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Cost of Capital.

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0% found this document useful (0 votes)
47 views22 pages

Cost of Capital.

Uploaded by

Bebegyn Aguilo
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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1.

SPECIFIC CAPITAL COMPONENT COSTS


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 rate a firm must pay on its new
debt. Firms can estimate this rate by inquiring from their bankers what it
will to borrow or by finding the yield to maturity on their currently
outstanding debt. However, the after-tax cast of debt should be used to
calculate the WACC. This is the interest rate on new debt less the tax
savings that result because interest is tax deductible.

After-tax cost of debt = Interest rate (1-Tax rate)

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.

Net proceeds of a = Market -

Flotation
bond sale Price costs

2. Compute the before-tax cost of the bond.


If the flotation costs are required and the bond sells at par, the before tax
cost of the bond is simply its coupon rate which is the interest rate paid
on the bond's par value. It is important to emphasize that the cost of
debt is the interest rate on new debt not on already outstanding debt
because our primary concern with the cost of capital is its use in capital
budgeting decision. For instance, would a new machine cam a return
greater than the cost of capital needed to acquire the machine? The
interest rate at which the firm has borrowed in the past is irrelevant
when answering this question because we need to know the cost of new
capital. For these reasons, the yield to maturity on outstanding debt
(which reflects current market condition) is a better measure of the cost
of debt than the coupon rate.
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.

NPd = 1 (PVIFAkd,n) + Pn (PVIFkd,n)

Where:
NPd = Net proceeds from the sale of bond, Pd - f

I = Annual Interest Payment in Pesos


Pn= Par or Principal repayment required in period n
Kd = Before-tax cost of a new bond issue
n = length of the holding period of the bond in years

t = Time period in years


PVIFA = Present value interest factor of an

annuity PVIF = Present value interest factor of a

single amount Pd - f = (Market price- Flotation


costs)

The before-tax cost of a new bond issue also means cost to maturity or yield to
maturity.

3. Compute the after-tax cost of debt using the following equation:

kdt = kd (1 – T)

Where:

kdt = After-tax cost of

debt kd = Before-tax

cost of debt T =

Marginal tax rate


Illustrative Case. Financing Through Issuance of Bonds
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, 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)

P954 = P95 (9.077) + P1,000


(0.092) P954 = P962.32 + P92 =
P1,054.32
Based on the results, the approximate cost of debt is less than 10%. It
can be computed as follows:
95+(1,000−954) 96.84
k = 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%

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. 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:

Kp = D
𝑝 �
N�
Where:
Dp = Annual dividend per share on preferred share.

NPp = Net proceeds from the sale of preferred share, (Market


price less flotation costs)

The cost of existing preferred share is determined by substituting the


current market price per share of preferred in the denominator in the
above equation that is, in lieu of net proceeds from sale of preferred
share.

Illustrative Case. Determination of Cost of New Preferred Share


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 costs of 3 percent of the par value
or P1.50 (0.03 x P25.00). Substituting Dp = P2.40 (4 x P0.60), NPp =
P23.50 (P25.00 – P1.50), the cost of new preferred share is:

Solution:
P2.40
K =
p
= 0.1021 or 10.21%
P23.50

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.

C.1 Cost of Equity


C.1.1 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 (rRF). 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 (bi) 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.

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:
rs = rRF + (RPm) bi
= rRF + (rM – rRF) bi

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. Calculation of Cost of Equity Shares Using the CAPM


Approach
Assume that in today's market, rRF = 5.6%, the market risk premium is
RPm = 5.0 %, and Zeta's beta is 1.48. Using the CAPM approach, Zeta's
cost of equity is estimated to be 13.0%.

Solution: rs = 5.6% + (5.0%) (1.48) = 13.0%

Illustrative Case. 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?

Solution: rs = 0.3 + (.09-.03)1.3 = .1080 or 10.80%

This approach is also used to measure the cost of retained earnings.

C.1.2.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 (rp). 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 k s is also
judgmental. Ks = kd + rp
Where:
kd = Base rate of long-term bonds of bond

yield rp = Risk premium

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.

Solution: Ks = 0.095 + 0.03 = 0.1250 or 12.50%

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 be used is as follows:

D𝑙
K�=
P
+
g� 𝑜
Where:

Ks = Cost or required rate of return of ordinary

equity Dl = Dividend expected to be paid at the

end of year 1 Po = Current stock price

g = Expected dividend growth rate

C.1.3. 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 l /
Po), but also a capital gain (g) for a total expected return of K s and
in equilibrium this expected return is also equal to the required rate
of return.

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%.

C.1.4.Earnings-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 (Po).

E
Ks
= P�

Where :

E = Current earnings per share


Po = Current market price of ordinary equity share
Illustrative Case. 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 o = P45.00.

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:

Ks = Cost of new ordinary equity shares

Di = Dividends to be received during the year [Do (1+g)]


Do = Dividend Yield

g = Dividend growth rate


NPs = Net proceeds of the new ordinary equity shares,

(Po - F) Po = Current Market price of the firm's Ordinary

equity shares F = Flotation costs

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.

When Must External Equity Be Used?


Because of flotation costs, pesos raised by selling new stock must "work
harder" than pesos raised by retaining earnings. Moreover, because no
flotation costs are involved, retained earnings cost less than new shares.
Therefore, firms should utilize retained earnings to the greatest extent
possible. However, if a firm has more good investment opportunities
than- can be financed with retained earnings plus the debt and preferred
share supported by those retained earnings, it may need to issue new
ordinary equity or ordinary share. The total amount of capital that can be
raised before new shares must be issued is defined as the retained
earnings breakpoints and it can be calculated as follows:

Illustrative Case. Determination of Retained Earnings Breakpoint


Zeta's addition to retained earnings in 2014 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 2014 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 Ks = 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.
2. PROBLEMS TO CONSIDER WITH ESTIMATES OF COST OF CAPITAL
There are a number of issues related to the cost of capital estimation
that an analyst should be aware of and choice of the applicable method
would require the use of the analyst's considerable judgment.
 Privately Owned Firms
The discussion of the cost of equity generally focused on publicly
owned firms and concentration was made on the rate of return by
public shareholders. What about the measurement of the cost of
equity for a firm whose shares are not traded? As a general rule,
the same principles of cost of capital estimation apply to both
privately held and publicly owned firms, but the problem of
obtaining input data are somewhat different. Tax issues are also
especially important in these cases.

 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.

 Capital Structure Weights


In the previous illustrations we took as given the trget capital
structure. The establishment of the target capital structure is a
major task in itself.

 Cost of Capital for Projects of Differing Risk


Different projects can differ in risk and, thus in their required rates
of return. Also it is difficult to measure a project's risk hence to
adjust the cost capital for capital budgeting projects with different
risks would also present some problems.

 Although the list of problems appears formidable, the procedures


presented in this section can be used to obtain costs of capital
estimates that are sufficiently accurate for practical purpose. Also,
the problems listed previously merely indicate the desirability of
refinements. The refinements are important but the problems
noted do not necessarily invalidate the usefulness of the
procedures outlined in this chapter.
3. DETERMINATION OF WEIGHTED AVERAGE COST OF CAPITAL
Once the specific cost of capital of each long term financing source is
measured, the firm's weighted average cost of capital (WACC), Ka, can be
determined.

The target proportions of debt, preferred share, and ordinary equity


along with the costs of those components are used to calculate the firm's
weighted average cost of capital.
Assuming that all new ordinary equity is raised as retained earnings, as is
true for most companies, the WACC can be computed as follows:

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.

Illustrative Case. WACC Determination Using Historical Weights and Market


Value Weights
A. The following data are available for Copper Pipe Company.

Required: Determine the WACC if the firm obtains new capital in Book
Value Proportions
Solution: The WACC is computed as follows:

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

Solution: The WACC is computed as follows:

Allocation of Ordinary Equity Share’s Market Value of P45,000,000


using the proportion to the sum of their book value.
B. TARGET WEIGHTS
Target weights are based on a firm's desired capital structure. Firms using target
weights establish these proportions on the basis of optimal capital
structure they wish to attain. Thus, the firm raises additional funds so as
to remain constantly on target with its optimal capital structure. The
preferable approach though is to use target weight based on market
values rather than historical weights. If these weights (market values)
are used, the share price will be maximized and the cost of capital
simultaneously will be minimized.

Illustrative Case. Calculation of WACC Using Target Weights


In addition to the data provided in A and B, Copper Pipe Company has
determined that its optimal capital structure is 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:

lllustrative Comprehensive Case: Calculation of Cost of Capital Components


Suppose that Whaller Corporation has a beta of 80. The market risk
premium is 6%, and the risk-free rate is 6%. Whaller's last dividend w
PL.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 Whaller's cost of equity capital or
expected return on Whaller's ordinary equity share?
2. Using the dividend growth model, what the expected return on
Whaller's ordinary equity share?
3. What is the average cost of equity?
4. In addition to the information given in the previous problem, Whaller
has a target debt-equity ratio of 50 percent. Its cost of debt is 9 percent
before taxes. If the tax rate is 35%, what is the WACC?
5. Suppose that Whaller is seeking P30 million for a new project. The
necessary funds will have to be raised externally. Whaller's flotation
costs for selling debt and equity are 2% and 16%, respectively. If
flotation costs are considered, what is the true cost of the new project?

Solution:
1. Using CAPM approach, the expected return on Whaller's ordinary
equity share is computed as follows:
Ks = rf + bi (rm -
rf)
Where:

rf = Risk-free rate of return


rm = Expected return on the market

portfolio rm - rf = Market risk premium

bi = Beta coefficient of ordinary equity share i

Ks = 6% + .80 (6%) = 10.80%


2. Using the dividend growth rate approach, the expected return on
ordinary equity is:
D𝑖
K�=
P
+
Where:
g� 𝑜
Di = Projected dividend per share
Po = Current price of ordinary equity
share g = Dividend growth rate

K𝑠
=
P1.20 x 1.08
P45 + .08

= + . 08
P1.296
P45

= 10.88%
3.
The average cost
of ordinary equity
share

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