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Advanced Cost and Management Accounting adapted from:


UNIT 1 Cost of Capital

Notes are not exhaustive. Please attend lectures/ tutorials to get a full exposure to this subject.

Capital might be thought of as financing for a business. Businesses usually raise finance by a
variety of methods eg. debt, equity, or preferred stock. These three sources are referred to as
capital components, and each has its own component cost.

Cost of Debt: takes the form of interest. Failure to meet the payment schedule can force the
company into bankruptcy. Debt instruments, usually either a loan or a bond, can still be attractive
to a company because debt enjoys tax advantages which reduce interest costs, thereby lowering
the real cost of debt. The other two classes of capital do not benefit from such tax concessions.
Jamaican companies rarely raise debt capital by issuing bonds, preferring bank loans instead.

Cost of Preferred Stock takes the form of preference dividends. Preferred stock might be
regarded as a hybrid, having elements of both stocks (equity) and bonds (debt). Like bonds it has
a par value, and preference dividends are fixed, like interest. Like common stock, if its dividend
is not paid, it doesnt necessarily force the company into bankruptcy. It is not as widely used as
debt and common equity.

Cost of Equity: Common equity takes two forms; (i) retained earnings (ii) issuing new common
stock. The portion of a firms net earnings not paid out as dividends, is retained earnings, and is
an important source of funding for companies. Retained earnings, or internal equity, still belongs
to shareholders, and forms part of shareholders equity. They have an opportunity cost ie the firm
must invest them to provide at least returns that shareholders could otherwise have earned if it
was paid to them as dividends. New equity, or external equity, has flotation costs, ie payments to
investment bankers for structuring, pricing, and selling new stock, which make it more costly to
the firm than internal equity .

Cost of equity not as easily determined as those of debt and preferred stock. The Capital Asset
Pricing Model (CAPM), a widely used method of estimating it states: kS =kRF + (kM-kRF) where
kS is the required rate of return on the stock, kRF is the risk free rate, kM is the market rate, is the
stocks market risk.
Other methods of estimating cost of equity are also used; (a) bond yield + risk premium in which
a best judgment risk premium (3 5%) is added to the firms long term debt rate. Long term
debt cost is a good proxy for a firms riskiness. Strong firms (less risky) will have lower cost
long term debt than weaker (riskier) firms and will benefit from lower equity costs. (b) the
constant growth equation in which kE = D1 + g. where D1= next dividend, P0 =current price of
P0 the stock, g = growth rate

This is the dividend yield plus growth rate method.

Weighted Average Cost of Capital (WACC) Firms can have an optimal capital structure, ie a mix
of debt, preference, and common equity that maximizes their stock price. Some firms determine
their optimal capital structure and raise capital in a manner that maintains it. Proportions and
costs of these components are used to determine WACC.

Example 1

Eg a firms optimal capital structure was 45% debt at a cost (kD) of 10%, 2% Preference stock at
a cost (kp) of 10.3%, and 53% common equity at a cost (kc) of 13.4%. If the tax rate is 40%:


Find the weighted cost of capital


WACC = wdkd(1 T) + wpkp + wckc

= (.45 x 6%) + (.02 x 10.3%) + (.53 x 13.4%)
= 10%
NB. The WACC has a different cost from all the individual capital components. To maintain this
optimal capital structure, every $ of new capital should have debt 45 cents @ 6% (after tax), 2
cents preference @ 10.3% and 53 cents common equity @ 13.4%.

Factors affecting cost of capital Some factors eg interest & tax rates are outside a firms control.
Some arent, eg (i) capital structure. If this changes, cost of capital can change. Borrowing more
might (initially) tend to reduce WACC since debt is cheaper than equity. Increasing levels of debt
also tend to increase riskiness of the firm as the proportion of debt rises, eventually having the
opposite effect of raising WACC to compensate for increasing risk (ii) Dividend policy affects
retained earnings, the cheapest way of raising shareholders equity. High dividends reduce
retained earnings and might compel the firm to seek more external financing at higher cost for
future investments. (iii) The WACC assumes that the riskiness of investments the firm is going to
make are the same as those it has already made. Investment policy can therefore affect the firms
cost of capital. eg NCBs investment in a citrus plantation in the 1990s is far outside its normal
line of business and perhaps outside its ability to manage optimally. Such a venture is riskier
than its existing assets and financing is likely to be at a higher cost than the WACC.

(This unit was substantially covered in FOF, and a review of those Tutorial Questions would
suffice to prepare students to move on into the Corporate Finance module.)

Example 2

XYZ Company evaluates all projects using WACC. All projects consist of 60% leverage with the
remainder as equity. To finance the project, the entity floated a bond that has a yield of 15%
which is twice the risk free rate of interest.

Meanwhile, an average shareholder in the market requires a return of 20%. The stocks beta is
currently 1.20. The entitys marginal tax rate is 25%


Compute WACC


Risk Free Rate (krf) = 15%/2 = 7.5%

Using CAPM: Ke = krf + [ km - krf ]

Ke : 7.5% + [ 20% - 7.5% ] 1.2

Ke : 6% + [ 12.5% ] 1.5
Ke= 15%
Kdnet : (1 - 0.25) x 15% = 11.25%

WACC = wdkd+ wckc

Computation of: WACC

% Cost WACC
Debt 60% 11.25% 6.75%
Equity 40% 15% 6.00%
Total 100% 12.75%