Financial Management 2

1
Cost of Capital

Cost of Capital

Welcome to another important lesson of the program- Cost of Capital. In this

module, we will study the components of the cost of capital, the calculation of
the costs of capital using the different approaches, weighted average cost of
capital.
After studying this module, you should be able to:
1. Understand the importance of computing the cost of capital.
2. Understand more of the investor-supplied capital- debt, preferred shares,
and ordinary equity shares.
3. Compute the after-tax cost of debt, cost of preferred shares, cost of
ordinary equity using the different methods, cost of retained earnings.
4. Calculate the weighted average cost of capital.

Introduction
Cost of Capital includes the cost of debt and the cost of equity. The company
employs debt, preferred shares and ordinary equity to raise funds for new
projects. It is the required return needed to make a capital budgeting
decision or project.
Capital structure describes how a company finances its overall operations
and growth using a variety of finance sources. It is a mixture of long-term
debt (bonds), some specific short-term obligations, and ordinary and
preferred equities.

Controllable Factors Affecting Cost of Capital

A company has control over some of the factors that affect cost of capital.
These factors are
1. Capital Structure Policy- A company has control over its capital structure.
More debts or bonds issued mean increases in cost of debt so with the
equities.
2. Dividend Policy – a company can also control its payoff ratio.
3. Investment Policy- Changes in investment policies in relation to the
degree of risk cause changes in the cost of debt and cost of equity.
There are also some uncontrollable factors that affect the cost of capital.
1. Level of Interest Rates- as the level of interest rates goes up so with the
cost of debt.
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 2. Tax rate- this affects the after-tax cost of debt. As the tax rate increases,
the cost of debt decreases,

Capital Component Costs

Capital components refer to the capital items shed out by the investors such
as debt, preferred shares and ordinary shares.
The costs of capital consist of cost of debts (interest), preferred shares and
ordinary shares (dividend s).
1. Cost of Debt ( Kd)
This is the investors’ minimum required rate of return.
The before-tax cost of debt is the interest rate a company must pay on its
new debt. This can be estimated by asking the bankers what it will
borrow or by finding the yield to maturity.
The after-tax cost of debt is the interest rate on new debt minus the tax
savings that resulted out of interest being a tax deductible item. The after-
cost of debt is used in calculating the weighted average cost of capital
(WACC). Its formula is:
After-tax cost of debt = Interest Rate X (1-tax rate)
Interest is tax deductible that is why, it is said that the government pays a
part of the cost of debt.
Example: EBC Corporation borrows at an interest rate of 15% and the
corporate tax rate is 32%, its after-tax cost of debt is 10.2%, computed as
follows:
+After-tax cost of debt = 15% x (1-32%) = 10.2%

Calculating the Cost of a New Bond Issue

The cost of a new bond issue can be calculated following the three steps:
a) Determine the net proceeds from the sales of each bond. Use the
following formula:
Net proceeds of a bond sale = Market Price –Flotation Costs
b) Get the before-tax cost of the bond
The before-tax cost of the bond is the coupon rate which is the
interest rate paid on the bond’s par value. This is so, if the flotation
cost is required. Give emphasis on the interest rate on new debt not
on the outstanding or past debt because the concern here is the cost of
capital for capital budgeting decision. The yield to maturity on
outstanding debt, reflecting the current market condition, is a better
alternative that the coupon rate. The before-tax cost on a new bond
issue also refers to the yield to maturity or cost to maturity.
The before-tax rate of the debt issue is the rate of return that parallels
the present value of the future interest payments and the principal
payments with the net proceeds from the sale of the bonds. The
formula is:
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Cost of Capital

NPd = I (PVIFAkd,n) + Pn (PVIFkd,n)

Where: NPd = Net proceeds from the sale of bond, Pd-f
I = Annual interest Payments in pesos
Pn = Par of principal repayment required in period n
kd = Before-tax cost of a new bond issue
n = length of the holding period of the bond in years
t = time period in years
PVIFA = Present value interest factor of an annuity
PVIF = present value interest factor of a single amount
Pd-f = (Market price-flotation cost)
c) Calculate the after-tax cost of debt using the equation
kdt = kd (1-T)
Where: kdt = After-cost of debt
kd = Before-tax cost of debt
T = marginal tax rate

Illustrative Problem 5.1 Financing Through Issuance Of Bonds

EBC Corporation intends to issue 20-year bonds with a face value of P5,
000,000. Par value per bond is P5, 000 and carries a coupon rate of 9.5%. The
bond is expected to sell for 95 percent of par value. The flotation costs are
estimated at P 30 per bond and the company’s marginal tax rate is 32%.
Interest payments are made annually.
Required: Calculate the following: a) net proceeds per bond, b) before-tax
cost of the bond, c) after-tax cost of the bond
Solutions:
a) Net proceeds of a bond sale = Market Price –Flotation Costs
= (P5, 000 x .95) - P30
= P 4,750 – P30
= P4, 720

b) The before-tax cost of the bond (using trial and error approach; trial at
10%)

NPd = I (PVIFAkd,n) + Pn (PVIFkd,n)

P4, 720 = P475 (8.51356) + P 5,000(.14864)

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 P 4,720 = P 4,043.94 + P743.20
P 4,720 = P4, 787.14

Kd = P 475 + (P5, 000-P4, 720)/ 20

(P5, 000 + P 4,720)/2
= P489 / P 4,860
= 10.06%

c) The after-tax cost of new bond is

Kdt = kd (1-T)
= 10.06% (1-.32)
= 6.84%

2. Cost of Preferred Share

Preferred share is a hybrid security with properties of both equity and a
debt. It represents degree of ownership in a firm but doesn’t have voting
rights. It is paid-off dividends before ordinary shareholder, but, after the
bondholders. Just like bonds, preferred shares are rated by major credit
rating companies and some people consider them to be more like debt than
equity.

If preferred share is considered as debt, computation of the cost of capital is

the same as number 1. If it has fixed dividend payments and no stated
maturity dates, the cost of capital of new preferred share is calculated using
the following formula:
Kp = Dp / NPp

Where: Dp = Annual dividend per share on preferred shares

NPp = Net proceeds from the sale of preferred share, (market price –
flotation costs)

Note: in lieu of net proceeds from the sale of preferred share, current market
price per preferred share is used.

Illustrative Problem 5.2 Calculating Cost of Preferred Share

EBC Company plans to sell P 100 par value preferred shares. Estimated
annual dividend payment is P 10.00. Flotation cost is P 5.

Required: the cost of preferred share

Solution: Kp = Dp / NPp
= P10 / P95
= 10.53%

3. Cost of Ordinary Equity Share

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Cost of Capital

The cost of ordinary shares is more difficult to calculate as compared to

bonds and preferred shares, simply because it does not represent a
contractual commitment to make specific payments.
External sourcing of capital involves selling ordinary shares while
obtaining funds internally is through the retained earnings. Retained
Earnings is the portion of the after-tax earnings not distributed to the
shareholders, instead, they are reinvested by the firm in it.
The cost of the current ordinary shares and retained earnings are just the
same and no flotation costs adjustment is being made. The cost of new
ordinary shares and retained earnings are not equal. The earlier is higher
than the latter because of the flotation costs incurred in selling ordinary
shares which in turn reduced the net proceeds of the company.
Therefore, the firm will apply the lower-cost retained earnings prior to
their issuance of new ordinary shares.

3.1 The Cost of Ordinary Equity

3.1.1 CAPM Approach
Capital Asset pricing Model (CAPM) is the most widely used
method of approximating the cost of ordinary shares. This
requires the following steps:
a) Estimate the risk-free rate (rRF). This generally uses the 10-
year Treasury bond rate as the risk-free rate, but short-
term Treasury bill rate is also applied in some analysis.
b) Estimate the share’s beta coefficient ( bi) and use it as an
index of the share’s risk. The i represents the ith company’s
beta. Beta coefficient, b is a metric that shows the extent to
which a given share returns goes up and down with the
share market. This measures the systematic market risk of
the asset relative to the average.
c) Estimate the expected market risk premium. Market risk
premium is the difference between the return that
investors require on an average share and the risk-free
rate.
d) Substitute the preceding values in the CAPM formula to
calculate the required rate of return on the share:
rs = rRF + (RPm) bi
= rRF + (RM - rRF) bi
Thus, the CAPM estimate of is equal to the risk-free
rate (rRF ) plus a risk premium that is equal to the risk
premium on an average share (RM - rRF ) scaled up and

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 down to reflect a particular stock’s risk as measured by its
beta coefficient (bi).

Illustrative Problem 5.3 Cost of Equity using the CAPM

Taking the following assumptions: risk-free rate in current market
situation is 6.5%, market risk premium is 6% and beta is 1.75,
What is the estimated cost of equity?
Solution: rs = rRF + (RPm) bi
= 6.5% + (6%) (1.75)
= 17%

Illustrative Problem 5.4 Cost of Equity

EBC Corporation’s ordinary shares sell at P 35 each. The company sets
their next future dividend at P 1.85 per share and expects a growth of
5% per year, indefinitely. The current risk-free rate is 3.5%, the
expected market return is 10% and its beta is 1.6.
What will the company’s cost of equity be?
Solution:
rs = rRF + (RPm) bi
= rRF + (RM - rRF) bi
= .035 + (.10- .035) (1.6)
= 13.9%
This approach is also applied in computing the cost of retained
earnings.

3.1.2 Bond Yield Plus Risk Premium Approach

The bond-yield-plus-risk-premium required rate of return on
shareholder’s equity. The formula is:
Ks = kd + rp
Where: kd = Base rate of long-term bonds or bond-yield
rp = Risk premium
The base rate is often the rate on treasury bonds or the
company’s own bonds. The risk premium is based on a
judgmental estimate.

Illustrative Problem 5.5 Calculating the Cost of Equity Using

the Bond Yield plus Risk Premium Model
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Cost of Capital

EBC Company has a 9% long-term bond rate. The firm

estimates that the cost of equity should require a 2.5% risk
premium above the cost of its bonds.
What is the cost of the equity using this approach?
Solution: Ks = kd + rp
= 9% + 2.5%
= 11.5%

3.1.3 Dividend Yield Plus Growth Rate Approach

The price and the expected rate of return of ordinary share
depend on the share’s expected cash flows (dividends). The
required rate of return on ordinary equity is equal to the
expected rate of return. The formula;
Ks = (DI / Po) + g
Where: Ks = cost of required rate of return of ordinary
equity
DI = dividend expected to be paid at the end of
Year 1
Po = current stock price
g = expected dividend growth rate

3.1.4 Discounted Cash Flow (DCF) Approach

The DCF method, aside from the dividend yield, also considers
the capital gain for a total expected return which is also the
required rate of return. The equation to calculate the cost of
equity follows:
Ks = (DI / Po) + expected g

Illustrative Problem 5.6 Calculating the cost of equity

under the DCF Approach
EBC Company sells its share for P 35.50 with the next expected
dividend of P 2.20. Expected growth rate is 9%.
What is the cost of equity?
Solution:
Ks = (DI / Po) + expected g
= (P 2.20 / P35.50) + 9%
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 = 15.20%

Based on this approach, the minimum rate of return of 15.20%

should be earned on retained earnings to warrant reinvesting
earnings back into the business rather than paying them out to
shareholders as dividends.

3.1.5 Earnings-Price Ratio Method

The earnings-price ratio method is a simple method in
estimating the cost of ordinary equity because it is based on
readily available information. This is based on the inversed
firm’s price –earnings ratio.
The equation is:
Ks = E / Po
Where: E = current earnings per share
Po = current market price of ordinary equity share.

Illustrative Problem 5.7 Calculation of cost of Equity using

the Earnings-Price Ratio
For the past years, the earnings per share of EBC Company are
P 8.75 and its ordinary shares are being sold at P 50 each.
What is the cost of retained earnings?
Solution:
Ks = E / Po
= P8.75 / P50
= 17.5%

3.2 Cost of the New Ordinary Equity

Generally, the Constant Growth Model for Ordinary Equity Share is
used in measuring the cost of the new ordinary equity share. This
model assumes that dividends grow at a constant annual rate. The
estimated dividend growth rate is based on historical growth rates or
on analysis forecast. The formula is:
Ks = (Di / NPs) + g
Where : Ks = cost of the new ordinary equity share
Di = Dividends to be received during the year
[Do ( i +g)]
Do = dividend yield
NPs = net proceeds of the new ordinary shares issue
(Po – F)
Po = current market price of the firm’s ordinary equity
F = Flotation costs
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Cost of Capital

g = dividend growth rate

The cost of new ordinary share is greater than the cost of retained
earnings due to the adjustment for flotation costs. The flotation costs
include underpricing and underwriting fee. Underwriting fee is the
cost of marketing ne price is below the current market price of the
outstanding ordinary equity.
Illustrative Problem 5.8 Calculation of Flotation-adjusted cost of
Equity
EBC Corporation‘s ordinary equity’s current market price is P50 and
an expected dividend growth rate of 6%. It is also expected to give P
4.00 per share dividend next year. The sale of ordinary share has an
underpricing of P 1.50 per share and underwriting fees of P1 per
share.
What is the cost of ordinary share?
Solution:
Ks = (Di / NPs) + g
= P4 / (P50-P2.50) + 6%
= 14.42%

4. Cost of Retained Earnings

Opportunity costs are the cost of retained earnings. Retained earnings are
the income left in the firm after all the dividends are paid and there is no
direct cost associated with this.
Management should understand that there is an opportunity cost involve
should the shareholders received the earnings as dividends and have
invested the same in other securities.
As previously mentioned, the cost of ordinary equity share is the same as
the cost of retained earnings.

Weighted Average Cost of Capital Calculation

Weighted average cost of capital (WACC) is an estimate of a firm's cost of
capital in which each category of capital is proportionately weighted. All
capital sources - common stock, preferred stock, bonds and any other long-
term debt - are included in a WACC calculation.
The WACC can be computed as follows:
WACC = (% of debt) (After-tax cost of debt) + (% of Preferred Shares) (Cost
of Preferred Shares) + (% of Ordinary Equity) (Cost of Ordinary Equity)

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 You will notice that only debt has an adjustment (1-T). This is because
interest on debt is tax deductible while dividends on preferred and ordinary
equities are not.
Methods in Computing WACC
1. Historical weights
1.1. Book value weights
1.2. Market value weights
2. Target Weights

The firm based their historical weights on its current capital structure
which it believes to be optimal. An optimal capital structure is the debt
and equity combination that maximizes the company’s market value and
minimizes its WACC at the same time
There are two kinds of historical weights: Book value weights and market
value weights.
Book value weights determine the actual proportion of each kind of
permanent capital in the structure based on accounting values reflected
in the Statement of Financial Condition or Balance Sheet. This may not
give a useful cost of capital for assessing current strategies because this
may not state the WACC correctly as it ignore the variable market values
of bonds and equity.
Market value weights calculate the actual proportion of each type of
permanent capital in the company’s structure at current market prices.
This weight is better than the book value weights as it stipulates
estimates of investors required rate of return. But these weights are less
stable in computing cost of capital because of the changing market prices.

Illustrative Problem 5. 9. Calculation of WACC using historical weights

EBC Company has the following data available on its capital structure:
Current Capital Structure
at Book Values
Specific
Sources of Capital Amount Proportion Cost
Bonds (P1,000 par 10%
coupon) P15,000,000 20% 7.50%
Preferred Shares, 150,000 shares
@P50 par 7,500,000 10% 11.00%
Ordinary Equity , 1,500,000
shares at P25 par 37,500,000 50% 14.00%
Retained Earnings 15,000,000 20% 13.50%
Total P 75,000,000 100%

Required: Calculate the WACC if the firm acquires new capital in book value
proportions.
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Cost of Capital

Solution:
Weighted
cost
Sources of Capital Proportion Specific cost of Capital
Bonds 20% 7.50% 1.50%
Preferred Shares 10% 11.00% 1.10%
Ordinary Equity
Shares 50% 14.00% 7.00%
Retained Earnings 20% 13.50% 2.70%
100% 12.30%

Adding the following data/assumptions in the problem above, compute for the
company’s WACC if the firm acquires new capital in market value proportions.
Securities Market prices
Bonds P 950 per bond
Preferred Shares P 50 per share
Ordinary Share P 50 per share

Solution:
Current Capital Structure
at Book
Values Weighted
Sources of Capital Amount (P) Proportion Specific Cost CC
Bonds (P980 par x 15,000 14,700,000 15% 7.50% 1.13%
Preferred Shares, 150,000
shares
@P50 par 7,500,000 8% 11.00% 0.88%
Ordinary Equity , 1,500,000
shares at P50 par 53,250,000 55% 14.00% 7.77%
Retained Earnings 21,750,000 22% 13.50% 2.97%
Total 97,200,000 100% 12.75%

Allocation of Ordinary share market value of P75,000,000 (1,500,000 X P50) using the
proportion to the sum of their book value.

Book Value Proportion Allocation

Ordinary Equity 37,500,000 71% 53,250,000

Retained Earnings 15,000,000 29% 21,750,000

52,500,000 100% 75,000,000

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Target Weights

Using target weights, company tries to establish proportions of capital structure

based on the optimal structure they want to achieve. In doing so, it make use of
market values instead of historical weights. This will maximized the share price and
lessen the cost of capital simultaneously.

Illustrative Problem 5.10 Using the problem 5.9 and adding the following data,
Compute the WACC if the firm intends to raise new capital in target proportions.

EBC Company has established its optimal capital structure as follows:

Bonds 20%
Preferred Shares 15%
Ordinary Shares 65%

Solution:

Target Weights Specific Costs Weighed Cost of Capital

Bonds 20% 7.5% 1.50%
Preferred Share 15% 11.0% 1.65%
Ordinary Equity Share 65% 14.0% 9.10%
12.25%

References and Online References

Book References

Brigham, Eugene, Houston, Joel (2012) fundamentals of Financial Management,

South-Western Cengage Learning, Ohio, USA.

Cabrera, Ma. Elenita Balatbat (2015) Financial Management, Principles and

Applications, Vol. 2. GIC Enterprises Co. Inc. Manila

Horngren, Charles T., Harrizon Jr., Walter T, & Bamber, Linda S. Accounting. Fifth
Edition. Prentice Hall International Edition

Medina, Roberto G. (2016 reprint) Business Finance. Rex Book Store, Manila.

Supplementary Reading Materials

A Refresher on Cost of Capital - Harvard Business Review

https://hbr.org/2015/04/a-refresher-on-cost-of-capital
Apr 30, 2015 - “The cost of capital is simply the return expected by those who
provide capital for the business,” says Knight. There are two groups of people ...
Accessed: October 31, 2017

What is the cost of capital? - IESE Business School | Coursera

https://www.coursera.org/learn/corporate.../lecture/mey84/1-what-is-the-cost-
of-capita...
Feb 1, 2016 - In this session we will discuss how companies assess their cost of debt,
their cost of equity, and ultimately their cost of capital. We will also ...
 Financial Management 2
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Cost of Capital

Accessed: October 31, 2017

Do You Know Your Cost of Capital? - Harvard Business Review

https://hbr.org/2012/07/do-you-know-your-cost-of-capital
Read more. That's a big problem, because assumptions about the costs of equity and
debt, overall and for individual projects, profoundly affect both the type and ...
Accessed: October 31, 2017

Supplementary Online Videos

Introduction to cost of capital - YouTube

https://www.youtube.com/watch?v=jKCz36tPjsk
Apr 20, 2015 - Uploaded by CA N Raja Natarajan
Did you liked this video lecture? Then please check out the complete course related
to this lecture, FINANCIAL ...
Accessed: October 31, 2017

Cost Of Capital - Video | Investopedia

www.investopedia.com/video/play/cost-capital/
Cost of capital is the cost of funds used to fin
Accessed: October 31, 2017

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