Cost of Capital: Sources, Weights, WACC & Real-World Applications

TAKEAWAYS:

• The cost of capital is the minimum return a firm must earn on investments to satisfy all investors (debt + equity).
• WACC (Weighted Average Cost of Capital) combines the costs of debt, preferred stock, and equity, weighted by their proportions in the capital structure.
• Marginal cost of capital (MCC) shows how the cost changes as new financing is raised—critical for capital budgeting decisions.
• Real-world examples: Ncell uses WACC to evaluate 5G expansion projects; NEPSE-listed banks (e.g., NMB) adjust dividend policies based on retained earnings costs.
• Exam focus: Calculate WACC, compare financing sources, and explain trade-offs between debt and equity.

1. Definitions: What is Cost of Capital?

The cost of capital is the opportunity cost of funds used by a company. It represents the minimum return investors expect for providing capital (debt or equity). If a project earns less than the cost of capital, it destroys value.

Why does it matter?

• Guides capital budgeting (NPV, IRR decisions).
• Determines optimal capital structure (debt vs. equity mix).
• Influences dividend policy (retained earnings vs. payouts).

2. Components of Cost of Capital

The total cost of capital is a weighted average of:

1. Cost of Debt ($k_d$): Interest rate on loans/bonds.
2. Cost of Preferred Stock ($k_p$): Dividend yield on preferred shares.
3. Cost of Equity ($k_e$): Required return on common stock (from retained earnings or new shares).

Visual: Capital Structure Pie Chart

pie
    title Capital Structure of a Typical Nepali Firm (e.g., NMB Bank)
    "Debt (40%)" : 40
    "Equity (60%)" : 60

3. Calculating Each Component

A. Cost of Debt ($k_d$)

• Formula: $$k_d=\text{Interest Rate}\times (1-\text{Tax Rate})$$ (Tax shield reduces after-tax cost.)

• Example: Ncell borrows ₹500M at 10% interest. With a 27% corporate tax rate: $$k_d=10\%\times (1-0.27)=7.3\%$$

B. Cost of Preferred Stock ($k_p$)

• Formula: $$k_p=\frac{\text{Annual Dividend}}{\text{Market Price per Share}}$$
• Example: A preferred share pays ₹10/year and trades at ₹100. $$k_p=\frac{10}{100}=10\%$$

C. Cost of Equity ($k_e$)

Two methods:

1. Dividend Growth Model (DGM): $$k_e=\frac{D_1}{P_0}+g$$

   • $D_1$ = Expected dividend next year
   • $P_0$ = Current stock price
   • $g$ = Growth rate

2. Capital Asset Pricing Model (CAPM): $$k_e=R_f+\beta (R_m-R_f)$$

   • $R_f$ = Risk-free rate (e.g., 6% for Nepali government bonds)
   • $\beta$ = Stock’s beta (e.g., 1.2 for NEPSE-listed banks)
   • $R_m$ = Market return (e.g., 12% for NEPSE index)

• Example: For a Nepali retail firm (β = 1.1, $R_f=6\%$, $R_m=10\%$): $$k_e=6\%+1.1\times (10\%-6\%)=9.4\%$$

4. Weighted Average Cost of Capital (WACC)

WACC blends the costs of all financing sources, weighted by their market value proportions.

Formula:

$$WACC=(w_d\times k_d)+(w_p\times k_p)+(w_e\times k_e)$$

• $w_d,w_p,w_e$ = Weights of debt, preferred stock, equity (as % of total capital).

Example: Kathmandu Retail Shop

Interpretation: The shop must earn ≥8.56% on new projects to add value.

5. Marginal Cost of Capital (MCC) Curve

As a firm raises more capital, costs change:

• Debt: Cheaper initially (lower interest rates), but risk rises → higher cost.
• Equity: Always expensive (higher $k_e$ than $k_d$).

Visual: MCC vs. Investment Opportunities

graph LR
    A["Low Investment"] -->|"WACC=8%"| B["Project A"]
    B --> C["Accept"]
    D["High Investment"] -->|"WACC=12%"| E["Project B"]
    E --> F["Reject"]

Key Insight: Accept projects only if their IRR > current MCC.

6. Real-World Applications in Nepal

A. Ncell’s 5G Expansion

• Idea Used: WACC for project evaluation.
• How: Ncell calculates WACC (e.g., 9%) to decide if 5G’s IRR (11%) justifies the ₹20B investment.

B. NEPSE-Listed Banks (e.g., NMB)

• Idea Used: Cost of retained earnings vs. new equity.
• How: Banks compare:
  • Retained earnings cost (≈WACC, no flotation costs).
  • New equity cost (higher due to underwriting fees).

C. Daraz’s Inventory Financing

• Idea Used: Debt vs. equity trade-off.
• How: Daraz uses low-cost debt (7% from banks) for short-term inventory, avoiding expensive equity.

7. Advantages and Disadvantages of Financing Sources

8. Exam Tip: How to Score Full Marks

1. Always show calculations for WACC, $k_d$, and $k_e$—examiners check formulas.
2. Compare debt vs. equity in a table (like above) for trade-off questions.
3. Link to real firms: Mention Ncell, NMB, or Daraz in numerical examples.
4. Draw the MCC curve in exams—it’s a high-mark question.
5. Memorize:
   • WACC formula.
   • CAPM components ($R_f$, $\beta$, $R_m$).
   • Tax shield effect on $k_d$.

9. Worked Example: NEPSE-Listed Firm (Himalayan Bank)

Given:

• Debt: ₹50M at 8% (tax rate = 27%).
• Equity: ₹100M, $k_e=12\%$ (from CAPM).
• No preferred stock.

Calculate WACC:

1. $k_d=8\%\times (1-0.27)=5.84\%$.
2. Weights: Debt = 50/150 = 33.3%, Equity = 66.7%.
3. WACC = $(0.333\times 5.84\%)+(0.667\times 12\%)=9.96\%$.

Decision: Accept projects with IRR > 9.96%.

10. Common Pitfalls

• Ignoring taxes on debt cost ($k_d$ must be after-tax).
• Using book values instead of market values for weights.
• Assuming constant costs: MCC rises as more capital is raised.