COST OF CAPITAL

COST OF CAPITAL
These are specific costs of using long-term
funds, obtained from the different
sources: borrowed (debt) and invested
(equity) capital.
Cost of Debt
Source: Creditors

After-tax interest rate:

Interest yield rate (1 tax rate)
Cost of Preferred Stock
(PS)
Source: Preferred Stockholders

Formula:
Preferred dividend per share
Current market price or Net issuance
price
Cost of Common Stock/Retained
Earnings
Source: Common Stockholders

Formula:
Expected cash divided per share + DGR*
Market price per common share

*dividend growth rate

Important Notes
The dividend growth rate is assumed to
be constant over time.
In computing cost of CS & PS, the market
price should be net of flotation costs.
In computing the cost of RE, flotation cost
should be ignored as RE is not sold or
issued.
Alternatively, cost of equity capital may
be computed based on Capital Asset
Pricing Model (CAPM).
Flotation Costs
Is the cost of issuing securities in the
market.
Is normally incurred by issuing Initial Public
Offering shares in the exchange market.
E.G.
underwriting fees
Abnormal returns
Underpricing
Other direct and indirect expenses
Other terms used to denote Cost
of Capital/WACC
(Minimum) required rate of return
(Minimum) acceptable rate of return
Cut-off rate
Target rate
Desired rate of return
Standard rate
Hurdle rate
Opportunity cost of capital
Cost of Debt
The before-tax cost of debt for a firm
which has a 40 percent marginal tax rate
is 12 percent. The after-tax cost of debt
is
Cost of Debt
The before-tax cost of debt for a firm
which has a 40 percent marginal tax rate
is 12 percent. The after-tax cost of debt
is

7.2% = 12% (1 40%)

Cost of Preferred Stock
(PS)
What is the after-tax cost of preferred
stock that sells for $10 per share and
offers a $1.20 dividend when the tax rate
is 35%?
Cost of Preferred Stock
(PS)
What is the after-tax cost of preferred
stock that sells for $10 per share and
offers a $1.20 dividend when the tax rate
is 35%?

Cost of preferred = $1.20/$10.00 = 0.12,

or 12%
Cost of Common Stock
A firm has common stock with a market
price of $25 per share and an expected
dividend of $2 per share at the end of
the coming year. The growth rate in
dividends has been 5 percent. The cost
of the firm's common stock equity is
Cost of Common Stock
A firm has common stock with a market
price of $25 per share and an expected
dividend of $2 per share at the end of
the coming year. The growth rate in
dividends has been 5 percent. The cost
of the firm's common stock equity is

2/25 + 5% = 13%
Cost of Common Stock
What would be the cost of new common
stock equity for Klay Corp. if the firm
expects a dividend of $4.25, the stock
price is $55.00, dividends are expected
to grow at 8.5 percent indefinitely, and
flotation costs are $6.25 per share?
Cost of Common Stock
What would be the cost of new common
stock equity for Klay Corp. if the firm
expects a dividend of $4.25, the stock
price is $55.00, dividends are expected
to grow at 8.5 percent indefinitely, and
flotation costs are $6.25 per share?

4.25/(55-6.25) + 8.5% = 17.21%

Cost of Common Stock
What would be the cost of new common
stock equity for Thompson Corp. if the
firm just paid a dividend of $4.25, the
stock price is $55.00, dividends are
expected to grow at 8.5 percent
indefinitely, and flotation costs are $6.25
per share?
Cost of Common Stock
What would be the cost of new common
stock equity for Thompson Corp. if the
firm just paid a dividend of $4.25, the
stock price is $55.00, dividends are
expected to grow at 8.5 percent
indefinitely, and flotation costs are $6.25
per share?
(4.25*1.085%)/(55-6.25) + 8.5% =
17.96%
Weighted-Average Cost of
Capital (WACC)
Expected rate of return on a portfolio of all
the firms securities, adjusted for tax
savings due to interest payments.
 Example
Capital structure ROR
Debt 385.7 .243 9%
Common Stock 1200 .757 12%
Total 1585.7

*tax rate 35%

 WACC
Security Market Value COC
Debt 20 million 6%
PS 10 million 8%
CS 50 million 12%

Tax rate 35%

 WACC
The market value of Bato Corps common stock
(book value P65M) is estimated at P60M and the
market value of its interest bearing debt (book
value P35M) is estimated at P40M. The average
before tax yield on these liabilities is 15% per year.
Tax rate is 40%. The company is expected to pay
a dividend of P10 per share and the stock is
selling at a price of P100 per share. The growth
rate of dividend is projected to be 2.5% per year.
What is the WACC?
CAPITAL ASSET PRICING MODEL

The basic theory that links risk and

return for all assets.
TYPES OF RISK
Diversifiable risk the portion of an
assets risk that is attributable to firm-
specific, random causes; can be
eliminated through diversification. Also
called UNSYSTEMATIC RISK.

Firm-specific events, such as strikes,

lawsuits, regulatory actions, or the loss
of a key account.
Diversification
To reduce overall risk, it is best to
diversify by combining, or adding to the
portfolio, assets that have the lowest
possible correlation.

Combining assets that have a low

correlation with each other can reduce
the overall variability of a portfolios
returns.
TYPES OF RISK
Nondiversifiable risk The relevant portion
of an assets risk attributable to market
factors that affect all firms.

Cannot be eliminated through

diversification. Also called as systematic
risk.

Factors such as war, inflation, the overall

state of the company, international
incidents, and political events.
Beta Coefficient
A relative measure of nondiversifiable
risk. An index of the degree of
movement of an assets return in
response to a change in the market
return.
Market return
The return on the market portfolio of all
traded securities.
CAPM FORMULA
Ke = RF + B(RM RF)

Ke = Cost of Equity
Rf = Risk-free rate determined by
government securities
B = Beta coefficient
Rm = market return
CAPM
Benjamin Corporation wishes to determine
the required return on an asset Z, which
has a beta of 1.5. The risk-free rate of
return is 7%; the return on the market
portfolio of assets is 11%. What is the
cost of equity?
CAPM
Benjamin Corporation wishes to determine
the required return on an asset Z, which
has a beta of 1.5. The risk-free rate of
return is 7%; the return on the market
portfolio of assets is 11%.

Ke = 7% + 1.5(11%-7%)
Ke = 13%
CAPM
Button Corporation has a beta of 1.25, a
risk-free rate of 8% and a market risk
premium of 5%. What is the
corporations cost of equity.
CAPM
Button Corporation has a beta of 1.25, a
risk-free rate of 8% and a market risk
premium of 5%. What is the
corporations cost of equity.

Re = 8% + 1.25(5%)
Re = 14.25%