CALCULATING
THE
COST OF CAPITAL
1
Introduction
Firms need money to operate and grow, and they usually get it from debt or
equity. Debt means loans, while equity means selling shares. Each source has
a cost because investors expect returns. Since companies use different
amounts of debt and equity, they compute the weighted average cost of
capital or WACC to know the overall cost. Interest on debt is cheaper because
it is tax deductible, but dividends to shareholders are not. Firms balance debt
and equity to minimize costs.
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Specific Capital
Component Costs
Debt, preferred shares, and ordinary shares are called capital components.
These are the funds provided by investors. When calculating WACC, we only
include capital that comes directly from investors like interest-bearing debt,
preferred shares, and ordinary equity. Items like accounts payable and
accruals are not included because they come from operations, not from
investors.
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A. Cost of Debt (Kd)
The cost of debt is the minimum rate of return required by suppliers of debt.
The before-tax cost of debt is the interest a firm pays when it borrows money.
This can be estimated by asking banks or checking the yield on existing debt.
But for WACC, firms use the after-tax cost of debt, which is lower because
interest is tax deductible and reduces taxes.
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A. Cost of Debt (Kd)
In effect, the government pays part of the cost of debt because interest is tax
deductible. If XYZ Corporation can borrow at an interest rate of 12% and its
marginal corporate tax rate is 35%, its after-tax cost of debt will be 7.8%.
After-tax cost of debt
= 12% (1 - 35%)
= 7.8%
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Computing the Cost of
a New Bond Issue
The computation requires three steps:
1. Determine the net proceeds from the sale of each bond.
2. Compute the before-tax cost of the bond.
If flotation costs are included and the bond sells at par, the cost of debt is just the
coupon rate, which is the interest paid on the bond’s value. But what really matters is
the cost of new debt, not old debt, because we use it to decide if new projects, like
buying a machine, will earn more than they cost. That’s why the yield to maturity,
which shows the current market rate, is a better measure than the coupon rate.
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Flotation cost – This is the extra cost a company pays when it raises
money by selling new bonds or shares. It includes things like fees to
investment banks or legal expenses. Think of it like a service charge when
you sell or buy something.
Coupon rate – This is the fixed interest rate a bond pays to its investors
based on its face value (par value). For example, if a bond’s par value is
₱1,000 and the coupon rate is 10%, the investor gets ₱100 each year as
interest.
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The before-tax cost of the debt issue is the rate of return that equates the
present value of the future interest payments and principal payment with the
net proceeds from the sale of the bond using the equation.
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Prime Pipe Company plans to issue 25-year bonds with a face value of
P4,000,000. Each bond has a par value of P1,000 and carries a coupon rate of
9.5 percent. However, the bond is expected to sell for 98 percent of par
value. The flotation costs are estimated to be approximately P26 per bond
and the firm's marginal tax rate is 34 percent. (Assume that interest
payments are made annually.)
Required:
Management wants to calculate the (a) net proceeds per bond, (b) the before-
tax cost of this bond issue, (c) the after-tax cost of the bond issue's flotation
costs.
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Prime Pipe Company plans to issue 25-year bonds with a face value of
P4,000,000. Each bond has a par value of P1,000 and carries a coupon rate of
9.5 percent. However, the bond is expected to sell for 98 percent of par
value. The flotation costs are estimated to be approximately P26 per bond
and the firm's marginal tax rate is 34 percent. (Assume that interest
payments are made annually.)
Solution:
(a) The selling price of the bond P980 (0.98 x P1,000). The net proceeds per
bond are calculated by subtracting the P26 flotation cost from the bond's
P980 selling price.
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Solution:
(b) Using the trial and errors approach, the before-tax cost of debt is
computed as follows:
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Solution:
(c) The after-tax cost of new debt is computed as follows:
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B. Cost of Preferred
Share (Kp)
Although preferred share is a part of a firm's permanent financing mix but is not
frequently issued. Preferred share is a hybrid security that has characteristics of
both debt and equity. Under Philippine Financial Reporting Standard, when the
preferred share is considered as debt, the computational procedure in Section A
will apply.
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B. Cost of Preferred
Share (Kp)
However, if the preferred shares have fixed dividend payments and no stated
maturity dates, the component cost of new preferred share is computed as
follows:
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Prime Pipe Company plans to sell preferred share for its par value of P25.00
per share. The issue is expected to pay quarterly dividends of P0.60 per
share and to have flotation cots of 3 percent of the par value or P1.50 (0.03
x P25.00). Substituting Dp = P2.40 (4 x P0.60), NP, = P23.50 (P25.00 – P1.50),
the cost of new preferred share is:
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C. COST OF ORDINARY EQUITY SHARE
Ordinary equity share does not represent a contractual obligation to make specific
payments thus making it more difficult to measure its costs than the cost of bonds or
preferred share.
Business firms raise equity capital externally through the sale of new ordinary equity
shares and internally through retained earnings. Retained earnings represent the
portion of accumulated after-tax profits that the firm has not distributed to its
shareholders and therefore is reinvested in itself.
Cost of existing ordinary equity share is the same as the cost of retained earnings. No
adjustment is made for flotation costs in determining either the cost of existing
ordinary equity share or the cost of retained earnings.
The costs of new ordinary equity share and retained earnings are similar but not equal.
The cost of new ordinary equity share is higher than the cost of retained earnings
because of the flotation costs involved in selling new ordinary equity share which
reduce the net proceeds to the firm. Thus, firms will use the lower-cost retained
earnings before they issue new ordinary equity share.
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C. COST OF ORDINARY EQUITY SHARE
A . Cost of Equity
1. The CAPM Approach
The most widely used method for estimating the cost of ordinary equity is the Capital
Asset Pricing Model (CAPM).
Step 1: Estimate the risk-free rate (rar). We generally use the 10-year Treasury bond rate
as the measure of the risk-free rate, but some analysis use the short-term Treasury bill
rate.
Step 2: Estimate the stock's beta coefficient (b.) and use it as an index of the stock's
risk. The i signifies the ith company's beta. Beta coefficient, b is a metric that shows the
extent to which a given stock's returns move up and down with the stock market. Beta
thus measures systematic market risk of the asset relative to average.
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C. COST OF ORDINARY EQUITY SHARE
A . Cost of Equity
1. The CAPM Approach
The most widely used method for estimating the cost of ordinary equity is the Capital
Asset Pricing Model (CAPM).
Step 3: Estimate the expected market risk premium. Recall that the market risk
premium is the difference between the return that investors require on an average
stock and the risk-free rate.
Step 4: Substitute the preceding values in the CAPM equation to estimate the required
rate of return on the stock in question:
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C. COST OF ORDINARY EQUITY SHARE
A . Cost of Equity
Step 3: Estimate the expected market risk premium. Recall that the market risk
premium is the difference between the return that investors require on an average
stock and the risk-free rate.
Step 4: Substitute the preceding values in the CAPM equation to estimate the required
rate of return on the stock in question:
Thus, the CAPM estimate of r, is equal to the risk-free rate (TRF) plus a risk
premium that is equal to the risk premium on an average stock (FM-PRP),
scaled up or down to reflect the particular stock's risk as measured by its
beta coefficient (b.).
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C. COST OF ORDINARY EQUITY SHARE
A . Cost of Equity
Calculation of Cost of Equity Shares Using the CAPM Approach
Assume that in today's market, TRF 5.6%, the market risk premium is RP = 5.0%, and
Zeta's beta is 1.48. Using the CAPM approach, Zeta's cost of equity is estimated to be
13.0%.
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C. COST OF ORDINARY EQUITY SHARE
A . Cost of Equity
Calculation of Cost of Equity
ABC Company's ordinary equity shares sell for P32.75 per share. ABC expects to set
their next annual dividend at P1.54 per share. If ABC expects future dividends to grow
by 6% per year, indefinitely, the current-risk-free rate is 3%, the expected return on the
market is 9%, and the stock has a beta of 1.3, what should the firm's cost of equity be?
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C. COST OF ORDINARY EQUITY SHARE
A . Cost of Equity
2. Bond Yield Plus Risk Premium Approach
In situation such as closely held companies where reliable inputs for the CAPM
approach are not available, analysts often use a somewhat subjective procedure to
estimate the cost of equity.
The generalized risk premium or bond-yield-plus-risk premium required rate of return
on shareholder's equity. The equation below shows that the required rate of return is
equal to some base rate (k_{d}) plus a risk premium (r_{p}) The base rate is often the
rate on Treasury bonds or the rate on the firm's own bonds. The risk premium on a
firm's own stock over its own bonds is based on a judgmental estimate but empirical
studies suggest that it ranges between 3 to 5 percentage points above the base rate.
However, risk premiums are not stable over time, hence the estimated value of is also
judgmental.
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C. COST OF ORDINARY EQUITY SHARE
A . Cost of Equity
2. Bond Yield Plus Risk Premium Approach
In situation such as closely held companies where reliable inputs for the CAPM
approach are not available, analysts often use a somewhat subjective procedure to
estimate the cost of equity.
The generalized risk premium or bond-yield-plus-risk premium required rate of return
on shareholder's equity. The equation below shows that the required rate of return is
equal to some base rate (k_{d}) plus a risk premium (r_{p}) The base rate is often the
rate on Treasury bonds or the rate on the firm's own bonds. The risk premium on a
firm's own stock over its own bonds is based on a judgmental estimate but empirical
studies suggest that it ranges between 3 to 5 percentage points above the base rate.
However, risk premiums are not stable over time, hence the estimated value of is also
judgmental.
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C. COST OF ORDINARY EQUITY SHARE
A . Cost of Equity
Determination of Cost of Equity Using the Bond Yield plus Risk Premium Approach
Prime Pipe Company's long-term bond rate is 9.5 percent. The firm's management
estimates that its cost of equity should require a 3 percentage point risk premium
above the cost of its own bonds. Using the generalized risk premium approach, the cost
of ordinary equity would be 12.5 percent. This is found by substituting k_{d} = 0.095 and
r_{p} = 0.03
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C. COST OF ORDINARY EQUITY SHARE
A . Cost of Equity
3. Dividend Yield Plus Growth Rate Approach
Generally, both the price and the expected rate of return on an ordinary equity share,
depend ultimately on the share's expected cash flows. For business firms that expect to
remain in business indefinitely the cash flows are the dividends.
The required rate of return on ordinary equity which for the marginal investor is also
equal to the expected rate of return. The equation that could use follows:
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C. COST OF ORDINARY EQUITY SHARE
A . Cost of Equity
4. Discounted Cash Flow (DCF) Approach
The method of estimating the cost of equity called the discounted cash flow or DCF
method considers not only the dividend yield (D_{I} / P_{a}) but also a capital gain (g)
for a total expected return of K, and in equilibrium this expected return is also equal to
the required rate of return.
It is not difficult to calculate the dividend yield but if stock prices fluctuate, the yield shall vary from
day to day which leads to fluctuations in the DCF cost of equity. Also it is not easy to determine the
proper growth rate. If part growth rates in earnings and dividend have been relatively stable, and if
investors expect a continuation of past events, g may be based on the firm's historic growth rate.
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C. COST OF ORDINARY EQUITY SHARE
A . Cost of Equity
4. Discounted Cash Flow (DCF) Approach
Determination of Cost of Equity Under the DCF Approach
Zeta stock sells for P23.06, its next expected dividend is P1.25, and analysts expect its
growth rate to be 8.3%. Thus, Zeta's expected and required rates of return (hence, its
cost of retained earnings) are estimated to be 13.7%.
Based on the DCF method, 13.7% is the minimum rate of return that should be earned on retained
earnings to justify plowing earnings back into the business rather than paying them out to shareholders
as dividends. In other words, since the investors are thought to have an opportunity to earn 13.7% if
earnings are paid out as dividends, the opportunity cost of equity from retained earnings is 13.7%.
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C. COST OF ORDINARY EQUITY SHARE
A . Cost of Equity
[Link]-Price Ratio Method
The earnings-price ratio method is a simplistic technique used to estimate the cost of
ordinary equity, which is based on the inverse of the firm's price-earnings ratio. The
earnings-price ratio is easy to compute because it is based on readily available
information, but there is little economic logic to support the use of the earnings-price
ratio to measure the cost of ordinary equity. For example, this technique is unsuitable
for a firm that is operating at a loss because it would generate a negative cost of
ordinary equity. The following equation shows that the earnings-price ratio is found by
dividing the current earnings per share (E) by the current market price of the firm's
ordinary equity share (P.).
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C. COST OF ORDINARY EQUITY SHARE
A . Cost of Equity
Determination of Cost of Equity Using the Earnings Price Ratio
Prime Pipe Company had earnings per share for the past year of P6.50, and the firm's
ordinary equity share is currently priced at P45.00. Using the earnings-price ratio
method, the cost of retained earnings would be 14.44%. This is found by substituting E
=P6.50 and P_{e} =P45.00.
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B. Cost of New Ordinary Equity Shares
The Constant Growth Model for New Ordinary Equity Shares is generally used in
measuring the cost of new ordinary equity share. The equation is:
where:
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Illustrative Case 15-8. Computation of Flotation-Adjusted Cost of Equity
Suppose that ABC Company's ordinary equity shares are selling for P32.75 per share, and the
company expects to set its next annual dividend at P1.54 per share. All future dividends are
expected to grow by 6% per year, indefinitely. In addition, let's also suppose that ABC faces a
flotation cost of 20% on new equity issues. Calculate the flotation-adjusted cost of equity.
Solution:
Twenty percent of P32.75 will be P6.55, so the flotation-adjusted cost of equity will be:
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Illustrative Case 15-9.
Prime Pipe Company's ordinary equity share has a current market price of P45.00 and an
expected dividend growth rate of 5%. The firm is expected to pay P3.60 per share in ordinary
equity share dividends during the next year. The sale of new ordinary equity share involves
underpricing of P1.00 per share and underwriting fee of P0.80 per share. What is the cost of the
new ordinary equity share?
Solution:
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C. Cost of Retained Earings
Retained earnings aren't cost-free. They have an opportunity cost
because shareholders could have received the money as dividends
and invested it elsewhere. Therefore, firms should earn at least as
much on retained earnings as stockholders could earn on
alternative investments with similar risk.
The cost of retained earnings is similar to the cost of existing
ordinary equity shares.
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When Must External Equity Be Used?
Firms should maximize the use of retained earnings due to lower costs
compared to issuing new stock, which incurs flotation costs. However, when
investment opportunities exceed the capacity of retained earnings plus
associated debt and preferred stock, issuing new ordinary equity may be
necessary. The retained earnings breakpoint is the total capital amount raised
before new shares must be issued, and it can be calculated as follows:
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Illustrative Case 15-10 . Determination of Retained Earnings Breakpoint
Zeta's addition to retained earnings in 2017 is expected to be P66 M, and its target capital
structure consists of 45% debt, 2% preferred, and 53% ordinary equity. Therefore, its retained
earnings breakpoint for 2017 is as follows:
Retained earnings breakpoint = P66M / 0.53 = P124.5M
To prove that this is correct, note that a capital budget of P124.5M could be
financed as 0.45 (P124.5M) = P56M of debt, 0.02 (P124.5M) P2.5M of
preferred share, and 0.53 (P124.5M) = P66M of equity raised from retained
earnings. Up to a total of P124.5M of new capital, equity would have a cost of
K. = 13.5%. However, if the capital budget exceeded P124.5M, Zeta would
have to obtain equity by issuing new ordinary equity share at a higher cost because of the
flotation costs.
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Problems to Consider With Estimates of Cost of Capital
1. Privately Owned Firms: Cost of capital estimation principles apply to both private and
public firms, but obtaining input data differs, and tax issues are more important.
2. Measurement Problems: Estimating the cost of equity faces practical difficulties in
obtaining reliable inputs for CAPM, growth rate (g), and risk premium, affecting the
accuracy of cost of capital estimates.
3. Capital Structure Weights: Establishing the target capital structure is a significant task.
4. Cost of Capital for Projects of Differing Risk: Projects vary in risk, making it difficult to
measure project risk and adjust the cost of capital for capital budgeting.
Despite these challenges, the outlined procedures provide sufficiently accurate cost
of capital estimates for practical purposes, with refinements desirable but not
invalidating the overall usefulness.
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Determination of Weighted Average Cost of Capital
Definition: WACC (Ka ) is determined by measuring the specific cost of capital from
long-term financing sources.
Calculation:
Uses target proportions of debt, preferred share, and ordinary equity along with their
costs.
Formula:
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Determination of Weighted Average Cost of Capital
Tax Adjustment: Only debt has a tax adjustment factor (I - T) because interest on debt is tax-
deductible.
Can be computed for existing or new financing. Only WACC for new financing is generally
calculated, as historical costs are not relevant for current decisions.
Computation Method: Calculated by multiplying the specific cost of each type of capital by its
proportion (weight) in the firm's capital structure and summing the weighted values.
There two major schemes in computing the weighted average cost of capital,
namely:
A. Historical Weights
a) Book value weights
b) Market value weights
B. Target Weights
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HISTORICAL WEIGHTS
Historical weights reflect a firm's current capital structure, which is optimal for those firms. The optimal
capital structure combines debt and equity to maximize market value while minimizing the weighted
average cost of capital.
Book Value Weights Market Value Weights
The actual proportion of each type of The actual proportion of each type of
permanent capital in the firm's structure based permanent capital in the firm's structure at current
on accounting values shown on the firm's market prices. This is considered more superior
balance sheet. This basis however may to book value weights because they provide
misstate the WACC bacause they ignore the estimates of investors' required rates of return.
changing market values of bonds and equity However, market value weights are less stable
over time, and may not provide a useful cost of than book value weights in computing cost of
capital for evaluating current strategies. capital because market prices change frequently.
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40
Illustrative Case
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Illustrative Case
B. In addition to the data provided in A, assume that the security market prices of
Copper Pipe Company are:
Bonds = P980 per bond
Preferred shares = P25 per share
Ordinary equity shares = P45 per share
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Illustrative Case
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TARGET WEIGHTS
Firms establish target weights for capital structure based on their desired optimal proportions. They raise
funds to maintain this structure, ideally using market values for target weights instead of historical ones.
This approach maximizes share price and minimizes the cost of capital.
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Illustrative Comprehensive Case: Calculation of
Components Cost of Capital
Suppose that Walter Corporation has a beta of 0.80. The market risk premium is 6%, and the
risk-free rate is 6%. Walter's last dividends was P1.20 per share and the dividend is expected to
grow at 8% indefinitely. The stock currently sells for P45 per share.
Required:
1. Using the CAPM approach, what is Walter's cost of equity capital or expected return on
Walter's ordinary equity share?
2. Using the dividend growth model, what is the expected return on Walter's ordinary equity
share?
3. What is the average cost of equity?
4. In addition to the information given in the previous problem, Walter has a target debt-equity
ratio of 50%. Its cost of debt is 9% before taxes. If the tax rate is 35%, what is the WACC?
5. Suppose that Walter is seeking P30M for a new project. The necessary funds will have to be
raised externally. Walter's flotation costs are considered, what is the true cost of the new
project?
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Solution
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Solution
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Solution
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THANK
YOU
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