Cost of Capital.
Cost of Capital.
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%
Computing the Cost of a New Bond Issue
The computation requires three steps:
1. Determine the net proceeds from the sale of each bond.
Flotation
bond sale Price costs
Where:
NPd = Net proceeds from the sale of bond, Pd - f
The before-tax cost of a new bond issue also means cost to maturity or yield to
maturity.
kdt = kd (1 – T)
Where:
debt kd = Before-tax
cost of debt T =
Required:
Management wants to calculate the
(a) net proceeds per bond,
(b)the before-tax cost of this bond issue, and
(c) the after-tax cost of the bond issue's flotation costs.
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.
NPd = P980 - P26 = P954
(b) Using the trial and errors approach, the before-tax cost of debt is
computed as follows:
P954 = (P95) (PVIFAi,n) + P1,000 (PVIFi,n)
Trial at 10%:
P954 = P95 (PVIFA0,10,25) + P1,000 (PVIF0,10,25)
𝑑
= = 9.91%
977
1,000+954
2
(c) The after-tax cost of new debt is computed as follows:
kdt = 9.91 (1-.34) = 6.54%
Kp = D
𝑝 �
N�
Where:
Dp = Annual dividend per share on preferred share.
Solution:
P2.40
K =
p
= 0.1021 or 10.21%
P23.50
Thus, the CAPM estimate of r, is equal to the risk-free rate (r RF) plus a risk
premium that is equal to the risk premium on an average stock (r M – rRF),
scaled up or down to reflect the particular stock's risk as measured by its
beta coefficient (bi).
Illustrative Case. 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 kd =
0.095 and rp = 0.03.
D𝑙
K�=
P
+
g� 𝑜
Where:
D𝑙
K� =
P
+ expected
g� 𝑜
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 rate 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
rate.
Illustrative Case. 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%.
K𝑠 =
Solution:
P1.25 + 8.3%
P23.0
6
= 5.4% + 8.3%
= 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%.
E
Ks
= P�
�
Where :
P6.50
Solution:
Ks = = 0.14444 𝑜𝑟 14.44%
P45.00
C.2 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.
K� = D𝑖
The equation is:
NP
+g
�
𝑠
Where:
The cost of new ordinary equity (Ks) is higher than the cost of retained
earnings (K^) because of the new issue must be adjusted for flotation
costs. These flotation costs include both underpricing and an underwriting fee.
Underpricing occurs when new ordinary equity share sells below the
current market price of outstanding ordinary equity share, in order to
attract investors and to compensate for the dilution of ownership that will
take place. An underwriting fee covers the cost marketing the new issue.
The Constant Growth Model assumes that dividends grow perpetually at
a constant annual rate, g. Estimates of g are usually based on historical
growth rates, if earnings and dividend growth rates have been stable in
the past, or on analysts’ forecasts.
Illustrative Case. 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:
D𝑖
K𝑠 = +g
P𝑜−F
P1.54
K𝑠 = P32.75−P6.
+ .06
55
= .1188 or 11.88%
Illustrative Case.
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?
D𝑖
K𝑠 =
Solution:
NP𝑠
+g
= P43.20 + 0.05
P3.60
= 0.0833 + 0.05
= 0.1333 or 13.33%
C.3 Cost of Retained Earnings
Some have argued that retained earnings should be "cost-free" because
they represent money that is "left-over" after dividends are paid. While it
is true that no direct costs are associated with retained earnings, this capital
still has a cost, an opportunity cost. The managers who work for the
shareholders can either pay out earnings in the form of dividend or retain
earnings for reinvestment in the business. When the decision is made,
the manager should recognize that there is an opportunity cost involved,
that is, the shareholders could have received the earnings as dividend
and invested this money in other stocks, bonds, in real estate, etc.
Therefore the firm needs to earn at least as much as any earnings
retained as the stockholder could earn an alternative investment of
comparative risk.
The cost of retained earnings is similar to the cost of existing ordinary equity share.
Measurement Problems
There are practical difficulties that are encountered in estimating
the cost of equity. For example, it is quite a formidable task to
obtain good import for the CAPM, for g in the formula K, = D, / P, +
g, and the risk premium in the formula K, = Bond Yield + Risk
Premium. As a result, we can never be sure of the accuracy of our
estimated cost of capital.
Note that only debt has a tax adjustment factor (I- T). As discussed in this
section, this is because interest on debt is tax deductible but preferred dividends
and returns on ordinary equity share (dividends and capital gains) are not.
A WACC can be computed for either the firm's existing financing or new
financing. The cost of capital acquired by the firm in earlier periods is not
relevant for current decision making because it represents a historical or
sunk cost. Thus, only the WACC for new financing is generally calculated.
WACC is computed 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
A. HISTORICAL WEIGHTS
Historical weights are based on the firm's existing capital structure. Firms
that believe their existing capital structure is optimal should use
historical weights. An optimal capital structure is the combination of debt
and equity that simultaneously maximizes the firm's market value and
minimizes its weighted average ernge cost of capital. There are two
types of historical weights: (a) Book value weights, and (b) Market value
weights.
a) Book value weights measure the actual proportion of each type of
permanent capital in the firm's structure based on accounting
values shown on the firm's balance sheet. This basis however may
misstate the WACC because they ignore the changing market
values of bonds and equity over time, and may not provide a useful
cost of capital for evaluating current strategies.
b) Market value weights measure the actual proportion of each type
of permanent capital in the firm's structure at current market
prices. This is considered more superior to book value weights
because they provide estimates of investors' required rates of
return. However, market value weights are less stable than book
value weights in computing cost of capital because market prices
change frequently.
Required: Determine the WACC if the firm obtains new capital in Book
Value Proportions
Solution: The WACC is computed as follows:
Bonds 40%
Preferred share 10%
Ordinary equity 50%
share
100%
The firm wants to maintain its optimal capital structure increasing future
long-term capital. The firm also expects to have sufficient retained
earnings so that it can use the cost of retained earnings as the ordinary
equity cost component. If Copper Pipe Company raises new capital in
target proportions, the firm's WACC can be computed as follows:
Solution:
1. Using CAPM approach, the expected return on Whaller's ordinary
equity share is computed as follows:
Ks = rf + bi (rm -
rf)
Where:
K𝑠
=
P1.20 x 1.08
P45 + .08
= + . 08
P1.296
P45
= 10.88%
3.
The average cost
of ordinary equity
share