Chapter 27

CALCULATING
THE COST OF
CAPITAL

Team Eddie’s
1
 SPECIFIC CAPITAL COMPONENT COSTS
Capital Components • When calculating the Weighted Average Cost of
are investor supplied Capital (WACC, interest is with capital that must
items: be provided by investors – interest-bearing debt
• Debt (long term and short term), preferred shares and
• Preferred ordinary equity (ordinary shares and retained
Shares/Ordinary earnings).
Shares • Accounts payable and accruals which rise
spontaneously from operations are not included as
part of investor-supplied capital because they do
not come directly from investors.
 Team Eddie’s

Calculating the Cost of Capital

2
 SPECIFIC CAPITAL COMPONENT COSTS
A. Cost of Debt (Kd) Before-tax cost of debt
the interest rate a firm must pay on its new
Minimum rate of debt.
return required by
suppliers of debt. After-tax cost of debt
used to calculate weighted average cost of
capital. This is the interest on new debt less the tax
savings that result because interest tax is deductible.

After-tax costof
Team Eddie’s
debt = Interest rate (1 – Tax rate)
Calculating the Cost of Capital
3
Computing the Cost of a New Bond Issue
The computation Determine the net proceeds from
requires three steps:
the sale of each bond.

1 Net proceeds of a bond sale =

Market Price – Flotation Costs

 Team Eddie’s

Calculating the Cost of Capital

4
Computing the Cost of a New Bond Issue
The computation Compute the before-tax cost of the
requires three steps:
bond

2
NPd = 1 (PVIFAkdn) + Pa (PVIFkdn)

Where: NPd = Net proceeds from the sale of bond

1 = Annual interest payment in pesos
Pn = Par or principal repayment required in
period n
kj = before-tax cost of a new bond issue bond in
 Team Eddie’s years.
n = length of the holding period of the
t = time period in years 5
Computing the Cost of a New Bond Issue
The computation Compute the before-tax cost of the
requires three steps:
bond

2
NPd = 1 (PVIFAkdn) + Pa (PVIFkdn)

Where: PVIFA = Present value interest factor of an

annuity
PVIF = Present value interest factor of a single
amount
Pd – f = (Market price – flotation costs)
 Team Eddie’s
The before-tax cost of a new bond issue also
means cost to maturity or yield to maturity. 6
Computing the Cost of a New Bond Issue
The computation Compute the after-tax cost of debt
requires three steps:
using the following equation:

3
kd = kj (1 – T)

Where: kd = After-tax cost of debt

kj = Before-tax cost of debt
T = Marginal tax rate

 Team Eddie’s

7
 Prime Pipe Company plans to issue 25-year bonds with a
face value of P4,000,000. Each bond has a par value of
P1,000 and carries a coupon rate of 9.5 percent of par
value. The flotation costs are estimated to be
ILLUSTRATIVE approximately P26 per bond and the firm’s marginal tax
CASE 27-1 rate is 34 percent. (Assume that interest payments are
made annually.
Financing Through Required:
Issuance of Bonds
Management wants to calculate the:
a. net proceeds per bond
b. before-tax cost of this bond issue
c. after-tax cost of the bond issue’s flotation
costs

8
(a) Net proceeds per bond

The selling price of the bond P980 (.98 x P1,000). The

net proceeds per bond are calculated by subtracting SOLUTION
the P26 flotation cost from the bond’s P980 selling
price.

NPd = P980 – P26 = P954

(b) Before-tax cost of bond issue

Using the trial and errors approach, the before-tax cost of

debt is computed as follows:
P954 = (P95) (PVIFA) = P1,000 (PVIF)

Trial at 10%:
P954 = P95 (PVIFA) = P1,000 (PVIF)
SOLUTION
P954 = P95 (9.077) + P1,000 (0.092)
P954 = P962.32 + P92 = P1,054.32

95 + (1,000 – 954)
kd = 25 = 96.84 = 9.91%
1,000 + 954 977
2
 (c) After-tax cost of the bond issue’s flotation
costs
SOLUTION
The after-tax cost of new debt is computed as follows:

kd = 9.91 (1 - .34) = 6.54%

SPECIFIC CAPITAL COMPONENT COSTS
Preferred share
Preferred share
if the preferred shares have fixed dividend
payments and no stated maturity dates, the
B. Cost of Preferred the cost
component cost of preferred
of new existingsharepreferred
is computed
Share (Kp) as follows:is determined by substituting
share
the current marketKp =
price
Dp
per share of
preferred in denominator NPp in the
above equation that is, in lieu of net
Where: Dp = Annual dividend per share on preferred
 proceeds from sale of preferred
Team Eddie’sshare
shareNPp = Net proceeds from the sale of
Calculating the Cost of Capital preferred share, (Market price less flotation costs)
12
 Prime Pipe Company plans to sell preferred share for its
par value of P25.00 per share. The issue is expected to
ILLUSTRATIVE pay quarterly dividends of P0.60 per share and to have
CASE 27-2 flotation cot of 3 percent of the par value or P1.50 (0.03 x
P25.00). Substituting Dp = P2.40 (4 x P0.60), NPp =
Determination of P23.50 (P25.00 – P1.50), the cost of new preferred share
Cost of New is:
Preferred Share
Solution:

Kp = P2.40 = 0.1021 or 10.21%

P23.50

13
SPECIFIC CAPITAL COMPONENT COSTS
Ordinary Equity Share
does not represent a contractual obligation to make
specific payments thus making it more difficult to measure
C. Cost of Ordinary
its costs than the cost of bonds or preferred share.
Equity Share
Cost of Ordinary Equity Share
same cost as the cost of retained earnings. No
adjustment is made for flotation costs in determining
either the cost of existing ordinary equity share or the
cost retained earnings.
 Team Eddie’s

Calculating the Cost of Capital

14
 A. Cost of Equity

1. The Capital Estimate the risk-free rate. We generally

Asset Pricing use the 10-year Treasury bond as the
Model (CPAM) measure of the risk-free rate, but some
analysis use the short-term Treasury bill
rate.

 Team Eddie’s

Step 1 Calculating the Cost of Capital

15
 A. Cost of Equity

1. The Capital Estimate the stock’s beta coefficient (b) and

Asset Pricing use it as an index of the stock’s risk. The i
Model (CPAM) signifies the ith company’s beta. Beta
coefficient, b is a metric that shows the
extent to which a given stock’s returns
move up and down with the stock market.
Beta thus measures systematic market risk
of the asset relative to average.

 Team Eddie’s

Step 2 Calculating the Cost of Capital

16
 A. Cost of Equity

1. The Capital
Asset Pricing
Estimate the expected market risk premium.
Model (CPAM)
The market risk premium is the difference
between the return that investors require on
an average stock and the risk-free rate.

 Team Eddie’s

Step 3 Calculating the Cost of Capital

17
 A. Cost of Equity
Substitute the preceding values in the CAPM equation to
1. The Capital estimate the required rate of return on the stock in
Asset Pricing question:
r = rgf + (RP) b
Model (CPAM)
= rgf + (rm – rgf) b
Thus, the CAPM estimate of r, is equal to the risk-free
rate (rgf) plus a risk premium that is equal to the risk
premium on an average stock (rm – rgf), scaled up or
down to reflect the particular stock’s risk as measured
by its beta coefficient (bi).

 Team Eddie’s

Step 4 Calculating the Cost of Capital

18
 ABC Company’s ordinary equity shares sell for P32.75 per
share. ABC expects to set their next annual dividend at
P1.54 per share. If ABC expects future dividends to grow
ILLUSTRATIVE by 6% per year, indefinitely, the current risk-free rate is
CASE 27-4 3%, the expected return on the market is 9%, and the
stock has a beta of 1.3, what should the firm’s cost of
Calculation of Cost equity be?
of Equity
Solution:
R = .03 + (.09 - .03) 1.3) = .1080 or 10.80%

This approach is also used to measure the

cost of retained earnings.
19
 A. Cost of Equity
2. Bond Yield
Plus Risk the generalized risk premium or bond-yield-plus-risk
Premium premium required rate of return shareholder’s equity.
Approach
K = kd + rp

Where: kd = Base rate of long-term bonds or bond

yield
rp = Risk premium

 Team Eddie’s

Calculating the Cost of Capital

20
 Prime Pipe Company’s long-term bond rate is 9.5
percent. The firm’s management estimates that
ILLUSTRATIVE its cost of equity should require a 3 percentage
CASE 27-5
point risk premium above the cost of its own
Determination of bonds. Using the generalized risk premium
Cost of Equity approach, the cost of ordinary equity would be
Using the Bond
Yield plus R isk
12.5 percent. This is found by substituting kd =
Premium Approach 0.095 and rp = 0.03.

K = 0.095 + 0.03 = 0.1250 or 12.50%

21
 A. Cost of Equity
The required rate of return on ordinary equity which
for the marginal investor is also equal to the
expected rate of return. The equation that could use
follows:
K = Dj + g
3. Dividend
Pn
Yield Plus
Growth Rate Where: K = Cost or required rate of return of
ordinary equity
Approach
Dj = Dividend expected to be paid at the
end of year 1
Pn = Current stock price
 Team Eddie’s
g = Expected dividend groth rate

Calculating the Cost of Capital

22
 A. Cost of Equity

Considers not only the dividend yield (D/P), but also

a capital gain (g) for a total expected return of K,
and in equilibrium this expected return is also equal
4. Discounted to the required rate of return.
Cash Flow (DCF)
K= D + expected g
Approach
P

 Team Eddie’s

Calculating the Cost of Capital

23
 Zeta stock sells for P23.06, its next expected
dividend is PP1.25, and analysts expect its
ILLUSTRATIVE growth rate to be 8.3%. Thus, Zeta’s expected
CASE 27-6
and required rates of return (hence, its cost of
retained earnings) are estimated to be 13.7%.
Determination of
Cost of Equity
Under the DCF
Solution:
Approach K = P1.25 + 8.3%
P23.06
= 5.4% + 8.3%
= 13.7%
24
 A. Cost of Equity
Simplistic technique used to estimate the cost of
ordinary equity, which is based on the inverse of the
firm’s price-earnings ratio.

Price-earnings ratio is easy to compute because it is

5. Earnings – based on readily available information, but there is little
Price Ratio economic logic to support the use of the earnings-price
ratio to measure the cost of ordinary equity.
Method K=E
Pn
Where: E = Current earnings per share
Pn = Current market price of ordinary equity
share
 Team Eddie’s

Calculating the Cost of Capital

25
 Prime Pipe Company had earnings per share for
the past year of P6.50, and the firm’s ordinary
ILLUSTRATIVE equity share is currently priced at P45.00. Using
CASE 27-7
the earnings-price ratio method, the cost of
retained earnings would be 14.44%. This is
Determination of found by substituting E = P6.50 and P = P45.00
Cost of Equity
Using the Earnings
Price Ratio Solution:
K = P6.50 = 0.1444 or 14.44%
P45.00

26
 B. Cost of New Ordinary
Equity Shares
The equation is:
K= D +g
The Constant Growth NP
Model for New Ordinary Where: K = Cost of new ordinary equity shares
Equity Shares is generally Di = Dividends to be received during the
used in measuring the cost of year [D (i + g)]
new ordinary equity share. Do = Dividend yield
g = Dividend growth rate
NP = Net proceeds of the new ordinary equity shares
issue (Po – F)
Po = Current market price of the firm’s ordinary
equity
 Teamshares
Eddie’s
F = Flotation costs
27
Calculating the Cost of Capital
 B. Cost of New Ordinary Equity Shares

The cost of new ordinary equity (K) is higher than the cost of retained earnings (K)
because of the new issue must be adjusted for flotation cost. Those flotation costs
include both underpricing and an underwriting fee.

Underpricing occurs when new ordinary equity share sells below the current market
price of outstanding ordinary equity share, in order to attract investors and to
compensate for the dilution of ownership that will take place.

Underwriting fee covers the cost marketing the new issue

Constant Growth Model assumes that dividends grow perpetually at a constant

 Team Eddie’s annual rate

28
Calculating the Cost of Capital
 Suppose that ABC Company’s ordinary equity shares are
selling for P32.75 per share, and the company expects to set
its next annual dividend at P1.54 per share. All future
dividends are expected to grow by 6% per year, indefinitely.
In addition, let’s also suppose that ABC faces a flotation cost
ILLUSTRATIVE of 20% on new equity issues. Calculate the flotation-
CASE 27-8 adjusted cost of equity.

Computation of Solution:
Flotation-Adjusted Twenty percent pf P32.75 will be P6.55, so the
Cost of Equity flotation-adjusted cost of equity will be:

K= D +g
Po – F
K = P1.54 + .06
P32.75 – P6.55
K = .1188 or 11.88% 29
 Prime Pipe Company’s ordinary equity share has a
current market price of P45.00 and an expected
dividend growth rate of 5%. The firm is expected to
pay P3.60 per share in ordinary equity share involves
ILLUSTRATIVE underpricing of P1.00 per share and underwriting fee
CASE 27-9 of P0.80 per share. What is the cost of the new
ordinary equity share?

Solution:
K= D +g
NP
K = P3.60 + .05
P43.20
K = .0833 + 0.05
K = 0.1333 or 13.33% 30
C. Cost of Retained Earnings

The Cost of Retained Earnings is similar

to the cost of existing ordinary equity
share.

 Team Eddie’s

31
Calculating the Cost of Capital
Because of flotation costs, pesos raised by selling new stock must “work
harder” than pesos raised by retained earnings. Moreover, because no
flotation costs are involved, retained earnings cost less than new shares.
Therefore, firms should utilize retained earnings to the greatest extent
possible.

The total amount of capital that can be raised before new shares must be
issued is defined as the and it can be retained earnings breakpoint is
calculated as follows:

Retained earnings breakpoint = Addition to retained earnings for the

year / Equity fraction

Why Must External Equity

Be Used?
 Zeta’s addition to retained earnings in2017 is
expected to be P66M, and its target capital
structure consists of 45% debt, 2% preferred,
To prove that this is correct, note that a capital
ILLUSTRATIVE and
budget53% ordinarycould
of P124.5M equity. Therefore,
be financed its
as 0.45
CASE 27-10 retained earnings breakpoint for 2017
(P124.5M) = P56M of debt, 0.02 (P124.5M) is as
follows:
P2.5M of preferred share, and 0.53 (P124.5M)
Determination of
Retained Earnings = P66M of equity raised from retained
Breakpoint Retained earnings breakpoint = P66M /
earnings. Up to a total of P124.5M pf new0.53 =
P124.5M
capital, equity would have a cost of K = 13.5%
However, if the capital budget exceeded
P124.5M, Zeta would have to obtain equity by
issuing new ordinary equity share at a higher
cost because of the flotation costs.
33
DETERMINATION OF WEIGHTED
AVERAGE COST OF CAPITAL
 Once the specific cost of capital of each long term financing source is measured,
the firm’s weighted average cost of capital (WACC), K, can be determined.

 The target proportions of debt, preferred share, and ordinary equity along with the
costs of those components are used to calculated the firm’s weighted average cost
of capital.

 Assuming that all new ordinary equity is raised as retained earnings, as is true for
most companies, the WACC can be computed as follows:

 WACC = (% of debt) (After-tax Cost of Debt) + (% of Preferred Share)

(Cost of Preferred Share) + (% of Ordinary Equity) (Cost of Ordinary
Equity
DETERMINATION OF WEIGHTED
AVERAGE COST OF CAPITAL
 Note that only debt has a tax adjustment factor (1 – T). This is because interest on
debt is tax deductible but preferred dividends and returns on ordinary equity share
(dvidends and caoital gains) are not.

 A WACC can be computed for either the firm’s existing financing or new
financing. The cost of capital acquired by the firm in earlier periods is not
relevant for current decision making because it represents a historical or
sunk cost. Thus, only the WACC for new financing is generally calculated.

 WACC is computed by multiplying the specific cost of each type of capital

by its proportion (weight) in the firm’s capital structure and assuming the
weighted values.
DETERMINATION OF WEIGHTED
AVERAGE COST OF CAPITAL

Two major schemes in computing the weighted

average cost of capital:

A. Historical Weights
a. Book Value Weights
b. Market Value Weights

B. Target Weights
A. Historical Weights
are based on the firm’s existing capital structure.

Optimal capital structure is the combination of debt and equity that

simultaneously maximizes the firm’s market value and minimizes its
weighted average cost of capital.
 Book value weights measure the actual proportion of each type of
permanent capital in the firm’s structure based on accounting values
shown on the firm’s balance sheet.
 Market value weights measure the actual proportion of each type of
permanent capital in the firm’s structure at current market prices. This is
considered superior to book value weights because they provide
estimates of investors’ required rates of return.