Module 3 - FINANCIAL RISK MANAGEMENT

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Lesson 2 – Cost of Capital
 Module 3 - FINANCIAL RISK MANAGEMENT
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Lesson 2 – Cost of Capital

Lesson 2: Cost of Capital

SPECIFIC LEARNING OUTCOMES

In this lesson, you should be able to:

1. describe costs of capital;

2. understand the concept of costs of capital;
3. analyze the problem in determination of cost of capital;
4. compute the investor supplied capital.

PRE-ASSESSMENT

Instructions: Answer each of the following multiple-choice questions. Choose the letter of your choice.

1. CHOOSE: (A) if C alone support the test stem… (B) if neither B nor A supports the test stem… (C) if D
alone support the test stem… (D) if A alone support the test stem…

The key sources of value (earning an excess return) for a company can be attributed primarily to __________.

A. competitive advantage and access to capital

B. quality management and industry attractiveness

C. access to capital and quality management

D. industry attractiveness and competitive advantage

a. A
b. B
c. C
d. D
2. CHOOSE: (A) if C alone support the test stem… (B) if A alone support the test stem… (C ) if D alone
support the test stem… (D) if B alone support the test stem…

The overall (weighted average) cost of capital is composed of a weighted average of __________.

A. the cost of common equity and the cost of debt

B. the cost of common equity and the cost of preferred stock

C. the cost of preferred stock and the cost of debt

D. the cost of common equity, the cost of preferred stock, and the cost of debt

a. A
b. B
c. C
d. D
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Lesson 2 – Cost of Capital

3. CHOOSE: (A) if neither D nor C supports the test stem… (B) if A alone support the test stem… (C ) if
C alone support the test stem… (D) if B alone support the test stem…

For which of the following costs is it generally necessary to apply a tax adjustment to a yield
measure?
A. Cost of debt

B. Cost of preferred stock

C. Cost of common equity

D. Cost of retained earnings

a. A
b. B
c. C
d. D

4. CHOOSE: if (A) B alone support the test stem… (B) D alone support the test stem… (C ) if neither A
nor D supports the test stem… (D) if C alone support the test stem…

Which of the following is not a recognized approach for determining the cost of equity?

A. Dividend discount model approach

B. Before-tax cost of preferred stock plus risk premium approach

C. Capital-asset pricing model approach

D. Before-tax cost of debt plus risk premium approach

a. A
b. B
c. C
d. D

5. CHOOSE: I(A) if C alone support the test stem… (B) if A alone support the test stem… (C ) if D alone
support the test stem… (D) B alone support the test stem…

Jacques Fauxpas is attempting to determine his company's weighted-average cost of capital. His first step was
to determine the required rates of return for his company's long-term debt, preferred stock, and common stock.
He then adjusted these required rates of return by multiplying each return by one minus the company's marginal
tax rate. Jacques is planning on using these three adjusted required return figures as his component costs of
capital. How is Jacques doing so far?

A. All three of Jacques' component cost figures are

B. All three component cost figures are

C. Only the required return (yield) on preferred stock and debt should have been adjusted for taxes

D. Only the required return (yield) on debt should have been adjusted for taxes

a. A
b. B
c. C.
d. D

6. CHOOSE: (A) if D alone support the test stem… (B) if A alone support the test stem…(C ) if B alone
support the test stem… (D) if C alone support the test stem…
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Lesson 2 – Cost of Capital

A company that has more than half of its voting shares owned by another company is generally referred
to as a __________ of the other firm.

A. joint-venture partner

B. Proxy

C. Subsidiary

D. division

a. A
b. B
c. C
d. D

7. CHOOSE: (A) if C alone support the test stem… (B) if A alone support the test stem… (C ) if D alone
support the test stem… (D) if B alone support the test stem…

Which of the following is correct regarding the capital component costs for a group?

A. The component cost of common equity is based on the firm's component cost of common equity

B. The component cost of debt is based on the firm's component cost of debt

C. Both of the above answers are correct

D. A proxy firm is a privately held firm in the same industry as the firm

a. A
b. B
c. C
d. D

8. CHOOSE:(A) if B alone support the test stem.. (B) if D alone support the test stem… (C ) if A alone
support the test stem… (D) if C alone support the test stem…

Choose the right statement from the following:

A. Cost of debt is always higher than cost of equity

B. Cost of debt can be higher or lower than cost of equity

C. Cost of debt is always lower than cost of equity.

D. When company doesn't pay dividend, the cost of equity is zero

a. A
b. B
c. C
d. D

9. CHOOSE:(A) if B alone support the test stem… (B) if neither D nor A supports the test stem… (C ) if C
alone support the test stem… (D) if A alone does not support the test stem…

A firm should use .............. when evaluating an investment

A. the least costly source of financing

B. the weighted average cost of all financing sources

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Lesson 2 – Cost of Capital

C. the most costly source of financing

D. the current opportunity cost

a. A.
b. B
c. C
d. D

10. CHOOSE: (A) if B alone support the test stem… (B) if D alone support the test stem… (C ) if A alone
support the test stem… (D) if C alone support the test stem…

A corporation has concluded that its financial risk premium is too high. In order to decrease this, the
firm can

A. increase the proportion of short term debt to decrease the cost of capital

B. increase the proportion of long term debt to decrease the cost of capital

C. increase the proportion of common stock equity to decrease financial risk

D. decrease the proportion of common stock equity to decrease financial risk

a. A
b. B
c. C
d. D

LESSON MAP

COSTS OF CAPITAL

Understanding Cost of Problems in Determination

Capital External Equity of Cost of Capital

The map shows that the cost of capital is the average rate of return required by
the investors who provide long-term funds. In other words, cost of capital refers to the
minimum rate of return a firm must earn on its investment so that the market value of
company's equity shareholders does not fall.
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Lesson 2 – Cost of Capital

CORE CONTENTS

ENGAGE: Describing Costs of Capital

Activity 1: Photo Analysis

Instruction: Analyze the given picture and answer the given questions in 1-3 sentences.

1. Define in your own words the costs of capital?

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2. What is the difference between a value from a price?

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Lesson 2 – Cost of Capital

EXPLORE: Understanding the Concept of Costs of Capital

Activity 2: Reading Activity

Instruction: Read and understand each concept and answer the given questions after reading.

a. COSTS OF CAPITAL

- is the rate of return the firm expects to earn from its investment in order to increase the value of the firm
in the market place. In other words, it is the rate of return that the suppliers of capital require as compensation
for their contribution of capital.

- is the required return necessary to make a capital budgeting project, such as building a new factory,
worthwhile. When analysts and investors discuss the cost of capital, they typically mean the weighted average
of a firm's cost of debt and cost of equity blended together.

Many companies use a combination of debt and equity to finance their businesses and, for such companies,
the overall cost of capital is derived from the weighted average cost of all capital sources, widely known as the
weighted average cost of capital (WACC).

Debt- an amount of money that you owe to a person, bank, company, etc. and that they usually have
to pay interest on

Equity- represents the amount of money that would be returned to a company’s shareholders if all of
the assets were liquidated and all of the company's debt was paid off in the case of liquidation.

a. Capital budgeting is the process a business undertakes to evaluate potential major projects or
investments. Construction of a new plant or a big investment in an outside venture are examples of projects
that would require capital budgeting before they are approved or rejected.

As part of capital budgeting, a company might assess a prospective project's lifetime cash inflows and outflows
to determine whether the potential returns that would be generated meet a sufficient target benchmark. The
capital budgeting process is also known as investment appraisal.
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Lesson 2 – Cost of Capital

Understanding Cost of Capital

Cost of capital represents a hurdle rate that a company must overcome before it can generate value, and
it is used extensively in the capital budgeting process to determine whether a company should proceed with
a project.

Hurdle Rate- is the minimum rate of return on a project or investment required by a manager or investor. It
allows companies to make important decisions on whether or not to pursue a specific project.

The cost of capital concept is also widely used in economics and accounting. Another way to describe the
cost of capital is the opportunity cost of making an investment in a business. Wise company management
will only invest in initiatives and projects that will provide returns that exceed the cost of their capital.

Opportunity Costs- represent the potential benefits an individual, investor, or business misses out on when
choosing one alternative over another. The idea of opportunity costs is a major concept in economics.

Because by definition they are unseen, opportunity costs can be easily overlooked if one is not careful.
Understanding the potential missed opportunities foregone by choosing one investment over another allows
for better decision-making.

Cost of capital, from the perspective of an investor, is the return expected by whoever is providing the
capital for a business. In other words, it is an assessment of the risk of a company's equity. In doing this,
an investor may look at the volatility (beta) of a company's financial results to determine whether a certain
stock is too risky or would make a good investment.

Volatility- is a statistical measure of the dispersion of returns for a given security or market index.

In the securities markets, volatility is often associated with big swings in either direction. For example, when
the stock market rises and falls more than one percent over a sustained period of time, it is called a "volatile"
market. An asset's volatility is a key factor when pricing options contracts.

How to Calculate Costs of Capital?

To calculate the weighted average cost of capital, all forms of debt and equity are considered. As a result, the
weighted average cost arrives at a blended rate. Broadly speaking, to calculate the cost of debt, the company’s
interest rate on its debt is divided by a company’s total debt. Meanwhile, to calculate the cost of equity, investors
use a capital asset pricing model, which arrives at an approximate value. This is calculated by taking the risk-
free rate of return, which is then added to the value of beta multiplied by the market rate of return minus the
risk free rate of return.

Example:

Suppose, a company started a project of shopping mall construction for that it took a loan of $1,000,000 from
the bank, cost of equity is $500,000. Now, one has to calculate the cost of capital for the project.

Cost of Capital = Cost of Debt + Cost of Equity

Cost of Capital = $1,000,000 + $500,000

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Lesson 2 – Cost of Capital

Cost of Capital = $1,500,000

So, the cost of capital for project is $1,500,000.

External Equity

External equity the situation that exists when an organization's pay rates are at least equal to market
rates. It is also known as matching strategy. An employer's goal should be to pay what is necessary to attract,
retain and motivate a sufficient number of qualified employees. This requires a base pay program that pays
competitively. Among others, internal data such as turnover rates and exit interviews can be helpful in
determining the competitiveness of pay rates.

Employees also compare their jobs and pay to the jobs and pay in other organizations. Generally,
employees consider much more than base pay in determining external equity. Depending on the employee,
more weight may be given to employee benefits, job security, physical work environment, commuting distance,
opportunity for advancement and the employee relations practices of the employer in determining external
equity issues.

An important issue to employees in determining external equity is the transferability of their skills. If an
employee's skills are valued more highly in a different type of job or industry in the area, the employee may
believe that s/he is being treated inequitably.

Problems in Determination of Cost of Capital

It has already been stated that the cost of capital is one of the most crucial factors in most financial
management decisions. However, the determination of the cost of capital of a firm is not an easy task. The
finance manager is confronted with a large number of problems, both conceptual and practical, while
determining the cost of capital of a firm. These problems in determination of cost of capital can briefly be
summarized as follows:

1. Controversy regarding the dependence of cost of capital upon the method and level of
financing
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Lesson 2 – Cost of Capital

There is a, major controversy whether or not the cost of capital dependent upon the method and level of
financing by the company. According to the traditional theorists, the cost of capital of a firm depends upon the
method and level of financing. In other words, according to them, a firm can change its overall cost of capital by
changing its debt-equity mix.

2. Computation of cost of equity

The determination of the cost of equity capital is another problem. In theory, the cost of equity capital may be
defined as the minimum rate of return that accompany must earn on that portion of its capital employed, which
is financed by equity capital so that the market price of the shares of the company remains unchanged. In other
words, it is the rate of return which the equity shareholders expect from the shares of the company which will
maintain the present market price of the equity shares of the company. This means that determination of the
cost of equity capital will require quantification of the expectations of the equity shareholders. This is a difficult
task because the equity shareholders value the equity shares on the basis of a large number of factors, financial
as well as psychological. Different authorities have tried in different ways to quantify the expectations of the
equity shareholders. Their methods and calculations differ.

3. Computation of cost of retained earnings and depreciation funds

The cost of capital raised through retained earnings and depreciation funds will depend upon the approach
adopted for computing the cost of equity capital. Since there are different views, therefore, a finance manager
has to face difficult task in subscribing and selecting an appropriate approach.

4. Future costs versus historical costs

It is argued that for decision-making purposes, the historical cost is not relevant. The future costs should be
considered. It, therefore, creates another problem whether to consider marginal cost of capital, i.e., cost of
additional funds or the average cost of capital, i.e., the cost of total funds.

5. Problem of weights

The assignment of weights to each type of funds is a complex issue. The finance manager has to make a
choice between the risk value of each source of funds and the market value of each source of funds. The
results would be different in each case. It is clear from the above discussion that it is difficult to calculate the
cost of capital with precision. It can never be a single given figure. At the most it can be estimated with a
reasonable range of accuracy. Since the cost of capital is an important factor affecting managerial decisions,
it is imperative for the finance manager to identify the range within which his cost of capital lies.

EXPLAIN: Deepening My Thoughts

Activity 3: Enrichment Activity

Instructions: Based on your own understanding of the lesson answer the following questions below.

1. What are the problems in determining cost of capital?

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Lesson 2 – Cost of Capital

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2. Why is it important for pay to be externally fair?

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3. What is a cost of capital?

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TOPIC SUMMARY
In this lesson, you learned that,

⚫ Cost of capital represents the return a company needs in order to take on a capital project, such as
purchasing new equipment or constructing a new building.

⚫ Cost of capital typically encompasses the cost of both equity and debt, weighted according to the
company's preferred or existing capital structure, known as the weighted average cost of capital (WACC).

⚫ A company's investment decisions for new projects should always generate a return that exceeds the
firm's cost of the capital used to finance the project; otherwise, the project will not generate a return for
investors.

POST-ASSESSMENT
Instructions: Answer each of the following multiple choice questions. Choose the letter of your choice.

1. CHOOSE: (A) if C alone support the test stem… (B) if neither B nor A supports the test stem…
(C ) if D alone support the test stem… (D) if A alone support the test stem…

The key sources of value (earning an excess return) for a company can be attributed primarily
to __________.

A. competitive advantage and access to capital

B. quality management and industry attractiveness
C. access to capital and quality management
D. industry attractiveness and competitive advantage
 Module 3 - FINANCIAL RISK MANAGEMENT
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Lesson 2 – Cost of Capital

a. A
b. B
c. C
d. D
2. CHOOSE: (A) if C alone support the test stem… (B) if A alone support the test stem… (C ) if D
alone support the test stem… (D) if B alone support the test stem…

The overall (weighted average) cost of capital is composed of a weighted average of __________.

A. the cost of common equity and the cost of debt

B. the cost of common equity and the cost of preferred stock
C. the cost of preferred stock and the cost of debt
D. the cost of common equity, the cost of preferred stock, and the cost of debt
a. A
b. B
c. C
d. D
3. CHOOSE: (A) if neither D nor C supports the test stem… (B) if A alone support the test stem…
(C ) if C alone support the test stem… (D) if B alone support the test stem…

For which of the following costs is it generally necessary to apply a tax adjustment to a yield
measure?
A. Cost of debt
B. Cost of preferred stock
C. Cost of common equity
D. Cost of retained earnings

a. A
b. B
c. C
d. D

4. CHOOSE: if (A) B alone support the test stem… (B) D alone support the test stem… (C ) if neither
A nor D supports the test stem… (D) if C alone support the test stem…

Which of the following is not a recognized approach for determining the cost of equity?

A. Dividend discount model approach

B. Before-tax cost of preferred stock plus risk premium approach
C. Capital-asset pricing model approach
D. Before-tax cost of debt plus risk premium approach
a. A
b. B
 Module 3 - FINANCIAL RISK MANAGEMENT
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Lesson 2 – Cost of Capital

c. C
d. D

5. CHOOSE: I(A) if C alone support the test stem… (B) if A alone support the test stem… (C ) if D
alone support the test stem… (D) B alone support the test stem…

Jacques Fauxpas is attempting to determine his company's weighted-average cost of capital. His first step was
to determine the required rates of return for his company's long-term debt, preferred stock, and common stock.
He then adjusted these required rates of return by multiplying each return by one minus the company's marginal
tax rate. Jacques is planning on using these three adjusted required return figures as his component costs of
capital. How is Jacques doing so far?

A. All three of Jacques' component cost figures are

B. All three component cost figures are
C. Only the required return (yield) on preferred stock and debt should have been adjusted for taxes
D. Only the required return (yield) on debt should have been adjusted for taxes
a. A
b. B
c. C.
d. D

6. CHOOSE: (A) if D alone support the test stem… (B) if A alone support the test stem…(C ) if B alone
support the test stem… (D) if C alone support the test stem…

A company that has more than half of its voting shares owned by another company is generally referred
to as a __________ of the other firm.

A. joint-venture partner
B. Proxy
C. Subsidiary
D. division
a. A
b. B
c. C
d. D
7. CHOOSE: (A) if C alone support the test stem… (B) if A alone support the test stem… (C ) if D
alone support the test stem… (D) if B alone support the test stem…

Which of the following is correct regarding the capital component costs for a group?

A. The component cost of common equity is based on the firm's component cost of common equity
B. The component cost of debt is based on the firm's component cost of debt
C. Both of the above answers are correct
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Lesson 2 – Cost of Capital

D. A proxy firm is a privately held firm in the same industry as the firm
a. A
b. B
c. C
d. D
8. CHOOSE:(A) if B alone support the test stem.. (B) if D alone support the test stem… (C ) if A alone
support the test stem… (D) if C alone support the test stem…

Choose the right statement from the following:

A. Cost of debt is always higher than cost of equity

B. Cost of debt can be higher or lower than cost of equity
C. Cost of debt is always lower than cost of equity.
D. When company doesn't pay dividend, the cost of equity is zero
a. A
b. B
c. C
d. D
9. CHOOSE:(A) if B alone support the test stem… (B) if neither D nor A supports the test stem… (C )
if C alone support the test stem… (D) if A alone does not support the test stem…

A firm should use .............. when evaluating an investment

A. the least costly source of financing

B. the weighted average cost of all financing sources
C. the most costly source of financing
D. the current opportunity cost
a. A.
b. B
c. C
d. D

10. CHOOSE: (A) if B alone support the test stem… (B) if D alone support the test stem… (C ) if A
alone support the test stem… (D) if C alone support the test stem…

A corporation has concluded that its financial risk premium is too high. In order to decrease this, the
firm can

A. increase the proportion of short term debt to decrease the cost of capital
B. increase the proportion of long term debt to decrease the cost of capital
C. increase the proportion of common stock equity to decrease financial risk
E. decrease the proportion of common stock equity to decrease financial risk
a. A
b. B
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Lesson 2 – Cost of Capital

c. C
d. D

REFERENCES

• CABRERA, Ma. Elenita B., Financial Management Principles and Applications, 2012-13 Edition:GIC
Enterprises &Co.,Inc., Philippines copyright 2012

• ALMINAR-mutya, Ruby F. DBA. Basic Business Finance Management Approach: National Book Store,
Philippine copyright 2010.2011 Reprint

Internet Sources:

COSTS OF CAPITAL. Retrived from., https://www.yourarticlelibrary.com/financial-management/cost-of-

capital/cost-of-capital-concept-definition-and-significance/43849. retrieved on April 2023.

COST OF CAPITAL: Concepts,Components and Importance., retrieved from,

https://www.businessmanagementideas.com/financial-management/cost-of-capital/cost-of-capital-concept-
components-importance-example-formula-and-significance/19601.Retrieved on April 2023.