The Cost of Capital, Capital Structure, and Dividend Policy

A. The Cost of Capital

Cost of Capital
refers to the opportunity cost of making an investment
is the rate of return required to persuade the investor to make a given investment
refers to the cost of equity if the business is financed solely through equity, or to the
cost of debt if it is financed solely through debt
*See Video of Cost of Capital
Weighted Cost of Capital/Weighted Average Cost of Capital
is the rate that a company is expected to pay on average to all its security holders to
finance its assets. The WACC is commonly referred to as the firm's cost of capital
is a calculation of a firm's cost of capital in which each category of capital is
proportionately weighted
*See Video of WACC
*See Video of Difference between Market Value and Book Value

WACC=

E
D
xRe+ xRdx (1Tc)
V
V

Re = Cost of Equity
Rd = Cost of Debt
E = Market Value of the Firms Equity
D = Market Value of the Firms Debt
V=E+D
E/V = Percentage of Financing that is Equity
D/V = Percentage of Financing that is Debt
Tc = Corporate Tax Rate
Example:
C. Cabrera, Inc. (CCI), a natural gas company, has a target capital structure consisting of 47
percent common equity, 51 percent debt, and 2 percent preferred stock. The company plans to
finance future capital investments in these proportions. All common equity is expected to be
derived internally from additions to retained earnings.
The marginal cost of internal common equity has been estimated to be 10.4 percent using the
dividend valuation approach. The marginal cost of preferred stock is 8.1 percent and the pretax
marginal cost of debt is 8 percent. The marginal tax rate is 40 percent. Using these figures,
determine the weighted cost of capital for CCI.
Source of Capital
Internal Common Equity
Debt

After-tax Cost
10.4%
4.8%

Target Proportion of Capital

0.47
0.51

Preferred Stock

8.1%

0.02

The Problem of Lumpy Capital

the weighted (or composite) cost of funds, not the cost of any particular component of
funds, is the cost a company is interested in for capital budgeting purposes
it is generally incorrect to associate any particular source of financing with a particular
project, that is the investment and the financing decisions should be separate
Example:
DG Packaging and Supply Firm is financed with 50% percent with debt and 50% percent with
equity. The after-tax cost of equity is 16%, and the after-tax cost of debt is 10%. The firm has
two plants, A and B, which are identical in every respect.
Giesel, the manager of Plant A proposes to acquire a new automated packaging machine
costing P500M. A bank has offered to loan the firm the needed P500M at a rate that will be
given the firm a 10% after-tax cost. The IRR for this project has been estimated to be 12%.
Because the rate of return exceeds the cost of funds (debt) used to finance the machine, Giesel
argues that the investment should be made.
Sarah, the manager of Plant B now argues that she, too, should be allowed to make a similar
investment. Unfortunately, she is reminded that the firm has a target capital structure of 50%
debt and 50% equity and that her investment will have to be financed with equity in order for the
firm to maintain its target capital structure. Because the cost of equity is 16% and the project
only offers a 12% return, the investment is denied for Plant B.
Are the arguments of the two managers acceptable?
Source of Capital
Debt
Equity

Relative Costs of Capital

After-tax Cost
Proportion
10%
0.5
16%
0.5
Weighted Cost of Capital =

Composite Cost

Computing the Component Costs of Capital

Components of Cost of Capital

o Debt
o Preferred Stock
o Retained Earnings
o Common Equity

Marginal Costs
o Is the cost of the next increments of capital raised by the firm, i.e., the cost of
various capital funding components (debt, preferred stock, and common equity)

Cost of Debt
o Is the rate of return required by a firms creditors
o For a debt issue, this rate of return, kd, equates the present value of all expected
future receipts interest, I, and principal repayment, M, - with the net proceeds,
Pnet, of the debt security

*See video of Cost of Debt

n

Pnet =
i=1

1
M
+
t
(1+k d ) (1+ k d )n

k i=k d (1T )

For Example:

To illustrate the cost-of-debt calculation for CCI, assume that the firm sells P100M of 20-year 7.8
percent coupon bonds. The net proceeds to CCI after issuance costs are P980 for each P1,000
bond. Compute the pretax cost, kd, and assuming a 40% marginal tax rate, compute the aftertax cost of debt.

Cost of Preferred Stock

o It is the rate of return required by investors on preferred stock issued by the
company. (Perpetual)

*See video of Preferred Stock

P 0=

Dp
kp

However, if we are to compute for kp:

k p=

Dp
Pnet

To illustrate, CCI has just issued 3 million shares of a preferred stock that pay an annual
dividend of P4.05. The preferred stock was sold to the public at a price of P52.00 per share.
With issuance costs of P2.00 per share, compute for the marginal cost of preferred stock.
*note that payments in the form of dividends are not tax deductible, therefore, after-tax cost of
preferred stock is equal to the pretax rate

However, some Preferred Stocks are callable, have a sinking fund redemption provision, or
have a fixed maturity date. In these cases, the computation of the cost of preferred stock
financing is similar to that for bonds.

Example:

Progress Energy plans an offering of P50.00 par value preferred stock that will pay P5.00
dividend per year. The preferred stock is expected to yield Progress net proceeds of P46.40 per
share after all issue costs. The preferred stock must be retired at its par value in 15 years.
Determine the cost of preferred stock.

Cost of Internal Equity Capital

o It is the equilibrium rate of return required by the firms common stock investors
o Firms raise equity capital in two primary ways:
Internally, through retained earnings
Externally, through the sale of new common stock

Capital Asset Pricing Model (CAPM) Approach

o Required Rate of return

k j=r f + j ( r mr f )
Where:

k j=the required rate of return

r f =the expected risk free rate
f =systematic risk measure for security
r m=theexpected returnthe market portfolio