Cost of Capital

Outline

Meaning of Cost of Capital Significance of Cost of Capital Concept of Weighted Average Cost of Capital

(WACC) Cost of Components of Capital

Cost of Debt Cost of Preferred Stock Cost of Common Equity Flotation Costs

Cost of Capital

Given an unbiased estimate of cash flows of a project, at what rate should we discount the cash flows of the project?

Cash flows should be discounted at the required rate of return— the rate of return that similar risk class investments are

providing in the market or the minimum rate of return that a project must earn to

justify investment of resources The required rate of return is known as the cost of

capital for the project

Significance

Required rate chosen to discount the cash flows and to compute the NPV must be appropriate to the risk of the project.

What if we choose a required rate of return that is too high for the project given its riskiness? We will end up rejecting some good projects,

With unduly high discount rate, the NPV will either be very low or sometimes even negative,

because we are unnecessarily using a very conservative discount rate.

By rejecting good projects, the firm will compromise its competitiveness and market value

What if we choose a required rate of return that is too low for the project given its riskiness? We will end up accepting some bad projects,

because with a low discount rate the NPV will either be high and positive, because

we are unnecessarily using a very low discount rate.

By accepting bad projects, the firm will increase the risk of its cash flows.

This will compromise its competitiveness and market value

Weighted Average Cost of Capital

Choosing the right discount rate, also known as required rate of return for a project, is critical for its success

Use a weighted-average cost of capital A weighted-average of the cost of each component of

capital used to fund the project, where weights represent the proportion of each component in the total capital for the project

An optimal cost of capital is the cost at which value of the firm is maximum

WACC is defined as the weighted average of the cost of each component of capital, where weights represent the proportion of each component in the total capital