Module V. Cost of Capital

Republic of the Philippines
NUEVA VIZCAYA STATE UNIVERSITY

Bayombong, Nueva Vizcaya
INSTRUCTIONAL MODULE
IM No.:IM-FM-2ND SEM-2019-2020
College: College of Business Education

Campus : Bayombong Campus
DEGREE BSBA COURSE FM 2

PROGRAM NO.
SPECIALIZATION Financial COURSE Financial Analysis & Reporting
Management TITLE
YEAR LEVEL 1st Year/2nd Year TIME FRAME 6hrs WK 13- IM 05
NO. 15 NO.
I. UNIT TITLE/CHAPTER TITLE: COST OF CAPITAL
II. LESSON TITLE :

Lesson 1: Understanding Cost of Capital
Lesson 2: Cost of Debt
Lesson 3: Cost of Preferred Stock
Lesson 4: Cost of Common Equity
Lesson 5: Cost of Retained Earnings
Lesson 6: Cost of New Common Stock
Lesson 7: Optimum Capital Structure
Lesson 8: Cost of Capital in the Capital Budgeting Process
Lesson 9: Capital Asset Pricing Model
III. LESSON OVERVIEW
In the corporate finance setting, the more likely circumstance is that an investment will be
made today- promising a set of inflows in the future- and we need to know the appropriate
discount rate. This chapter sets down the methods and procedures for making such a
determination.
The cost of capital represents the overall cost of financing to the firm. The cost of capital is
normally the discount rate to use in analyzing an investment. The cost of the capital is based
on the valuation techniques from the previous chapter and is applied to the bonds preferred
stock, and common stock.
A firm attempt to find a minimum cost of capital through varying the mix of its sources of
financing. The cost of capital may eventually increase as larger amounts of financing are
utilized.
IV. DESIRED LEARNING OUTCOMES:
1. Explain the relationship of the valuation concepts in the previous module to the cost of a
source of capital.
2. Enumerate and explain the three main source of capital use by a firm.
3. Determine the cost of debt, preferred share, common share and cost of retained earnings.
4. Determine and explain the after-tax cost of debt.
5. Determine the approximate yield to maturity.
6. Determine and explain the weighted average cost of capital.
7. Determine the optimal capital structure of a firm.
8. Calculate the required rate of return using the capital asset pricing model.
V. LESSON CONTENT
“In accordance with Section 185, Fair Use of Copyrighted Work of Republic Act 8293, the copyrighted works included in this material may be reproduced for
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NVSU-FR-ICD-05-00 (081220) Page 1 of 9
Lesson 1. UNDERSTANDING COST OF CAPITAL
If we invest money today to receive benefits in the future, we must be absolutely certain we are
earning at least as much as it cost us to acquire the funds for investment – that in the essence,
is the minimum acceptable return.
If funds cost the firm 10 percent, then all projects must be tested to make sure they earn at least
10 percent
By using this as the discount rate, we can ascertain whether we have earned the financial cost
of doing business.
.
Lesson 2. COST OF DEBT
The cost of debt is the effective interest rate a company pays on its debt. It’s the cost of debt
such as bonds and loans, among others. The cost of debt, which is the company’s cost of debt
before taking taxes into account.
However, the difference in the cost of debt before and after taxes lies in the fact that interest
expenses are deductible.
Formula 5-1. Approximate yield to maturity (Y’) =
Annual Interest + Principal payment - Price of the Bond

Payment Number of years to maturity
0.6 (Price of the bond) + 0.4 (Principal Payment)
Example. Assume the debt issue Baker Corporation pays $101.50 per year in the interest, has
a 20-year life, and is currently selling for $940. To find the current yield to maturity on the debt,
we could use the trial and error process described in the previous chapter. That is, we would
experiment with discount rates until we found the rate that would equate the current bond price
of $ 940 with interest payments of $ 101.50 for 20 years and a maturity payment of $1000.
For the bond under discussion, the approximate yield to maturity (Y’) would be:
$101. $1,000 - $940

Y' = +
5 15
0.6 ($ 940) + 0.4 ($1,000)
= 10.84 %
Since interest in tax deductible, its true cost is less than its stated cost because the government
is allowing the firm to pay less tax. The after tax cost of debt is actually the yield to maturity
times one minus the tax rate. This is presented in formula 5-2.
Formula 5-2. Cost of Debt
Kd (Cost of Debt) = Y (Yield) (1-T)

= 10.84% (1-.35)
= 10.84% (.65)
= 7.05%
(Note: Yield used above is actually the interest of the debt paid to the creditor.)
Lesson 3: COST OF PREFERRED STOCK
The cost of preferred stock to the company is effectively the price it pays in return or the income
it gets from issuing and selling the stock. Similar to the cost debt in that a constant annual
payment is made but dissimilar in that there is no maturity date on which a principal payment
must be made.
Flotation Cost- selling cost of new preferred share issued.
Considering the floatation cost, the cost of preferred stock is presented as formula 3-3.
Formula 5-3. Cost of Preferred Stock
Dp
Kp =
Pp - F
Where: Kp = Cost of Preferred Stock
Dp = The annual dividend on preferred stock
Pp = Price of preferred stock
F = Floatation Cost
In the case of the Baker Corporation, we shall assume the annual dividend is $10.50, the
preferred stock price is $100, and the flotation, or selling cost is $4. The effective cost is:
$10.50
Kp =
$100-$4
K p = $10. 94%
Lesson 4: COST OF COMMON EQUITY
Formula 5-4. Valuation Approach: Cost of Common Equity
D1
Po =
Ke - g
Where:
P₀ = Price of the stock today
D₁ = Dividend at the end of the first year (or period)
Kₑ = Required rate of return
g = Constant growth rate in dividends
We could arrange the terms in the formula to solve for ‘Ke’ instead of ‘P’. This is
presented in Formula 5-4.
K = D1 + g
Po
If D₁ = $2 P₀ = $40 and g = 7%, we would say Kₑ equals 12 percent.
$2
K = + 7%
$40
K = 12%
Alternative calculation of the required return on common stock
Formula 5-5.
K ⱼ = Rϝ + β (Km- Rϝ)
Where:
Kⱼ = required return on common stock
Rϝ = risk free rate of return; usually the current rate on treasury bill securities
β = beta coefficient. The beta measures the historical volatility of an individual stocks
return relative to a stock market index. A beta greater than indicates greater
volatility (price movement) than the market, while the reverse would be true for a
beta less than 1.
Km = return in the market as measured by an appropriate index.
For the Baker Corporation example, we might assume the following values:
Rϝ = 5.5%
Km = 12%
β = 1.0
Kⱼ. based on formula 5-5

Kⱼ = 5.5% + 1(12% - 5.5%) = 5.5% 1(6.5%)
=5.5% + 6.5% = 12%
Lesson 5. COST OF RETAINED EARNINGS
Accumulated retained earnings represent the past and present earnings of the firm minus
previously distributed dividends. Retained earnings, by law, belong to the current stockholders.
They can be paid out to the current stockholders in the form of dividends or reinvested in the
firm.
Formula 5-6: Cost of Retained Earnings

D1
Ke = + g
Po
Kₑ = cost of common equity in the form of retained earnings

D₁ = dividend at the end of the first year, $2
P₀ = price of the stock today, $40
g = constant growth rate in individuals in dividends, 7%
we arrive at the value of 12%
Computation of Cost of Retained Earnings

$2
Ke = + 7%
$40
Lesson 6: COST OF NEW COMMON STOCK
The cost of common stock is common stockholders required rate of return. If we are issuing
new common stock, we must earn slightly higher return of present stockholders. The higher
return is needed to cover the distribution of costs of new securities.
Common Stock Formula (5-4)
Ke = D1 + g
Po
Formula 5-7. New Common Stock
Ke = D1 + g
Po - F
Assume the required return for present stockholders is 12 percent and shares are quoted to the
public at $40. A new distribution of securities must earn slightly more than 12% to compensate
the corporation for not receiving the full $40 because of sales commission and other expenses.
The only new term is F (flotation, or selling costs). Assume:

D₁ = $2; P₀ = $40; F = $4; g = 7%
Then:
Ke = $2 + 7%
$40 - $4
K e = 12.6%
THE MARGINAL COST OF CAPITAL
The marginal cost of capital is the cost of raising an additional dollar of a fund by the way of
equity, etc.
It is the combined rate of return required by the debt holders and shareholders for the financing
of additional funds of the company.
Lesson 7. OPTIMUM CAPITAL STRUCTURE
The Optimal Capital Structure of a firm is the best mix of debt and equity financing (preferred
share and common share) that maximizes a company’s market value at the same time
minimizing its capital. It is then necessary for a company to determine its lowest weighted
average cost of capital (WACC). The optimal capital structure may also be defined as the
proportion of debt and equity that results in the lowest weighted average cost of capital.
After establishing the techniques for computing the cost of the various elements in the capital
structure, assign weight to capital components according to the desire to achieve a minimum
overall cost of capital- OPTIMUM CAPITAL STRUCTURE.
For purpose of this discussion, Cost of Capital of Baker Corporation is provided below:
Assume that you are going to start your own company and are considering three different
capital structures. For ease of presentation, only debt and equity are being considered.
The firm is able to reduce the weighted average cost of capital with debt financing, but beyond
Plan B, the continued use of debt becomes unattractive and greatly increases the cost of
sources of financing.
Capital Acquisition and Investment Decision Making
 Financial Capital consists of bonds, preferred stock and common equity.

 These forms of capital appear on corporate balance sheet under liabilities and
Shareholders’ equity.
 The money raised by selling these securities and retained earnings is invested in the
real capital of the firm, the long-term productive assets of plant and equipment.
 Long-term funds are usually invested in long-term assets, with several asset financing
mixes possible over the business cycle.
 A firm has to find a balance between debt and equity to achieve its minimum cost of
capital
Lesson 8. Cost of Capital in the Capital Budgeting Process
Regardless of the particular source of funds the company is using for the purchase of an asset,
the require rate of return or discount rate will be the weighted average cost of capital. As long
as the company earns its cost of capital, the common stock value of the firm will be maintained.
Assume that Baker Corporation was considering making an investment in eight projects with the
return and costs shown below:
Cost of Capital and Investment Projects for the Baker Corporation
The use of the weighted cost of capital assumes the Baker Corporation is in its optimum
capital structure range
 The cost of capital has no guarantee that it will remain constant for as much money as it
wants to raise even if a given capital structure is maintained.
 If a large amount of financing is desired, the market may demand a higher cost of capital
for each amount of fund desired.
CAPITAL ASSET PRICING MODEL (CAPM)

The Capital Asset Pricing Model describes the relationship between systematic risk and
expected return for assets, particularly stocks. It is being used throughout finance for pricing
risky securities and generating expected returns for assets given the risk of those assets and
cost of capital.
The determination of the required rate of return of an asset is use as a basis in making
decisions about adding assets to a diversified portfolio.
The CAPM Formula

Expected Return = Risk-Free Rate + Beta (Market Return – Risk-Free Rate)
For example, if the risk free rate is 5%, the market return is 10%, and the stock’s beta is 2, then
the expected return on the stock would be 15%.
15% = 5% + 2 (10% – 5%)
 Risk-free rate is the rate of return of investment without risk;
 Beta is a factor that measures an asset’s sensitivity to movements in the overall stock
market.
 The market risk premium is the difference between the expected return on a market
portfolio and the risk-free rate.
VI. LEARNING ACTIVITIES
Activity 1.
1. The Charitable Foundation,which is tax exempt, issued debt last year at 8 percent to help
finance a new playground facility in Chicago. This year, the cost of debt is 15 percent higher;
that is, firms that paid 10 percent for debt last year would be paying 11.5 percent this year.
A. If the Charitable Foundation borrowed money this year, what would be the aftertax cost of
debt be, based on their cost last year and the 15 percent increase?
B. If the Foundation was found to be taxable by International Reporting Standards at a rate of
35% because it was involved in political activities, what would be the after-tax cost of debt?
2. Burger Queen can sell preferred stock for P70 with an estimated floatation cost of P2.50. It
is anticipated that the preferred stock will pay P6 per share in dividends.
A. Compute the cost of preferred stock for Burger Queen.
B. Do we need to make a tax adjustment for the issuing firm?
VII. ASSIGNMENT
3. Global Technology’s capital structure is as follows:

Debt 35%
Preferred Stock 15%
Common Equity 50%
The after-tax cost of debt is 6.5 percent; the cost of preferred stock is 10 percent; the cost of
common equity (in the form of retained earnings) is 13.5 percent. Calculate Global
Technology’s weighted average cost of capital.
4. As an alternative to the capital structure shown in Problem 3 for Global Technology, an

outside consultant has suggested the following modifications:
Debt 60%
Preferred Stock 5%
Common Equity 35%
Under this new and more debt-oriented arrangement, the after-tax cost of debt is 8.8 percent,
the cost of preferred stock is 11 percent and the cost of common equity is 15.6 percent.
4.1. Recalculate Global Technology’s weighted average cost of capital.
4.2. Which plan is optimal in terms of minimizing the weighted average cost of capital?
VIII. REFERENCES
Block, S. and Hirt G. (Ninth Edition) Foundations of Financial Management, US: Irwin McGraw-
Hill
Cabrera, M.E and Cabrera, M.A. (2017). Management Accounting Concepts and Application.
2017 Edition. GIC Enterprises & Co., Inc., Manila, Philippines
Higgins, R.,(Eleventh Edition). Analysis for Financial Management, McGraw Hill Education:
Singapore
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Republic of the Philippines

NUEVA VIZCAYA STATE UNIVERSITY

College: College of Business Education

DEGREE BSBA COURSE FM 2

I. UNIT TITLE/CHAPTER TITLE: COST OF CAPITAL

II. LESSON TITLE :

III. LESSON OVERVIEW

IV. DESIRED LEARNING OUTCOMES:

Lesson 1. UNDERSTANDING COST OF CAPITAL

Formula 5-1. Approximate yield to maturity (Y’) =

Annual Interest + Principal payment - Price of the Bond

$101. $1,000 - $940

Formula 5-2. Cost of Debt

Kd (Cost of Debt) = Y (Yield) (1-T)

Lesson 3: COST OF PREFERRED STOCK

Flotation Cost- selling cost of new preferred share issued.

Formula 5-3. Cost of Preferred Stock

Lesson 4: COST OF COMMON EQUITY

Formula 5-4. Valuation Approach: Cost of Common Equity

Alternative calculation of the required return on common stock

Kⱼ. based on formula 5-5

Lesson 5. COST OF RETAINED EARNINGS

Formula 5-6: Cost of Retained Earnings

Kₑ = cost of common equity in the form of retained earnings

we arrive at the value of 12%

Computation of Cost of Retained Earnings

Lesson 6: COST OF NEW COMMON STOCK

Common Stock Formula (5-4)

The only new term is F (flotation, or selling costs). Assume:

THE MARGINAL COST OF CAPITAL

Lesson 7. OPTIMUM CAPITAL STRUCTURE

Capital Acquisition and Investment Decision Making

 Financial Capital consists of bonds, preferred stock and common equity.

Lesson 8. Cost of Capital in the Capital Budgeting Process

Cost of Capital and Investment Projects for the Baker Corporation

CAPITAL ASSET PRICING MODEL (CAPM)

The CAPM Formula

15% = 5% + 2 (10% – 5%)

 Risk-free rate is the rate of return of investment without risk;

VI. LEARNING ACTIVITIES

3. Global Technology’s capital structure is as follows:

4. As an alternative to the capital structure shown in Problem 3 for Global Technology, an

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