Scribd
Upload
213 views18 pages

Cost of Capital

The document discusses the basic concepts of cost of capital including the cost of long-term debt, preferred stock, and common equity using the dividend growth model and capital asset pricing model. It provides sample problems and exercises for calculating the weighted average cost of capital for companies based on their capital structure and costs of individual sources of capital.

Uploaded by

Joshua Cabinas
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
213 views18 pages

Cost of Capital

The document discusses the basic concepts of cost of capital including the cost of long-term debt, preferred stock, and common equity using the dividend growth model and capital asset pricing model. It provides sample problems and exercises for calculating the weighted average cost of capital for companies based on their capital structure and costs of individual sources of capital.

Uploaded by

Joshua Cabinas
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 18

Cost of Capital

Basic Concepts

Cost of Long-term Debt

Cost of Preferred Stocks

Outline Cost of Common Equity – Dividend


Growth Model

Cost of Common Equity – Capital Asset


Pricing Model

Weighted Average Cost of Capital (WACC)


Cost of Capital – described as the hurdle rate
for investment decisions.

Businesses must strive to earn at least as


much as the cost of funds that its uses.

Basic Concepts Capital Structure – refers to the mix of debt,


preferred stock and common equity that the
firm uses to finance its assets and resources.
To maximize the market value of the firm through an
appropriate mix of long-term sources of funds.
Objective of
Capital Long-term Debt
Structure Asset Preferred Shares

Common Shares
SOURCE CAPITAL COST OF
CAPITAL

Creditors Long-term Debt After – tax Cost


of Debt

Preferred Preferred Dividend Per


Stockholders Shares Share / Net
Basic Concepts Issue Price

Common Common CAPM or DGM


Stockholders Shares
• Required Rate of Return to Creditors
• Yield to Maturity x (1 – Tax Rate)

Cost of Long- The before – tax cost of debt is computed by using the yield to maturity
formula:

term Debt
Suppose the company issue bonds with a before tax cost of 10%.
Since interest payments are tax deductible, the true cost of the debt is the
after-tax cost.

Sample Cost of If the company’s tax rate is 40%, the after-tax cost of debt is:
Cost of Debt = 10%(1-0.4) = 6%

Debt
ABC CORP. has a P1,000 par value bond outstanding with 25 years to maturity.
The bond carries an annual interest payment of P88 and is currently selling for
P925. ABC is in a 30% tax bracket. The firm wishes to know what the after - tax
cost of a new bond issue is likely to be. The yield to maturity on the new issue will
be the same as the yield to maturity on the old issue because the risk and
maturity date will be similar.

Sample Cost of REQUIREMENTS:


(1) Compute the approximate yield to maturity on the old issue and use this as

Debt the yield for the new issue.


(2) Make the appropriate tax adjustment to determine the after – tax cost of
debt.
Cost of preferred shares is computed as:

Cost of
Preferred Stock
XYZ Company has issued preferred stock. The stock has 10% annual dividend and
a P100 par value and was sold at P95.00 per share. In addition, floatation costs
P2.50 per share must be paid.

REQUIREMENT: Calculate the cost of preferred stock.


Sample
Problem
Two types of Common Stock Financing
1. Retained earnings (internal common equity)
2. Issuing new shares of common stock (external common equity)

Cost of Two Methods of Determining Cost of Common Stock

Common Stock
3. Dividend Growth Model (DGM)
4. Capital Asset Pricing Model (CAPM)
This is known as GORDON GROWTH MODEL named after Myron Gordon.
This model assumes that dividends grow either at a stable rate in perpetuity
or at a different rate during the period.

Cost of Retained Earnings:

Dividend
Growth Model Cost of new ordinary shares:

How to convert D0 to D1:


D1 = [D0 X (1+Growth rate)]
Compute Ke and Kn under the following circumstances:
CASE A:
D1 = P4.50, P0 = 60.00, G=6%, F=4.00

CASE B:
Dividends just paid is P3, g = 9%, P0 = 60.00 F =3.50

Sample
Problem
This model describes the relationship between systematic risk and expected
return.

This model assumes the expected return of a particular stock depends on its
volatility (beta) relative to the overall stock market.

Capital Asset NOTE: If beta coefficient is greater than one, then there would be a higher
Pricing Model risk in price variation.
Using the basic equation for the capital asset pricing model (CAPM), find the
required return for an asset with a beta of 0.80 when the risk-free rate and
market return are 8 and 12 percent, respectively.

SAMPLE
EXERCISE
This is the calculation of the firm’s effective cost of capital, taking into
account the portion of its capital that was obtained from various sources.

Weighted To compute for the WACC, multiply the cost of each type of capital by their
respective weights (percentage of each source to the firm’s total capital

Average Cost of structure) and add up the individual weighted cost of capital.

Capital
Philippine Corp.’s capital structure is as follows:
Debt 35%
Preferred stock 15%
Common Equity 50%

Sample The after – tax cost of debt is 6.5% percent; the cost of preferred stock is 10 percent; and
the cost of common equity (in the form of retained earnings) is 13.5 percent.
REQUIRED: Calculate Philippine’s weighted average cost of capital.

Problem
Olympus Corp.’s capital structure is as follows:
Debt 40%
Preferred stock 20%
Common Equity

Sample New Stock 30%


Retained Earnings 10%

Problem The before – tax cost of debt is 10% percent; the cost of preferred stock is 8 percent; the
cost of common equity in the form of retained earnings is 10 percent; and the cost of
common equity in the form of new shares is 12%. Olympus’ tax rate is 40%.
REQUIRED: Calculate Olympus’ weighted average cost of capital.

You might also like