UNIT 3: COST OF CAPITAL

INTRODUCTION

The acceptance criterion for capital investments is perhaps the most difficult and
controversial topic in finance. We know that in theory the minimum acceptable rate
of return on a project should be the rate that will leave the market price of the
company’s common stock unchanged. The difficulty lies in determining this rate in
practice. The reason is that predicting the effect of capital investment decisions on
stock prices is an inexact science (some would call it an art form), estimating the
appropriate required rate of return is inexact as well. Rather than skirt the issue, we
address it head on and propose a general framework for measuring the required
rate of return. The idea is a simple one. We try to determine the opportunity cost
of a capital investment project by relating it to a financial market investment with
the same risk.

UNIT LEARNING OBJECTIVES

By the end of this unit you should be able to:

◼ explain the importance of knowing the concept of cost of capital;
◼ identify the different components of a firm’s capital structure;
◼ examine each of the key assumptions underlying the computation of cost of
capital;
◼ exemplify the need to compute for the weighted average cost of capital;
◼ apply the formula for computing the cost of long-term debt;
◼ calculate the cost of preferred stock;
◼ determine the cost of common stock in any given stock issuance;
◼ explain the theory behind the formula in computing the cost of retained earnings;
◼ exemplify the need to compute for the weighted average cost of capital;
◼ correlate economic value added to weighted average cost of capital; and
◼ distinguish marginal cost from weighted average cost of capital.

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 TIMING

This unit is good for one week. It covers the 4th week of this course from November
4 - 10, 2020 To get the most out of this unit I encourage you to spend at least 1 hour per
day studying it. Consistency helps you build momentum in your study which makes you
more productive. Besides, the content is easy to understand which helps you to build
momentum in your study.

GETTING STARTED

3.1 Concept of Cost of Capital

The cost of capital is the cost of raising money through debt or equity or both. If you are
starting a small business, you will encounter one of the first roadblocks of business – how
to raise capital. Most small businesses would then resort to the simplest solution which is
borrowing money. When you raise capital through borrowing money from the bank or
any other financial institution, the borrowed money is never lent for free. The bank or
financial institution will charge you interest. Such interest is what we call as the cost of
capital raised through borrowing.

On the other hand, big corporations may also resort to borrowing in order to raise money.
Another way for them to raise money though, is through the issuance of shares. When
corporations issue shares the shareholder becomes one of the owners of the corporation.
In exchange for such ownership, the shareholder would give the corporation cash as a
consideration in buying a certain number of shares.

The Magic Number

The cost of capital acts as a link between the firm’s long-term investment decisions
and the wealth of the owners as determined by investors in the marketplace.
It is the “magic number” that is used to decide whether a proposed investment will
increase or decrease the firm’s stock price. Formally, the cost of capital is the rate of return
that a firm must earn on the projects in which it invests to maintain the market value of its
stock. However, in order to maximize shareholder’s wealth, the rate of return of an
investment or project must be greater than the cost of capital required to finance it.
For example, a firm wants to pursue a P100 million worth investment. The
investment would give the firm 10% annual return on investment. In order to finance such
investment, the firm needs to borrow money from a local bank that offers a 6% rate of
interest. Now, should the firm pursue the project or not? Let’s make a simple computation:

Annual Return from the project (P100M x 10%) P 1,000,000

Less: Cost of capital (P100 x 6%) (600,000)
Net income P 400,000

Since the project would be contributing a net positive income of P400,000 per year
to the company, the project should be pursued. As a rule of thumb, if the rate of return of
a project (10%) is greater than the cost of capital (6%) required to finance the project,
then a firm should say pursue the project.
Otherwise, if the cost of capital is greater than the rate of return of any project,
then the company must not invest on such a project. This is because if it does, it will just
incur a loss.

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Hence, assuming the abovementioned scenario. If the project will only generate a 6%
annual return on investment and given a cost of capital of 10%, following computation
would result:

Annual Return from the project (P100M x 6%) P 600,000

Less: Cost of capital (P100 x 10%) (1,000,000)
Net loss P (400,000)

3.2 Capital Structure

Capital structure refers to the mix (or proportion) of a firm’s permanent long-term
financing represented by debt, preferred stock, and common stock equity. It is important
to know each of the elements of the capital structure since each of them has a
corresponding cost.

The first component of the capital structure is the firm’s long-term debt. The cost associated
with this element is the interest payable to the creditor either annually or at the maturity
of the debt depending upon the stipulations of the contract.

The second component of the capital structure is the preferred stock. This represents money
raised by issuing preferred shares to investors. The cost associated with this element is the
dividend which the preferred shareholders expect to receive from the firm in exchange for
their investment.

The third element of the capital structure is the common stock. Unlike preferred
shareholders who are merely investors of the firm, common shareholders are owners of
the corporation. The cost associated with this element is also in the form of dividends
expected to be received by each common shareholder.

3.3 Key Assumptions

Some of the key assumptions underlying the computation of cost of capital are:

1. Business Risk—the risk to the firm of being unable to cover operating costs—is
assumed to be unchanged. This means that the acceptance of a given project does
not affect the firm’s ability to meet operating costs.
2. Financial Risk—the risk to the firm of being unable to cover required financial
obligations—is assumed to be unchanged. This means that the projects are financed
in such a way that the firm’s ability to meet financing costs is unchanged.
3. After-tax costs are considered relevant—the cost of capital is measured on an after-
tax basis.

3.4 Cost of Long-term Debt

As discussed in the underlying key assumptions in the computation of cost of capital, the
cost of capital is measured on an after-tax basis. Hence, in computing for the cost of long-
term debt, we need to factor in the applicable tax rate. The following formula would then
result after integrating tax in the equation:

After-tax Cost of Debt = Before-tax cost of debt (1 – Tax rate)

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ILLUSTRATION: UNIQUE Corporation, a major hardware manufacturer, is contemplating
selling P10 million worth of 20-year, 9% coupon bonds with a par value of
P1,000. The applicable tax rate is 20%. Assuming the proceeds of the loan
is equal to its face value of P10 million, what is the after-tax cost of long-
term debt?

Solution:
After-tax Cost of Debt = 9% (1 – 20%)
= 7.2%
Take note that, since the proceeds from the loan is equal to its face
value P10 million, the stated rate of 9% is automatically the before-
tax cost of debt.

3.5 Cost of Preferred Stock

The cost of preferred stock is a function of its stated dividend. This dividend is not a
contractual obligation of the firm but, rather, is payable at the discretion of the firm’s
board of directors. Consequently, unlike debt, it does not create a risk of legal
bankruptcy.

To the holders of common stock, however, preferred stock is a security that takes
priority over their securities when it comes to the payment of dividends and to the
distribution of assets if the company is dissolved. Most corporations that issue preferred
stock fully intend to pay the stated dividend. The market-required return for this stock,
or simply the yield on preferred stock, serves as our estimate of the cost of preferred
stock.

The formula in computing the cost of preferred stock is as follows:

Cost of P/S = Stated Annual Dividend ÷ Current Market Price

Example:

If a company were able to sell a 10 percent preferred stock issue (P50 par value) at a current
market price of P49 a share, what is the cost of preferred stock?

The cost of the issued preferred stock will simply be computed as follows:

Cost of P/S = Stated Annual Dividend ÷ Current Market Price

= P 5 ÷ P49
= 10.20 %

Take note that the P5 annual dividend was computed by multiplying the annual
dividend rate of 10% to the par value of the preferred stock.

3.6 Cost of Common Stock

The cost of equity capital is by far the most difficult cost to measure. Equity capital can be
raised either internally by retaining earnings or externally by selling common stock. In
theory, the cost of both may be thought of as the minimum rate of return that the company
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must earn on the equity-financed portion of an investment project in order to leave the
market price of the firm’s common stock unchanged. If the firm invests in projects having
an expected return less than this required return, the market price of the stock will suffer
over the long run.

There are two forms of common stock financing: retained earnings and new issues of
common stock. In addition, there are two different ways to estimate the cost of common
equity: any form of the dividend valuation model, and the capital asset pricing
model (CAPM). The dividend valuation models are based on the premise that the value
of a share of stock is based on the present value of all future dividends.

Using the Constant Growth Model, we have:

Cost of C/S = Expected dividend

+ Growth Rate
Current Market Price

Example:

Assume a firm has just paid a dividend of P2.50 per share, expects dividends to grow at
10% indefinitely, and is currently selling at P50 per share. What is the cost of common
stock using constant growth model?

Solution:
P 2.50 x ( 1+.10 )
Cost of C/S = + .10
P 50

= P 2.50 x ( 1.1 )
+ .10
P 50

P 2.75
= + .10
P 50

= 0.055 + .10

= 0.155

Therefore, the cost of preferred stock is 15.5%.

Capital Asset Pricing Model (CAPM)

Rather than estimating the future dividend stream of the firm and then solving for the cost
of equity capital, we may approach the problem directly by estimating the required rate
of return on the company’s common stock. The formula for computing the cost of
common equity using CAPM is as follows:

Cost of C/S = Rf + (Rm – Rf) β

where. Rf is the risk-free rate, Rm is the expected return for the market portfolio, and β
the beta coefficient. We know that because of the market’s aversion to systematic risk, the
greater the beta of a stock, the greater its required return. It implies that in market
equilibrium, security prices will be such that there is a linear trade-off between the required
rate of return and systematic risk, as measured by beta.

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EXAMPLE:

Suppose that the beta for San Miguel Company was found to be 1.20, based on monthly
excess return data over the last five years. Furthermore, assume that a rate of return of
about 13 percent on stocks in general is expected to prevail and that a risk-free rate of 8
percent is expected.

SOLUTION:

Based on the information above the computation of the cost of common stock would
be:

Cost of C/S = 8% + (13% - 8%) x 1.20

= 8% + (5%) x 1.20
= 8% + 6%
= 14%

3.7 Cost of Retained Earnings

The cost of retained earnings is the cost to a corporation of funds that it has generated
internally. If the funds were not retained internally, they would be paid out to investors in
the form of dividends. Therefore, the cost of retained earnings approximates the return
that investors expect to earn on their equity investment in the company, which can be
derived using the capital asset pricing model (CAPM) or Dividend Growth Model.

3.8 Weighted Average Cost of Capital (WACC)

The simple rule is this: if the promised return of an investment is greater than the cost of
capital, the firm should pursue the investment. So, if an investment promises a 12% return
on investment and the cost of capital required to finance such investment is only 5%, the
firm should say yes to the investment.

However, consider a P100 million worth of investment. If 20 million is to be financed by

debt with a cost of 6% and the other 80% is to be finance by preferred equity costing
10%. Would it be profitable for the firm to pursue the 100M investment if the promised
return is 8% annually?

If the 8% return is compared to the cost of debt of 6%, then the company should pursue
the investment. The problem is, if the 8% return is compared to the 10% cost of capital
from preferred equity, then the company should say no to the project since the cost of
preferred equity (10%) is greater than the return (8%). Obviously, this creates a dilemma
to the decision-maker in that if cost of debt is used as a basis, the investment seems
profitable. However, if the benchmark rate used is the cost of the preferred equity, the
investment seems financially unattractive.

This is the scenario which the computation of weighted average cost of capital wished to
solve. In a project financed by multiple elements of capital structure, the different rates
confuse the decision maker in making investment decisions. Therefore, the obvious
workaround is for the decision maker to use only one rate as a benchmark in which to
evaluate investment decisions. This single rate benchmark is called the weighted average
cost of capital.

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How To Compute WACC

The Dumaguete Co. has an equity cost of capital of 17%. The after-tax cost of debt is 10%.
The capital structure is composed of 40% debt and 60% equity. What is the weighted
average cost of capital of the firm?

Solution:

WACC = (Cost of Debt x Debt%) + (Cost of Equity x Equity %)

= (10% x 40%) + (17% x 60%)
= 4% + 10.2%
= 14.2%

3.9 Economic Value Added (EVA)

Another way of expressing the fact that to create value a company must earn returns on
invested capital greater than its cost of capital is through the concept of Economic Value
Added (EVA). Economic value added (EVA) is a measure of business performance. It is a
type of economic profit, which is equal to a company’s after-tax net operating profit minus
a peso cost of capital charge (and possibly including some adjustments).

More specifically, it is a firm’s net operating profit after tax (NOPAT) minus a peso-amount
cost of capital charge for the capital employed.

Illustration:

TELCO Technologies Inc. one of Philippines’ largest Information Technology company

reported the following figures in its annual report:

Net Operating Profit After Tax (NOPAT) P 10,000,000

Less: Average Capital Employed x Cost of capital
P50,000,000 x 12% (6,000,000)
Economic Value-Added P 4,000,000

This says that TELCO earned roughly P4,000,000 million more in profit than is required
to cover all costs, including the cost of capital.

3.10 Marginal Cost of Capital

Marginal cost of capital is the weighted average cost of the last dollar of new capital raised
by a company. It is the composite rate of return required by shareholders and debt-holders
for financing new investments of the company. It is different from the average cost of
capital which is based on the cost of equity and debt already issued.

The Weighted Average Cost of Capital (WACC), the most common measure of cost of
capital used in capital budgeting and business valuation, is the weighted average of the
marginal cost of common stock, marginal cost of preferred stock and marginal after-tax
cost of debt.
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The distinction between average cost of capital and marginal cost of capital is important.
The marginal cost of capital rises as the company raises more and more capital. This is
because capital is scarce, just like any other factor of production, and must be compensated
through a higher required return. The return available on new projects must be compared
with the marginal cost of capital and not the average cost of capital and the projects should
be accepted only when the expected return is higher than the required return.

Marginal cost of capital increases in steps and not linearly. This is because a company can
finance a certain portion of new investments by reinvesting earnings and raising enough
debt and/or preferred stock to maintain the target capital structure. The reinvestment of
earnings comes without any increase in cost of equity. However, as soon as the expected
capital exceeds the combined amount of retained earnings and debt and/or preferred stock
raised to maintain the target capital structure, the marginal cost of capital increases.

SELF–CHECK

Select the best answer for each of the following questions. This self-check is not graded
and is not to be submitted. You may encircle your answer or put it on a clean sheet of
paper. Afterwards, feel free to check the suggested answers in Appendix 1.

1. Cost of capital is
a. The amount the company must pay for its plant assets.
b. The dividends a company must pay on its equity securities.
c. The cost the company must incur to obtain its capital resources.
d. The cost the company is charged by investment bankers who handle the issuance of
equity or long-term debt securities.

2. The theory underlying the cost of capital is primarily concerned with the cost of
A. Long-term funds and old funds.
B. Short-term funds and new funds.
C. Long-term funds and new funds.
D. Any combination of old or new, short-term or long-term funds.

3. Management knowledge of the cost of capital is useful for each of the following except
a. Making capital investment decisions.
b. Managing working capital.
c. Setting the maximum rate of return on new investments.
d. Evaluating performance.

4. The pre-tax cost of capital is higher than the after-tax cost of capital because
a. Interest expense is deductible for tax purposes.
b. Principal payments on debt are deductible for tax purposes.
c. The cost of capital is a deductible expense for tax purposes.
d. Dividend payments to stockholders are deductible for tax purposes.

5. The overall cost of capital is the

A. Rate of return on assets that covers the costs associated with the funds employed.
B. Average rate of return a firm earns on its assets.
C. Minimum rate a firm must earn on high-risk projects.
D. Cost of the firm's equity capital at which the market value of the firm will remain
unchanged.
6. The mix of debt, preferred stock, and common equity with which the firm plans to raise
capital is called the:
A. financial risk C. business risk
B. operating leverage D. target capital structure
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