CHAPTER 7

COST OF CAPITAL
PFN1223 FINANCIAL MANAGEMENT
 LEARNING OBJECTIVES
At the end of this chapter, you should be able to:

 Determine the cost of debt, cost of preferred shares and cost of equity.
 Perform the calculation of the after tax cost of debt, preferred shares and equity.
 Perform the calculation of firm’s weighted average of cost of capital (wacc).
7.0 INTRODUCTION
• Cost of capital is the required rate of return that the firm must achieve
in order to cover the cost of generating funds in market place.

• The important in determine cost of capital because it links the firm’s

investment decision with its financing decision.

• Factors that affected the cost of capital is earnings riskiness, debt-

equity mix, firm’s financial health and relative interest rate levels.
7.1 INSTRUMENTS
COST OF CAPITAL
 7.1
INSTRUMENTS
COST OF
CAPITAL

7.1.2 7.1.3
7.1.1
PREFERRED COMMON SHARE
DEBT
SHARES OR EQUITY
7.1.1 DEBT

 A legal obligation on the issuer (or taker) to repay the borrowed sum along with interest to the lender on a timely
basis.

 Debt instrument can be in paper or electronic form. Examples debt instruments is bonds, debentures, leases,
certificates, bills of exchange and promissory notes.

 Individuals, businesses and governments use common types of debt instruments such as
 loans, bonds and debentures to raise capital or generate investment income.

 Debt Instruments essentially act as an IOU between the issuer and the purchase.

 In exchange for a lump sum payment, the lender guarantees the purchaser full repayment of the
 Investment at a later date.

 The terms of these types of contracts often include the payment of interest over time, resulting in cumulative profit
for the lender.
 GAIN
CAPITAL

Lender (Financial
institutions/investor/bu
• Loans siness)
• Bonds
• Debentures • Profit
• Amount investment

Individuals, or
businesses or
governments

RECEIVED
PROFIT
7.1.2 PREFERRED SHARES

 A class of ownership in a corporation that has a higher claim on its assets and earnings than common stock.

 Preferred shares generally have a dividend that must be paid out before dividends to common shareholders, and the
shares usually do not carry voting rights.

 Preferred shares combines features of debt, in that it pays fixed dividends, and equity, in that it has the potential to
appreciate in price.

 The details of each preferred shares depend on the issue.

7.1.3 COMMON SHARE OR EQUITY

 A security that represents ownership in corporation.

 Common shareholders exercise control by electing a board of directors and voting on corporate policy.

 Common shareholders are on the bottom of the priority ladder for ownership structure, in the event of liquidation,
common shareholders have rights to a firm’s assets only after bondholders, preferred shareholders and other creditors
are paid in full.
 PAR VALUE FOR BOND = RM1000

PAR VALUE FOR PREFERRED SHARE = RM100

7.2 SOURCES OF
FINANCING
7.2.1 Cost of Debt (Kd)
The cost of debt (Kd) is merely the interest rate paid by the firm on such debt. Cost of debt before tax is
calculated by:
• However, since interest expense is tax-deductible, the after-tax cost of debt, KdAT is
calculated as;
ILLUSTRATION 1

Cempaka Berhad plans to issue bonds yielding 8% interest for a 15 year bond. The bond par value
is RM1,000 and the current market price is RM975. The corporate tax rate is 28%. Determine the
after tax costs of debt for Cempaka Berhad.

Solution:
Given,
Par value = 1,000 T = 28% CMP = 975 n = 15

CR = 8%
CP = 8% x 1,000 = 80
STEP 1:Calculate cost of debt (before tax) Kd
STEP 2:Calculate cost of debt (after tax) Kd AT
ILLUSTRATION 2
Ixora Berhad is issuing a RM1,000 par value bond that pays 7% interest annually. Investors
expected to pay RM877 for a 10 year bond. Ixora will have to pay RM75 per bond as a floatation
cost. Determine the after tax cost of debt if the firm’s corporate tax is 28%.

Solution:
Given,
Par value = 1,000 T = 28% n = 10 CMP = 877

Other cost = 75

CR = 7%
CP = 7% x 1000 = 70
STEP 1:Calculate cost of debt (before tax) Kd
STEP 2:Calculate cost of debt (after tax) Kd AT
7.2.2 Irredeemable bonds
• can be issued if they do not have maturity period. Hence, the calculation for irredeemable
bond is as follow:
• ILLUSTRATION 3
• Daisy Berhad plans to issue 6% irredeemable bonds at RM950. The par value of the
bond is RM1,000. Floatation costs of the new bonds will be 6% of the market value. If
the corporate rate is 28%, calculate the after tax cost of debt of the bond.

• Solution:
• Given,
• Par value = 1,000 CMP = 950 Other Costs = 6% x 950 = 57

• CR = 6%,
• CP = 6% x 1,000 = 60
STEP 1:Calculate cost of debt (before tax) Kd
STEP 2:Calculate cost of debt (after tax) Kd AT
7.2.3 Cost of preferred shares (Kp)

• Cost of preferred shares (Kp) is the rate of return required by the holders of a firm's preferred shares.
• It is calculated by dividing the annual dividend payment on the preferred shares by the preferred shares'
current market price.
• In finance, the value of any asset equals the present value of its future net cash flows.

• The cost of preferred shares is calculated as follow:

ILLUSTRATION 4
Mawar Merah Berhad preferred shares is selling for RM13 and pays RM0.50 dividend. The floatation costs
is 5% of the current market price. Calculate the cost of capital for the preferred shares.

Solution:
Given;
D = 0.50 CMP = 13 Other Costs = 5% x 13 = 0.65
ILLUSTRATION 5
Teratai Berhad issued RM100 par value preferred shares six years ago. The stock provided 6% yield at the
time of issue. The current market price of these shares is RM80. Ignore floatation costs. Determine the
current yield or cost of the preferred shares.

Solution:
Given;
D = 6% x 100 = 6 CMP = 80
• 9.2.4 Cost of Equity

• The cost of equity is the return a firm requires to decide if an investment meets capital return requirements.
It can provide additional capital in two ways of sources of financing:

• 1) Internal common equity (Ke)

• The earnings available to common shareholders can be retained in whole or part within the firm and used to
finance future investments.

• 2) External common equity (Kne)

• New common stock may be issued by a firm to raise financing for its investments.
• 1) Cost of Internal Common Equity (Ke)
• The cost of internal equity is the required rate of return on funds supplied by existing common
shareholders. The calculation is as follow:
• ILLUSTRATION 6
• Kenanga Berhad’s common stock is currently selling for RM12. Last year’s dividend was RM0.70 per
share. Investors expect dividends to grow at an annual rate of 9%.

• Solution:
• Given;
• D0 = 0.70 CMP = 12 g = 9%

• D1 = D0 (1+g)
• = 0.70 (1 + 0.09)
• = 0.763
• ILLUSTRATION 6
• 2) Cost of External Common Equity (Kne)

• The cost of external equity occurred if the firm issued new common stock to raise financing of
investments. The calculation of the external common equity almost similar with the internal common equity
but it includes other costs such as floatation cost, legal fees, brokerage fees and accounting fees.
• ILLUSTRATION 7
• Referring and using to the example in Illustration 6, if floatation cost incurred is 3% of the current market
price, determine the cost of external equity.

• Solution: Given;
• CMP = 12 Other Costs = 3% x 12 = 0.36 g = 9%

• D0 = 0.70, D1 = D0 (1+g)
• = 0.70 (1 + 0.09)
• = 0.763
• ILLUSTRATION 7
 7.3 WEIGHTED
AVERAGE COST OF
CAPITAL (WACC)
WACC refers to the average of the firm’s cost of funds from all investors where each of sources of
financing are proportionate accordingly. A firm’s WACC is a composite of the individual costs of
financing. The calculation of WACC is as follow:
The mixture of debt, preferred shares and common equity in its capital structure is the cost of capital
of a firm’s WACC.
7.3.1 Decision on WACC

There are different techniques have been used to decide the projects of capital budgeting. The
minimum rate of return represents the firm’s weighted average cost of capital. As long as the project’s
return equals or more than the firm’s WACC, the value of the firm’s common stock will remain
unchanged and therefore the project can be accepted because the shareholder’s required rate of return
is met.
WACC analysis can be looked at from two angles – the investor and the firm. From
the firm’s angle, it can be defined as the blended cost of capital which the firm has to
pay for using the capital of both owners and debt holders. In other words, it is the
minimum rate of return a firm should earn to create value for the investors. From
investor’s angle, it is the opportunity cost of their capital. If the return offered by the
firm is less than its WACC, it is destroying value and hence, the investors may
discontinue their investment in the firm or reject the project.
ILLUSTRATION 10
The financial manager of Lily Berhad is responsible to measure the cost of sources of financing before they plan
to invest in a new project next year. The firm’s capital structure is as follows:

Long term debt 35%

Preferences shares 19%
Retained earnings 15%
Ordinary share 31%

The firm plans to sell a 15 year RM1,000 par value bonds at RM980. The bonds pay annual interest of 9% per
annum. A floatation cost of 5% of the current market price would be paid.

10 percent preference shares with a par value of RM100 can be sold at 5% discount. An additional fee of 3% of
the market price must be paid.

The firm’s ordinary share are currently selling at RM8. The floatation cost is 2% of the current market price. The
last year’s dividend was RM0.60 and it will grow at 10% per annum for the foreseeable future.

The corporate tax rate is 28%. Currently, the firm has RM220,000 retained earnings that can be used to finance
profitable investments.
Cont ILLUSTRATION 10

Calculate:

a. The after tax cost of;

i. Debt
ii. Preferred shares
iii. Retained earnings
iv. New issue of ordinary shares

b. Determine the maximum capital expenditure if the firm uses internal equity only for the
equity financing.

c. Calculate the WACC for the firm.

Cont ILLUSTRATION 10

Calculate:

a. The after tax cost of;

i. Debt

n = 15 CMP = 980 CP = 9% x 1,000 = 90

Other Costs = 5% x 980 = 49 TAKE OUT THE

KEY WORDS
FOR THE
FORMULA
Cont ILLUSTRATION 10

Calculate:

a. The after tax cost of;

i. Debt

STEP 1

STEP 2
Cont ILLUSTRATION 10

Calculate:

ii. Preferred shares

TAKE
OUT THE
KEY
WORDS
FOR THE
FORMUL
A
Cont ILLUSTRATION 10

Calculate:
TAKE
OUT THE
KEY
WORDS
FOR THE
FORMUL
A
Cont ILLUSTRATION 10

Calculate:
ILLUSTRATION 11

The CEO of Kekwa Berhad is planning to invest in a new project costing RM10 million.
The capital of structure of the firm as 31 December 2017 is as follows:

Capital structure RM
Debentures 35,000,000
Preference shares 17,000,000
Ordinary shares 23,000,000
Share premium 7,500,000
Retained earnings 5,500,000
88,000,000
Cont ILLUSTRATION 11

Kekwa Berhad plans to issue 11% debentures with a par value of RM1,000 at RM980 to
finance the project. The debentures can be redeemed after 12 years. The issuance cost is
5% of the selling price will be incurred.

The 8% preference stock of RM100 par value can be issued at RM125. A floatation cost of
5% of the issued price will be incurred.

The ordinary share is currently selling at RM12.50 per share. To issue new shares, a
floatation cost of 3% of the market price will incurred. They expected to give dividend
RM2.60 next year with expected growth rate of 7%.

The firm has allocated RM4.6 million of their retained earnings for investment purposes.
The corporate tax rate is 28%.
Cont ILLUSTRATION 11

Calculate:

a. i. The after tax cost of debt.

ii. The cost of preferred shares.
iii. The cost of retained earnings.
iv. The cost of a new issue of ordinary shares.

b. Determine the maximum capital expenditure that the firm can invest if it does not intend
to issue new ordinary shares.

c. Calculate the WACC for the firm.

Cont ILLUSTRATION 11
Cont ILLUSTRATION 11
Cont ILLUSTRATION 11
Cont ILLUSTRATION 11
Cont ILLUSTRATION 11
7.4 CONCLUSION
The firm’s cost of capital refers to the weighted average cost of capital which is made
up of the cost of debt, cost of preferred shares and cost of equity (internal or external).
The cost of capital is an important financial concept because it acts as major link
between the firm’s investment decision and the wealth of the investors.

A firms need to determine its cost of capital to make an investment decisions. If the
project’s required rate of return is equal or more than the WACC, then, the project
can be accepted. If the project’s required rate of return is less than the WACC, then,
the project should be rejected.
 REFERENCES
FINANCIAL MANAGEMENT (JULY2018)