COLLEGE OF BUSINESS AND PUBLIC ADMINISTRATION

CBPA Building
Burauen Sports Complex, San Diego, Población District
Burauen, Leyte
Phone: 0977 313 2561
Email: localcollegebcc@gmail.com

COST OF CAPITAL
COST OF CAPITAL

The cost of capital is also called by other names as cut-off rate, minimum desired rate, minimum
acceptable rate, target rate, standard rate, and hurdle rate.

An understanding of the concept of cost of capital is essential in the evaluation of capital investment
proposals because cost of capital serves as the standard rate with which comparisons are to be made.

The cost of capital is the cost of using funds. When a business uses funds to finance a project, such
funds may come from various sources like bonds, notes payable, common stocks, preferred stocks,
or even from earnings retained in the business. When the company floats bonds or obtains debt to
finance a project, it is obliged to pay interest; when it issues stocks, it has to pay dividends. Even when
the company uses the earnings retained in business, there is an interest cost implicit in the utilization
of the company’s own resources. These dividends and interests that the company must incur or pay
for using funds to finance a project represent the cost of capital.

KEY ASSUMPTIONS

The cost of capital is a dynamic concept affected by a variety of economic and firm-specific factors.
To isolate the basic structure of the cost of capital, we make some key assumptions relative to risk
and taxes:

1. Business risk – the risk to the firm of being unable to cover operating costs – is assumed to
be unchanged. This assumption means that the firm’s acceptance of a given project does not
affect its ability to meet operating costs.
2. Financial risk – the risk to the firm of being unable to cover required financial obligations
(interest, lease payments, preferred stock dividends) – is assumed to be unchanged. This
assumption means that projects are financed in such a way that the firm’s ability to meet
required financing costs is unchanged.
3. After-tax costs are considered relevant. In other words the cost of capital is measured in an
after-tax basis.

SPECIFIC SOURCES OF CAPITAL

There are four basic sources of long-term funds for the business firm. These sources include long-
term debt, preferred stock, common stock, and retained earnings. These sources of long-term funds
can be illustrated as follows:
Balance Sheet
Current Liabilities
Long-term Debt
Stockholders’ Equity
Assets Preferred Stock
Common Stock Equity
Common Stock
Retained Earnings

Although not every firm will use all of these methods of financing, each firm is expected to have
funds from some of these sources in its capital structure.

THE COST OF LONG-TERM DEBT

The cost of long-term debt (Cd), is the after tax cost today of raising long-term funds through
borrowing. Typically the funds are assumed to be raised through the sale of bonds and therefore pay
interest. The net proceeds from the sale of a bond, or any security are the funds that are actually
received from the sale. Flotation costs, on the other hand, is the total costs of issuing and selling a
security – reduce the net proceeds from the sale. They include two components: (1) Underwriting
costs – compensation earned by investment bankers for selling the security, and (2) Administrative
costs – issuer expenses such as legal, accounting, printing and other expenses.

BEFORE-TAX COST OF DEBT

The before tax cost of debt for a bond can be obtained in any of the following ways – quotation,
calculation or approximation.

1. Using Cost quotations

When the net proceeds of a bond is equal to its par value, the before tax cost equals the coupon
interest rate. A second quotation that is sometimes used is the yield to maturity (YTM) on a similar
risk bond. For example, if a similar-risk bond has a YTM of 10%, this value can be viewed as the before
tax cost of the debt.

2. Calculating the cost

This approach finds the before tax cost of debt by calculating the internal rate of return (IRR) on the
bond cash flows. From the issuer’s point of view, this value is the cost to maturity of the cash flows
associated with the debt. The cost to maturity can be calculated by using a trial-and-error technique
also known as interpolation process.

3. Approximating the cost

The before-tax cost of debt for a bond can be approximated by using the following equation:

PV – NP
I+
n
Cd =
NP + PV
2

I = annual interest in Pesos

NP = Net Proceeds from the sale of debt
PV = Par Value
n = number of years to the bond’s maturity

AFTER-TAX COST OF DEBT

As previously indicated, the specific cost of financing must be stated on an after-tax basis. Because
interest on debt is tax deductible, it reduces the firm’s taxable income. The after-tax cost of debt can
be found from the following equation:

Cd after tax = Cd before tax x (1 – T%)

THE COST OF PREFERRED STOCK

Preferred stock represents a special type of ownership interest in the firm. It gives preferred
stockholders the right to receive their stated dividends before any earnings can be distributed to
common stockholders. Because preferred stock is a form of ownership, the proceeds from its sale are
expected to be held for an indefinite period of time.

CALCULATING THE COST OF PREFERRED STOCK

The cost of preferred stock (Cps) is the ratio of the preferred stock dividend to the firm’s net proceeds
from the sale of the preferred stock. The net proceeds represent the amount of money to be received
minus any flotation costs. The cost of preferred stock can be calculated using the following equation:

Dp
Cps =
Np

Cps = cost of preferred stock

Dp = annual peso preferred dividend
Np = Net proceeds

Note: Because preferred stock dividends are paid out of the firm’s after-tax cash flows, a tax
adjustment is not necessary.

THE COST OF COMMON STOCK

The cost of common stock is the return required on the stock by investors in the marketplace. There
are two forms of common stock financing: (1) retained earnings and (2) new issues of common stock.
As a first step in finding each of these costs, we must estimate the cost of common stock equity.

CALCULATING THE COST OF COMMON STOCK EQUITY

The cost of common stock equity (Ccs) is the rate at which investors discount the expected dividends
of the firm to determine its share value. Two techniques are used to measure the cost of common
stock equity. One relies on constant valuation model, the other on the capital asset pricing model
(CAPM).

1. Constant-Growth Valuation (Gordon) Model

Using the Gordon Model the value of a share of stock is found to be equal to the present value of all
future dividends, which is assumed to grow at a constant rate over an infinite time horizon. The
Gordon Model expression is presented below:

D1
Mp =
Ccs – g%

Mp = Market Price of common stock

D1 = Dividend per share expected at the end of year 1
Ccs = required return on common stock
g% = constant growth rate

Solving the above equation, the following expression for the cost of common stock equity will
result:

D1
Ccs = + g%
Mp

Note: Because common stock dividends are paid from after-tax income, no tax adjustment is
required.
2. Capital Asset Pricing Model

The capital asset pricing model (CAPM) links nondiversifiable risk and return for all assets of a firm
as measured by the beta coefficient. The basic CAPM is:

Ccs = Rf + [b x (Mr – Rf)]

Rf = risk-free rate of return

b = beta coefficient
Mr = Market return; return on the market portfolio of assets

Using CAPM indicates that the cost of common stock equity is the return required by investors as
compensation for the firm’s nondiversifiable risk, measured by beta.

Note: The beta coefficient is a relative measure of nondiversifiable risk. It is an index of the degree of
movement of an asset’s return in response to a change in the market return. An asset’s historical
returns are used in finding the asset’s beta coefficient.

THE COST OF RETAINED EARNINGS

We would all agree that dividends are paid out of a firm’s earnings. Their payment made in cash to
common stockholders, reduces the firm’s retained earnings. Suppose a firm needs common stock
equity financing of a certain amount. It has two choices relative to retained earnings: It can issue
additional common stock in that amount and still pay dividends to stockholders out of retained
earnings, or it can increase common stock equity by retaining the earnings in the needed amount. In
a strict accounting sense, the retention of earnings increases common stock equity in the same way
that the sale of additional shares of common stock does.

Thus, the cost of retained earnings to the firm is the same as the cost of an equivalent fully subscribed
issue of additional common stock. Viewing retained earnings as a fully subscribed issue of additional
common stock, we can set the firm’s cost of retained earnings equal to cost of common stock equity.

Cr = Ccs

Note: The cost of retained earnings is always lower than the cost of a new issue of common stock,
because it entails no flotation costs.
THE COST OF NEW ISSUES OF COMMON STOCK

The purpose in finding the firm’s overall cost of capital is to determine the after-tax cost of new funds
required for financing projects. The cost of a new issue of commons stock (Ccsn) is determined by
calculating the cost of common stock, net of underpricing and associated flotation costs. Normally,
for a new issue to sell, it has to be underpriced-sold at a price below its current market price.

The cost of new issues of commons stock can be expressed as follows:

D1
Ccsn = + g%
Np

D1 = Dividend per share expected at the end of year 1

Np = Net proceeds
g% = growth rate

Note: The net proceeds from sale of new common stock will be less than the current market price.
Therefore, the cost of new issues will always be greater than the cost of existing issues which is equal
to the cost of retained earnings. The cost of new common stock is normally greater than any other long-
term financing cost. Because common stock dividends are paid from after tax cash flows, no tax
adjustment is required.

THE WEIGHTED AVERAGE COST OF CAPITAL (WACC)

The weighted average cost of capital (WACC) reflects the expected average future cost of funds over
the long run. It is found by weighting the cost of each specific type of capital by its proportion in the
firm’s capital structure.

CALCULATING THE WACC

Calculating the WACC is simple. Multiply the specific cost of each form of financing by its proportion
in the firm’s capital structure and sum the weighted values. WACC can be expressed as follows:

WACC = (Cd x %) + (Cp x %) + (Ccs x %)

PRACTICE EXERCISES
(Sources: CMA/CIA/RPCPA/AICPA/Various test banks)

THEORY
1. All of the following statements are correct except:
a. The matching of asset and liability maturities is considered desirable because this strategy
minimizes interest rate risk.
b. Default risk refers to the inability of the firm to pay off its maturing obligations.
c. The matching of assets and liability maturities lowers default risk.
d. An increase in the payables deferral period will lead to a reduction in the need to non-
spontaneous funding.

2. Which of the following would increase risk?

a. Increase the level of working capital.
b. Change the composition of working capital to include more liquid assets.
c. Increase the amount of short-term borrowing.
d. Increase the amount of equity financing.

3. A firm’s financial risk is a function of how it manages and maintains its debt. Which one of the
following sets of ratios characterizes the firm with the greatest amount of financial risk?
A. High debt-to-equity ratio, high interest coverage ratio, stable return on equity.
B. Low debt-to-equity ratio, low interest coverage ratio, volatile return on equity.
C. High debt-to-equity ratio, low interest coverage ratio, volatile return on equity.
D. Low debt-to-equity ratio, high interest coverage ratio, stable return on equity.

4. Which of the following classes of securities are listed in order from lowest risk/opportunity for
return to highest risk/opportunity for return? (E)
A. U.S. Treasury bonds; corporate first mortgage bonds; corporate income bonds; preferred
stock.
B. Corporate income bonds; corporate mortgage bonds; convertible preferred stock;
subordinated debentures.
C. Common stock; corporate first mortgage bonds; corporate second mortgage bonds;
corporate income bonds.
D. Preferred stock; common stock; corporate mortgage bonds; corporate debentures.

5. If the return on the market portfolio is 10% and the risk-free rate is 5%, what is the effect on a
company's required rate of return on its stock of an increase in the beta coefficient from 1.2 to
1.5?
A. 3% increase B. 1.5% increase
C. No change D. 1.5% decrease.
6. Cost of capital is
a. The amount the company must pay for its plant assets.
b. The dividends a company must pay on its equity securities.
c. The cost the company must incur to obtain its capital resources.
d. The cost the company is charged by investment bankers who handle the issuance of equity
or long-term debt securities.

7. All of the following are examples of imputed costs except

a. The stated interest paid on a bank loan.
b. Assets that are considered obsolete that maintain a net book value.
c. Decelerated depreciation.
d. Lending funds to a supplier at a lower-than-market rate in exchange for receiving the
supplier’s products at a discount.

8. The theory underlying the cost of capital is primarily concerned with the cost of
A. Long-term funds and old funds.
B. Short-term funds and new funds.
C. Long-term funds and new funds.
D. Any combination of old or new, short-term or long-term funds.

9. Management knowledge of the cost of capital is useful for each of the following except
a. Making capital investment decisions.
b. Managing working capital.
c. Setting the maximum rate of return on new investments.
d. Evaluating performance.

10. The pre-tax cost of capital is higher than the after-tax cost of capital because
a. interest expense is deductible for tax purposes.
b. principal payments on debt are deductible for tax purposes.
c. the cost of capital is a deductible expense for tax purposes.
d. dividend payments to stockholders are deductible for tax purposes.

11. The overall cost of capital is the

A. Rate of return on assets that covers the costs associated with the funds employed.
B. Average rate of return a firm earns on its assets.
C. Minimum rate a firm must earn on high-risk projects.
D. Cost of the firm's equity capital at which the market value of the firm will remain unchanged.

12. The explicit cost of debt financing is the interest expense. The implicit cost(s) of debt financing
is (are) the
a. Increase in the cost of debt as the debt-to-equity ratio increases.
b. Increases in the cost of debt and equity as the debt-to-equity ratio increases.
c. Increase in the cost of equity as the debt-to-equity ratio decreases.
d. Decrease in the weighted-average cost of capital as the debt-to-equity ratio increases.

13. In computing the cost of capital, the cost of debt capital is determined by
a. Annual interest payment divided by the proceeds from debt issuance.
b. Interest rate times (1 – the firm’s tax rate)
c. Annual interest payment divided by the book value of the debt.
d. The capital asset pricing model.

14. The interest rate on the bonds is greater for the second alternative consisting of pure debt than
it is for the first alternative consisting of both debt and equity because
A. The diversity of the combination alternative creates greater risk for the investor.
B. The pure debt alternative would flood the market and be more difficult to sell.
C. The pure debt alternative carries the risk of increasing the probability of default.
D. The combination alternative carries the risk of increasing dividend payments.
15. If a $1,000 bond sells for $1,125, which of the following statements are correct?
I. The market rate of interest is greater than the coupon rate on the bond.
II. The coupon rate on the bond is greater than the market rate of interest.
III. The coupon rate and the market rate are equal.
IV. The bond sells at a premium.
V. The bond sells at a discount.
a. I and IV. b. I and V.
c. II and IV. d. II and V.

16. Companies experience changes in interest expenses, variable cost per unit, quantity of units sold,
and fixed costs. Their degree of operating leverage is not affected by the change in
A. Interest expenses. C. Quantity of units sold.
B. Variable cost per unit. D. Fixed costs.

17. If the return on total assets is 10% and if the return on common stockholders’ equity is 12% then
a. The after-tax cost of long-term debt is probably greater than 10%.
b. The after-tax cost of long-term debt is 12%.
c. Leverage is negative.
d. The after-tax cost of long-term debt is probably less than 10%.

18. The basis for measuring the cost of capital derived from bonds and preferred stock, respectively,
is the
A. after-tax rate of interest for bonds and stated annual dividend rate for preferred stock
B. pretax rate of interest for bonds and stated annual dividend rate less the expected earnings

per share for preferred stock

C. pretax rate of interest for bonds and stated annual dividend rate for preferred stock
D. after-tax rate of interest for bonds and stated annual dividend rate less the expected

earnings per share for preferred stock

19. The market value of a firm’s outstanding common shares will be higher, everything else equal, if
a. Investors have a lower required return on equity.
b. Investors expect lower dividend growth.
c. Investors have longer expected holding periods.
d. Investors have shorter expected holding periods.

20. When calculating the cost of capital, the cost assigned to retained earnings should be
A. Zero.
B. Lower than the cost of external common equity.
C. Equal to the cost of external common equity.
D. Higher than the cost of external common equity.

PROBLEMS
1. Based on the following information about stock price increases and decreases, make an estimate
of the stock's beta: Month 1 = Stock +1.5%, Market +1.1%; Month 2 = Stock +2.0%, Market +1.4%;
Month 3 = Stock -2.5%, Market -2.0%.
A. Beta is greater than 1.0.
B. Beta equals 1.0
C. Beta is less than 1.0.
D. There is no consistent pattern of returns.
2. What is the yield to maturity on Fox Inc.'s bonds if its after-tax cost of debt is 9% and its tax rate
is 34%?
A. 5.94% B. 9%
C. 13.64% D. 26.47%

3. Maylar Corporation has sold $50 million of $1,000 par value, 12% coupon bonds. The bonds were
sold at a discount and the corporation received $985 per bond. If the corporate tax rate is 40%,
the after-tax cost of these bonds for the first year (rounded to the nearest hundredth percent) is
A. 7.31%. B. 4.87%.
C. 12.00%. D. 7.09%.

4. The MNO Company believes that it can sell long-term bonds with a 6% coupon but at a price that gives a yield-to-maturity of
9%. If such bonds are part of next year’s financing plans, which of the following should be used for bonds in their after-tax (40%)
cost-of-capital calculation?
A. 3.6% B. 5.4%
C. 4.2% D. 6%

5. Ambry Inc. is going to use an underwriter to sell its preferred stock. Four underwriters have given
estimates (below) on their fees and the selling price of the stock, as well as the expected dividend
for each:
Fees Selling Price Dividends
Underwriter 1 $5 $101 $10
Underwriter 2 7 102 11
Underwriter 3 3 97 7
Underwriter 4 3 98 8
Which underwriter will produce the lowest cost of funds for the preferred stock?
A. Underwriter 1. B. Underwriter 2.
C. Underwriter 3. D. Underwriter 4.

6. Gravy Company expects earnings of P30 million next year. Its dividend payout ratio is 40%, and
its debt/equity ratio is 1.50. Gravy uses no preferred stock.
At what amount of financing will there be a break point in Gravy’s marginal cost of capital?

A. P45 million. B. P30 million.

C. P20 million. D. P18 million.

7. Allison Engines Corporation has established a target capital structure of 40 percent debt and 60
percent common equity. The current market price of the firm’s stock is P0 = $28; its last dividend
was D0 = $2.20, and its expected dividend growth rate is 6 percent. What will Allison’s marginal
cost of retained earnings, ks, be?
a. 15.8% b. 13.9%
c. 7.9% d. 14.3%

8. Doris Corporation's stock has a market price of $20.00 and pays a constant dividend of $2.50.
What is the required rate of return on its stock?
A. 13.0% B. 12.5%
C. 12.0% D. 11.5%

9. The ABC Company is expected to have a constant annual growth rate of 5 percent. It has a price

per share of P32 and pays an expected dividend of P2.40. Its competitor, the DEF Company is

expected to have a growth rate of 10%, has a price per share of P72, and pays an expected

P4.80/share dividend. The required rates of return on equity for the two companies are:

A. B. C. D.

ABC 13.8% 9.6% 12.5% 16.2%

DEF 15.4% 8.6% 16.7% 18.2%

10. Frostfell Airlines is expected to pay an upcoming dividend of $3.29. The company's dividend
is expected to grow at a steady, constant rate of 5% well into the future. Frostfell currently has
1,600,000 shares of common stock outstanding. If the required rate of return for Frostfell is 12%,
what is the best estimate for the current price of Frostfell's common stock?
A. $65.80 B. $62.51
C. $47.00 D. $27.41

11. Newmass, Inc. paid a cash dividend to its common shareholders over the past 12 months of $2.20
per share. The current market value of the common stock is $40 per share, and investors are
anticipating the common dividend to grow at a rate of 6% annually. The cost to issue new
common stock will be 5% of the market value. The cost of a new common stock issue will be
A. 11.50% B. 11.79%
C. 11.83% D. 12.14%

12. What return on equity do investors seem to expect for a firm with a $50 share price, an expected
dividend of $5.50, a beta of .9, and a constant growth rate of 4.5%?
A. 15.05% B. 15.50%
C. 15.95% D. 16.72%

13. Blair Brothers’ stock currently has a price of $50 per share and is expected to pay a year-end
dividend of $2.50 per share (D1 = $2.50). The dividend is expected to grow at a constant rate of 4
percent 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 $3 per
share. What is the company’s cost of equity capital?
a. 10.14% b. 9.21%
c. 9.45% d. 9.32%

14. The DCL Corporation is preparing to evaluate the capital expenditure proposals for the coming
year. Because the firm employs discounted cash flow methods of analyses, the cost of capital for
the firm must be estimated. The following information for DCL Corporation is provided.
 Market price of common stock is $50 per share.
 The dividend next year is expected to be $2.50 per share.
 Expected growth in dividends is a constant 10%.
 New bonds can be issued at face value with a 13% coupon rate.
 The current capital structure of 40% long-term debt and 60% equity is considered to be
optimal.
 Anticipated earnings to be retained in the coming year are $3 million.
 The firm has a 40% marginal tax rate.
If the firm must assume a 10% flotation cost on new stock issuances, what is the cost of new
common stock?
A. 14.50%. B. 15.56%.
C. 15.32%. D. 15.50%.

15. Fitzgerald is interested in investing in a corporation with a low cost of equity capital. By using

the dividend growth model, which of the following corporations has the lowest cost of equity

capital?

Stock Price Dividend Growth Rate

C.S. Inc. $25 $5 8%
Lewis Corp. 30 3 10%
Screwtape Inc. 20 4 6%
Wormwood Corp. 28 7 7%
A. C.S. Inc. C. Screwtape Inc.
B. Lewis Corp. D. Wormwood Corp.
16. The common stock of Anthony Steel has a beta of 1.20. The risk-free rate is 5 percent and the
market risk premium (kM - kRF) is 6 percent. Assume the firm will be able to use retained earnings
to fund the equity portion of its capital budget. What is the company’s cost of retained earnings,
ks?
a. 7.0% b. 7.2%
c. 11.0% d. 12.2%

17. Colt, Inc. is planning to use retained earnings to finance anticipated capital expenditures. The beta
coefficient for Colt's stock is 1.15, the risk-free rate of interest is 8.5%, and the market return is
estimated at 12.4%. If a new issue of common stock were used in this model, the flotation costs would
be 7%. By using the Capital Asset Pricing Model (CAPM) equation [R = RF + ß(RM - RF)], the cost of
using retained earnings to finance the capital expenditures is
A. 13.21% B. 12.99%
C. 12.40% D. 14.26%

18. Stock J has a beta of 1.2 and an expected return of 15.6%, and stock K has a beta of 0.8 and an
expected return of 12.4%. What must be the expected return on the market and the risk-free rate
of return, to be consistent with the capital asset pricing model?
A. Market is 14%; risk-free is 6%.
B. Market is 14%; risk-free is 4%.
C. Market is 12.4%; risk-free is 0%.
D. Market is 14%; risk-free is 1.6%.

19. If the return on the market portfolio is 10% and the risk-free rate is 5%, what is the effect on a
company's required rate of return on its stock of an increase in the beta coefficient from 1.2 to
1.5?
A. 3% increase B. 1.5% increase
C. No change D. 1.5% decrease

20. An investor was expecting a 15% return on his portfolio with beta of 1.25 before the market risk
premium increased from 6% to 9%. Based on this change, what return will now be expected on
the portfolio?
A. 15.00% B. 18.00%
C. 18.75% D. 22.50%