COST OF CAPITAL

COST OF CAPITAL
- the cost of using funds; it is also called hurdle rate, required rate of return, cut-off
rate, opportunity cost of capital.
- the weighted average rate of return the company must pay to its long-term
creditors and shareholders for the use of their funds.

Bond valuation. The market price of the bond is equal to the present value of the
cash flows associated with the bonds (principal at maturity and periodic interest)
discounted at the interest rate prevailing in the market at the time of the sale or issue.

- If the bonds’ stated rate or coupon rate happens to be the same as the market
rate at the time of sale, the present value of the bonds will exactly equal their
face value.
- If the bonds’ stated or coupon rate is lower than the market rate, investors must
be offered an incentive to buy the bonds, since the bonds’ periodic interest
payments are lower than those currently available in the market. Therefore, the
bonds should be issued at a discount where the issuer receives less cash than
the face value.
- If the bonds’ stated rate is higher than the market rate, investors are willing to
pay more for the bonds; the bonds therefore are issued with a premium.

Computation of Cost of Capital:

Source Capital Cost of Capital

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

Common Common Capital Asset Pricing Model or Dividend

stock Discount Model

Preferred stock valuation. The present value of the future cash flows associated
with the security discounted at the prevailing interest rate as required by the investors.
The annual cash flows are the estimated future annual cash dividends.

P0 = dp/k
 Common stock valuation:
1. Capital Asset Pricing Model
R = Rf + B (Rm – Rf)
Where: R = rate of return
Rf = risk-free rate determined by government securities
B = beta coefficient of an individual stock which is the correlation of the volatility
of the stock market and the volatility of the price of the individual stock

Rm = market return
(Rm – Rf) = market risk premium or the amount above risk-free rate required
to induce average investors to enter the market

2. Dividend Discount Model (Dividend Growth Model)

a. Cost of Retained Earnings

(D1 / P0) + G
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 / P0 – Flotation Cost) + G

Flotation Cost = the cost of issuing new securities

Problem 1: Stef Inc.’s currently outstanding 10% coupon bonds have a yield to maturity
of 12%. Stef believes it could issue new bonds at par that would provide a similar yield to
maturity. If the income tax rate is 30%, what is Stef Inc.’s after-tax cost of debt?

Problem 2: Federer Motors’ bonds have 5 years remaining to maturity. Interest is

paid annually. The bonds have a P1,000 face value, and the coupon interest rate is
6 percent. The bonds have a yield to maturity of 7.5 percent.
1. What is the current market price of these bonds?
2. Assuming that the YTM is 5.25%, what is the current market price?

Problem 3: Nadal Company is planning to issue P10 million bonds that will mature
in ten years. The bonds have a face value of P1,000 and a yield to maturity of 8
percent. They pay interest annually and have a 9 percent coupon rate. What is their
current yield?
Problem 4: Novak Company’s 5-year 8% bonds are issued at P1,075 per bond.
1. What is the yield to maturity for these bonds?
2. What is the YTM for these bonds assuming they are issued at P975 before
P50 flotation costs.

Problem 5: Sharapova Corporation has a 6%, P 1,000 par value bond outstanding with
10 years to maturity. The bond is currently selling for P 980. The corporation pays the
corporate tax rate of 30%. It wishes to know what the after-tax cost of a new bond issue
is likely to be. The yield to maturity on the new issue will be the same as the yield to
maturity on the old issue because the risk and maturity date will be similar.
- Compute the approximate yield to maturity on the old issue and use this as the
yield for the new issue. What is the after-tax cost of debt?
- Compute the new after-tax cost of debt if the bond is issued at P 1,200 per
bond.
- Compute the current yield if the bond is issued at P 1,200 per bond.

Problem 6: Serena Corporation plans to issue some P 90 par preferred stock with a 6%
dividend. A similar stock is selling on the market for P 100. Serena must pay flotation
costs of 3% of the issue price. The income tax rate is 30%. What is the cost of preferred
stock?

Problem 7: The P 100 par value preferred stock for Rafael Corporation pays an annual
dividend of 5%, it has required rate of return of 8%. Compute the price of the preferred
stock.

Problem 8: Wagyu Corporation’s common stock is currently trading at P 50 a share. The

stock is expected to pay a dividend of P 4 a share at the end of the year, and the dividend
is expected to grow at a constant rate of 5% year. What is its cost of common equity?

Problem 9: Forda Corporation just paid a dividend of P 10 per share on its stock. The
dividends are expected to grow at a constant rate of 5% per year, indefinitely.
1. If investors require a 12% return on Forda Corporation stocks, what is the current
price?
2. What will the price be in three years?

Problem 10: Moon Electronics wants you to calculate its cost of common stock. At
the end of 12 months the company expects to pay dividends of P1.20 per share,
and the current price of its common stock is P36 per share. The expected annual
dividend growth rate is 4% and the flotation cost is P2.50 per share.
1. Compute the cost of retained earnings.
2. Compute the cost of new common stock.
Problem 11: Use the basic equation for the capital asset pricing model (CAPM) to work
on each of the following:
a. Find the required rate of return for an asset with a beta of 1.0 when the risk-
free rate and market return are 7% and 12%, respectively.
b. Find the required rate of return for an asset with a beta of 0.80 when the risk-
free rate of return is 6% and the market risk premium is 4%.
c. Find the beta for an asset with a required return of 7.4% when the risk-free rate
and market return are 6% and 8%, respectively.

Problem 12: Cortez Corporation is expanding its research and production capability
to introduce a new line of products. Current plans call for the expenditure of P100
million on four projects of equal size (P25 million each), but different returns. Project
A is in blood clotting proteins and has an expected return of 14 percent. Project
B relates to a hepatitis vaccine and carries a potential return of 12.5 percent.
Project C, dealing with a cardiovascular compound, is expected to earn 11.8
percent and Project D, an investment in orthopedic implants, is expected to show
a 10.5 percent return.

The firm has P15 million in retained earnings. After a capital structure with P15 million
in retained earnings is reached (in which retained earnings represent 60 percent of
the financing), all additional equity financing must come in the form of new common
stock. Common stock is selling for P24 per share and underwriting costs are estimated
at P3 if new shares are issued. Dividends for the next year will be P2.00 per share
(D1), and earnings and dividends have grown consistently at 6 percent.

The yield on comparative bonds has been hovering at 9.2 percent. The investment
banker feels that the first P20 million of bonds could be sold to yield 9.2 percent while
additional debt might require a 2 percent premium and be sold to yield 11.2 percent.
The corporate tax rate is 40 percent. Debt represents 40 percent of the capital
structure.

1. Based on the two sources of financing, what is the initial weighted average cost
of capital?
2. At what capital structure size will the firm run out of retained earnings?
3. What will the marginal cost of capital be immediately after that point?
4. At what capital structure size will there be a change in the cost of debt?
5. What will the marginal cost of capital be immediately after that point?
6. Based on the information about potential returns on investments in the first
paragraph and information on marginal cost of capital (in parts 1, 3, and 5),
how large a capital investment budget should the firm use.