FM - Cost of Capital

COST OF CAPITAL
FIRM
EQUITY DEBT
REQUIRE A RETURN
COST OF CAPITAL
COST OF CAPITAL
• Is defined as the minimum rate of return that must be
made on an investment to maintain the market values
of the firm’s securities.
• The cost of capital in primarily dependent upon the use
of funds, not the source.
USE OF COST OF CAPITAL
• Capital-budgeting decision
• Establish the optimal capital structure
• Making other financial decision
COST OF DEBT
• It measures the current cost of a firm to finance its

project, it is determined by the following variables:
• The current level of interest
• The default risk of company
COST OF DEBT
The formula for the cost of debt before tax is: Where:
=approximate yield to maturity on a
bond
I=annual interest payment
FV= par value or face value of the
bond ( or the maturity value of the
bond)
The formula for the cost of debt after-tax is: IP= value or proceed of the bond
N= term of the bond
(1-t) 2= constant(it is used to get the
average of the FV and IP)
Where:
= cost of debt after tax
t= the tax rate
COST OF DEBT
Example:
Assume that the Sprinkle Corporation issues a 1,000,000, 12%, a 10-year bond whose
net proceeds are 920,000. The tax rate on the firm is 35%.
To compute the cost of debt before tax:
( ) ( , , , )
( ) = ( , , , ) = = 13.33%
To compute the cost of debt after tax:
(1-t) = 13.33%(1 – 0.35) = 8.66%

COST OF PREFERRED STOCKS
The cost of preferred stock measures the cost of financing through the
issuances of preferred shares of stocks.
Formula:
Where:
= dividends to be received in
1 year
= proceeds from the sales
of the preferred stocks
F= flotation cost
COST OF PREFERRED STOCKS
Example:
Sprinkle Corp Issued preferred stocks with an underwriting cost of 2% per share.
The stocks are expected to provide 6 dividend per share at the time of issue.
They are now selling in the market for 50 each. What is the cost of preferred
stocks?
= 12.245 %
COST OF COMMON STOCK
Several techniques can be used to compute the cost of common-stock equity.
These are follows:
• Gordon’s Growth Model (GGM) – it is based on the current market price of a
common stock.
Where:
=market price of common stock
=dividends received in 1 year
=cost of equity
g= constant growth rate(g= re[1-dpo])
where re is the past rate of return on the
common stocks and dpo refers to the
dividend payout ratio.
GORDON’S GROWTH MODEL
Example:
Assume that the stock of Sprinkle Corporation has a market
price of 60. at the end of the year, dividend are expected to
per paid at 6 per share. The growth rate is also expected to be
constant at an annual rate of 5%. The cost of equity using
GGM is as follows:
= 15%
GORDON’S GROWTH MODEL
ISSUANCE OF A NEW COMMON STOCKS
Example:
From previous example, assume that new shares of common stocks with a
flotation cost of 5% of the market price of the stock are issued. The cost of the
new common stock is estimated as follows:
5%
( . )
15.53 %
• Capital Asset Pricing Model (CAPM) –is used in finance to theoretically
determine the appropriate required rate o return of an asset.
=rf + b (rm – rf)
Example:
Assume that Sprinkle Corporation uses the CAPM to estimate its cost of equity.
The treasury bill rate at the time of estimation is 8% with a beta of 1.2 and the
expected return on the market is 15%. What is the firm’s cost of Equity?
= 8% +1.2 (15% - 8%)
= 16.4%
• Bond Plus Approach – It is applied by simply adding a risk premium to the firms
cost of debt after tax.
Formula:
(1-t) + Risk Premium

Example:
Assume that the Sprinkle Corporation issues a 1,000,000, 12%, a 10-year bond
whose net proceeds are 920,000. The tax rate on the firm is 35%.
To compute the cost of debt before tax:
( ) ( , , , )
( ) = ( , , , ) = = 13.33%
BOND PLUS APPROACH
To compute the cost of debt after tax:
(1-t) = 13.33%(1 – 0.35) = 8.66%

Compute the cost of equity using the bond plus approach with the assumption
that the risk premium is at 5%
Applying the bond plus approach result in the following:
(1-t) + Risk Premium
= 8.66% +5%
= 13.66%
COST OF RETAINED EARNINGS
• The cost of retained earning (kr)is said to be identical to that of
the cost of common stock (ke).
• Therefore, the cost of retained earnings is the required rate of
return that the investor expects for the reinvestment of the
retained earnings.
• Since (kr) = (ke) , then (kr) is estimated as follows:
COST OF CAPITAL
FIRM
EQUITY DEBT
Investor 10% Bank 5%
WACC
WEIGHTED AVERAGE COST OF CAPITAL(WACC)
• It is the overall cost of a firm should consider before undertaking an
investment decision.
• In computing a firm’s WACC, the formula used is as follows:
Where: cost of common stock

=WACC weight of cost of common
=Cost of Debt after Tax stock
=weight of the cost of debt cost of retained earnings
after tax =weight of the cost of retained
cost of preferred stock earnings
=weight of the cost of
preferred stock
BOOK VALUE WEIGHTS
• Assume that the overall capital structure of sprinkle corporation uses the computed cost
of equity for each type of the capital from the previous examples.
Book Value Per unit / share

Mortgage Bonds (1,000 par) 10,000,000 1,050
Preferred Stock (100 par) 5,000,000 85
Common Stock (50 par) 15,000,000 70
Retained Earnings 10,000,000
Total 40,000,000
Using Book Value weights what is the WACC?

BOOK VALUE WEIGHTS
Book Value Weights Cost Weighted Cost

Mortgage Bonds 10,000,000 25% 8.66% 2.17
Preferred Stock 5,000,000 12.5 12.24% 1.53
Common Stock 15,000,000 37.5 15.53% 5.82
Retained Earnings 10,000,000 25 15.00% 3.75
Total 40,000,000 Ka = 13.27%
MARKET VALUE WEIGHTS
Using previous example:
Book Value Per unit / share Number of

securities
Mortgage Bonds 10,000,000/10 1,050 10,00
(1,000 par) 00
Preferred Stock (100 5,000,000/100 85 50,000
par)
Common Stock (50 15,000,000 70 300,000
par)
Total 40,000,000
Find the firm’s number of securities in each category
Therefore, The market value are:
Book Value Market Price Market value

Debt 10,000 1,050 10,500,000
Preferred Stock 50,000 85 4,250,000
Common Stock 300,000 70 12,600,000
• Using market Value weights what is the WACC?
Market Value Weights Cost Weighted Cost

Mortgage Bonds 10,500,000 29.37 8.66% 2.54
Preferred Stock 4,250,000 11.89 12.24% 1.46
Common Stock 12,600,000 35.24 15.53% 5.47
Retained Earnings 8,400,000 23.50 15.00% 3.53
Total 35,750,000 Ka = 13%
TARGET AND MARGINAL WEIGHTS
• Example: Sprinkle Corporation plans to raise 12 million for plant expansion. The firm
wants to maintain its present capital structure, believing that such is its structure. Assume
that the cost of Debt is 10%; the cost of common stock is 12.60%; and the cost of retained
earnings is 12%. Listed below are the components of the firm’s balance sheet.
Sprinkle Corporation
Balance Sheet
December 15,2020
Current Asset 7,000,000 Current Liabilities 5,000,000
Fixed Asset 18,000,000 Long-Term Liabilities 7,500,000
Common Stock 6,250,000

Total Assets 25,000,000 Total Liabilities and 25,000,000
Stockholders’ Equity
TARGET AND MARGINAL WEIGHTS
Weights Cost Weighted Cost
Debts 37.5% 10.00% 3.75

Common Stock 31.25 12.60% 3.94
Retained Earnings 31.25 12.00% 3.75
Total Ka = 11.44%

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COST OF CAPITAL

• It measures the current cost of a firm to finance its

To compute the cost of debt after tax:

(1-t) = 13.33%(1 – 0.35) = 8.66%

(1-t) + Risk Premium

(1-t) = 13.33%(1 – 0.35) = 8.66%

(1-t) + Risk Premium

Where: cost of common stock

Book Value Per unit / share

Using Book Value weights what is the WACC?

Book Value Weights Cost Weighted Cost

Book Value Per unit / share Number of

Book Value Market Price Market value

Market Value Weights Cost Weighted Cost

Common Stock 6,250,000

Weights Cost Weighted Cost

Debts 37.5% 10.00% 3.75

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