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Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Corporate finance
Eighth Edition
Chapter 9
The cost of capital and
capital structure
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
2
An Overview of the Cost of Capital
•The cost of capital acts as a link between the
firm’s long-term investment decisions and the
wealth of the owners as determined by investors
in the marketplace.
•It is the “magic number” that is used to decide
whether a proposed investment will increase or
decrease the firm’s stock price.
•Formally, the cost of capital is the rate of return
that a firm must earn on the projects in which it
invests to maintain the market value of its
stock.
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WHAT IS THE COST OF CAPITAL?
•All providers of finance require returns.
•The required return will reflect the risk of the
investment and the returns of alternatives.
•Companies need information about the cost of
different sources of finance in order to find
the overall cost of finance and to make
investment and financing decisions.
•Perhaps an ‘optimum’ capital structure exists
which a firm can seek to achieve.
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THE FIRM’S COSTS OF CAPITAL
•For Investors, the rate of return on a security is a
of investing.
•For Financial Managers, that same rate of return
is a way of raising funds (financing) that are
needed to operate the firm, adjusted by flotation
costs and taxes.
•In other words, the cost of raising funds is the
firm’s cost of capital.
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THE FIRM’S COST OF CAPITAL
•In an efficient market, investor’s required return and
expected return are the same.
•Cost of capital from the firm’s perspective is
actually the expected return from investor’s
perspective, adjusted for the effects of taxes
and flotation costs.
•Afirm’s cost of capital serves as the linkage
between financing and investing decisions. The
cost of capital becomes the hurdle rate that must
be achieved by an investment before it will increase
shareholders’ wealth.
•It is the firm’s required return on investment
projects under consideration.
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HOW CAN THE FIRM RAISE CAPITAL?
•Bonds / Debentures & Bank Loans
•Preferred Stock
•Common Stock
–Each of these offers a different rate of return
to investors.
–This return is a cost to the firm.
– “Cost of capital” actually refers to the
weighted cost of capital - a weighted average
cost of financing sources.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
WHAT IS THE COST OF CAPITAL?
•All providers of finance require returns.
•The required return will reflect the risk of the
investment and the returns of alternatives.
•Companies need information about the cost of
different sources of finance in order to find
the overall cost of finance and to make
investment and financing decisions.
•Perhaps an ‘optimum’ capital structure exists
which a firm can seek to achieve.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Ordinary shares
•The cost of equity can be found from the
rearranged dividend growth model:
Ke = cost of equity
P0= the current ex dividend share price
D1= the dividend received each year
g= the expected growth rate of dividends
g
P0
D1
Ke+
=
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Ordinary shares (continued)
Calculating Keusing dividend growth model:
•Current ex dividend share price = 417p
•Current dividend per share = 23p
•Expected dividend growth rate = 5%
•Next year’s dividend (D1) = 23 × 1.05 = 24.2p
•Ke= (24.2/417) + 0.05 = 0.058 + 0.05 = 0.108
•Ke= 10.8%
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Ordinary shares (continued)
•The cost of equity can also be found from the
CAPM:
Rj= Rf+ βj(Rm–Rf) = Ke
where:
Rm= return of the market
Rf= risk-free rate of return
(Rm–Rf) = equity risk premium
βj= beta value of ordinary share
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•The CAPM differs from dividend valuation
models in that it explicitly considers the firm’s
risk as reflected in beta.
•On the other hand, the dividend valuation
model does not explicitly consider risk.
•Dividend valuation models use the market
price (P0)as areflection of the expected risk-
return preference of investors in the
marketplace.
Cost of Common Stock
Retained earnings
•Retained earnings have an opportunity
cost which is equal to the cost of equity.
•The cost of retained earnings can thus be
