z

COST OF CAPITAL
z IMPORTANCE OF
Cost of capital is defined as the financing costs a
company has to pay when borrowing money, using: COST OF CAPITAL
 equity financing
 How companies will finance a project
 selling bonds or make an investment is an important
In each case, the cost of capital is expressed as an decision, since that choice will
annual interest rate, such as 7%. determine a firm's capital structure.

Beta is the volatility of a company's financial results
to determine whether a certain stock is too risky or
would make a good investment.  their operations and fund their
When weighing a big investment, like funding a new
manufacturing plant, the cost of capital represents
the return rate the company could garner if it
invested cash in an alternative investment, with the
same risk applied.
 Cost of capital is very important to
companies who need capital to expand
business.
 At minimum, any capital used by a
company must have a minimum return
that's in line with what shareholders,
stakeholders, and lenders expect for
the use of their money.
z
CAPITAL ASSET PRICING MODEL
where:
R= Cost of capital (rate of return)
R = rf + B (rm-rf) rf = the rate of return on risk-free securities
(typically Treasuries)
B = the beta of the investment in question
rm = the market's overall expected rate of return

Example:
The return on market portfolio is 12% and risk free rate is 5%. The beta
coefficient is 1.4.
 
R = rf + B (rm-rf)
= 5%+1.4(12%-5%)
= 14.8%
 z
DIVIDEND GROWTH MODEL
Cost of New Ordinary Shares
Example:
Re = [D1 / P0(1-Flotation Cost)] + g
Common Stock has a par value of P10
where: and is selling for P42 per share, net of P3
Re = Cost of Capital per share flotation cost. The company
had a P3.6 dividend per share in 2018
D1 = Dividends/share next year
and a growth rate of 9% per year.
P0 = Current market price
Cost = [D1 / P0(1-Flotation Cost)] + g
g = Dividend growth rate (it is assumed
that this is constant) = [(P3.6*1.09)/42]+9%

Flotation cost= cost of issuing new =18.34%

securities
 
z
Cost of Retained
Earnings
Re = (D1 / P0) + g
where:
Re = Cost of Capital
D1 = Dividends/share next year
P0 = Current share price
g = Dividend growth rate (it is
assumed that this is constant
Example:
Common Stock has a par value of
P10 and is selling for P42 per
share, net of P3 per share flotation
cost. The company had a P3.6
dividend per share in 2018 and a
growth rate of 9% per year.
Cost of RE= (D1 / P0) + g
=[(P3.6*1.09)/42+3] + 9%
= 17.72%
z

PREFERRED STOCK COST OF DEBT

Rp = D / P0 Effective Interest rate (1-Tax rate)

Where: Example:
D= dividends
The 10% yield on bonds is applicable
P0= Current price to a maximum of 70M bonds. The
Example: corporate tax rate is 30%.
16% Preferred Stock, 100 par value. Cost of bonds= Effective Interest rate
Preferred Stock may be issued at par. (1-Tax rate)
Cost = Dividends/ Current Price = 10% (1-30%)
= (P100*16%)/100
= 7%
= 16%
z
WEIGHTED AVERAGE COST OF
CAPITAL
We use WACC by getting the average cost of financing, which is
weighted by its proportion to the total capital structure. With this, we
could determine how much interest a company owes for each peso
financed.

WACC = [(E/Cs)*(Re)] + [(D/Cs)*(Rd)]

where:
E/Cs = proportion of equity over the total capital structure
D/Cs =proportion of debt over the total capital structure
Re = cost of equity
Rd = cost of debt
 Example: WACC if the cost of RE was used
z At the end of 2019, Y Corp had the following capital structure Source of Cost of Proportion Weighted
considered to be optimal (in millions of pesos). Fund Capital of Funds Cost
Amount %
42.00 25%
Bonds 7% 25% 1.75%
Debt (10% coupon Bonds

16% Preferred Stock, 100 par value 25.20 15%

Preferred 16% 15% 2.4%
Common Stock and RE 100.80 60% Stock
RE 17.72% 60% 10.63%

Preferred Stock may be issued at par. Common Stock has a

WACC 14.78%
par value of P10 and is selling for P42 per share, net of P3 per
share flotation cost. The company had a P3.6 dividend per
share in 2018 and a growth rate of 9% per year. The 10% yield
on bonds is applicable to a maximum of 70M bonds. The
corporate tax rate is 30%. WACC if the cost of common
Solution stocks is used
Cost of bonds = Effective Interest rate (1-Tax rate)
Source of Cost of Proportion Weighted
= 10% (1-30%) Fund Capital of Funds Cost
= 7%
  Bonds 7% 25% 1.75%
Cost of Preferred Stock= Dividends/ Current Price
= (P100*16%)/100 Preferred 16% 15% 2.4%
Stock
= 16%
  Common 18.34% 60% 11.00%
Stock
Cost of RE = (D1 / P0) + g
WACC 15.15%
=[(P3.6*1.09)/42+3] + 9%
= 17.72%
 
Cost of Capital= [D1 / P0(1-Flotation Cost)] + g
= [(P3.6*1.09)/42]+9%
=18.34%