MODULE 5– COST OF CAPITAL 1

MODULE 5 – COST OF CAPITAL

INTRODUCTION

Financing activity would include borrowing money or taking loans from a financial
institution. The said sources of funds would carry some cost in order to acquire it from
the lender and the said cost is known as the “cost of capital”. Simply stated, cost of
capital is the cost incurred in order to raise the needed fund for business operations.
The said cost is also referred to as financing cost (interest rate) the company pays when
securing a loan. Business firms normally define their own “cost of capital” in one of two
ways:
Firstly, “cost of capital” simply refers to the financing cost that needs to be paid when
borrowing funds, either by securing a loan or by selling bonds, or equity financing and
this comes in the form of an annual interest rate, such as 5% or 10%. Secondly, if it
refers to investment decision making, cost of capital may be referred to as the rate of
return that can be earned on such investment.

LEARNING OUTCOMES:

After reading this module, the learner should be able to:

1. Compute and explain the Weighted Average Cost of Capital (WACC)
2. Compute and explain Cost of Borrowing, Cost of Debt, and Cost of Equity

TIME:

The time allotted for this module is six (3) hours.

LEARNER DESCRIPTION

The participants in this module are 3rd year BSBA students

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 MODULE 5– COST OF CAPITAL 2

MODULE CONTENTS:

Lesson 5.1: WEIGHTED AVERAGE COST OF CAPITAL

What is Weighted Average Cost of Capital (WACC)?

 WACC is the arithmetic average (mean) capital cost that weighs the contribution
of each capital source by the proportion of total funding it provides.
 It usually appears as an annual percentage
 Calculating WACC is a matter of summing the capital cost components,
multiplying each by its appropriate weight. For example, in simplest terms:

WACC = (Proportion of total funding that is equity funding) x (Cost of Equity)

+ (Proportion of total funding that is debt funding) x (Cost of Debt)
X (1-Corporate Tax Rate)

To illustrate:

A firm has determined its cost of each source of capital and optimal capital structure,
which is composed of the following sources and target value proportions:

Source of Capital Target Market After Tax Cost WACC

Proportions (TMP) (ATC) (TMP x ATC)
Long Term Debt 40% 6% 2.40%
Preferred Stock 10% 11% 1.10%
Common Stock 50% 15% 7.50%
Total 100% 11.00%

It will be noted based on the above illustration that WACC is simply computed by
multiplying the total market proportion to the after tax cost. Thus, the WACC for the
given example is 11%.

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Lesson 5.2: COST OF BORROWING

Cost of Borrowing refers to the total amount a debtor pays to secure a loan and use
funds, including costs, account maintenance, loan origination, and other loan-related
expenses.

When a debtor repays a loan over time, the following equation holds:

Total payments = Repayment of loan principal + cost of borrowing

Cost of borrowing may include, for instance, interest payments, and (in some cases)
loan origination fees, loan account maintenance fees, borrower insurance fees, and still
other fees. As an example, consider a loan with the following properties:

LOAN PROPERTIES

Amount to borrow (loan principal) P100,000.00

Annual Interest Rate 6%
Amortization Time 10 Years
Payment Frequency Monthly
Annual borrower insurance P25.00

*Such a loan calls for 120 monthly payments of P1,110.21. Therefore, the borrower
makes all payments on schedule ends up repaying a total of 120 x 1,110.21, or
P133,225. The borrower will also pay P200 for loan origination, P600 in account
maintenance fees (120 x P5), and P250 in borrower insurance. The cost of borrowing,
therefore, calculates as:

COST OF BORROWING CALCULATIONS

Total Repayments P133,225.20

Less Principal Paid: (P100,000.00)
Total Interest Payments 33,225.20
Loan Origination fee: P200
Account Maintenance fee: P600
Borrower insurance fee: P250
The Total Cost of Borrowing: P34,255.20

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Lesson 5.3: COST OF DEBT

Cost of Debt is the overall average rate an organization pays on all its obligations.
These typically consist of bonds and bank loans. Cost of Debt usually appears as an
annual percentage.
For a company with a marginal income tax rate of 30% and a before-tax cost of debt of
6%, the after-tax cost of debt is as follows:

After-tax cost of debt = (Before tax cost of debt) x (1-Marginal tax rate)
= (0.06) x (1.00 – 0.30)
= ((0.6) x (0.70)
= 0.042 or 4.20%

As with “cost of capital”, “cost of debt” tends to be higher for companies with lower credit
ratings – companies that the bond market considers riskier or more speculative.
Whereas “cost of capital” is the rate the company must pay now to raise more funds,
cost of debt is the cost the company is paying to carry all debt it has acquired.
Cost of debt becomes a concern of stockholders, bondholders, and potential investors
for “high-leverage” companies (i.e, companies where debt financing is large relative to
owners’ equity). High leverage is riskier and less profitable in a weak economy when the
company’s ability to service a massive debt load may be questionable.
The cost of debt may also weigh in management decisions regarding asset acquisitions
or other investments bought with borrowed funds. The additional cost of debt in such
cases reduces the value of investment tools such as return on investment (ROI) or
internal rate of return (IRR).

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Lesson 5.4: COST OF EQUITY

Cost of Equity is part of company’s “capital structure”. COE measures the returns
demanded by stock market investors who will bear the risks or ownership. COE usually
appears as an annual percentage.
One approach to calculating cost of equity refers to equity appreciation and dividend
growth

Cost of Equity = (Next Year’s Dividend per Share + Equity Appreciation per Share)
(Current Market Value of Stock) + Dividend Growth

For example, consider a stock whose current market value is P8.00, paying an annual
dividend of P.20 per share. If those conditions held for the next year, the investor’s
return would be simply 0.20/8.00 or 2.5%. When the investor requires a return of, say
5%, one or two terms of the above equation must change:

1. If the stock price appreciates 0.20 to 8.20, the investor would experience a 5% return:
(.20 dividend +.20 stock appreciation) / (8.00 current value of stock)

2. When, instead, the company doubles the dividend (dividend growth) to 0.40, while
the stock price remains at 8.00, the investor also experiences a 5% return.

FINANCIAL MANAGEMENT