**Cost of Capital**

Cost of capital is the rate of return that the providers of capital—debt holders and owners—require as compensation for their contribution. For example, if NTPC Ltd raises money by issuing bonds to the public @9% p.a, it has to offer some return to the public to induce them to provide capital, as investors can also park their money in other investment avenues.

It has three components

- Cost of Debt
- Cost of Equity Capital (Common Stock)
- Cost of Preferred Capital

Let us learn how to estimate these:

**Cost of Debt**:

**Yield to Maturity Method**: If the company has issued bonds and the bonds are publicly listed, the yield to maturity (YTM) on a long-term bond can be used as the interest rate. The interest rate must be adjusted for the tax rate, as interest expense is tax deductible. Let us understand with an example:

** XYZ company has a $200 MN debt outstanding with a coupon rate of 5%, maturity of 10 ****years, ****and current market price of $98. The tax rate is 40%**

** YTM = ****5.26% (calculated by using yield function in MS Excel)**

**Cost of debt = **** 5.26% ****(1-0.4)**

**Cost of ****debt = ****3.15%**

**Cost of Equity**:

**Capital Asset Pricing Model**: It is one the most popular methods for calculating cost of equity

- The CAPM model states that the required return on equity, E(Ri), is the sum of the risk-free rate of interest, RF, and a premium for bearing market risk,

βi [E(Rm) – Rf] **E(Ri****) = Rf + βi [E(Rm) – Rf****],**where

βi is the return sensitivity of stock i to changes in the market return of the benchmark

E(Rm) is the expected return on the market

E(Rm) – Rf is the expected market risk premium or equity risk premium (ERP)

Let us understand with an example:

Expected market return in the Indian Stock Market is 15%. The 10 year govt bond rate is 8%. The beta for Unitech is 1.5.

Calculate the cost of equity for stock of Unitech

**Cost of Unitech Equity**** = 8% + 1.5 * (15% – 8%)**

= **18.5%**

**Cost of Preferred Capital**:

The cost of preferred shares is the rate of return paid effectively by the company on its preferred equity

Cost of preferred shares = (Annual Preferred Dividend Per share)/(Current Market Price of Preferred Stock)

**Let us understand with the help of an example:**

XYZ company has 3,000 shares of $1,000 par value preferred stock. The fixed coupon rate is 7.5%. The preferred stock current market price is $1,225. Calculate the cost of preferred stock?

Cost of preferred shares = (Annual Preferred Dividend Per share)/(Current Market Price of Preferred Stock)

= (7.5% of $1,000)/1,225

= 6.12%

**Weighted Average Cost of Capital (WACC)**

WACC represents the weighted average of the required return on the invested capital (debt and equity) in a given company.

**WACC is useful in the following situations****:**

- It is used to calculate the value of a firm
- It is used as a hurdle rate (minimum return), which is required by a company for a new project

**WACC ****(r) = ****w****d*****k****d** **(1 ****– ****t) + ****w****p*****k****p** **+ ****w****e*********k****e** **,**where

- wd is the proportion of debt that the company uses when it raises new funds
- kd is the before-tax marginal cost of debt
- t is the company’s marginal tax rate
- wp is the proportion of preferred stock the company uses when it raises new funds
- kp is the marginal cost of preferred stock
- we is the proportion of equity that the company uses when it raises new funds
- ke is the marginal cost of equity

Let’s learn how to calculate it with the help of an illustration. We advise you to try it first on your own and then compare the answers with our solution.

Let’s assume KFC has the following capital structure:

- Debt = $10 BN
- Common Equity = $30 BN
- Preferred Equity = $10 BN

Additional Information:

- Before tax cost of debt = 10%
- Tax rate = 40%
- Required rate of return on equity = 20%
- Cost of preferred equity = 14%

Solution:

**WACC **= (10/50) * 10% * (1 – 0.4) + (30/50) * 20% + (10/50) * 14%

= 1.2% + 12% + 2.8%

= 16%

This is a very important concept to build financial models in the investment banking space. It is paramount to understand this concept before learning Financial Modeling.

We look forward to your comments and shares.

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