Cost of Capital Questions and Answers [With PDF]

Every rupee a company raises has a price. Lenders want interest, shareholders want dividends and growth, and the business must earn at least that much on its investments, or it destroys value. That price of money is the cost of capital. This chapter covers the cost of debt, preferred shares, common equity and retained earnings, flotation costs, and the weighted average cost of capital (WACC), which is used as the discount rate in capital budgeting. Here are 35 important questions with clear answers and worked examples. Every formula and calculation has been rechecked.

This is Chapter 5 of our Finance course. It follows Long Term Financing and comes before Capital Budgeting.

Meaning and Components

Q1. What is the cost of capital?

The cost of capital is the minimum rate of return that a company must earn on its investments to keep the market value of its shares unchanged and to satisfy those who supplied the money (lenders and shareholders).

Q2. What is the importance of the cost of capital?

• It is the discount rate for evaluating investment projects.
• It helps determine the best capital structure.
• It helps in choosing between sources of finance.
• It guides dividend policy.
• It measures the financial efficiency of management.
• It supports a sound debt policy.

Q3. What are the limitations of calculating the cost of capital?

• It is hard to estimate when price levels and markets change.
• Future dividends and growth rates are uncertain, so the cost of equity is an estimate.
• Inflation affects the required rates but is not always reflected.
• Choosing the right discount rate for equity involves judgement.
• It rests on assumptions, such as a stable capital structure.

Q4. What are the four long-term sources of funds?

• Long-term debt (loans, debentures and bonds)
• Preferred (preference) share capital
• Common (ordinary) share capital
• Retained earnings (reserves)

Q5. What are the components of the cost of capital?

• Cost of debt (bonds)
• Cost of preferred stock
• Cost of common stock
• Cost of retained earnings

Cost of Debt

Q6. What is the cost of debt?

The cost of debt is the effective rate that a company pays on its borrowings. Because interest is tax deductible, the cost that matters is the after-tax cost.

Q7. What are the two types of bonds, from the cost point of view?

• Redeemable bonds (repaid at a stated maturity date)
• Irredeemable bonds (no fixed repayment date)

Q8. What is an irredeemable bond?

A debt with no specific repayment date. Its holders receive interest at a fixed rate for as long as the company exists.

Q9. How is the cost of irredeemable debt calculated?

• Before tax: Kd = I / NSV
• After tax: Kd = (I / NSV) x (1 – t)

Here Kd is the cost of debt, I is the annual interest, NSV is the net sale value (the money actually received after issue costs) and t is the corporate tax rate.

Example: A 100 debenture pays 10 interest a year and is sold for a net 95. The tax rate is 30%. Before-tax cost = 10 / 95 = 10.53%. After-tax cost = 10.53% x 0.70 = 7.37%.

Q10. What is a redeemable bond?

A bond that is repaid to its holder at the end of a specified period, at its redemption value.

Q11. How is the cost of a redeemable bond calculated?

Kd = [ I x (1 – t) + (RV – NSV) / N ] / [ (RV + NSV) / 2 ]

Here I is the annual interest, t is the tax rate, RV is the redemption value, NSV is the net sale value and N is the number of years to maturity.

Example: A bond has a redemption value of 1,000, is sold for a net 950, pays 100 interest a year, matures in 5 years, and the tax rate is 30%. Kd = [100 x 0.70 + (1,000 – 950) / 5] / [(1,000 + 950) / 2] = (70 + 10) / 975 = 8.21%.

Q12. What is flotation cost?

Flotation cost is the cost of issuing and selling new securities, such as underwriting fees, legal and advertising costs. It reduces the net money the company actually receives, so it raises the cost of capital.

Q13. What is the effect of flotation cost on the cost of capital?

If there were no flotation cost, a security would be sold at its issue price and the company would receive the full amount. With flotation costs, the company receives less than the issue price, so the same interest or dividends are paid on a smaller net amount, and the cost rises. Flotation cost matters for three types of capital: common shares, preferred shares and bonds.

Example: A new common share sells for 100, the next dividend is 8, growth is 5% and the flotation cost is 5%. Without flotation: Ke = 8 / 100 + 5% = 13%. With flotation: Ke = 8 / (100 x 0.95) + 5% = 8.42% + 5% = 13.42%.

Q14. How is the tax-adjusted cost of debt calculated?

After-tax cost = Pre-tax cost x (1 – tax rate). Example: a pre-tax cost of loan capital of 15% and a tax rate of 25% give 15% x (1 – 0.25) = 11.25%.

Q15. Why is debt a lower-cost source of funds?

• Interest is tax deductible, which lowers the effective cost.
• Lenders are paid before shareholders and have a fixed claim, so their risk is lower, and they accept a lower return.
• Debt has a fixed, contractual repayment, so the lender is not exposed to the ups and downs of profit.

Cost of Preferred and Common Equity

Q16. How is the cost of preferred shares calculated?

Kp = Annual preferred dividend / Net proceeds from the sale of the share.

Example: A company sells 10% preferred shares with a face value of 1,000. Each share brings in a net 800. Dividend = 1,000 x 10% = 100. Kp = 100 / 800 = 12.5%. Preferred dividends are not tax deductible, so no tax adjustment is made.

Q17. What is the difference between loan capital and preferred share capital?

Q18. What are the methods of calculating the cost of common (equity) share capital?

• Zero-growth dividend method
• Constant-growth dividend method (Gordon model)
• Capital asset pricing model (CAPM)

Q19. How is the cost of equity calculated with the zero-growth method?

If the dividend is expected to stay the same each year: Ke = D / P₀, where D is the annual dividend and P₀ is the current market price. Example: a share trades at 120 and pays a dividend of 10. Ke = 10 / 120 = 8.33%.

Q20. How is the cost of equity calculated with the constant-growth method?

If dividends are expected to grow at a constant rate each year: Ke = D₁ / P₀ + g, where D₁ = D₀ x (1 + g) is the dividend expected next year, and g is the growth rate. If the dividend is 10 now and grows 10% a year, the dividends are 11, 12.1, 13.31 and so on.

Example: P₀ = 200, the last dividend D₀ = 20 and g = 6%. D₁ = 20 x 1.06 = 21.20. Ke = 21.20 / 200 + 6% = 10.6% + 6% = 16.6%.

Q21. How is the cost of equity calculated with CAPM?

Ke = Rf + Beta x (Rm – Rf), where Rf is the risk-free rate, Rm is the expected market return and Beta measures the share’s risk compared with the market. Example: Rf = 6%, Rm = 12%, Beta = 1.2. Ke = 6% + 1.2 x (12% – 6%) = 6% + 7.2% = 13.2%.

Q22. What are the problems in determining the cost of common equity?

• Future dividends are hard to forecast, because the dividend on common shares is not fixed.
• Estimating the company’s future earnings and the growth rate of dividends is difficult.
• Beta and the market return must be estimated.

Q23. What is the cost of retained earnings?

Retained earnings belong to the common shareholders. By letting the firm keep them, shareholders give up cash dividends, so there is an opportunity cost. They expect to earn at least the same return that they would on their common shares, so the cost of retained earnings equals the cost of common equity (without flotation cost).

Q24. Why is the cost of new common stock higher than the cost of retained earnings?

When new shares are issued, the firm bears flotation costs, so it receives less than the issue price. Retained earnings are already in the firm and carry no flotation cost. So the cost of new common stock is higher. (In the example above: 13.42% against 13%.)

Q25. “Equity capital is cost-free.” Do you agree?

No. Equity capital is share capital plus retained earnings. It may seem free because a company is not forced to pay a dividend, but shareholders expect dividends and growth in the share price, and they would otherwise invest elsewhere. New shares also carry flotation costs. So equity has a real cost, and it is usually higher than the cost of debt, because shareholders bear more risk.

Weighted Average Cost of Capital (WACC)

Q26. What is the weighted average cost of capital (WACC)?

WACC is the average cost of all the sources of capital a firm uses, each weighted by its share in the total capital structure. It is the minimum return the firm must earn on its assets to satisfy all its suppliers of funds.

Q27. What are the steps in calculating WACC?

1. Calculate the cost of each source of capital separately (after tax for debt).
2. Find the weight of each source in the capital structure.
3. Multiply each cost by its weight.
4. Add the results. The total is the WACC.

Q28. Can you show a complete WACC example?

A company has 5,000 million of common share capital, 3,000 million of loan capital at 10% interest and 2,000 million of preferred share capital paying 9. Market prices are 270 (common) and 120 (preferred). The company paid a common dividend of 15, growing 5% a year. The tax rate is 30%.

Q29. How does inflation affect the cost of capital?

Inflation reduces the purchasing power of money, so lenders and shareholders demand higher returns to compensate. Interest rates tend to rise, and so the cost of capital rises as well.

Q30. What are the assumptions about the cost of capital?

• The firm’s business risk and financial risk stay unchanged.
• After-tax costs are relevant.
• Short-term loans are not included in the capital structure.
• The dividend policy is stable.
• The capital structure of the firm stays unchanged.

Types of Cost

Q31. What are explicit and implicit costs of capital?

• Explicit (direct) cost: the actual rate paid to the supplier of capital, such as interest on a loan or the dividend rate on preferred shares.
• Implicit cost: the return that is given up on the best alternative use of funds when a project is accepted. Accepting one project means forgoing other possible returns, and this lost return is the implicit cost.

Q32. What are historical cost and future cost?

• Historical cost: the cost actually incurred in the past to raise funds. It is used for reference and to compare with the future.
• Future cost: the expected cost of raising capital from each source now or in the near future. It is what matters for investment decisions.

Q33. What is the overall cost of capital?

The combined cost of all the specific sources of capital, found by weighting each component by its share of total capital. It is also known as the weighted average cost of capital (WACC).

Q34. What is opportunity cost?

The rate of return given up when funds are used in one way rather than in the best alternative way. It explains why retained earnings have a cost.

Q35. How is the cost of capital used in capital budgeting?

The cost of capital (usually the WACC) is the discount rate used to find the net present value (NPV) of a project, and the hurdle rate that the project’s internal rate of return must beat. A project that earns more than the cost of capital adds value. You will practise this in the Capital Budgeting chapter.

Quick Revision Points

• After-tax cost of debt = Kd x (1 – t). Debt is the cheapest source.
• Cost of preferred = dividend / net proceeds. No tax adjustment.
• Cost of equity = D₁ / P₀ + g, or Rf + Beta x (Rm – Rf).
• Flotation costs raise the cost. New equity costs more than retained earnings.
• WACC = sum of (cost x weight). It is the discount rate for capital budgeting.

Test yourself with the chapter quiz below, then read the last Finance chapter, Capital Budgeting.