Mamamsnsms

ReSA - THE REVIEW SCHOOL OF ACCOUNTANCY CPA Review Batch 41  May

2021 CPA Licensure Examination  Week No. 15 MANAGEMENT ADVISORY SERVICES
C.P. Lee  E.S Arañas  K.L. Manuel Page 1 of 8
0915-2303213  www.resacpareview.com MAS-13: COSTS OF CAPITAL, LEVERAGE & CAPITAL
STRUCTURE COSTS of CAPITAL  COST of CAPITAL is the rate of return necessary to maintain market
value of a firm or firm’s stock price.  Cost of capital is used for: (1) capital budgeting decisions, (2)
helping establish the optimal capital structure, and (3) making decisions such as leasing and working
capital management. It is often called by a variety of names: minimum required rate of return, hurdle
rate, desired rate, standard rate, cut-off rate.  The cost of capital is computed as a weighted average of
the various capital sources or components, which are items mostly found on the right-hand side of the
balance sheet such as LONG-TERM DEBT, PREFERRED STOCK, COMMON STOCK and RETAINED
EARNINGS: CAPITAL COST Long-Term Debt Yield Rate (100% - Tax Rate) Preferred Stock Yield Rate
Common Stock Yield Rate + Growth Rate Retained Earnings Yield Rate + Growth Rate  Cost of Long-
Term Debt  “KD”  Yield rate is based on a debt instrument’s EFFECTIVE interest rate, rather than its
nominal interest rate.  In lieu of doing the interpolation process to determine effective interest rate,
the following formula may be used to approximate the YIELD-TO-MATURITY (YTM) rate on a debt
instrument like bonds: YTM = Interest + [(Face Value – Net Proceeds) ÷ Life] (Net Proceeds + Face
Value) ÷ 2  Another way to compute YTM, although rarely used nowadays, is to express the
denominator as a weighted average (“60-40”) of the net proceeds and face value, rather than as a
simple average.  YTM must be distinguished from CURRENT YIELD (CY). CY = Annual Interest ÷ Current
Market Price  Cost of long-term debt is expressed as “after-tax” since interest charges are tax-
deductible expenses.  Cost of Preferred Stock(PS)  “KP”  Yield rate that must be used is actually the
DIVIDEND YIELD. Dividend Yield = Dividend per share Market price per share  Dividend per share =
preferred dividend rate x par value per share  Market price per share should be net of any flotation or
issue costs.  FLOTATION COST is the cost of issuing or ‘floating’ securities in the market,
normally incurred by issuing Initial Public Offering (IPO) shares in the exchange market. The
typical costs of selling stock include underwriter’s spread, direct expenses, indirect expenses,
abnormal returns, underpricing.  Growth rate is not considered since preferred dividends are
relatively fixed every year.  Tax is not considered since dividends paid are not deductible for tax
purposes (i.e., no tax shield).  Cost of Common Stock (CS) & Retained Earnings (RE)  “KE”  Yield rate,
like the cost of preferred stock, is also the DIVIDEND YIELD.  Dividend per share must be based on the
next dividend to be paid (i.e., expected dividend).  Expected dividend per share = past/present
dividend per share x (100% + Growth Rate)  In computing cost of CS & PS, market price per share
should be net of any flotation or issue costs.  In computing cost of RE, flotation cost should be ignored
as RE is neither being sold nor issued.  The formula “KE = Yield Rate + Growth Rate” is actually
based on the GORDON’s GROWTH MODEL, named after the American economist Myron Gordon who
invented the model along with Eli Shapiro.  Under the Gordon model, the growth rate of dividends is
assumed to be constant throughout perpetuity.  Tax is not considered since dividends paid are not
deductible for tax purposes (i.e., no tax shield).  Alternatively, the cost of equity capital may be
computed using the CAPITAL ASSET PRICING MODEL. CAPITAL ASSET PRICING MODEL (CAPM): A RISK-
BASED APPROACH  A security risk consists of two components: 1) diversifiable risks and 2) non-
diversifiable risks. 1) DIVERSIFIABLE RISK, a.k.a. controllable risk or unsystematic risk or company-specific
risk, represents the portion of a security’s risk that can be controlled through diversification. This type of
risk is unique to a given security. Business, liquidity, and default risks fall into this category.  BUSINESS
RISK is caused by fluctuations of earnings before interest and taxes (operating income). It depends on
variability in demand, sales price, input prices, and amount of operating leverage.  LIQUIDITY RISK is
the possibility that an asset