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SAN BEDA COLLEGE ALABANG
Master in Business Administration
GSMBA204 - Financial Management
Cost of Capital
Dr. John Williams
Financial Management: Core Concepts
Principles of Managerial Finance
Lawrence Gitman, Chad Zutter
Erica A. Reyes
1. The Purpose of the Cost of Capital
2. Cost of Capital Concepts
a. Capital Components
b. Capital Structure
c. Return on Investments and the Costs of Capital Components
d. The Weighted Average Calculation – the WACC
e. Capital Structure and Cost – Book versus Market Value
3. Calculating the WACC
The Purpose of the Cost of Capital
• A company’s cost of capital is the average rate it pays for the use of its capital funds.
• No one should invest in any project that will return less than the cost of invested funds.
• A firm’s cost of capital is the best estimate of the cost of money it invests, it should never
take on a project that doesn’t return at least the rate.
• A company’s cost of capital can be thought of as its required return for all capital
budgeting projects that have risk level approximately equal to its own risk. Where a
project’s expected return is its IRR, hence, a firm won’t invest in a project unless its IRR
exceeds that firm’s cost of capital.
“No one should invest in any project that will return less than the cost of invested funds”
Therefore, a project must either have an IRR that exceeds the cost of capital or an NPV that is
positive when computed at that rate.
In Professional life:
Accounting – You need to understand the various sources of capital and how their costs are
calculated to provide the data necessary to determine the firm’s overall cost of capital
Management – You need to understand the cost of capital to select long-term investments after
assessing their acceptability and relative rankings.
In Personal Life:
Knowing your personal cost of capital will allow you to make informed decisions about your
personal consuming, borrowing, and investing. Understanding the cost of capital concepts will
allow you to make better long term-term decisions and maximize the value of your personal
Cost of Capital Concepts
Capital refers to the money acquired for use over long periods of time. The funds are generally
used for getting businesses started, etc. Capital can be divided into components according to
the way the money was raised. The two classifications are debt and common equity.
1. Debt is borrowed money raised through loans or the sale of bonds.
2. Common equity indicates the ownership interest, and comes from the sale of common
stock or from retaining earnings.
3. Preferred stock is the third kind of capital comes from the sale. It combines features of
debt, in that it pays dividends, and equity, in that it has the potential to appreciate the
price. Legally, it’s a kind of equity, but for many financial purposes it behaves more like
Capital Structure is the mix of capital components in use by the company at a point in time. We
generally describe capital structure in percentage terms referring to the relative sizes of the
components. For example, a firm that has the following capital components can be described as
30% debt, 10% preferred stock, and 60% equity.
Debt 30,000,000 30%
Preferred Stock 10,000,000 10%
Equity 60,000,000 60%
Raising on Money in the Proportions of the Capital Structure
As a practical matter, an exact capital structure can’t be maintained continuously, because
money tends to be acquired in finite amounts by issuing securities of one kind or another, one at
For example, suppose a firm had the capital structure just illustrated and that mix was also a
target. Suppose the company needed to raise an additional $1 million. To do that, it would
generally issue and sell $1 million of either debt, preferred stock or common stock would not be
Returns on Investment and the Cost of Capital Components
Investors provide capital to companies by purchasing their securities. The investors’ returns are
paid out by the companies, so those returns are costs to the firms in which the investments are
made. This is a fundamental point. The return received by an investor on a particular type of
security ( debt, preferred, or equity) and the cost to the company of funds raised through that
security are opposite side of the same coin.
For a particular company, investments in the securities underlying the three capital components
offer different risk characteristics. Thus, each capital component has a distinct cost that’s related
to the return earned by investors who provide that component. And because the returns are
different, so are the costs.
Generally, the return on an equity investment is higher than the return on debt or preferred
stock. The return/cost of debt tends to be the lowest of the three because debt is the less risky
investment. The cost of preferred is usually between the cost of debt or cost of equity.
Calculating the Components Cost of Capital
Adjustments – The Effect of Financial Markets and Taxes
Although the returns received by investors and the costs paid out by companies are the same
money, the amounts effectively paid and received can be different because of taxes and certain
transaction costs associated with doing business in financial markets.
Taxes – the effect applies only to debt and stems from the fact that interest payments are tax deductible to the paying firm. That effectively makes debt cheaper than it would be if interest