COST OF CAPITAL

Source Capital Cost of Capital

Creditors Long-term debt After-tax rate of
interest
Stockholders:
Preferred Preferred stock Preferred
dividends per
share
Current market
price or
Net issuance price
Common Common stock CAPM or DDM

1. CAPITAL ASSET PRICING MODEL (CAPM)

R = RF + β(RM – RF)

where:

R = rate of return

RF = risk-free rate determined by government

securities

Β = beta coefficient of an individual stock which is

the correlation between the volatility (price
variation) of the stock market and the volatility of
the price of the individual stock.

2. THE DIVIDEND DISCOUNT MODEL (OR DIVIDEND

GROWTH MODEL)

a. Cost of Retained Earnings

D1
+G
P0
where:

P0 = current price

D1 = next dividend

G = growth rate in dividends per share (it is

assumed that the dividend payout ratio,
retention rate, and therefore the EPS growth rate
are constant)

b. Cost of New Common Stock

D1
+G
P0 (1 – Flotation Cost)

Flotation Cost = the cost of issuing new securities.

- - END - -
PROBLEMS

1. Emmanuel Corporation has a target capital structure consisting of 20% debt, 20% preferred stock, and 60% common
equity.

▪ Assume the firm has insufficient retained earnings to fund the equity portion of its capital budget.
▪ Its bonds have a 12% coupon, paid semiannually, a current maturity of 20 years, and sell for P1,000.
▪ The firm could sell, at par, P100 preferred stock that pays a 12% annual dividend, but flotation costs of
5% would be incurred.
▪ The firm’s beta is 1.2, the risk-free rate is 10%, and the market risk premium is 5%.
▪ The corporation is a constant growth firm that just paid a dividend of P2.00, sells for P27.00 per share,
and has a growth rate of 8%.
▪ The firm’s policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-
premium method.
▪ Flotation costs on new common stock total 10%.
▪ The firm’s marginal tax rate is 40%.

Question 1: What is the component cost of debt?

a. 10.0% c. 8.6%
b. 9.1% d. 7.2%

Question 2: What is the cost of preferred stock?

a. 10.0% c. 12.0%
b. 11.0% d. 12.6%

Question 3: What is the cost of retained earnings using the CAPM approach?
a. 13.6% c. 16.0%
b. 14.1% d. 16.6%

Question 4: What is the cost of retained earnings using the DCF approach?
a. 13.6% d. 16.6%
b. 14.1% e. 16.9%
c. 16.0%

Question 5: What is the WACC, if the firm has insufficient retained earnings to fund the equity portion of its
capital budget?
a. 13.6% c. 16.0%
b. 14.1% d. 16.6%

2. Cristy Company’s stock currently has a price of P50 per share and is expected to pay a year-end dividend of P2.50
per share (D1 = P2.50). The dividend is expected to grow at a constant rate of 4% per year. The company has
insufficient retained earnings to fund capital projects and must, therefore, issue new common stock. The new
stock has an estimated flotation cost of P3 per share. What is the company’s cost of equity capital?
a. 10.14% c. 9.45%
b. 9.21% d. 9.32%

3. Ronelo Electric has a capital structure that consists of 70% equity and 30% debt.

▪ The company’s long-term bonds have a before-tax yield to maturity of 8.4%.

▪ The company uses the DCF approach to determine the cost of equity.
▪ The company’s common stock currently trades at P45 per share.
▪ The year-end dividend (D1) is expected to be P2.50 per share, and the dividend is expected to grow
forever at a constant rate of 7% a year.
▪ The company estimates that it will have to issue new common stock to help fund this year’s projects.
▪ The flotation cost on new common stock issued is 10%.
▪ The company’s tax rate is 40%.

What is the company’s weighted average cost of capital, WACC?

a. 10.73% c. 11.31%
b. 10.30% d. 7.48%
4. Marjon Corporation is estimating its WACC. The company has collected the following information:

▪ Its capital structure consists of 40% debt and 60% common equity.
▪ The company has 20-year bonds outstanding with a 9% annual coupon that are trading at par.
▪ The company’s tax rate is 40%.
▪ The risk-free rate is 5.5%.
▪ The market risk premium is 5%.
▪ The stock’s beta is 1.4.

What is the company’s WACC?

a. 9.71% c. 8.31%
b. 9.66% d. 11.18%

5. Princess Industries finances its projects with 40% debt, 10% preferred stock, and 50% common stock.

▪ The company can issue bonds at a yield to maturity of 8.4%.

▪ The cost of preferred stock is 9%.
▪ The risk-free rate is 6.57%.
▪ The market risk premium is 5%.
▪ The company’s beta is equal to 1.3.

Assume that the firm will be able to use retained earnings to fund the equity portion of its capital budget. The
company’s tax rate is 30%. What is the company’s weighted average cost of capital (WACC)?
a. 8.33% c. 9.79%
b. 8.95% d. 10.92%

6. Catherine Corporation has a capital structure that consists of 20% equity and 80% debt. The company expects to
report P3 million in net income this year, and 60% of the net income will be paid out as dividends. How large
must the firm’s capital budget be this year without it having to issue any new common stock?
a. P 1.20 million c. P 1.50 million
b. P13.00 million d. P 6.00 million