR technique

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(ii).Capital Asset pricing model

approach
Already discussed in Risk & Return Chapter
(see chapter #5 notes)

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Company s over all cost of capital or

Weighted average cost of Capital
(WACC):

It is the weighted average cost of the various

capital components employed by the firm. It is
calculated as under:
Suppose that the firm has been financed by
banks loan, bonds, common stock and as well
as by preferred stock
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WACC =
(Proportion wt of bond) (Cost of bond after tax)
+ (Proportion wt of banks loan) (Cost of
banks loan after tax) + (Proportion wt of
preferred stock) (Cost of preferred stock) +
(Proportion wt of equity stock) (Cost of equity
stock)

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Where as, proportion wt (weight) of each will be

calculated as under:
Book value or market value of respective capital

Aggregate (total) Book value or Market value

of total capital structure

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... The end

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