Cost of Capital

The cost of capital is the rate of return that a firm pays to bondholders and equity holders. Cost of capital is an important measure while making investment decisions, as any one making an investment would expect a higher return from his investment in a company compared to what he could earn from an alternative investment with equivalent risk.

A company raises capital in many forms such as common equity, preferred equity, debt and other instruments. The cost of each of these components of funding is called component cost of capital.

The cost of capital for the entire company averages out the cost of capital from all these components.

To calculate the required rate of return from an investment, we first calculate the marginal cost of capital for each source of capital, and then calculate a weighted average of these costs. This is called the Weighted Average Cost of Capital (WACC). It is also called the Marginal Cost of Capital (MCC) since this is the cost incurred by a company to get additional capital.
<div class="formula1">

WACC is calculated using the following formula:

[latex size=4]WACC = w_{d}r_{d}(1-t)+w_{p}r_{p}+w_{e}r_{e}[/latex]

&nbsp;

Where,

w represents the weights of debt, preferred equity, and equity.

d represents the marginal cost of each of these sources of capital, and

t represents the marginal cost of capital.

</div>
<strong>Example</strong>

Let’s assume that a company has the following capital structure:
<table border="1" cellspacing="0" cellpadding="0">
<tbody>
<tr>
<td valign="top" width="150"><strong> </strong></td>
<td valign="top" width="145"><strong>Weight</strong></td>
<td valign="top" width="130"><strong>Cost </strong></td>
</tr>
<tr>
<td valign="top" width="150">Equity</td>
<td valign="top" width="145">50%</td>
<td valign="top" width="130">20%</td>
</tr>
<tr>
<td valign="top" width="150">Preferred Stock</td>
<td valign="top" width="145">20%</td>
<td valign="top" width="130">12%</td>
</tr>
<tr>
<td valign="top" width="150">Debt</td>
<td valign="top" width="145">30%</td>
<td valign="top" width="130">8%*</td>
</tr>
</tbody>
</table>
*Before-tax cost of debt
<div class="formula1">

Weighted Average Cost of Capital Will be calculated as follows:

WACC = 0.30*0.08 (1-30%) + 0.20*0.12 + 0.50*0.20

= 14.08%

</div>
There are certain nuances of calculating WACC, which an analyst must be aware of. We will discuss these in the next article.

Weighted Average Cost of Capital (WACC)

Methods of Calculating Weights in WACC

The marginal cost of capital plays an important role in capital budgeting and investment decisions.

As a firm raises more and more capital, it's marginal cost of capital (MCC) increases. However, when a firm makes more investments, the returns from additional investments decrease. This is represented by the investment opportunity schedule (IOS).

The MCC schedule represents the cost of capital faced by the firm (ranking from the cheapest to the most expensive) while the IOS represents the projects that are available to the firm (ranking from the most

In order to construct the IOS, the firm needs to first estimate the IRR of each of the project it is considering. Once that is accomplished, the financial manager can plot the IOS, which is a chart of the IRRs of the firm’s projects arranged from the highest IRR to the lowest IRR.

The MCC curve is upward sloping while the IOS curve is downward sloping.

With respect to the investment decisions, the company can achieve optimal capital budget, which is the amount of capital at which the firms marginal cost of capital is equal to the marginal returns from investing.

While valuing individual projects, the company's WACC is used in the calculation of the project's NPV. If the NPV is positive, the company invests in the project otherwise not. When WACC is used in the calculation of a project's NPV, there are a few implicit assumptions such as the project has the same risk as the average risk of the company, and the firm's capital structure remains the same throughout the life of the project. This is because if the capital structure changes, the WACC will fluctuate.

An analyst can also use WACC for valuing securities, using many of the DCF approaches. If the cash flows are the free cash flows for the firm, the the analyst uses WACC to calculate the present value of cash flows. If, however, the cash flows are specifically for the company's owners, then the analyst uses cost of capital.

Applications of Cost of Capital

Previously, we reviewed the concept of weighted average cost of capital and its formula. This video provides a detailed example of WACC calculation and also discusses some of the issues while using it. The video also discusses in detail the concept of marginal cost and why a firm can't finance itself only from debt even though it looks cheaper.

<iframe width="600" height="335" src="http://www.youtube.com/embed/eKFy5HuOoQo?end=522" frameborder="0" allowfullscreen></iframe>

<strong>Estimating the Cost of Capital</strong>

<strong>Debt: </strong>You will notice that the cost of debt is adjusted for tax (1-t) because in most countries the interest on debt is taken as a deduction to arrive at the taxable income. So, what's taken into consideration is the after-tax cost of debt.

<strong>Preferred Equity:</strong> Estimating the cost of preferred equity is quite straight forward since the dividend is generally stated and fixed.

<strong>Common Equity: </strong>Estimating the cost of common equity is the most challenging among the three sources of capital. Cost of equity can be estimated using one of the two available methods: 1) using the CAPM model and 2) using the dividend discount model which is based on the discounted cash flows.

<em>In the next article we will look at how to determine the weights for each source of capital.</em>

Weighted Average Cost of Capital (WACC) - Practical Example and Issues

Cost of debt refers to the cost of financing a company using debt such as a bond issue or bank loan. It is stated as an interest rat rD. Since there is a tax shield on the interest component of debt, the component used in WACC is rD (1 –t)

In this article, we will estimate the cost of debt using two approaches: Yield-to-Maturity approach, and Debt-Rating approach.

<strong>Yield-to-Maturity Approach</strong>

The yield to maturity is the annual return from an investment purchased today and held till maturity, i.e., it is the rate at which the current market price of the bond is equal to the present value of all the cash flows from the bond.

Let’s take an example to understand this.

Assume that a company has issued a bond to raise funds.
<table width="161" border="0" cellspacing="0" cellpadding="0"><colgroup><col width="96" /> <col width="65" /> </colgroup>
<tbody>
<tr>
<td width="96" height="15">Par</td>
<td width="65">$1,000</td>
</tr>
<tr>
<td height="15">Market value</td>
<td>$1,050</td>
</tr>
<tr>
<td height="15">Coupon</td>
<td align="right">8%</td>
</tr>
<tr>
<td height="15">Coupon payment</td>
<td>Semi-annual</td>
</tr>
<tr>
<td height="15">Maturity</td>
<td>10 year</td>
</tr>
</tbody>
</table>
The YTM will be the rate at which the present value of all cash flows = $1,050.
<div class="formula1">
[latex size="4"]\$1,050 = \left ( \sum_{t=1}^{20} \frac{\$40}{(1+i)^{t}} \right)+\frac{\$1000}{(1+i)^{20}}[/latex]
</div>

We can use a financial calculator to solve for i.  In this case, i = 3.643%, which is the six-month yield. The annualized yield will be 7.286%.

Given a tax rate of 35%, the after-tax cost of debt will be = 7.286% (1-35%) = 4.736%.

<strong>Debt-Rating Approach</strong>

For certain types of debt, we may not have the market prices readily available, for example, bank loan. In such cases, the cost of debt can be based on company’s rating by comparing it with the bonds with similar characteristics.

For example, assume that the average maturity of a company’s debt is 10 years, and the company itself has a rating of BBB.

We will first observe that the yield on debt with a similar rating is 7%. Given the tax-rate of 35%, the after-tax cost of debt for the company will be:

= 7% (1-35%) = 4.55%

The key issue here for the analyst is to identify bonds with similar debt ratings and other characteristics. For example, the issuer rating is just one of the factors while rating a debt issue. Other factors such as seniority also affect the ratings.

Calculating Cost of Debt: YTM and Debt-Rating Approach

We discussed that the cost of debt for a company can be measured using the <a href="https://financetrain.com/calculating-cost-of-debt-ytm-and-debt-rating-approach/">YTM or Debt-Rating approach</a>.

An analyst faces certain issues while estimating the cost of debt. These issues are discussed below:

<strong>Floating/Fixed Rate Debt:</strong> In our previous article, our calculations assumed a fixed rate for debt. However, in reality, a firm may also issue floating rate debt. For such debt, the rate will be linked to a benchmark such as LIBOR, and will fluctuate periodically. This makes it difficult to estimate the cost of debt. The analyst may use the term structure while estimating the cost of debt.

<strong>Debt with Embedded Options:</strong>  Companies don’t always issue vanilla debt products.  There are also debt products that have features such as call option embedded in them. This makes their payoff non-linear. For example, the yield of a callable bond is higher than a non-callable bond. These features make estimating the cost of debt difficult for the analyst. If the company’s current debt already incorporates such features, then the analyst may use the current YTM. However, if the company is planning to introduce option-embedded debt, the analyst will have to adjust the YTM to reflect the value of these options.

<strong>Nonrated debt:</strong> Another problem is that the may not be able to use similarly rated debt securities. This could be because there is no existing debt rating for the company. In such a case an analyst may arrive at synthetic ratings using financial ratios, but this will not be accurate.

<strong>Leases:</strong> A lease, whether operating lease or capital, is considered as an alternative form of borrowing, even though only capital leases are shown on a company’s balance sheet. The cost of such lease should be included in the cost of debt. An analyst can use the company's long-term borrowing rate for estimating the cost of capital for leasing.

Issues in Estimating Cost of Debt

Cost of preferred stock is the cost that the company has committed to pay to the preferred stockholders in the form of preferred dividends.

For a plain vanilla preferred stock (No convertibility or callable features), the cost is calculated as follows:
<div class="formula1">

Cost of preferred stock, [latex size="3"]r_{p}=\frac{D_{P}}{P_{P}}[/latex]
Where,

D = Preferred stock dividend per share

P = Current price of each preferred stock

</div>
<strong>Example:</strong>

A company has certain preferred stock outstanding on which it pays a fixed dividend of $5 per share. The current price of this stock is $80.

The cost of preferred stock = $5/$80 = 6.25%

The preferred stock may have additional features, which affects its yield and the cost. For example, call options, convertible into common stock, cumulative dividends, adjustable-rate dividends, etc. While estimating the cost of the stock, the analyst will have to adjust the cost based on the impact of these features on the yield of the stock issue.

The analyst will also have to consider the changes in the cost of preferred stock for future issues. If a company has an existing preferred stock issue for which the dividend of 6%, but for a newly planned preferred stock issue requires the dividend to be 7%, then the cost of preferred stock will be considered based on the current terms (7%) rather than the past terms.

Also, unlike the interest on debt, the dividend paid on preferred stock is non tax-deductible, so the analyst cannot adjust the cost of preferred stock based on the marginal tax rate.

Estimating the Cost of Preferred Stock

The cost of common equity is represented as r<sub>e</sub>, and it is the rate of return required by the common shareholders.

The cost of common equity can be measured using the following methods:

1. Capital Asset Pricing Model (CAPM)

2. Dividend Discount Model

3. Bond Yield plus Risk Premium Method

Let's discuss each of these methods in some depth.

<strong>1. Capital Asset Pricing Model (CAPM)</strong>

The Capital Asset Pricing Model is a popular asset-pricing model in Finance. It is used to determine the expected rate of return of a risky asset. It says that the expected return on a risky asset is equal to the risk-free rate plus a risk premium.

The risk premium is a measure of non-diversifiable risk and is calculated using the asset’s <a href="https://financetrain.com/how-to-calculate-stock-beta-in-excel/" title="How to Calculate Stock Beta in Excel">Beta</a>. CAPM considers only systematic risk (non-diversifiable risk) as the security specific risk (unsystematic risk) can be diversified away.

According to the CAPM model, the expected return on a security is given as follows:
<div class="formula1">
[latex size="3" background="F0F0F0"]E(r)=R_{f}+\beta\left (E(R_{m}) - R_{f} \right )[/latex]

Where:
<ul>
	<li>E(R<sub>i</sub>) is the expected return on the security</li>
	<li>R<sub>f</sub> is the risk-free rate of return</li>
	<li>&Beta; is the beta of the stock</li>
	<li>R<sub>m</sub> is the expected return from the market</li>
</ul>
</div>
If the risk-free rate is 5.4%, the stock’s Beta is 1.5, and the expected market return is 8.4, then the stock is expected to return 9.9% (=5.4 + 1.5 * (8.4 – 5.4)).

If the actual returns offered by the stock are less than 9.9%, then you might want to avoid the investment.

As an alternative to CAPM, analysts may also use multi-factor models, such as <a href="https://financetrain.com/arbitrage-pricing-theory-apt/">Arbitrage Pricing Theory</a>, to capture the risks not captured by the market portfolio alone.

<strong>2. Dividend Discount Model</strong>

The second approach for valuing common stock is the dividend discount model. According to the dividend discount model, the intrinsic value of a stock is equal to the present value of all the expected cash flows (dividends) from the stock.
<div class="formula1">
The generic formula is as follows:

[latex size="3" background="F0F0F0"]V_{0}=\sum_{t=1}^{\infty }\left ( \frac{D_{t}}{\left ( 1+r_{e} \right )^{t}} \right )[/latex]

Where,

V<sub>0</sub> is the present value of the stock
D is the dividend received for each period t
And r<sub>e</sub> is the cost of equity
</div>
Considering a constant growth rate (g) of dividends for the life of the stock, the present value of the stock can be represented as follows.
<div class="formula1">
[latex size="3" background="F0F0F0"]P_{0}=\frac{D_{1}}{r_{e}-g}[/latex]
</div>
This is called the Gordan Constant Growth formula. We can rewrite the formula to estimate the cost of equity.
<div class="formula1">
[latex size="4" background="F0F0F0"]r_{e}=\frac{D_{1}}{P_{0}}+g[/latex]
</div>
So, an analyst will take the current stock price, estimate the dividends for the next year, and take the assumed growth rate to arrive at the cost of equity.

<strong>3. Bond Yield plus Risk Premium Approach</strong>

This approach assumes that the common equity is costlier than the debt, and estimates the cost of equity as a premium over the cost of debt.

We have already seen how to arrive at the before-tax <a href="https://financetrain.com/issues-in-estimating-cost-of-debt/" title="Issues in Estimating Cost of Debt">cost of debt</a>. 
<div class="formula1">
The cost of equity using this approach will be:

[latex size="3" background="F0F0F0"]r_{e}=r_{d}+ Risk\ Premium[/latex]
</div>
The risk premium represents the compensation for additional risk from equity. One of the ways to estimate this risk premium is to compare the historical spreads between the bond yields and stock yields. Generally, the risk premium is between 3 and 5%.

Estimating the Cost of Common Stock

While calculating the cost of equity, it is important for an analyst to calculate the beta of the company’s stock.

Beta of a publicly traded company can be calculated using the <strong>Market Model Regression (Slope).</strong>

In this method, we regress the company’s stock returns (r<sub>i</sub>) against the market’s returns (r<sub>m</sub>). The beta (β) is represented by the slope of the regression line.
<div class="formula1">

[latex size="3" background="F0F0F0"]r_{i}=\alpha +\beta r_{m}[/latex]

Where,

r<sub>i</sub> is the stock’s return

α represents the intercept

β is the stock’s beta

r<sub>m</sub> is the market returns

</div>
<img class="aligncenter size-full wp-image-4897" title="beta-regression" src="https://financetrain.com/wp-content/uploads/beta-regression.png" alt="" />

See this article – <strong><a href="https://financetrain.com/how-to-calculate-stock-beta-in-excel/">How to Calculate Stock Beta Using Excel</a></strong>

Some of the issues while calculating beta are discussed below:
<ol>
 	<li><strong>Estimation period:</strong>  Beta is usually estimated using the historical data for 2-9 years. The choice of estimation period affects the calculation of Beta. If the estimation period is short, it does reflect the current dynamics of the company. For example, for a company that has recently undergone structural changes, it’s better to use short estimation period for calculating beta. However, for a company that has a stable operating history, a long estimation period will be suitable.</li>
 	<li><strong>Return interval: </strong>An analyst may take daily, weekly, or monthly returns of the stock and market while performing regression. Generally a shorter observation period such as daily returns leads to lower standard error.</li>
 	<li><strong>Choice of the market index: </strong>The analyst also needs to carefully choose a market index to regress the returns against.</li>
 	<li><strong>Smoothing techniques:</strong> Betas also have a tendency to revert to 1. Analysts may have to use some smoothing techniques to adjust the beta.</li>
 	<li><strong>Small-cap stocks</strong>: The small cap stocks tend to be more risk with a higher return potential. Therefore, analysts may want to adjust the beta pf small cap stock upwards.</li>
</ol>
Using the above methods, we can easily estimate the beta of a publicly traded company, as all the information such as historical returns is publicly available. The problem arises when an analyst is required to estimate the beta of a non-public company or a project, for which there is no historical stock return data. The analyst may have to use a proxy of the beta by using some combination of the information available about the company/project and a comparable public limited company. A commonly used method is the <strong><a href="https://financetrain.com/calculating-beta-using-pure-play-method/">pure-play method</a></strong>, in which an analyst observes the beta of a comparable public company, and adjusts it for the difference in financial leverage.

Calculating Beta Using Market Model Regression (Slope)

In the previous article, we learned about how to calculate the <a href="https://financetrain.com/calculating-beta-using-market-model-regression-slope/">beta of a publicly traded company’s stock</a>.

However, the same method cannot be used for calculating the beta of a company or project that’s not traded in the market. In this article we will see how to calculate the beta of such a company using the pure-play method.

There are two key considerations while estimating the risk of a company: business risk and financial risk.

<strong>Business Risk:</strong> The business risk is the risk inherent in operating the business and is comparable for companies operating within the same industry. The pure-play method takes advantage of this by starting with taking the beta estimate of a comparable company. Pure-play refers to companies that are in the single line of business.

<strong>Financial Risk:</strong> This is the risk that arises due to financial leverage, and depends on the actions by the company’s management. The analyst therefore takes the beta of a comparable firm and adjusts it for the financial risk (adjusting for the leverage).

<strong>Steps:</strong>

Calculating beta using the pure-play method involves the following four steps:

<strong>Step 1: Find a comparable company</strong>

The analyst will first find a comparable company with similar business risk.

<strong>Step 2: Estimate beta of the comparable company</strong>

Once we have a comparable company, the next step is to observe its beta, which can be done using the market model regression method. Many financial websites also publish betas of large public companies.

<strong>Step 3: Calculate unlevered beta of the company</strong>

The next step is to unlever the beta for the company. This removes the financial risk element from beta. This is done using the following formula:
<div class="formula1">
[latex size="3" background="F0F0F0"]\beta _{Unlevered}= \frac{\beta _{Levered}}{1+(1-Tax)\frac{Debt}{Equity}}[/latex]
</div>
<strong>Step 4: level the beta for the company’s financial risk</strong>

The next step is to estimate the beta of the company or the project. This is done using the following formula:
<div class="formula1">
[latex size="3" background="F0F0F0"]\beta _{Company}= \beta _{Unlevered}\left ( 1+(1-Tax)\frac{Debt}{Equity} \right )[/latex]
</div>
One issue here is that for debt equity ratio, we only have the book values. The analyst can either use an industry average debt ratio (considering that the firm operates close to other firms in the industry, or it can use an optimal debt ratio based on the operating income and cost of capital.

<strong>Numerical Example:</strong>

Assume that we want to calculate the beta of Company A. The following information is available:
<table border="1" cellspacing="0" cellpadding="0">
<tbody>
<tr>
<td valign="top" width="213">Debt-Equity Ratio for Company A</td>
<td valign="top" width="213">1.6</td>
</tr>
<tr>
<td valign="top" width="213">Debt-Equity ratio of Comparable Company C</td>
<td valign="top" width="213">1.4</td>
</tr>
<tr>
<td valign="top" width="213">Beta of Comparable Company C</td>
<td valign="top" width="213">1.5</td>
</tr>
<tr>
<td valign="top" width="213">Marginal Tax rate</td>
<td valign="top" width="213">31%</td>
</tr>
</tbody>
</table>
The Beta of Company A can be calculated as follows:

Unlevered Beta = 1.5/(1+(1-0.31)*1.4= 0.763

Using the unlevered beta, the beta of Company can be calculated:

Beta<sub>A</sub> = 0.763*(1+(1-0.31)*1.6 = 1.605

Calculating Beta Using Pure Play Method

In developed nations, the beta of a stock adequately captures the country risk (Historical evidence). However, this doesn’t hold true for developing nations. Therefore, the calculation of cost of equity using CAPM requires adding a country risk spread to the market risk premium. This is also called the country equity premium.

The Country Risk Premium can be calculated using the following methods:

<strong>Method 1</strong>

The first method is to use the Sovereign Yield Spread as the country spread.
<div class="formula1">
<strong>Sovereign Yield Spread</strong> = Country’s Government Bond Yield – Treasury Bond Yield in a Developed Country
</div>
This method is considered too rough and is not generally used.

<strong>Method 2</strong>

The second method is more robust and calculates the country equity premium as follows:
<div class="formula1">
[latex size="1" background="#F0F0F0"]Country\ Equity\ Premium = Country\ Default\ Spread \frac{\sigma_{Equity} }{\sigma_{Country\ Bond}}[/latex]
</div>
As we can see, this method takes the Country Default Spread (Sovereign yield spread) as a measure of the general country risk and then adjusts it for the volatility of stock market relative to the bond market.

The country default spread can also be observed using the country ratings.

<strongExample</strong>

Assume that HighRisk Country was rated BB by a rating agency, which resulted in a default spread of 3%. The annualized standard deviation of the country’s equity index is 30%, and the annualized standard deviation for their bond market is 10%.
<div class="formula1">
The country equity risk premium will be calculated as follows:

HighRisk Country’s risk premium = 3% * (30%/10%)= 9%
</div>
If the credit rating of the country drops further, or if the equity market becomes more volatile, the equity risk premium will increase. The estimate is also affected by the time horizon used for calculating the premium.

<em>Note: This approach was suggested by Aswath Damodaran in his paper "<a href="http://archive.nyu.edu/bitstream/2451/26918/2/wpa99021.pdf" target="_blank">Estimating Equity Risk Premiums</a>".</em>

Estimating the Country Risk (Country Equity Premium)

MCC Schedule is a graph that relates the firm’s weighted average of each dollar of capital to the total amount of new capital raised.

It reflects changing costs depending on amounts of capital raised. As more funds are raised, the cost of various sources of capital can change because of various reasons:
<ul>
 	<li>The firm may have existing debt with a bond covenant that restricts the company from issuing debt with similar seniority as existing debt.</li>
</ul>
<ul>
 	<li>Debt incurrence test may restrict a company ’ s ability to incur additional debt at the same seniority based on one or more financial tests or conditions.</li>
</ul>
<ul>
 	<li>As the company experiences deviations from the target capital structure, the marginal cost of capital may increase, reflecting these deviations.</li>
</ul>
An additional amount of capital that changes the WACC is referred to as a break point. This is the point at which the cost of one of the sources of capital changes.

The break point is calculated using the following formula.
<div class="formula1">
Break Point = Amount of Capital at which Sources Cost of Capital Changes/Proportion of New Capital Raised from the Source</div>
<strong>Example</strong>

The following capital structure data is available:

<img class="aligncenter size-full wp-image-4922" title="mcc-example" src="https://financetrain.com/wp-content/uploads/mcc-example.png" alt="">

The MCC schedule will look as follows:

<img class="aligncenter size-full wp-image-4923" title="mcc-example-chart" src="https://financetrain.com/wp-content/uploads/mcc-example-chart.png" alt="">

<strong><a href="https://financetrain.com/ft-members/spreadsheets/" target="_blank" rel="noopener noreferrer">Download the MCC Schedule Excel Sheet</a></strong>

Marginal Cost of Capital (MCC) Schedule

While raising new capital, a company incurs cost, which is paid as a fee to the <a href="https://financetrain.com/what-do-junior-investment-bankers-do/">investment bankers</a>.

This fee is referred to as the flotation cost. The amount of fee depends on the size and type of offering.

Flotation cost is generally less for debt and preferred issues, and most analysts ignore it while calculating the <a href="https://financetrain.com/series/cost-of-capital">cost of capital</a>. However, the flotation cost can be substantial for issue of common stock, and can go as high as 6-8%.

In the <a href="https://financetrain.com/series/investment-services-industry/">investment industry</a>, there are different views about whether flotation costs should be incorporated in the calculation of cost of capital or not.

<strong>Including Flotation Cost in Calculating Cost of Capital</strong>

If we decide to include the flotation costs in our calculation, then the formula for the <a href="https://financetrain.com/estimating-the-cost-of-common-stock/">cost of equity</a> will be modified as follows:
<div class="formula1">
[latex size="3" background="F0F0F0"]r_{e}=\frac{D_{1}}{P_{0}(1-f)}+g[/latex]
</div>
Where f is the flotation costs expressed as a percentage.

<strong>Example</strong>

The following details about a company are available with us:
<table border="1" cellspacing="0" cellpadding="0">
<tbody>
<tr>
<td valign="top" width="213">Current Stock price</td>
<td valign="top" width="213">$105</td>
</tr>
<tr>
<td valign="top" width="213">Current dividend (D0)</td>
<td valign="top" width="213">$5 per share</td>
</tr>
<tr>
<td valign="top" width="213">Growth rate</td>
<td valign="top" width="213">5%</td>
</tr>
<tr>
<td valign="top" width="213">Flotation cost</td>
<td valign="top" width="213">4%</td>
</tr>
</tbody>
</table>
The cost of equity will be calculated as follows:
<div class="formula1">
[latex size="3" background="F0F0F0"]r_{e}=\frac{5(1+0.05)}{105(1-4\%)} + 0.05[/latex]

= 10.21%
</div>
Many analysts consider this approach inappropriate because flotation cost is actually a cash out flow at the beginning of the project. The project is actually affected as the initial cash flow reduces. What we are doing instead is adjusting the PV of future cash flows by a fixed percentage.

The alternative method is to adjust the cash flows while valuing the project. So, we first calculate the <a href="https://financetrain.com/net-present-value-of-a-project/">NPV of the project</a> and then deduct the flotation costs from it. This is a preferred method used by most analysts.

This approach was suggested by john R. Ezzell and R. Burr Porter in their paper "Flotation Costs and the Weighted Average Cost of Capital" In this paper they argue that the correct way of treating flotation costs is to deduct it as a part of the valuation.

Flotation Costs and WACC

This quiz is a part of the CFA Level 1 reading 'Cost of Capital'. 

This frontmatter description will appear below the title

Cost of Capital

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Data Science in Finance: 9-Book Bundle

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