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COST OF CAPITAL, OPTIMAL CAPITAL STRUCTURE, and LEVERAGES

1.0 The fundamental concept

1.1 Cost of capital refers to the cost of using funds from long-term investors.
1.2 Investors (ie fund providers, capitalists, money providers) could either be long-term creditors or
owners. Long-term creditors primarily refer to bondholders. Owners include both the preference
and ordinary shareholders.
1.3 Long-term funds are generated from the financial markets, be selling debt and equity securities.
1.4 Financial market investors expect the following returns:

Fund Providers Securities Expected Returns

Long-term creditors Debt Interest
Preference Preference shares Dividends
shareholders
Ordinary Ordinary shares Dividends and
shareholders Growth

1.5 Cost of capital is the minimum rate of return of an investment to avoid impairment in the
shareholders’ value.
1.6 The computation of the cost of capital is prospective. Hence, the interest and dividends to be
used in the calculation of the cost capital should be prospective as well.
1.7 Cost of capital serves as a benchmark in evaluating proposed investment. To be acceptable, a
project return (ie, IRR) must be greater than the cost of capital.
1.8 The lower the cost of capital, the better it would be for the business.
1.9 The cost of capital for each of the securities issued in the capital market, using the Gordon Growth
Model, is computed as follows:

Sources of Cost of Capital

LONG-TERM Formula Per Comments
funds Financial Security
Long-term debt Interest is a tax deductible expense, as such, the cost of debt
EIR (1- TR)
(ie, Bonds should be net of tax.
Payable) EIR x ATR
Preference It is the preferred stock’s “yield rate”. The market price of the
shareholders’ DPS / MPPS (net) stock serves as the cost of investment. The market price of
equity the stock is determined net of flotation rate.
D/Pn
Ordinary shares Ordinary shareholders are the real owners of the business
EDPS / MPPS (net) organizations. If the business fails, they absorb the greatest
+ G impairment in equity. If the business grows, they register the
greatest increase in wealth. As such the growth rate is
factored in the cost of using ordinary equity.
D/Pn + G

Retained EDPS / MPPS Ordinary shares and retained earnings basically comprise the
earnings (gross) + G total ordinary shareholders’ equity. However, in the
computation of the cost of capital of retained earnings, the
market price per share is determined at gross, not at net of
D/P + G flotation.

DPS = Dividend per share

EDPS = Expected dividend per share = DPS (1 + G)
EIR = Effective interest rate
G = Growth rate
MPPS = Market price per share
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TR = Tax rate
ATR = After-tax rate

2.0 The weighted average cost of capital

2.1 The weighted average cost of capital (WACOC) is the average cost of all the components of the
company’s funds.
2.,2 The basis used in evaluating project proposals would be the weighted average cost of capital.
2,3 The weighing of the cost of capital is basically based on the optimal capital mix.
2.4 If the optimal capital mix is not available, the average is determined based on the market value
contributions of the funds.
2.5 The WACOC is computed as follows (simple capital structure):

(a) (b) (c) (d) e = (c x d)

Funds MV Individual COC (in %) Fraction WACOC
LTD Y EIR x ATR = x y/Z x.xx%
PSE Y D / Pn = x y/Z x.xx
OSE Y D / Pn + G = x y/Z x.xx
RE Y D / Pg + G = x y/Z x.xx
Total Z x.xx%
D = Expected dividend per share
LTD = Long-term debt
MV = Market values
OSE = Ordinary shareholders’ equity
PSE = Preference shareholders’ equity
RE = Retained earnings
Pn = Market price per share, net of flotation
Pg = Market price per share, gross

2.6 The EIR is determined by dividing the net interest paid over the net proceeds from the issuance
of the bonds. Net proceeds equal market price less flotation costs.
2.7 The issuance of a financial instrument or security (ie, bonds, preference share, and ordinary
share) normally needs the services of an underwriter who charges underwriting costs or the costs
of selling the security in the capital market. These underwriting costs are technically called as
the “flotation costs”.
2.8 Preference dividend per share = Dividend rate x Preference share par value
2.9 Preference shareholders’ equity is computed based on the market value of the preference shares.
2.10 The cheapest source of money is debt (e.g., bonds payable). And the most expensive source of
money is the ordinary equity.
2.11 Debt is the cheapest source of money because the risk related to creditor’s exposure is lower
than that of the owner’s. Also, interest expense is a tax deductible item, as such, it lowers further
the net cost of funds.
2.12 If there is a presence of lease payable and retained earnings, the weighted average cost of capital
is computed as follows:

(a) (b) (c) (d) (e = c x d)

Capital MV Individual COC Fraction WACOC
BP P y EIR x ATR = x y/Z x.xx%
LP Y EIR x ATR = x y/Z x.xx
PSE Y D / Pn = x y/Z x.xx
OSE Y D / Pn + G = x y/Z x.xx
RE Y D / Pg + G = x y/Z x.xx
Total Z x.xx%
LP = Lease payable
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3.0 Trading on Equity (the concept of leveraging)

3.1 Reducing the WACOC by balancing the proportional mix of debt and owners’ equity is trading on
equity.
3.2 An intelligent way to reduce cost of capital is by increasing the proportional mix of the long-term
debt over the other sources of capital. This is because debt has the lowest cost of capital.
3.3 If the business uses more debt to finance its operations, we say that the business is highly
leveraged. It means more debt, lower cost of capital, higher exposure to financial risk, and
expectedly, higher returns on ordinary equity. Again, we have here a risk-return trade-off, the
higher the risk, the higher the return, and vice-versa.

4.0 The Pecking Order

4.1 It is a concept which relates to the process of raising long-term capital. First, the mix of raising
capital shall be based on the optimal capital structure of the firm. If the absence of the optimal
capital structure, the priority of financing source shall be the bonds payable, the preference
shares, the retained earnings, and the last is the ordinary shares.

5.0 The U-Shaped Average (or marginal) Cost Capital Graph

5.1 The marginal cost of capital resembles that of a saucer (U-shaped) as depicted below:

COC %

OL

0 D/E Ratio
COC % = Cost of capital percentage
OL = Optimum level of financing by leverage
D/E Ratio = Debt-equity ratio

5.2 The U-shaped curve indicates that the cost of capital is high when the debt-to-equity ratio is low.
As debt increases, the cost of capital declines because the cost of debt is less than the cost of
equity. Eventually, the decline in the cost of capital levels off because the cost of debt ultimately
rises as more debt is used. This impresses an optimal debt situation where the cost of capital is
at the lowest. Beyond this optimal point, additional increases in debt relative to equity will then
increase the cost of capital.
5.3 The implication is that some debt is present in the optimal capital structure because the cost of
capital initially declines when debt is added. However, a point is reached at which debt becomes
excessive and the cost of capital begins to rise. Still, use of at least some debt financing will
enhance the value of the firm.

6.0 The Dividend Growth (Gordon Growth) Model

6.1 The dividend growth model is used to determine the cost of financing by using the ordinary
shareholders’ equity, either by issuing ordinary shares of stock or by using the retained earnings.
Using this model, the current market price of the stock is computed as:

where:
P = D /(R – G) P = market price per share, net
D = expected dividend
R = rate of return (required rate of return)
G = growth rate
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6.2 And the cost of new ordinary equity financing is:

Cost of new ordinary shares = D / P (net) +

G

7.0 The Capital Asset Pricing Model (CAPM)

7.1 The CAPM is the more practical way of determining the cot of capital of the firm. It takes the
perspective of the investor by starting from the risk-free rate and including the risk-premium rate
of investment as it deviates from the risk-free rate of long-term investment eg, Treasury Bonds.
By using the CAPM model, the cost of ordinary equity is computed as follows:

COE = RF +  (MR – RF) where :

COE = RF +  (Risk- COE= Cost of ordinary
Premium Rate) equity
RF = Risk-free rate
MR = Market risk
 = Beta coefficient

7.2 The beta coefficient () measures the risk of an investment relative to other corporate
investments. There is a positive correlation between the firm’s beta value and discount rate
applied to cash flows. That is, if the beta value increases, the discount rate increases, and vice-
versa. The beta coefficient of an individual stock is the correlation between the volatility (price
variation) of the stock market and the price of the individual stock. For example, if an individual
stock goes up by 14%, and the composite price index in the stock market rises only by 10%, the
company’s beta is 1.4 (i.e., 14%/10%).
8.0 The DOL, DFL, and TL
8.1 Leverage is the instrument used to create value.
8.2 There are two leverages in business, the operating leverage and the financial leverage.
8.3 Financial leverage is the funds from bondholders and preference shareholders to increase to
ordinary shareholders’ value.
8.4 The computations of the leverages are as follows:

DOL CM / EBIT
DFL EBIT / (EBIT – Interest expense – Preference
dividends before tax)
TL DOL x DFL
TL EBIT /(EBIT – Interest expense – Preference
dividends before tax)
where:
DOL Degree of operating leverage
DFL Degree of financial leverage
TL Total leverage
- done -
Problem 1
Cost of capital, basic principles. COC Corporation wishes to compute its weighted average cost of
capital to be used in evaluating capital expenditure proposals. Earnings, capital structure and current
market prices of the company’s securities on December 31, 2009 are as follows:

Par Value Total Par Amount Market Price/sh Flotation Costs Exp Growth Rate
10%, BP P1,000 P20 M P1,250 5%
15%, PS 100 5M 250 5%
OS 20 15 M 40 7% 8%
RE 10 M 8%
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EBIT P20 million

Current dividend per ordinary share P3
Tax rate 40%
Required:
a. Determine the weighted average cost of capital.
b. Assume all other data to be constant, except that that the capital structure of the company shall be as
follows:
Mortgage bonds, 10%, 10 years P31,000,000
Preference shares, 15%, P100 par value 5,000,000
Ordinary shares, no par, 300,000 shares 4,000,000
outstanding
Retained earnings 10,000,000
P50,000,000
Determine the new average cost of capital of COC Corp.
Solution Guide
a. Weighted average cost of capital = ?
Sources of Funds Market Values Financing Mix WA
Individual COC Ratio COC
10% BP
PSEquity
OSEquity
Total

b. Weighted average cost of capital = ?

Sources of Funds Market Values Financing Mix WA
Individual COC Ratio COC
10% BP
PSEquity
OSEquity
Total