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1 MEANING OF THE COST OF CAPITAL
The cost of capital is the minimum rate of return that a firm must earn in order to satisfy the overall rate of return required by its investors. It is also the minimum rate of return a firm must earn on its invested capital to maintain the value of the firm unchanged. The second definition considers the cost of capital as a break even rate. If a firm’s actual rate of return exceeds its cost of capital, the value of the firm would increase. If on the other hand, the cost of capital is not earned, the firm’s market value will decrease. So the cost of capital is the rate of return that is just sufficient to leave the price of the firm’s common stock unchanged. The cost of capital serves as a discount rate when a firm evaluates an investment proposal. Suppose a firm is considering investment on a plant. The finance required for this investment is to be raised by selling a common stock issue. Now, after raising capital, the firm is expected to provide required rate of return to those who invest on the common stock. This in effect is the firm’s cost of capital. So to decide to invest on the plant, the minimum rate of return from the investment at least should be equal to the required rate of return by the common stockholders. If the required rate of return by the firm’s common stockholders is 13%, then the firm should earn a minimum of 13% on its investment on the plant. The 13% minimum rate of return that should be earned by the firm is, therefore, its cost of capital. 4.2 MEASURING THE SPECIFIC COST OF CAPITAL
The cost of capital for any particular capital source or security issue is called the specific cost of capital. It is also called individual cost of capital or component cost of capital. Each type of capital contained the capital structure of a firm include: 1. Debt 2. Preferred stock Page 1
So raising money in the form of debt results in the smallest tax burden.1 The cost of debt This is the minimum rate of return required by suppliers of debt. 4. Meaning. the cost of debt is the lowest specific cost of capital. One is that it is computed on an after-tax basis. the tax implication is only on debt sources of finance. hence. Second. generally.2. They receive interest payments before preferred and common dividends are paid. if there would be any tax implication on the individual source of capital. First. their return is the lowest. Their lowest return would be the lowest cost of capital to the firm. The cost of capital is not stated in terms of birrs. raising capital through debt sources entails interest expense. The second point is that the specific cost of capital is expressed as an annual percentage or rate like 6%. assume the lowest risk among all suppliers of capital.3. In almost all circumstances. 9%. the firm’s cost of debt would be the lowest. Since they assume the smallest risk. debt is the cheapest source of finance to a firm and. or 10%. Here. Generally. and finally. Computing the cost of new bond issue involves three steps: i) Determine the net proceeds from the sale of each bond NPd = Pd – f Where: NPd = the net proceeds from the sale of each bond Pd = the market price of the bond Page 2 . The interest expense in turn reduces the firm’s income which ultimately would cause tax payment to be reduced. There are two basic explanations for this. bank loans. Common stock 4. for our convenience we consider bond issue to illustrate the cost of debt. it should be considered. promissory notes. debt suppliers. The relevant specific cost of debt is the after-tax cost of new debt. Retained earnings Two important points you should bear in mind about the specific cost of capital. Debt sources of finance may take several forms like bonds.
Required: Calculate the after tax cost of Abyssinia’s new bond issue: Solution: Given: Pn = Br. 120 (Br. Abyssinia bonds can be sold for Br.000 x 12%). 1.36% Page 3 . Flotation costs of Br.26% Br.010 – Br.1. f = Br. 1. t = 40%.010 each. 980 Br.120 + ii) Kd = Br. Kdt = ? Then apply the three steps: i) NPd = Br. Abyssinia Industrial Group is planning to sell 15-year. 30.980 15 = 12. 30 per bond will be incurred in the process of issuing the bonds.980 2 iii) Kdt = 12.1. 1. I = Br.26% (1 – 40%) = 7.000. 1.000 + Br.f = Flotation costs ii) Compute the effective before tax cost of the bond using the following approximation formula: P −P n Nd I + n Kd = P +P n Nd 2 Where: Kd = The effective before tax cost of debt I = Annual interest payment Pn = The par value of the bond n = Length of the holding period of the bond in years. The firm’s marginal tax rate is 40%. n = 15. Pd = Br.000 par-value bonds that carry a 12% annual coupon interest rate. 1. Br.010. 1. 30 = Br. iii) Compute the after-tax cost of debt Kdt = Kd (1 – t) Where: Kdt = The after-tax cost of debt t = The marginal tax rate Example: Currently. As a result of lower current interest rates.000 − Br.
Calculate the cost of the preferred stock. it is expected to pay fixed amount of dividends to the preferred stockholders. Page 4 . the after – tax cost of Abyssinia’s new bond issue is 7. 2.50 per share must be paid. 100 par value and was sold at 102% of the par value. NPpf = Ppf – f Where: NPpf = Net proceeds from the sale of each preferred stock Ppf = Market price of the preferred stock f = Flotation costs ii) Compute the cost of preferred stock issue Kps = Dps__ NPpf Where: Kps = The cost of preferred stock DPs = The pre share annual dividend on the preferred stock Example: Sefa Computer Systems Company has just issued preferred stock. When a firm raises capital by issuing new preferred stock. That is. In addition. the firm’s value will decline. 4. Otherwise. So it is the dividend payment that is the cost of the preferred stock to the firm stated as an annual rate. It is also the minimum rate of return a firm’s preferred stock investors require if they are to purchase the firm’s preferred stock.2 The cost of preferred stock The cost of preferred stock is the minimum rate of return a firm must earn in order to satisfy the required rate of return of the firm’s preferred stock investors. The cost of a new preferred stock issue can be computed by following two steps: i) Determine the net proceeds from the sale of each preferred stock.36%. Abyssinia should be able to earn a minimum of 7. flotation costs of Br. The stock has 12% annual dividend and Br.2.Therefore.36% to satisfy bondholders.
50 = Br. Otherwise. 99. As a result. 100 x 102%).50.06% on any investment financed by the new preferred stock issue. 102 (Br.50 ii) Kps = Br.3 The cost of common stock The cost of common stock is the minimum rate of return that a firm must earn for its common stockholders in order to maintain the value of the firm.2. A firm does not make explicit commitment to pay dividends to common stockholders. 4. common stocks implicitly involve a return in terms of the dividends expected by investors and hence.06% Page 5 . 12 (Br 100 x 12%).Solution: Given: Pps = Br. when common stockholders invest their money in a corporation. 102 – Br. They compensate the maximum risk by requiring the highest return. Generally. common stock dividends are paid after interest and preferred dividends are paid. Kps =? Then apply the two steps: i) NPpf = Br. Dps = Br. 99. However. Therefore. 12 Br. common stock investors assume the maximum risk in corporate investment. =12. they expect returns in the form of dividends. the firm’s value will decrease.06% =12. f = Br. 2. Sefa Company should be able to earn a minimum of 12. 2. they carry cost. This highest return expected by common stockholders make common stock the most expensive source of capital.50 Therefore.
the firm should be able to earn a minimum return of 14. f = Br. The current dividend is Br. 1. 20 per share. g = 6%. 20 – Br.50 (1.37% Npo Br.06) = 14. 19 Therefore. 1.50. Do = Br. 1. Compute the specific cost of this common stock issue. Ks = ? Then apply the two steps: i) NPo = Br. Page 6 .The cost of common stock can be computed using the constant growth valuation model. 1 per share. The issuing corporation incurs a selling expense of Br. 19 ii) Ks = D1 + g = Br. Solution Given: Po = Br.50 per share and it is expected to grow at 6% annual rate. 20. 1. Ks = D1 + g NPo Where: Ks = The cost of new common stock issue D1 = The expected dividend payment at the end of next year NPo = Net proceeds from the sale of each common stock g = The expected annual dividends growth rate The net proceeds from the sale of each common stock (NPo) is computed as follows: NPo = Po – f Where: Po = the current market price of the common stock f = flotation costs Example: An issue of common stock is sold to investors for Br. 1 = Br.37% on investments that are financed by the new common stock issue.
the specific cost of capital of retained earnings is equated with the specific cost of common stock. 3 is involved to sale a share of common stock. The cost of retained earnings is the rate of return a corporation’s common stockholders expect the corporation to earn on their reinvested earnings. Computing the cost of retained earnings involves just a single procedure of applying the following formula: Kr = D1 + g Po Where: Kr = The cost of retained earnings D1 = The expected dividends payment at the end of next year Po = The current market price of the firm’s common stock g = The expected annual dividend growth rate. 2. Retained earnings are not securities like stocks and bonds and hence do not have market price that can be used to compute costs of capital. Example: Zeila Auto Spare Parts Manufacturing company expects to pay a common stock dividend of Br.50 per share during the next 12 months. A flotation cost of Br. The firm’s current common stock price is Br.4. at least equal to the rate earned on the outstanding common stock. However. 50 per share and the expected dividend growth rate is 7%. Page 7 . flotation costs are not involved in the case of retained earnings.2.4 The cost of Retained Earnings Retained earnings represent profits available for common stockholders that the corporation chooses to reinvest in itself rather than payout as dividends. Therefore.
Practically. investments are financed by two or more sources of capital. Each capital source accounts to some portion of the total finance. however. the weighted average cost of capital can be computed as: Page 8 . g = 7%. The firm’s capital structure is composed of debt.50.3 Br. Rather we should use the average cost of capital employed by the firm. and retained earnings.Required: Compute the cost of retained earnings Solution Given: Po = Br. preferred stock. 2. It is also called the composite cost of capital. In such a situation. preferred stock and common equity (common stock and retained earnings). Kr = ? Then apply the formula: Kr = D1+ g = Br. 50. 50 WEIGHTED AVERAGE COST OF CAPITAL (WACC) In the previous section we have seen how to compute the cost of capital for each individual source of capital. D1 = Br. But the percentage contribution of one source is usually different from another. If the weights of the component capital sources are all given. 2.50 + 7% = 12% Po 4. common stock. So we must compute the weighted average cost of capital rather than the simple average. we cannot make use of the individual cost of capital. The specific cost of capital is used in evaluating an investment proposal to be financed by a particular capital source. The weighted average cost of capital (WACC) is the weighted average of the individual costs of debt.
375.050.000 84.000 1.000 Br. 2.0 Br.100.WACC = WdKdt + WpsKps + WceKs Where: WACC = the weighted average cost of capital WD = the weight of debt Wps = The weight of preferred stock Wce = The weight of common equity Kdt = The after – tax cost of debt Kps = The cost of preferred stock Ks = The cost of common equity The WACC is found by weighting the cost of each specific type of capital by its proportion in the firm’s capital structure. Weights of the individual capital sources can be calculated based on their book value or market value.500.000 Required: Calculate the firm’s weighted average cost of capital using: 1) book value weights 2) market value weights Page 9 . Source of capital Debt Preferred stock Common equity Total Book value Market value Specific cost 5. Mona Tools Manufacturing Company’s financial manager wants to compute the firm’s weighted average cost of capital.000 Br. The book and market values of the amounts as well as specific after-tax costs are shown in the following table for each source of capital.000. look at the following example.000 966. 2.3% 12.0 16. To illustrate the computation of the WACC.000 1. 1.000 125. Br.
000 Br. Meaning. 2.4 (5.3%) + 0.49% 2) Total Market value = Br. 2.0%) + 0. 966.4 MARGINAL COST OF CAPITAL (MCC) Br.000__ = 0.46 Br.500. 2.12% + 0. 2.49% The minimum rate of return on all projects should be 10.5.4.49%.Solution: 1) Total book value = Br. Technically speaking. the marginal cost of capital (MCC) is the cost of obtaining additional new capital.000 = 0. the cost of each birr will rise at capital.000 = 0.0%) = 2. 1. 84.000.60% + 8. some point.100. Wce = Br.55 Br. Wce = Br.000 Wd = Br.000 Br.100.05 (12. As a firm tries to have more new capital.05. 1.04 (12. the MCC is the weighted average Page 10 .52% 4.000 = 0.000 2.65% + 0. 125.36% = 10.0%) + 0. 2.100.55 (16.52% If the market value weights are used. Muna should accept all projects with a minimum rate of return of 11.000 Br.000 = 0.500.050.0%) = 2. Wps = Br.000 WACC = 0.80% = 11. 2.04.5 (5.100.48% + 7.3%) + 0.500.375. Wps = Br.000 WACC = WdKdt + WpsKps + WceKs = 0.000 Wd = Br.000 = 0.46 (16. 2. 1. Thus. Muna should accept all projects so long as they earn a return greater than or equal to 10.500.
therefore.000 of debt at 7.06% Preferred stock -------------------10% Common equity ----------------.1%. preferred stock. 1.000? 2) Determine the ranges of total new financing where the WACC will rise 3) Calculate the WACC for each range of finance. Additional debt will have an after-tax cost of 9.3% after-tax costs. As a firm raises larger and larger amounts of capital. in computing the MCC is to determine the breaking points where the cost of capital will increase. 12. Example: The target capital structure of Shala Corporation and other pertinent data are given below. In addition. the weighted average cost of capital also rises. Long-term debt -----------------. The technical aspects of the MCC can be better understood using an example.200. the firm expects that it can borrow up to Br.40%.cost of the last birr of new capital obtained. Increment of debt between Br. But when the firm fully utilizes its retained earnings. 0 to Br. Page 11 .000 available retained earnings.50% cost of retained earnings (Kr) = 14% cost of common stock (Ks) = 15% cost of preferred stock (Kps) = Shala Corporation has Br. But the question would be at what point the firm’s costs of debt. it must use the more expensive new common stock financing to meet its equity needs.200. and common equity as well as WACC increase? The first point. Required 1) What is the breaking point associated with the a. 900. 1. So the concept of marginal cost of capital is discussed in the context of the weighted average cost of capital. Exhausting of retained earnings? b.
000. 3. and 3rd Range: Br. shala can raise any debt at 7.000 = Br.000.800.10 (12.35% Page 12 . Breaking point (BP) long-term debt = Br.000 will cause the cost of debt to rise to 9. 1. 0 to Br. 3.000 = Br.21% + 7.06%) + 0.000.50% = 12.1%. 1.000.21% + 7.200.000.10 (12. Any further finance need beyond Br.40 (9.40 (7.000. 3.Solutions 1) a.63% WACC (3rd range) = 0. 2nd Range: Br.1%) + 0. 1.3%) + 0. 3.000 50% b. Similarly.64% + 1.13% WACC (2nd range) = 0.06%) + 0.000 40% The breaking points computed above can be interpreted as: Shala can meet its equity needs using retained earnings until its total finance need is Br.000.10 (12. 3.50% = 11.40 (7.000.00% = 11. But when total capital required is more than Br. 2) There are three ranges of finance that could be identified on the basis of the breaking points: 1st Range: Br.92% + 1.50 (14%) = 2. 900.000 and above 3) WACC (1st range) = 0. 1.800.21% + 7.06%) + 0.800.3%) + 0.800.000. Breaking point (BP) common equity = Br. until the firm’s total finance need reaches Br. 1.000.92% + 1.50 (15%) = 2.50 (15%) = 3. 1. its equity needs should be met with common stock.800.000 to Br.3% cost.
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