Cost of Capital

I. The fundamental concept

1. Cost of capital refers to the cost of using funds from long-term investors.
2. Investors (i.e. fund providers, capitalists, money providers) could either be long-term creditors
or owners. Long-term creditors primarily refer to bondholders. Owners include both the
preference and ordinary shareholders.
3. Long-term funds are sourced from the financial markets, by selling debt and equity securities.
4. Financial market investors expect the following returns.

Fund Providers Expected Returns

Long-term creditors Interest
Preference shareholders Dividends
Ordinary shareholders Dividends and Growth

5. Cost of capital is the minimum required rate of return of an investment to avoid impairment in
the shareholder’s value.
6. The computation of the cost of capital is prospective. Hence, the interest and dividends to be
used in the calculation of the cost capital should be prospective as well.
7. Cost of capital serves as a benchmark in evaluating proposed investment. To be acceptable, a
project return must be greater than the cost of capital.
8. The lower the cost of capital, the better it would be for the business.
9. The cost of capital for each of the securities issued in the capital market, using the Gordon
Growth Model, is computed as follows:

Sources of Long-term Funds Cost of Capital Formula per Comments

Financial Security
Long-term debt (i.e. Bond EIR (1-TR) Interest is a tax deductible
Payable) expense, as such, the cost of
EIR x ATR debt should be net of tax
Preference shareholder’s DPS/MPPS (net) It is the preferred stocks yield
equity rate. The market price of the
D/Pn stock serves as the cost of
investment. The market price
of the stock is determined
net of flotation rate
Ordinary shares EDPS/MPPS (net) + G Ordinary shareholders are
the real owners of the
D/Pn + G business organizations. If the
business fails, they absorb
the greatest impairment in
equity. If the business grows.
They register the greatest
increase in wealth. As such
the growth rate is factored in
the cost of using ordinary
equity.
Retained earnings EDPS / MPPS (gross) + G Ordinary shares and retained
earnings basically comprise
D/P + G the total ordinary
shareholders’ equity.
However, in the computation
of the cost of capital of
retained earnings, the market
price per share is determined
at gross, not at net of
flotation.
Legend:
DPS – Dividend per share
EDPS – Expected dividend per share = DPS (1+G)
EIR – Effective interest rate
MPPS – Market price per share
TR – Tax rate
 ATR – After-tax rate

II. The weighted average cost of capital

1. The weighted average cost of capital (WACOC) is the average cost of all the components of the
company’s funds.
2. The basis used in evaluating project proposals would be the weighted average cost of capital
3. The weighing of the cost of capital is basically based on the optimal capital mix
4. If the optimal capital mix is not available, the average is determined based on the market value
contributions of the funds
5. The WACOC is computed as follows:

A B C D E (C x D)
Funds MV Individual COC (in%) Fraction WACOC
LTD Y EIR x ATR = XX y/Z Xx%
PSE Y D/Pn = XX y/Z Xx%
OSE Y D/Pn + G = XX y/Z Xx%
RE Y D/Pg + G = XX y/Z Xx%
Total Z Xx%
D = Expected dividend per share
LTD = Long-term debt
MV = Market Values
OSE – Ordinary shareholder’s equity
PSE – Preference shareholder’s equity
RE – Retained earnings
Pn – Market price per share, net of flotation
Pg – Market price per share, gross

6. The EIR is determined by dividing the net interest paid over the net proceeds from the issuance
of the bonds.
7. The issuance of a financial instrument or security normally needs the services of an underwriter
who charges an underwriting costs or the costs of selling the security in the capital market.
These underwriting costs are herein called as the “flotation costs”
8. Preference dividend per share = Dividend rate x Preference share par value
9. Preference shareholder’s equity is computed based on the market value of the preference
shares.
10. The cheapest source of money is debt (i.e. bonds payable). And the most expensive source of
money is the ordinary equity.
11. Debt is the cheapest source of money because the risk related to creditor’s exposure is lower
than that of the owner’s. Another reason is that the interest expense is a tax deductible item, as
such, it lowers further the net cost of funds.
12. If there is a presence of lease payable and retained earnings, the weighted average cost of
capital is computed as follows:

A B C D E (C x D)
Funds MV Individual COC (in%) Fraction WACOC
BP Y EIR x ATR = XX y/Z Xx%
LP Y EIR x ATR = XX y/Z Xx%
PSE Y D/Pn = XX y/Z Xx%
OSE Y D/Pn + G = XX y/Z Xx%
RE Y D/Pg + G = XX y/Z Xx%
Total Z Xx%
LP = Lease payable
D = Expected dividend per share
LTD = Long-term debt
MV = Market Values
OSE – Ordinary shareholder’s equity
PSE – Preference shareholder’s equity
RE – Retained earnings
Pn – Market price per share, net of flotation
Pg – Market price per share, gross
Exercise:
1. Basic cost of capital.
Puhunan Corporation wishes to compute its weighted average cost of capital to be used in
evaluating capital expenditure proposals. Earnings, capital structure and current market
prices of the company’s securities on December 31, 2022 are as follows:

Par Total Market Flotation Expected

Value Amount of Price Costs Growth rate
Par per
share
10%, Bond payable P100 P40 Million P1,250 5%
0
15%, Preference P100 P10 Million P250 5%
Equity
Ordinary shares P20 P50 Million P40 7% 8%
Retained earnings P10 Million 8%

Profit before interest and tax P20 Million

Current dividend per ordinary share P3
Tax rate 30%

Required:
1. Determine the weighted average cost of capital
2. Assume all other data to be constant, except that the capital structure of the company
shall now be as follows:

Mortgage bond, 10%, 10 years P60,000,000

Preference shares, 15%, P100 par value P10,000,000
Ordinary share, no par, 800 shares outstanding P30,000,000
Retained earnings P10,000,000
P110,000,000
Solution:

A B C D E (C x D)
Source of Funds MV Individual COC (in%) Fraction WACOC
Bonds payable 50,000,000 8.42% (1-30%) = 50/175 1.68%
5.89%
PSE 25,000,000 P15/(250x95%) = 25/175 .92%
6.32%
OSE 100,000,000 (P3 x 108%) / (P40 x 100/175 9.55%
93%) + 8% = 16.71%
Total 175,000,000 12.15%
*Bonds payable = (40Million/P1000) x 1250 = P50,000,000
Preferred equity = (10Million/P100) x 250 = P25,000,000
Ordinary equity = (50Million/P20) x P40 = P100,000,000

* Effective interest rate = (P1,000 X 10%) / (P1,250 x 95%) = 8.42%

A B C D E (C x D)
Source of Funds MV Individual COC (in%) Fraction WACOC
Bonds payable 75,000,000 8.42% (1-30%) = 75/132 3.35%
5.89%
PSE 25,000,000 P15/(250x95%) = 25/132 1.15%
6.32%
OSE 32,000,000 (P3 x 108%) / (P40 x 32/175 4.05%
93%) + 8% = 16.71%
Total 132,000,000 8.55%
*Bonds payable = (60Million/P1000) x 1250 = P75,000,000
Preferred equity = (10Million/P100) x 250 = P25,000,000
Ordinary equity = 800,000 shares x P40 = P32,000,000
* Effective interest rate = (P1,000 X 10%) / (P1,250 x 95%) = 8.42%
 Exercise:
Eve Corporation desires to raise 60 Million to finance its capita expenditures in 2006. The
following data are assembled for consideration.
 Relevant data on company’s securities are as follows:

Shares Par Value MV FC Optical .Cap mix

8% Bonds payable, 10-year 400,000 P1,000 120 4% 60%
10%, Preference share 640,000 P100 125 5% 10%
Ordinary share, P10 par 3 Million P20 80 5% 30%

 Expected common dividend per share, P9

 Expected growth rate, 6.5%
 Tax rate 40%

Required:
1. The before-tax cost of debt
2. The after-tax cost of debt
3. Cost of preferred equity
4. Cost of ordinary equity

Exercise:
Olympic Corporation identifies capital project opportunities in line with the company’s growth
strategies. Data relative to the company’s long-term equities are as follows:
 Preferred financing mix and pre tax cost of capital are as follows:
Optimal financing mix Pre-tax cost of money
Bond payable 50% 10%
Preferred equity 30% 12%
External ordinary equity ? 15%
Internal ordinary equity ? 12%
 Retained earnings available for reinvestment, P12 million
 Marginal tax rate, 40%

Required: Compute the marginal cost of capital if the company needed to raise long-term
financing amounting to:

a. 50 Million
b. 80 Million