COST OF CAPITAL

RISK AND RETURN

Generally, the higher the potential return of an investment, the higher the risk. There
is no guarantee that you will actually 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 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 has to meet.

For an investment to be worthwhile, the expected return on capital must be greater

than the cost of capital. The cost of capital is the rate of return that capital could be
expected to earn in an alternative investment of equivalent risk. If a project is of similar
risk to a company's average business activities it is reasonable to use the company's
average cost of capital as a basis for the evaluation. A company's securities typically
include both debt and equity; one must therefore calculate both the cost of debt and
the cost of equity to determine a company's cost of capital. However, a rate of return
larger than the cost of capital is usually required.

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).

The cost of debt is computed by taking the rate on a risk free bond whose duration
matches the term structure of the corporate debt, then adding a default premium. This
default premium will rise as the amount of debt increases (since, all other things being
equal, the risk rises as the amount of debt rises). Since in most cases debt expense
is a deductible expense, the cost of debt is computed as an after tax cost to make it
comparable with the cost of equity (earnings are after-tax as well). Thus, for profitable
firms, debt is discounted by the tax rate. The formula can be written as:

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 After-tax cost of debt = (Rf + credit risk rate) (1-T)

Where:
T is the corporate tax rate
Rf is the risk-free rate

The yield to maturity can be used as an approximation of the cost of capital. Yield to
maturity (YTM) is the annual return that a bond is expected to generate if it is held till
its maturity given its coupon rate, payment frequency and current market price.

Yield to maturity is essentially the internal rate of return of a bond i.e. the discount rate
at which the present value of a bond’s coupon payments and maturity value is equal
to its current market price.

Yield to maturity can also be calculated using the following approximation formula:
C + (F – P)/n
YTM =
(F + P)/2
Where:
C is the annual coupon amount
F is the face value of the bond
P is the current bond price
n is the total number of years till maturity

After-tax cost of debt can be determined using the following formula:

After-Tax Cost of Debt = Pre-Tax Cost of Debt × (1 – Tax Rate)
The gross or pre-tax cost of debt equals yield to maturity of the debt. The applicable
tax rate is the marginal tax rate.
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.

Cost of equity = Risk free rate of return + Premium expected for risk
Cost of equity = Risk free rate of return + Beta x (market rate of return- risk free
rate of return)
Es = Rf + βs (RM-Rf)
Where:
Es - The expected return for a security
Rf - The expected risk-free return in that market (government bond yield)
βs - The sensitivity to market risk for the security
RM - The historical return of the stock market/ equity market
(RM-Rf) - The risk premium of market assets over risk free assets.

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 The risk-free rate is taken from the lowest yielding bonds in the particular market, such
as government bonds

The Capital Asset Pricing Model (CAPM) describes the relationship between
systematic risk and expected return for assets, particularly stocks. CAPM is widely
used throughout finance for pricing risky securities and generating expected returns
for assets given the risk of those assets and cost of capital. The goal of the CAPM
formula is to evaluate whether a stock is fairly valued when its risk and the time value
of money are compared to its expected return.

Once cost of debt and cost of equity have been determined, their blend, the weighted-
average cost of capital (WACC), can be calculated. This WACC can then be used as
a discount rate for a project's projected cash flows.

COST OF RETAINED EARNINGS/COST OF INTERNAL EQUITY

Note that retained earnings are a component of equity, and therefore the cost of
retained earnings (internal equity) is equal to the cost of equity as explained above.
Dividends (earnings that are paid to investors and not retained) are a component of
the return on capital to equity holders, and influence the cost of capital through that
mechanism.

EXPECTED RETURN
The expected return (or required rate of return for investors) can be calculated with
the "dividend capitalization model", which is
DividendPayment/Share
Kcs = +
PriceMarket
GrowthRate

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.
Companies raise money from a number of sources: common equity, preferred equity,
straight debt, convertible debt, exchangeable debt, warrants, options, pension
liabilities, executive stock options, governmental subsidies, and so on. Different
securities, which represent different sources of finance, are expected to generate
different returns. The WACC is calculated taking into account the relative weights of
each component of the capital structure. The more complex the company's capital
structure, the more laborious it is to calculate the WACC. Companies can use WACC
to see if the investment projects available to them are worthwhile to undertake.

The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm's
cost of capital. The total capital for a firm is the value of its equity (for a firm without
outstanding warrants and options, this is the same as the company's market

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 capitalization) plus the cost of its debt (the cost of debt should be continually updated
as the cost of debt changes as a result of interest rate changes). Notice that the
"equity" in the debt to equity ratio is the market value of all equity, not the shareholders'
equity on the balance sheet. To calculate the firm’s weighted cost of capital, we must
first calculate the costs of the individual financing sources: Cost of Debt, Cost of
Preference Capital and Cost of Equity Capital. Calculation of WACC is an iterative
procedure which requires estimation of the fair market value of equity capital.

A calculation of a firm's cost of capital in which each category of capital is

proportionately weighted. All capital sources - common stock, preferred stock, bonds
and any other long-term debt - are included in a WACC calculation. All else equal, the
WACC of a firm increases as the beta and rate of return on equity increases, as an
increase in WACC notes a decrease in valuation and a higher risk.

The WACC equation is the cost of each capital component multiplied by its
proportional weight and then summing:
E D
WACC = x Re + x Rd x (1 -
T T
Tax)
Where:
Re - cost of equity
Rd - cost of debt
E - market value of the firm's equity
D - market value of the firm's debt
T-E+D
E/T - percentage of financing that is equity
D/T - percentage of financing that is debt
Tax - corporate tax rate

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.
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.

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 Illustrative Problem:
The Company went public by issuing 1,000,000 shares of common stock at P25 per
share. The shares are currently trading at P30 per share. Current risk-free rate is 4%,
market risk premium is 8% and the company has a beta coefficient of 1.2.

During last year, it issued 50,000 bonds of P1,000 par paying 10% coupon annually
maturing in 20 years. The bonds are currently trading at P950. The tax rate is 30%.

Required:
a. Calculate the proportion of equity and debt in capital structure.
b. Calculate the cost of equity
c. Calculate the after-tax cost of debt
d. Calculate the weighted average cost of capital

Solution:
a. Calculating Capital Structure Weights
Current Market Value of Equity
= 1,000,000 × P30
= P30,000,000
Current Market Value of Debt
= 50,000 × P950
= P47,500,000

Total Market Value of Debt and Equity

= P30,000,000 + P47,500,000
= P77,500,000

Weight of Equity
= P30,000,000 ÷ P77,500,000
= 38.71%

Weight of Debt
= P47,500,000 ÷ P77,500,000 (or 100% − 38.71%)
= 61.29%

b. Use either the dividend discount model (DDM) or capital asset pricing model
(CAPM). In the current example, the data available allow us to use only CAPM to
calculate cost of equity.

Cost of Equity
= 4% + (1.2 × 8%)
= 13.6%

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 100 + (1,000 – 950)/20
c. YTM =
(1,000 + 950)/2

= 10.51%

After-tax cost of debt = 10.51% × (1 − 30%)

= 7.36%

d. Calculating WACC
WACC = (38.71% × 13.6%) + (61.29% × 7.36%)
= 5.26% + 4.51%
= 9.77%

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 PROBLEMS

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.)

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?

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?

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.

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.

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.

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.

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.

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