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MPA 10703 Financial Management Cost of Capital
MPA 10703 Financial Management Cost of Capital
Financial Management
Cost of Capital
Definition & Concept
Investors required rate of return
The minimum rate of return
necessary to attract an investor
to purchase or hold a security.
Not equal to Cost of Capital
because of
1. Taxes, and
2. Floatation Costs
Taxes
When a firm borrows money, the
interest expenses is tax deductible.
Leads to lower cost of borrowing.
Eg: A firm borrows @ 9% interest,
and interest is deducted before
paying taxes. Assuming 34% tax
rate, for each Ringgit of interest it
pays, the firm reduces its taxes by
34.
Actual cost of borrowing is 5.94%.
= (I (1-T)) = 0.09 (1 0.34)
Floatation cost
Refers to the cost associated with
issuing new securities. Eg: Legal fees,
printing prospectus, auditing, etc.
Example: A firm is issuing a new stock
@ RM25 per share, but incurs
transaction cost of RM5 per share.
Assume a required rate of return of
15%.
0.15 x RM25 = RM3.75 /year, the
amount needed to satisfy the
investors. However the firm only
Floatation cost
Thus, the cost of capital (k) calculated
as the rate of return should be earned
on RM20 net proceeds, that will yield a
return of RM3.75 is
20k = RM25 x 0.15 = RM3.75
k = RM3.75 / RM20 = 0.1875 =
18.75%
The actual cost of capital is higher than
the required rate of return.
Financial Policy
The firms policies regarding the
sources of financing and the particular
mix in which they will be used.
Weighted Average Cost of Capital
(WACC)
The average of the after-tax costs of
each of the sources of capital used by a
firm to finance a project. The weights
reflect the proportion of the total
financing raised from each source.
Determining Cost of
Capital
For Investors, the rate of return on
a security is a benefit of investing.
For Financial Managers, that same
rate of return is a cost of raising
funds that are needed to operate
the firm.
In other words, the cost of raising
funds is the firms cost of capital.
How can the firm raise
capital?
Bonds Amount of each
Preferred Stock source is determined
by the firms
Common Stock financial policy.
Kd = kd (1 - T)
D k = Dividend
p
Po Price
=
D Dividend
kps =
NPo Net Price
=
8.00__
(75 1 )
=
= 10.81%
Exercise
DCS Bhd had an issue of preferred
stock that had a market price of
RM26.25 and paid annual dividend
of RM2.06 per share. Assuming the
firm were to sell an identical issue of
preferred stock, it would incur
floatation costs of RM2.00 per share
using todays price. What is DCS
Bhds cost of preferred stock?
Cost of Common Equity