COST OF CAPITAL

- Short-Term Financing
- Long-Term Financing
 Cost of capital
DEFINITIONS
COST OF CAPITAL - is the cost of using the funds provided by
different sources (creditors and
stockholders).

SHORT TERM - Less than a year.

LONG TERM - More than a year.

 Illustration:
COST OF TRADE CREDIT

The first type of short-term A company purchases

financing is for cost of trade credit.
It deals with the cost of not taking
the credit terms of the trade
discount.
Formula:
Where: Day difference = Days
outstanding-Discount period
merchandise from its
supplier on credit
terms of 3/10, net 30.
what is the equivalent
interest rate if the
company foregoes
the discount and pays
on the 30th day.
Answer:
55.67%

COST OF bank loans
The second type of short term
financing is for cost of bank loans.
It deals with the cost of borrowing
from banks.
Formula:
Where: Usable Amount= Principal-
Interest taken in advance-
compensating balance
Illustration:
A company received a
500,000 line of credit from a
bank.
Stated Interest Rate 10%
compensating balance 20%
Assuming the company drew
down the entire amount at the
beginning of the year and that
the loan is discounted what is
the effective rate on the loan?
Answer:
14.29%

COST OF commercial paper
The third type of short term
financing is for cost of commercial
paper. The same as the previous
except for the determination of the
usable amount.
Formula:
Where: Usable Amount= Principal-
discount-flotation cost
Answer:
10.75%
Illustration:
A company received a
500,000 line of credit from a
bank.
Interest rate 10%
Flotation cost 2%
Discount 5%
Assuming the company drew
down the entire amount at the
beginning of the year and that
the loan is discounted what is
the effective rate on the loan?
 Illustration:
COST OF Long-Term Debts

The first type of long-term A company

financing is for cost of long-term
debts. It is equal to the nominal
obtained a long-
rate of interest. term bank loan of
500,000 at an
Formula:
annual interest
rate of 10% and a
tax rate of 30%
Where: ERI=Effective Rate of what is the cost of
Interest long term debt?
Answer: 7%

COST OF Preferred Equity
The first type of long term financing
is for cost of long term debts.
Formula:
Where: r = cost of preferred stock
D = preferred stock dividend
P = market price of preference
share
F = flotation cost
Illustration:
A firm has preferred stock with
an annual dividend of P3 and a
current stock price of P25.
What is the cost of preferred
stock?
Answer: 12%
What if there is a P500
flotation cost per 1000
preference shares?
Answer:
12.24%
 COST OF
ordinary equity
Cost of Ordinary Equity
Cost of Retained Earnings
WACC
Cost of Ordinary Equity
DEFINITIONS

COST OF ORDINARY EQUITY- is the cost of using the funds

provided by different sources (Retained earnings and
stockholders - ordinary shares).

Retained Earnings - earnings were not paid out to shareholders.

New Ordinary shares- issuance of more ordinary shares.

 Illustration:
COST OF retained earnings
Dividend Growth Model
A company is expected
Formula:
to pay a dividend of P1.5
per share next year and
there has been a steady
growth in dividends of
5.1% per year. The
current stock price is
Where:
MV = market price today(PV) P25, what is the cost of
D1 =dividend paid next period equity?
D0 = dividend paid last period Answer:
g = growth rate
rᵣₑ = annual discount rate (cost of 11.1%
retained earnings)

COST OF retained earning
CAPM Model
Formula:
Where:
Rf = risk free rate
B = Beta, systematic risk
Rm = average rate of return in the
capital market
rᵣₑ = expected rate of return (cost
of retained earnings)
Rm - Rf =r isk premium
Illustration:
A company has an
estimated Beta of 1.35
and Philippine treasury
bills are paying 4.9% of
return and the market
risk premium in large
companies’ stock is about
8.5%. What is the
company’s cost of equity.
Answer:
16.375%

COST OF retained earning
Bond Yield Plus Risk
Premium Approach
Formula:
Where:
Cost of long term bonds=risk free
rate(Rf)
Rm-Rf=risk premium
Illustration:
A company has an
estimated Beta of 1.35
and Philippine treasury
bills are paying 4.9% of
return and the market
risk premium in large
companies’ stock is
about 8.5%. What is the
company’s cost of
equity.
Answer:
13.4%

COST OF ordinary shares
Dividend Growth Model
Formula:
Where:
MV = market price today (PV)
D1 = dividend paid next period
D0 = dividend paid last period
g = growth rate F = flotation costs
rᵣₑ = annual discount rate (cost of
retained earnings)
Illustration:
A company is expected to
pay a dividend of P1.5 per
share next year and there
has been a steady growth
in dividends of 5.1% per
year. The current stock
price is P25, what is the
cost of equity?
With issuance costs of P5
per share. Answer:
12.6%
COST OF ordinary equity
All Models Illustration:
COST OF ordinary equity
AllAllModels
Models Answers
Weighted average cost
of capital

WACC
 wacc
AllAllCapital
Models Answers
thank you
Formative
Assessment