Financial Management 2

Calculating Cost of Capital

Erika Mae Y. Perez, Guia Lois Q. Perez, Al-Vie
B.Pineda, Paula Joy C. Regala, Alyssa T. Ricafort,
and Angelou Bernadette G.
Group III- BSA IV

I.

Rationale
Generally, firms use a combination of debt and equity
sources to fund their operations, projects, and any
expansions they may undertake. Investors face different
kinds of risks associated with debt, preferred share and
ordinary equity so that their required rates of return for
each debt or equity source differ as well as the firm uses a
combination of different financing sources, the investors
average required rate of return must be calculated. The
weighted average is generally used since firms seldom use
equal amounts of debt and equity capital sources. The
weights are based on the proportionate debt and equity
capital used. In other words, when the firms use multiple
sources of capital, they need to calculate the appropriate
interest rate for valuing their firms cash flows or a
weighted average of the capital component cost.
Because there are different advantage and risks
associated with debt and equity financing, it is essential
to compute for the cost of using these kinds of sources.
This aims to answer the question, how much must the firm pay
to finance its operations and expansions using debt and
equity sources?

II.

Objective
1. Explain the need to compute the firms cost of
capital
2. Understand the specific investor-supplied capital
3. Calculate:
a. After-tax cost of debt
b. Cost of preferred share
c. Cost of ordinary equity share
d. Cost of retained earnings

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III. Pre-test
Why does a firm need to have a combination of debt and
equity sources for capital?
What is the advantage of using financial leverage to a
firm?
How does debt financing affect the interests of the
firms shareholders?
IV.

Learning Cell
Calculating the Cost of Capital
Significance of Cost of Capital (Significance and Components
of Cost of Capital, 2009)
Cost of capital is considered as a standard of
comparison for making different business decisions. The
importances of cost of capital are enumerated as follows:
1. Making Investment Decision
Cost of capital is used as discount factor in
determining the net present value. Similarly, the actual
rate of return of a project is compared with the cost of
capital of the firm. Thus, the cost of capital has a
significant role in making investment decisions.
2. Designing Capital structure
The proportion of debt and equity is called capital
structure. The proportion which can minimize the cost of
capital and maximize the value of the firm is called optimal
capital structure. Cost of capital helps to design the
capital structure considering the cost of each sources of
financing, investor's expectation, effect of tax and
potentiality of growth.

3. Evaluating The Performance

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Cost of capital is the benchmark of evaluating the

performance of different departments. The department is
considered the best which can provide the highest positive
net present value to the firm. The activities of different
departments are expanded or dropped out on the basis of
their performance.
4. Formulating Dividend Policy
Out of the total profit of the firm, a certain portion
is paid to shareholders as dividend. However, the firm can
retain all the profit in the business if it has the
opportunity of investing in such projects which can provide
higher rate of return in comparison of cost of capital. On
the other hand, all the profit can be distributed as
dividend if the firm has no opportunity investing the
profit. Therefore, cost of capital plays a key role
formulating the dividend policy.
Specific Capital Component Costs (Cabrera, 2013)
The investor-supplied items-debt, preference shares and
ordinary shares are called capital components. For instance,
XYZ Corporation can borrow money at 10% (net of tax); so its
component cost of debt is 10%. This cost is then combines to
form a weighted average cost of capital (WACC).
The cost of capital is the expected return to equity
owners (or shareholders) and to debt holders. Hence,
weighted average cost of capital (WACC) can be defined as
the 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 (Cost of
Capital, 2014). WACC tells us the return that both
stakeholders - equity owners and lenders - can expect. WACC,
in other words, represents the investor's opportunity cost
of taking on the risk of putting money into a company.

Cost of Debt

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Debt is one component of the business firm's capital

structure and usually the cheapest form of financing for the
company. Companies usually try to use as much debt financing
as possible, without raising their risk too much, because of
debt is inexpensive compared to the other forms of
financing. Other possible forms of financing and components
of the capital structure of the firm are preferred stock,
retained earnings, and new common stock (Peavler, 2014).
The cost of debt is the minimum rate of return required
by suppliers of debt (Cabrera, 2013). This can be measured
in either before- or after-tax returns; however, because
interest expense is deductible, the after-tax cost is seen
most often.
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 borrow or by
finding the yield to maturity on their currently outstanding
debt. However, the after-tax cost 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)
The cost of debt is usually based on the cost of the
company's bonds. Bonds are a company's long-term debt and
are little more than the company's long-term loans. The cost
of newly issued bonds is the best rate to use if possible
when calculating the cost of debt (Peavler, 2014).
If a company has no publicly-traded bonds, then the
business owner can look at the cost of the debt of other
firms in the same industry in order to get an idea of the
cost of debt.

The computation for the cost of a new bond issue requires

three steps (Cabrera, 2013):

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1. Determine the net proceeds from the sale of each bond.

Net proceeds of a bond sale = Market Price Flotation
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 paid on the bonds 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.
NPd = I (PVIFAkd,n) + Pn (PVIFkd,n)
Where:
NPd
I
Pn
Kd
n

=
=
=
=
=

t
=
PVIFA
PVIF
Pd-f

net proceeds from the sale of bond, Pd f

Annual Interest Payment in Pesos
Par or Principal repayment required in
period n
before-tax cost of new bond issue
length of the holding period of the bond in
years
time period in years
=
Present value interest factor of an
annuity
=
Present value interest factor of a
single amount
(Market price Flotation costs)

3. Compute the after-tax cost of debt.

kdt = kd (1 - T)
Where:
kdt
kd
T

=
=
=

After-tax cost of debt

Before-tax cost of debt
Marginal tax rate

Since a company will use various bonds, loans and other

forms of debt, so this measure is useful for giving an idea
as to the overall rate being paid by the company to use debt

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financing. The measure can also give investors an idea as to

the riskiness of the company compared to others, because
riskier companies generally have a higher cost of debt.
Cost of Preferred Share
Although preferred share is a part of a firms
permanent financing mix but is not frequently issued.
Preferred share is a hybrid security that has
characteristics of both debt and equity.
If preferred shares have fixed dividend payments and no
stated maturity dates, the component cost of new preferred
share is computed as follows:
Kp = Dp / NPp
Where:
Dp = Annual dividend per share on preferred share
NPp = Net proceeds from the sale of preferred share
Illustrative case:
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
cost of 3% of the par value or P0.75 (0.03 x P25).
Substituting Dp = P2.40 (4 x P0.60), NPp = P24.25 (P25
P0.75), the cost of new preferred share is:
Kp = P2.40/24.25
=9.90%
Cost of Ordinary Equity Share
Cost of ordinary equity share is more difficult to
measure 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.
Cost of existing ordinary equity share is the same as
the cost of retained earnings. They are similar but not
equal. The cost of new ordinary equity share is higher than

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the cost of retained earnings because of the flotation costs

involved.
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.
Step 2: Estimate the stocks beta coefficient (b) and use it
as an index of stock risk.
Step 3: Estimate the expected market risk premium.
Step 4: Substitute the values.
rs = rRF + (RPm) bi
= rRF + (rm rRF) bi
Illustrative case:
Assume that in todays market, Rrf = 5.6%, the market risk
premium is RPm = 5.0% and Zetas beta is 1.48.
Solution: rs = 5.6% + (5.0% x 1.48)
= 13.0%
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 shareholders equity. The
equation below shows that the required rate of return is
equal to some base rate (kd) plus a risk premium (rp).
Ks = kd + rp
Where: kd = Base rate of long-term bonds or bond yield
rp = Risk premium
Illustrative Case:
Prime Pipe Companys long- term bond rate is 9.5%. The
firms management estimates that its cost of equity should
require a 3% point risk premium above the cost of its own

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bonds. Using the generalized risk premium approach, the cost

of ordinary equity would be 12.5%.
Solution: Ks = 0.095 + 0.03
= 12.50%
3. Dividend Yield Plus Growth Rate Approach
Generally, both the price the expected rate of return
on an ordinary equity share, depend ultimately on the
shares 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:
Ks = Di
Po
Where:

+ g

Ks = Cost or required rate of return of ordinary

equity
Di = Dividend expected to be paid at the end of
year 1
Po = Current stock price
g = Expected dividend growth rate

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, but also a capital gain for a total expected
return of Ks and in equilibrium this expected return is also
equal to the required rate of return.
Ks = Di
Po

Illustrative Case:
Zeta stock sells for P23.06 , its expected dividend is
P1.25, and analysts expects its growth rate to be 8.3%.
Thus, Zetas expected and required rates of return are
estimated to be 13.7%.
Solution:
Ks = P 1.25
+ 8.3%
P23.06

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= 5.4% + 8.3%
= 13.7%
5. 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 firms 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 earningsprice ratio to measure the cost of ordinary equity.

Where:
E = Current earnings per share
= Current market price of ordinary equity share
Cost of New Ordinary Equity Share
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: Ks = Cost of new ordinary equity shares.
Di = Dividends to be received during the year
[Do (i + g)
Do = Dividend yield
g = Dividend growth rate
NPs = Net proceeds of the new ordinary equity shares
issue, (Po F)
Po = Current market price of the firms
Ordinary equity shares
F = Flotation costs
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. An underwriting fee
covers the cost marketing the new issue.
Cost of Retained Earnings

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Some have argued that retained earnings should be

costs free because they represent money that is leftover 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 cost of retained earnings is similar to the cost of
existing ordinary equity share.
V.

Conclusion
The cost of capital is being used in making investment
decisions, designing capital structure, evaluating the
performance of different departments, and in formulating
dividend policy. There are three components in which the
company may apply in their company: the items-debt,
preference shares and ordinary shares. These components are
then used in computing the weighted average cost of capital
(WACC). The company may use the three components or it may
choose among the three in decision making.
In calculating the after-tax cost of debt, the interest
rate on new debt less the tax savings that result because
interest is tax deductible. Preferred share is a hybrid
security that has characteristics of both debt and equity
and is calculated by dividing the annual dividend per share
on preferred share to net proceeds from the sale of
preferred share. Cost of ordinary equity share is more
difficult to measure than the cost of bonds or preferred
share. It has five approaches that may be used in
calculating its cost: the CAPM Approach, Bond Yield Plus
Risk Premium Approach, Dividend Yield Plus Growth Rate
Approach, Discounted Cash Flow (DCF) Approach and Earnings
Price Ratio Method.

VI.

Post Test
Why is there a need to compute the firms cost of
capital?
Enumerate the different approaches in computing the
cost of ordinary equity share.
When should a firm use external equity?
What are the problems associated with estimating cost
of capital?

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VII. References
Cost Of Capital - Weighted Average Cost Of Capital (WACC).
2014. Retrieved August 13, 2014, from
http://www.investopedia.com/walkthrough/corporatefinance/5/cost-capital/wacc.aspx
Cabrera, M. Financial Management Principles and
Applications. 2012. GIC Enterprises & Co., Inc. Manila,
Philippines.
Peavler, R. 2014. Calculate the Cost of Debt Capital.
Retrieved August 13, 2014, from
http://bizfinance.about.com/od/cost-ofcapital/qt/calculate-the-cost-debt-capital.htm
Significance and Components of Cost of Capital. 2009.
Retrieved August 13, 2014, from
http://accountlearning.blogspot.com/