Cost of Capital, Bond and Stock Valuation

1.0 The Fundamental Concept

1.1) Cost of capital refers to the cost of using funds from long term investors

1.2) Investors 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 sourced from the financial markets, by selling debt and equity securities.

1.4) Financial market investors expect the following returns:

Fund Providers Expected Returns

Long-term creditors Interest
Preference shareholders Dividends
Ordinary Shareholders Dividends and Growth

1.5) Cost of capital is the minimum required rate of return of an investment to avoid impairment iin 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 of 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 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 Long Term Funds Cost of Capital Formula Per Comments

Financial Security
Long-term debt Eir(1-tr) or Eir*atr Interest is a tax deductible
expense, as such, the cost of
debt should be net of tax.
Preference shareholders’ equity Dps/MPPS (net) or D/Pn It is the preferred stock’s yield
rate. The market price of the
stock serves as the cost of
investment. The market price of
the stock is determined net of
flotation rate.
Ordinary shares EDPS/MPPS(net) or D/Pn+G Ordinary shareholders are the
real owners of the business they
absorb the greatest impairment
in equity. If the business grows,
 they register the greatest
increase in wealth. As such
growth rate is factored in the
cost of using ordinary equity
Retained earnings EDPS/Mpps(gros)+G Ordinary shares and retained
earnings basically comprise the
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 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
TR= Tax Rate
ATR= After tax rate

2.0 The weighted average cost of capital

2.1 The weighted average cost of capital 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.

2.3The 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 weighted average cost of capital (WACOC) is computed as follows

(A) (B) (C) (D) (E)

Funds MV Individual COC (in% Fractio (WACOC)
n
LTD Y EIRXATR=X Y/Z X.XX%
PSE Y D/PN=X Y/Z X.XX
OSE Y D/Pn+G Y/Z X.XX
RE Y D/Pg+G=X Y/Z X.XX
TOTAL Z X.XX%
D= Expected dividend per share
TD= Longterm debt
Mv= Market values
OSE=P Ordinary shareholders’ equity
SE=RE Preference shareholders’ equity
= 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.

2.7 THe issuance of a financial instrument or security (ie, bonds, preference share, ordinary share)
normally needs the services of an underwriter who charges an underwriting costs are herein 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. 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. Another reason is that the 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)

Funds MV Individual COC Fraction (WACOC)
(in%
BP P Y EIRXATR=X Y/Z X.XX%
LP Y EIRXATR=X Y/Z X.XX%
PSE Y D/PN=X Y/Z X.XX
OSE Y D/Pn+G Y/Z X.XX
RE Y D/Pg+G=X Y/Z X.XX
TOTAL Z X.XX%
LP= LEASE PAYABLE

3.0 Trading on equity (the concet 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 in 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 such, the priority of source shall be
the bonds payable, the preference shares, the retained earnings, and the last the ordinary shares.

5.0 The U-Shaped Marginal Cost Capital Graph

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

COC

OPTIMUM LEVEL OF FINANCING

DEBT TO 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 debt
ultimately rises as more debt is used. This impresses an 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, both by issuing ordinary shares of stock or by using the retained earnings. The Cost
of capital using the growth model is
 K = (D/P) + G WHERE:
K = Yield Rate + Growth Rate K = Cost of Capital
Yield Rate – required rate of return P = MPPS, net
D = Expected Divident
G = growth rate

7.0 The Capital Asset Pricing Model (CAPM)

7.1 The CAPM is used to determine the cost of ordinary equity, both of ordinary shares and retained
earnings, to finance expenditures. By using CAPM model, the cost of ordinary equity is computed as
follows

COE= RF+BETA(MR-RF) WHERE:

COE= RF+BETA(RISK-PREMIUM RATE COE=cost of ordinary equity
RF=risk free rate
MR= Market risk
Beta=Beta coefficient
7.2 Risk-free rate represents the rate of return in relatively risk-free investment such as the treasury
bonds.

7.3 Risk-premium rate represents the business risk attendant to a given business project or undertaking.
This risk includes organizational risk arising from mismanagemnet

7.4 Adjusted risk-premium is the basic risk premium adjusted by the company’s beta coefficient

7.5 The beta coefficient measures the risk of an investment relative to other corporate investments.
There is a positive correlation between the firm’s beta 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 of the stock market and the price of the individual stock.

8.0 Business leverages

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 computation of the leverages are as follows

DOL CM/PBIT
DFL PBIT/(PBIT-INTEREST EXPENSE- PREFERENCE DIVIDENDS BEFORE TAX)
TL DOLXDFL
TL WHERE: PBIT/(PBIT-INTEREST EXPENSE- PREFERENCE DIVIDENDS BEFORE TAX)

DOL DEGREE OF OPERATINGLEVERAGE

DFL DEGREE OF FINANCIAL LEVERAGE
TL TOTAL LEVERAGE