Module 5 CFMA

CHARTERED FINANCIAL
MANAGEMENT ANALYST
(MODULE 5)
JOHN ANTHONY M. LABAY

CPA, MBA, CAP, CFMA
COST OF CAPITAL
✓ RISK AND RETURN
✓ COST OF DEBT
✓ COST OF EQUITY
✓ WEIGHTED AVERAGE COST OF CAPITAL (WACC)
✓ CAPITAL STRUCTURE
RISK AND RETURN
Generally, the higher the potential return of an

investment, the higher the risk. There is no guarantee that
you will get a higher return by accepting more risk. The
risk is the chance that an investment's actual return will
be different than expected.
RISK AND RETURN
Risk means you have the possibility of losing some, or

even all, of your original investment. Returns are the gains
or losses from a security in a particular period and are
usually quoted as a percentage. Low levels of uncertainty
(low risk) are associated with low potential returns. High
levels of uncertainty (high risk) are associated with high
potential returns.
COST OF CAPITAL
The cost of capital is a term used in the field of financial

investment to refer to the cost of a company's funds
(both debt and equity), or, from an investor's point of view
"the shareholder's required return on a portfolio of all the
company's existing securities". It is used to evaluate new
projects of a company as it is the minimum return that
investors expect for providing capital to the company,
thus setting a benchmark that a new project must meet.
COST OF DEBT
The cost of debt is relatively simple to calculate, as it is

composed of the rate of interest paid. In practice, the
interest-rate paid by the company can be modeled as the
risk-free rate plus a risk component (risk premium), which
itself incorporates a probable rate of default (and amount
of recovery given default). For companies with similar risk
or credit ratings, the interest rate is largely exogenous
(not linked to the company's activities).
COST OF EQUITY
The cost of equity is more challenging to calculate as

equity does not pay a set return to its investors. Similar to
the cost of debt, the cost of equity is broadly defined as
the risk-weighted projected return required by investors,
where the return is largely unknown. The cost of equity is
therefore inferred by comparing the investment to other
investments (comparable) with similar risk profiles to
determine the "market" cost of equity. It is commonly
equated using the Capital Asset Pricing Model (CAPM)
formula.
WEIGHTED AVERAGE COST OF CAPITAL
The weighted average cost of capital (WACC) is the rate

that a company is expected to pay on average to all its
security holders to finance its assets. The WACC is the
minimum return that a company must earn on an existing
asset base to satisfy its creditors, owners, and other
providers of capital, or they will invest elsewhere.
CAPITAL STRUCTURE
Because of tax advantages on debt issuance, it will be

cheaper to issue debt rather than new equity (this is only
true for profitable firms, tax breaks are available only to
profitable firms). At some point, however, the cost of
issuing new debt will be greater than the cost of issuing
new equity. This is because adding debt increases the
default risk - and thus the interest rate that the company
must pay in order to borrow money.
CAPITAL STRUCTURE
By utilizing too much debt in its capital structure, this

increased default risk can also drive up the costs for other
sources (such as retained earnings and preferred stock)
as well. Management must identify the "optimal mix" of
financing – the capital structure where the cost of capital
is minimized so that the firm's value can be maximized.
SAMPLE PROBLEMS
11
PROBLEM 1
Suppose today is January 1, 2020; on January 1, 2010, ACC

Industries issued a 30-year bond with a 9% coupon and a
P1,000 face value, payable on January 1, 2040. The bond now
sells for P915. Use this bond to determine the firm's after-tax
cost of debt. (Assume a 34% tax rate.)
PROBLEM 1
Yield to Maturity (YTM)/Effective Rate = Interest + Amortization of Discount

(0.60 X Price) + 400
=
P90 + (P85 / 20) .
(0.60 X P915) + 400
= P94.25 / P949
= 9.93%
After-tax cost of debt = 9.93% X (1 - .34)
= 6.55%
PROBLEM 2
Suppose ACC Industries (see Problem 1) also issued a 30-year

bond five years ago; it has a P1,000 face value and a 10%
coupon. If the bond currently sells for P1,000, what is the after-
tax cost of debt capital, as indicated by the market value of
this outstanding bond?
PROBLEM 2
Yield to Maturity (YTM)/Effective Rate = Interest .

(0.60 X Price) + 400
= P100 .
(0.60 X P1,000) + 400
= P100 / P1,000
= 10%
After-tax cost of debt = 10% X (1 - .34)
= 6.60%
PROBLEM 3
Suppose five years from now the ACC bond described in the
Problem 2 has a market price of P1,100. What is the after-tax
cost of debt capital at that time?
PROBLEM 3
Yield to Maturity (YTM)/Effective Rate = Interest - Amortization of Premium

(0.60 X Price) + 400
= P100 - (P100 / 20) .
(0.60 X P1,100) + 400
= P95 / P1,060
= 8.96%
After-tax cost of debt = 8.96% X (1 - .34)
= 5.91%
Note: If there is given flotation cost deduct it to market price of the bonds
(and in premium/discount).
PROBLEM 4
ACC Industries just declared a dividend of P3.50 per share of

common stock. The current stock price is P25 per share, and
the dividend is expected to increase at a rate of 4% per year for
the foreseeable future. Use the dividend growth model
approach to compute the cost of equity capital.
PROBLEM 4
To compute the cost of equity,
first compute D1: D1 = D0 × (1 + g) = P3.50 × 1.04 = P3.64.
Using the dividend growth model:
Cost of Equity = D1/P0 + g
= P3.64/P25 + .04
= .1456 + .04
= .1856 or 18.56%
According to the dividend growth model, the cost of equity capital is 18.56%.
Note: Dividend Growth Model OR Gordon Growth Model

P0 – flotation costs
PROBLEM 5
Suppose the market risk premium is 8.5%, the risk-free rate is 7.0%,
and ACC Industries has ß equal to 1.35. Use the Security Market Line
(SML)/Capital Asset Pricing Model (CAPM) to compute the firm's cost
of equity capital.
PROBLEM 5
The cost of equity is: Ke = Rf + ßE × [RM - Rf]

= .070 + (1.35 × .085)
= .18475 or 18.475%.
Note: Capital Asset Pricing Model (CAPM) OR Security Market Line (SML)
PROBLEM 6
Assume the debt-equity ratio for ACC is .50. Use the data of
Problems 1 through 5 to compute the WACC for ACC Industries.
PROBLEM 6
A debt-equity ratio of 0.50 indicates that the firm has P0.50 of debt for
each P1.00 of equity.
Therefore, E/V = P1.00/(P.50 + P1.00) = 2/3, and D/V = P.50/(P1.00 + P.50) = 1/3.
Ke is approximately 18.5%,
after-tax Kd is approximately 6.60%.
The WACC is therefore:

WACC = [(E/V) × Ke] + [(D/V) × Kd × (1 - T)}]
= (2/3 × .185) + [1/3 × .10 × (1 - .34)]
= .14533 or 14.533%
PROBLEM 7
ACC Industries has a preferred stock issue outstanding which

pays an annual dividend of P3.25 per share and currently has a
market price of P25 per share. Compute the cost of preferred
stock.
PROBLEM 7
Kps = D/P0
= P3.25/P25
= .1300 or 13.00%
so the cost of preferred stock for ACC is 13.00%.

PROBLEM 8
Suppose ACC's capital structure is 30% debt, 10% preferred

stock and 60% equity. Assume all other data as presented in
Problems 1 through 7; compute the WACC.
PROBLEM 8
WACC = [(E/V) × Ke] + [(D/V) × Kd × (1 - T)] + [(P/V) × Kps]

= (.60 × .185) + (.30 × .066) + (.10 × .13)
= .1438 or 14.38%
GOODLUCK &
GODBLESS!!!
jalcpa

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CHARTERED FINANCIAL

JOHN ANTHONY M. LABAY

Generally, the higher the potential return of an

Risk means you have the possibility of losing some, or

The cost of capital is a term used in the field of financial

The cost of debt is relatively simple to calculate, as it is

The cost of equity is more challenging to calculate as

The weighted average cost of capital (WACC) is the rate

Because of tax advantages on debt issuance, it will be

By utilizing too much debt in its capital structure, this

Suppose today is January 1, 2020; on January 1, 2010, ACC

Yield to Maturity (YTM)/Effective Rate = Interest + Amortization of Discount

Suppose ACC Industries (see Problem 1) also issued a 30-year

Yield to Maturity (YTM)/Effective Rate = Interest .

Yield to Maturity (YTM)/Effective Rate = Interest - Amortization of Premium

ACC Industries just declared a dividend of P3.50 per share of

Note: Dividend Growth Model OR Gordon Growth Model

The cost of equity is: Ke = Rf + ßE × [RM - Rf]

The WACC is therefore:

ACC Industries has a preferred stock issue outstanding which

so the cost of preferred stock for ACC is 13.00%.

Suppose ACC's capital structure is 30% debt, 10% preferred

WACC = [(E/V) × Ke] + [(D/V) × Kd × (1 - T)] + [(P/V) × Kps]

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