Cost of Capital: WACC, Sources, Weights & Decision Rules

What is Cost of Capital?

Cost of capital is the minimum return a company must earn on its investments to satisfy all its investors (shareholders, debtholders, preference shareholders). It represents the opportunity cost of funds used in projects. If a project’s expected return exceeds the cost of capital, it creates value for the firm.

Why Does It Matter?

• Capital budgeting decisions: Only projects with returns > cost of capital are accepted.
• Valuation: Used in discounted cash flow (DCF) models to estimate firm value.
• Financing mix: Helps determine the optimal blend of debt and equity.

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Components of Cost of Capital

The cost of capital is a weighted average of the costs of different financing sources. The three primary sources are:

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Weighted Average Cost of Capital (WACC)

WACC is the overall cost of capital for a firm, calculated as:

$$\text{WACC}=\left(\frac{E}{V}\times k_e\right)+\left(\frac{D}{V}\times k_d\times (1-T)\right)+\left(\frac{P}{V}\times k_p\right)$$

Where:

• $E$ = Market value of equity
• $D$ = Market value of debt
• $P$ = Market value of preference shares
• $V=E+D+P$ (Total market value of capital)
• $T$ = Corporate tax rate

How WACC Works in Nepal

Consider Nepal Investment Bank Limited (NIBL), which has:

• Equity (E) = Rs. 500 million (Market cap)
• Debt (D) = Rs. 300 million (Bonds at 10% interest)
• Preference shares (P) = Rs. 100 million (8% dividend)
• Tax rate (T) = 25%
• Cost of equity ($k_e$) = 12% (from CAPM)
• Cost of debt ($k_d$) = 10%
• Cost of preference shares ($k_p$) = 8%

| Component          | Weight (V) | Cost (%) | After-Tax Cost | Weighted Cost (Rs) |
|--------------------|------------|----------|-----------------|--------------------|
| Equity             | 50%        | 12%      | 12%             | 6%                 |
| Debt               | 30%        | 10%      | 7.5%            | 2.25%              |
| Preference Shares  | 20%        | 8%       | 8%              | 1.6%               |
| **Total WACC**     | **100%**   |          |                 | **9.85%**          |

Interpretation: NIBL’s WACC is 9.85%, meaning it must earn at least this return on new projects to add value.

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In the Real World

1. eSewa (Nepal):

   • Uses WACC to evaluate expansion projects (e.g., adding new payment methods like QR codes).
   • Example: If eSewa’s WACC is 11%, it will only fund projects expected to generate >11% return (e.g., a new merchant acquisition drive).

2. Ncell (Nepal Telecom):

   • Calculates cost of debt from bond issuances (e.g., 9% bonds in 2022) and cost of equity using CAPM (β ≈ 1.2, market risk premium = 6%).
   • Uses WACC to decide whether to build new 5G towers (capital-intensive projects).

3. Daraz (Nepal’s Amazon):

   • Compares cost of equity (retail investors) vs. cost of debt (bank loans) to optimize financing for warehouse expansions.
   • Example: If Daraz’s WACC is 14%, it rejects a logistics hub project with only 12% ROI.

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Marginal Cost of Capital (MCC)

The MCC curve shows how the cost of capital changes as a firm raises more funds. It is upward-sloping because:

• Early funds (cheaper sources like retained earnings) have lower costs.
• Later funds (expensive equity issuance) increase the cost.

graph TD
    A[Low Investment] -->|Cheap Capital| B[Retained Earnings]
    B --> C[Debt]
    C --> D[Preference Shares]
    D --> E[Expensive Equity]
    F[High Investment] --> E
    G[IOS Curve] -->|Optimal Range| H[Where MCC = IOS]

Key Insight: The optimal capital budget occurs where the MCC curve intersects the Investment Opportunity Schedule (IOS).

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Worked Example: Kathmandu Retail Shop’s Expansion

Scenario: A Kathmandu-based retail shop wants to expand by opening a new branch. It has:

• Current equity (E) = Rs. 2,000,000
• Debt (D) = Rs. 1,000,000 (8% interest, tax rate = 20%)
• Cost of equity ($k_e$) = 10% (from CAPM)
• Cost of debt ($k_d$) = 8%

Step 1: Calculate WACC $$\text{WACC}=\left(\frac{2,000,000}{3,000,000}\times 10\%\right)+\left(\frac{1,000,000}{3,000,000}\times 8\%\times (1-0.20)\right)$$ $$=6.67\%+1.78\%=8.45\%$$

Step 2: Evaluate the Project

• Project Cost = Rs. 500,000
• Expected NPV = Rs. 60,000 (at 8.45% discount rate)

Decision: Since NPV > 0, the project is acceptable.

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Sources of Capital and Their Costs

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Exam Tip

1. Memorize WACC Formula: Always show the breakdown of weights and after-tax adjustments.
2. Real-World Application: Relate WACC to capital budgeting (NPV, IRR) and financing decisions.
3. Common Mistakes:
   • Forgetting to adjust debt cost for taxes ($k_d\times (1-T)$).
   • Using book values instead of market values for weights.
4. Graphs: Expect questions on MCC vs. IOS—know where the optimal capital budget lies.
5. Nepali Context: Use Nepal’s corporate tax rate (20-25%) and local interest rates in examples.

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Key Takeaways

• WACC is the minimum required return for a project to create shareholder value.
• Debt is cheaper than equity due to tax shields, but too much increases risk.
• MCC curve helps determine the optimal capital structure.
• Retained earnings are the cheapest source of capital.
• WACC is used in DCF valuation and capital budgeting decisions.

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Final Thought: "A firm’s cost of capital is not just a number—it’s the benchmark that separates value-creating projects from value-destroying ones. Master WACC, and you master corporate finance."