02FINMAN

FINMAN202
Financial Management#
Financial Management [FINMAN202]

STUDENT
Name:
Student Number:
Program:
Section:
Home Address:
Email Address:
Contact Number:
PROFESSOR
Name: Annieleah D. Debasa; Dr. Ramon George Atento
Academic Department: Department of Business and Accountancy
Consultation Schedule: Monday to Friday, 5:30 pm – 8:30 pm;
Email Address: addebasa@ccc.edu.ph;
Contact Number:
General Instructions

1
GENERAL INSTRUCTIONS:
MODE OF STUDY AND ATTENDANCE

For this school year, the City College still adopted a blended study program – a mix of offline and online
instructions. This learning modality entails that there shall be scheduled online classes requiring student
attendance and interaction for the entire semester. Likewise, in this learning approach, the College still crafted
modular materials in three (3) correlated modules designed for synchronous and asynchronous instructions to be
given to the student through e-Guro--the in-house Learning Management System adopted by the school.
LEARNING MATERIALS AND REFERENCES

The inclusive topics of this module shall also be the basic flow of virtual discussion. The students are
encouraged to read the module before joining the scheduled online interaction. As for study references and
materials, several textbooks are available in the college library, wherein you can collectively or individually
request an electronic/physical copy. Alternatively, you can source related references available in the web
portal. When looking for study resources and materials either offline or across the net, please be reminded of the
so-called law on Data Privacy Act of 2012. The City College of Calamba owns the content of the modular
materials provided to you, henceforth the author of the books, websites, journals/videos content, etcetera unless
tolerable for learning duplication. You shall be mindful and practice due diligence in dealing with exclusive rights
issues, especially our modular materials, to avoid mishaps on your part.
GRADING SYSTEM
The student's learning progress will be measured through output activities in the form of enrichment and
assessment. These activities are pre-formatted designed by your respective instructor, which can be given to the
student synchronously or asynchronously. You can expect a combination of fill-in-the-blank, true-or-false,
traditional multiple-choice, analytical illustrations, and essays in a time-bounded manner. The outputs, including
the virtual performance, shall be the basis for your grade. The grading scheme for these activities shall be 40% for
assessment, 40% for enrichment, and 20% for virtual performance, and it is to be uploaded per activity per student
and can be viewed through the LMS. For final grade merit, the following are the weight of each Module: Module
1, 30%; Module 2, 30%; and 40% for Module 3.
Starting this school year, a student who cannot complete and pass the assessment and evaluation
activities given during the term in the prescribed manner by the professor with or without a valid reason will be
marked as failed. Likewise, the original grading scheme to evaluate the student shall be reverted and take effect
without reservations.
COMMITMENT OF INTEGRITY
As an enrolled student in this institution, you shall always uphold and perform your task with utmost honesty
and integrity. The City College will NOT tolerate any misconduct or misbehavior, especially any protocol violation
in the implemented learning modality. Whoever is found guilty of these shall be given sanctions written in your
student's manual.

2
LEARNING MODULE INFORMATION
I. Course Code FINMAN202
II. Course Title FINANCIAL MANAGEMENT
III. Module Number 2
IV. Module Title CAPITAL SOURCING AND DIVIDEND
V. Overview of the Module This module 2 has three (3) main topics such as Long-term Financing,
Dividend Policy and Cost of Capital, which is presented through discussion
and application at the same time, followed by a summary of the lesson
and enrichment activities at the end of each lesson. Then, an assessment
activity through a Midterm Examination shall be given to the students to
test their in-depth learning and understanding of the module's topics.
VI. Module Outcomes At the end of this module, the students are expected:
 To identify and understand the sources of capital for business firms; the
nature of debt financing; collateral restructure covenants and
repayment schedule; nature of bonds; credit risk and ratings;
dividends--its types, concepts and theories, advantages and
disadvantages; the types and factors influencing dividend policy;
stock splits and dividend reinvestment plans; and stock repurchase.
 To calculate the intrinsic value of preference and ordinary shares using
finite and infinite period valuation methods; cost of capital; after-tax
cost of debt, cost of preference shares and retained earnings,
weighted average cost of capital using historical weights and target
weights; and the cost of ordinary shares under different models and
approaches.

3
LESSON 1: LONG-TERM FINANCING
LESSON OBJECTIVES
At the end of the lesson, the students are expected:
 To identify and understand the sources of capital for business firms, the nature of debt financing, collateral
restructure covenants and repayment schedule, nature of bonds, credit risk and ratings, the features of
issuing share capital,
 To calculate the intrinsic value of preference and ordinary shares using finite and infinite period valuation
methods, and
 To evaluate lease or buy method under different methods.
DISCUSSION & APPLICATION
Sources of Capital
There are usually two common sources of long-term financing for business: debt and equity. Other sub-
categories include debentures, retained earnings, term loans, working capital loans, letter of credit, venture
funding etc. These sources of funds are used in different situations. They are classified based on time period,
ownership and control, and their source of generation (see figure below).
It is ideal to evaluate each source of capital before opting for it. There are many characteristics on the
basis of which sources of finance are classified. On the basis of a time period, sources are classified as long-term,
medium term, and short term. Ownership and control classify sources of finance into owned and borrowed

4
capital. Internal sources and external sources are the two sources of generation of capital. All the sources have
different characteristics to suit different types of requirements.
Debt Financing
Usually paid in installments, long-term debts are obligations that mature in 2 to 20 years. Firms without
access to financial market approach commercial banks, insurance companies, or other financial institutions as
an alternative even if the latter’s interest rates are considerably higher. Long-term debts are incurred to purchase
capital assets such as land, buildings, and machinery or equipment. They are obtained for the purpose of
expansion or payment of mature obligations. Similar to a bond, a long-term debt is sometimes collateralized by
real estate or chattel. In some instances, however, bonds do not require any security.
Advantages of issuing long-term debts

 Unlike dividends declared, the interest can serve as “tax shield”.
 Long-term debts help increase a firm’s EPS.
 The repayment of a long-term debt (in pesos) is cheaper during times of inflation.
 The outstanding shares of stock are diluted because new shares of stock are not issued.
 The issuer of bonds enjoys financial flexibility because of the call provision in the bond indenture. A call
provision permits a firm to redeem the bonds before the maturity date.
Disadvantages of issuing a long-term debt

 A scheduled interest payment is required regardless of the firm’s actual earnings.
 A firm with a considerable amount of outstanding loans does not project a “healthy” financial position.
 Companies with high financial leverage normally pay a higher interest due to their low credit rating.
 A covenant provision in the indenture which subjects a firm to certain constraints is very common.
What the proper combination of long-term debts and equity in a company should be depends on the
type of organization and credit availability and the after-tax cost of financing. If a firm has a high degree of
financial leverage, it can take steps to minimize other corporate risks.
Debt-financing is advisable in the following situations

 The firm’s revenue and earnings are stable.
 The firm has adequate liquidity and determinable cash inflows.
 The firm has a low debt-to-equity ratio.
 Inflation is expected.
 The indentures on the debt contract are not burdensome.
Term Loans
A term loan is a loan from a bank for a specific amount that has a specified repayment schedule and
either a fixed or floating interest rate. A term loan is often appropriate for an established small business with sound
financial statements. Also, a term loan may require a substantial down payment to reduce the payment amounts
and the total cost of the loan.
In corporate borrowing, a term loan is usually for equipment, real estate, or working capital paid off
between one and 25 years. Often, a small business uses the cash from a term loan to purchase fixed assets, such
as equipment or a new building for its production process. Some businesses borrow the cash they need to
operate from month to month. Many banks have established term-loan programs specifically to help companies
in this way.
Term loans come in several varieties, usually reflecting the lifespan of the loan:

5
 Short-term loan. It is usually offered to firms that don't qualify for a line of credit, generally runs less than a
year, though it can also refer to a loan of up to 18 months or so.
 Intermediate-term loan. It is generally running more than one—but less than three—years and is paid in
monthly installments from a company’s cash flow.
 Long-term loan. It runs for three to 25 years, uses company assets as collateral, and requires monthly or
quarterly payments from profits or cash flow. The loan limits other financial commitments the company
may take on, including other debts, dividends, or principals' salaries and can require an amount of profit
set aside for loan repayment.
Bonds
A bond is a long-term debt in which the corporation that issued the bonds owes the bondholders a debt
and is obliged to repay the principal at its face value on the maturity date or to make periodic interest payments
until the principal is paid.
When a firm needs a large sum to finance its activities, it may have to borrow from the general investing
public by using a bond issue. Prior to the issuance, the approval of the securities and Exchange Commission (SEC)
must be obtained. Bonds are used primarily by corporations and government agencies. In case the issuer
becomes insolvent, the bondholders have a priority of claim on the firm’s assets and dividends over the preferred
and common stockholders.
Features of a Bond Issue:

A bond indenture or deed of trust is a detailed document which contains the essential information
regarding the bond issued. It also includes the rights and duties of the borrower and the other parties to the
contract such as follows:
a. Details of the terms of the bonds issued – includes the: a) nominal rate or principal or face amount of
the bond issuance, b) issue price and c) maturity date
b. Covenants – part of the bond indentures that restricts certain actions of the issuer, e.g., incurring
additional obligations.
c. Call provision – provides the issuer of the bonds with the right to redeem the bonds previously issued
before maturity date, thus enabling the corporation to pay off the bonds due.
d. Retirement provision – details how the bonds issued are to be repaid.
e. Sinking-fund provision – a provision which requires the issuing corporation to set aside an amount to pay
off the bond issuance. This amount is given for safekeeping to the trustee who then uses it to pay off the
debt in part or in full.
A bond certificate which represents a portion of the total loan is used. The usual minimum denomination in
business practice is P1,000 although smaller denominations are occasionally issued.
 If property is pledged as a security for the bond issue, a trustee who will hold the title to the property
serving as the security is identified. The trustee acts as the representative of the bondholders and is usually
a bank or trust company.
 A bank or trust company is appointed as the registrar or disbursing agent. The issuing firm deposits the
interest and principal payments to the disbursing agents who will then distribute the fund to the
bondholders. In other words, the bank or trust company is the one which ensures that all the terms and
covenants indicated in the indentures are followed strictly by the issuing firm.
Type of Bonds
1. Term Bonds – are bonds that mature on a single date.

6
2. Serial Bonds – are bonds in which the principal amount matures in a series of payments (or installment)
rather than a single payment.
3. Secured Bonds – are bonds issued with fixed assets pledged as collateral.
4. Unsecured Bonds – are bonds issued without collateral.
5. Registered Bonds – requires that the name of the bondholders be registered in the books of the
corporation.
6. Coupon or Bearer Bonds – are bonds where a sheet of coupons is attached to the bond certificate. Each
coupon represents an interest payment to be made from the date of issue to the date of maturity.
7. Convertible Bonds – are bonds that can be exchanged for a pre-determined number of shares of
corporate stock.
8. Callable Bonds – are bonds which be called for redemption prior to maturity date.
9. Guaranteed Bonds – are made when a company or individual (other than the issuing company) accepts
the obligation to pay the interest and principal in case of default.
10. Junk Bonds – are high-risk, high-yield bonds issued by companies that have numerous outstanding
obligations or that are in a weak financial condition.
11. Floating-rate Bonds – are a type of bond where the interest payment changes due to the fluctuations in
the interest rate.
Credit Risk and Rating

Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet contractual
obligations. Traditionally, it refers to the risk that a lender may not receive the owed principal and interest, which
results in an interruption of cash flows and increased costs for collection. Excess cash flows may be written to
provide additional cover for credit risk. When a lender faces heightened credit risk, it can be mitigated via a
higher coupon rate, which provides for greater cash flows.
When lenders offer mortgages, credit cards, or other types of loans, there is a risk that the borrower may
not repay the loan. Similarly, if a company offers credit to a customer, there is a risk that the customer may not
pay their invoices. Credit risk also describes the risk that a bond issuer may fail to make payment when requested
or that an insurance company will be unable to pay a claim.
Credit risks are calculated based on the borrower's overall ability to repay a loan according to its original
terms. To assess credit risk on a consumer loan, lenders look at the five Cs: credit history, capacity to repay,
capital, the loan's conditions, and associated collateral.
Some companies have established departments solely responsible for assessing the credit risks of their
current and potential customers. Technology has afforded businesses the ability to quickly analyze data used to
assess a customer's risk profile.
If an investor considers buying a bond, they will often review the credit rating of the bond. If it has a low
rating (< BBB), the issuer has a relatively high risk of default. Conversely, if it has a stronger rating (BBB, A, AA, or
AAA), the risk of default is progressively diminished.
Equity Financing
Another source of business financing is through equity issuances. Corporations issue stocks to raise funds
for the company that will be used to finance, in part or in full, the corporate assets. The firm’s equity capital is
composed of the capital stock, subscribed capital stock, additional paid-in capital, retained earnings, and
treasury stock. A corporation may issue two types of stock: common stocks and preferred stocks. If a corporation
issues only one kind of stock, then that stock must be common and is also the firm’s capital stock.
Equity financing is commonly used for long-term projects such as investments in property like machinery
and equipment. The proceeds from the issuance of the shares may also be used to pay off the firm’s obligations.
Features of Common Stocks

 The right to receive dividends after the claims of the preferred stockholders are met.

7
 The preemptive right or the right to buy new shares of stock before they can be offered to the public. This
right is given to the current stockholders so they can maintain their proportionate percentage of ownership
in the company. A dilution of ownership results in a dilution of net earnings because the claims of the
present stockholders on the firm’s earnings will correspondingly decrease.
 Common stockholders have the right to vote in the election of the board of directors, employee stock
award plans, and mergers. Hence, they can participate in the management of the firm.
 The right to share in the distribution of assets after all the preferential claims are met.
 The right to receive periodic financial reports regarding the firm.
 The receipt of a stock certificate which evidences part-ownership of the firm. The stock certificate may
then be sold by the holder to others in the secondary securities market.
Advantages of Issuing Common Stocks

 Because of increased liquidity, the credit rating of the company will improve. Financing through borrowing
decreases the firm’s financial ratios in relation to financial leverage.
 A dividend declaration is not required unless the board of directors decides otherwise. Unlike in the case of
bonds, stockholders cannot demand the receipt of interest.
 The common stocks issued do not have a maturity date.
 The common stocks issued can be repurchased by the company in the form of treasury shares.
Repurchased stocks help increase the company’s earnings per share (EPS).
 The company net income will increase because the dividends declared are not tax-deductible.
Disadvantages of Issuing Common Stocks

 The EPS of the company will be diluted. With the increase in the number of outstanding common shares,
the EPS will decline.
 The stockholders’ interest in the firm will decrease unless they exercise their preemptive right.
 The dividends declared are not tax-deductible. Unlike in the case of bonds, the interest expense is
deducted from the income.
 The retained earnings declared as dividends will be distributed to a larger number of stockholders.
 The flotation costs associated with a common stock issue are higher compared to those related to
preferred stock issuance and debt financing.
Features of Preferred Stocks

 A preferred stockholder has preferential rights over the dividends. As such, preferred stockholders are first
paid before any dividend is distributed to the common stockholders. The amount of the dividends is usually
fixed and stated as percentage of the preferred stocks’ par value. Preferred stocks are frequently
cumulative, if the annual dividend requirement cannot be satisfied, it becomes dividend in arrears which
must be first paid before any dividends can be distributed to the common stockholders. A non-cumulative
preferred stock, however, is not entitled to receive dividends not declared in the past. Furthermore, a
preferred stock may be participating or non-participating. A participating preferred stock means that the
holders of preferred stock have the right to participate in the earnings that normally go to common
stockholders while a non-participating preferred stock is one that does not participate in the remaining
dividends once the fixed-rate dividends are received.
 A preferred stockholder has no voting right. He/she cannot participate in most management-related issues.
 In case of corporate liquidation, the preferred stockholders have a preferential claim on the corporate
assets over the common stockholders but not over the creditors.
 A preferred stock may have a call provision. The company can buy back the preferred stock at a call price
(oftentimes pegged at a certain percentage of par values). For instance, a stock callable at 110 means
that the company can buy back the preferred stock at 110% of its par value.

8
 A preferred stock may have a convertible feature, i.e., it can be exchanged for a certain number of
common stocks at a pre-agreed ratio.
 The issuance of preferred stock does not dilute the ownership interest of the common stockholders.
However, it affects the computation of the earnings per share since the dividend requirement for a
preferred share has to be deducted first from the net income.
 Preferred dividends are not tax-deductible. The dividends declared are taken from the retained earnings.
However, in computing the earnings per share, the basis of the net income is the after-tax valuation.
 The price fluctuation of preferred stocks is greater than that of bonds already due because preferred stocks
have no maturity date. As compared to that of preferred shares, the price fluctuation of bonds decreases
as the maturity date approaches. Thus, the risk involved also diminishes.
Even a casual review of the above features quickly leads to the conclusion that preferred stocks have their
advantages and disadvantages, depending on how the individual features are implemented by a particular
company. Every company has different financing considerations and will customize the features to match those
issues. For instance, a company can issue a preferred stock that is very similar to a debt because of its fixed
periodic payment and with a fixed amount due at the date of maturity. In other cases, the preferred stocks are
similar to common stocks.
Valuation of Common Stocks

The value of a common stock may be measured by a shareholder as the present value of an expected
stream of future dividends in addition to the present value of the future price of stock at the time of sale. An
investor buys shares expecting that he/she will receive dividends and his/her capital will appreciate. Investors
buy stocks when they believe that the market price is undervalued and will sell them when the market price is
overvalued.
For an investor holding a common stock for 1 year, the value of his/her stock is the present value of both
the expected cash dividend to be received in one year (D1) and the expected market price per share of the
stock at year end (P1). The issuance of the common stock has no maturity date and is held as a short- or long-
term investment. The general common stock valuation model is the following:
𝐷𝑡 𝑃𝑛 1−(1+𝑘𝑒 )−𝑛
Formula: 𝑃0 = ∑𝑛𝑡=1 + 𝑜𝑟 𝐷𝑡 ( ) + 𝑃𝑡 (1 + 𝑘𝑒 )−𝑛
(1+𝑘𝑒 )𝑛 (1+ 𝑘𝑒 )𝑛 𝑖
where:
P0 = price of stock at year 0
Dt = dividend per share at the end of year t
ke = required rate of return
n = number of periods
Example:
Mr. X purchased stock Y at the beginning of the year. The dividend at the end of the year is expected to
be P2.50 per share and the market price is expected to be P60. If the investor’s required rate of return is 15%,
what is the value of stock?
Answer:
P0 = D1(1+ke)-n + P1(1+ke)-n
= P2.50 (1.15)-1 + P60(1.15)-1
= P54.35
Valuing common stocks is more difficult than valuing bonds and preferred stock. Unlike the latter,
common stocks do not have a pre-determined value to be received, i.e., interest for bonds and dividends for

9
preferred stocks. For common stocks, the dividends declared depend on the profitability of the firm and the
discretion of the management.
The Growth Factor

Growth is realized through the infusion of new capital. Capital increases by means of issuing bonds or new
shares of stock. Growth can also result from a merger with another company. However, unless the existing
stockholders participate in this increase through additional investments, their interest in the company will be
clearly diluted.
The growth factor is attributed to two sources, namely external (i.e., issuance of bonds and stocks) and
internal (i.e., reinvestment of the firm’s partial or entire net income). When using growth in the evaluation of stock,
this term refers to the second source. This growth is expected to increase the future earnings of the company and
the value of the common stock.
Three kinds of growth that can be associated with the valuation of stock
1. No Growth. This valuation assumes that the dividends are not growing at all. Thus, the amount of dividends
declared is constant. A non-growing dividend is valued in the same way as a preferred stock. If the growth,
denoted by g, is equal to zero, the formula states that the dividends expected after a year be divided by the
required rate of return.
𝐷1
Formula: 𝑃0 =
𝑘𝑒
Example:
Sunny Corporation’s common stock has paid a P5-dividend for so long that investors are now convinced
that the stock will continue to pay that annual dividend forever. If the next dividend is declared in 1 year and the
investors require a 10%-return on the stock, what is the stock’s expected price at year 0? What will its price be
immediately after the next dividend payment?
Answer:
𝐷1 𝑃5
𝑃0 = = = 𝐏 𝟓𝟎. 𝟎𝟎
𝑘𝑒 0.10
The expected price of the stock at year 0 is P50.00. However, as soon as the next dividend payment is
made, another dividend of P5 is due a year later, so the price at that time will also be P50. There is no expected
appreciation in the stock price. The entire 10% return comes from the stock’s dividend yield.
2. Constant Growth Model. When valuing stocks with a constant growth, a certain percentage of the net income
is reinvested in the firm and it is expected that dividends will grow at a constant rate. To be valid, the growth rate
must be less than the required rate of return. The growth, denoted by g, is the growth rate of future earnings and
the growth in the common stockholders’ investment in the company. This growth is computed by multiplying the
return on equity (ROE) by the retention rate (1 – dividend pay-out ratio):
P0 = D1 where P0 = price of the stock at year 0

ke – g D1 = expected dividend in one year
ke = required rate of return
g = growth rate
Note that for this model to be valid, the following conditions should be met:
1. The firm must have a constant dividend growth rate (g).
2. The discount rate (ke) must not be less than the growth rate (g).

10
Example:
Merry Corporation expects the dividends for the year to be P10 per share. The required rate of return is
13%. The growth rate is expected to be constant at 8%. What is the price per share?
Answer:
P0 = D1 = 10 = P 200
ke – g 0.13 – 0.08
3. Variable Growth Model. It is used if the firm is expected to grow at a rapid rate for a few years and then revert
to a normal growth rate. This situation usually occurs when a firm develops a new product that is expected to be
highly successful and profitable. This product has little competition for about 2 to 3 years, but then faces
competition from other firms that develop substitute or similar goods.
Example:
A firm paid a dividend over the last 12 months of P1.67 (i.e., this amount represents the current dividend
rate). Dividends are expected to grow by 20% per year over the supernormal growth period of 3 years. On its 4th
year, the dividend is expected to grow at a normal constant rate (g) of 5%. The required rate of return (ke) is 9%.
First, compute for the sum of the present value of all the dividend for 3 years:
Supernormal Present Value
Dividends at 9%
D1 1.67 x 1.20 = 2.00 P 1.83
D2 2.00 x 1.20 = 2.40 2.02
D3 2.40 x 1.20 = 2.88 2.22
Total P 6.07
Second, compute the price of the stock at year 3:

P3 = D4 = 2.88(1.05) = P 75.50
ke – g 0.09 – 0.05
Third, compute the present value of the stock price at the end of the third period to get (P0):
P0 = 75.50 (1.09)-3 = P 58.29
Fourth, add the present value of all the dividends and the present value of the stock price. Adding P 6.07
and P 58.29, the total present value of common stock is P 64.36.
Valuation of Preferred Stocks

Valuing a preferred stock is similar to valuing a bond or a common stock with no growth, i.e., there is a
fixed dividend and a par value.
To compute the value of a preferred stock, the following formulas are used
PP = D1 where Pp = value of the preferred stock
KP KP = required rate of return
The Expected Rate of Return (Er) is the rate of estimated income derived from investing a stock. It is
obtained by adding the dividend and the price of the stock after a year less the purchase price of the stock over
the purchase price.
Er = D1 + P1 – P0
P0

11
Example:
Consider a stock that sells for P50.00. The company is expected to pay a P3.00 cash dividend at the end
of the year, and the stock’s market price at the end of the year is expected to be P55.00 per share. Thus, the
expected return is as follows:
Er = D1 + P1 – P0 = 3 + (P55 – P50)
P0 P50
= 16%
SUMMARY OF THE LESSON

 The two common sources of long-term financing for business are debt and equity.
 Long-term debts are obligations that mature in 2 to 20 years. These are usually incurred to purchase capital
assets such as land, buildings, and machinery or equipment. Types of long-term debts include term loans,
bonds, mortgage, etc.
 Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet contractual
obligations.
 Another source of business financing is through equity issuances. Corporations issue stocks to raise funds for
the company that will be used to finance, in part or in full, the corporate assets. Equity financing is also
commonly used for long-term projects such as investments in property, settlement of obligations, etc.
 Two types of stock that companies may issue are common stocks and preferred stocks.
 Some of the features of common stocks are:
 Right to receive dividends after preferred stockholders
 Preemptive right
 Voting right
 Right to receive periodic financial reports
 Transferability of stock certificate
 Some of the features of preferred stocks are:
 Has preferential rights over the dividends
 Has no voting rights
 Has preferential claim on the corporate assets over common stockholders
 May have a call provision
 May have a convertible feature
 Common stocks can be valued using a no growth, constant growth and variable growth model.
 Valuation of preferred stocks is similar to valuing bonds or common stocks with no growth because it has a
fixed dividend pay-out and a par value.
REFERENCES
1. Cabrera, Cabrera, Cabrera (2021-2022) Financial Management: Principles and Applications
2. Timbang, Ferdinand L. (2015) Financial Management Part II
3. https://efinancemanagement.com/sources-of-finance
4. https://www.investopedia.com/terms/t/termloan.asp
5. https://www.investopedia.com/terms/c/creditrisk.asp

12
LESSON 2: DIVIDEND POLICY
LESSON OBJECTIVES:

 To understand dividends, its types, concepts and theories, advantages and disadvantages, and
 To identify the types and factors influencing dividend policy; stock splits and dividend reinvestment plans;
and stock repurchase as an alternative to cash dividend.
DISCUSSION & APPLICATION
Dividends
Dividends are the income distributed to investors. The dividends may take the form of cash, stock, stock
split, and stock repurchase. Sourced from the firm’s unappropriated retained earnings, they represent a source
of cash flow to the stockholders and provide information about the firm’s current and future performance. They
cannot be taken from the firm’s paid-in capital to protect the interest of the creditors. Moreover, if the retained
earnings exceed the stockholders’ equity account, the excess must be declared as dividends.
Firms with a good history of dividend declarations are attractive to investors. A dividend declaration
reinforces the profitable status of the company. Dividends may be declared for the full or partial amount of
unappropriated retained earnings. Any excess income after tax not distributed as dividend becomes a part of
the retained earnings which can be the source of internal financing.
Forms of Dividend
1. Cash Dividends. It is cash directly paid to the stockholders based on a certain percentage or amount per
share in the company. Cash dividends are the most common type of dividends.
2. Stock Dividends. Payment in the form of a common or preferred stock shall be given to the stockholders of
the firm. The stockholders’ proportion of ownership in the firm remains the same, despite an increase in stock
holdings. Stock dividends are declared by the board of directors as a replacement for cash dividends. In
reality, a stock dividend does not have any value at all. It only increases the number of shares held without
increasing the value of their equity.
3. Stock Splits. It is a corporate action that increases the number of the corporation’s outstanding shares by
dividing each share. The stock’s market capitalization, however, remains the same, just as the value of the
P100 bill does not change if it is exchanged for two-P50s. For example, with a 2-for-1 stock split, each
stockholder receives an additional share for each share held, but the value of each share is reduced by half;
two shares are now equal to the original value of one share before the split.
4. Stock Repurchase. It is a process in which a firm buys back its own shares. In some countries, a firm can
repurchase its own stocks by distributing cash to existing shareholders in exchange for a fraction of the
company’s outstanding equity. The practical motives for acquiring back its own shares include the
retirement of the stocks, enforcement of employee stock option plans, and avoidance of a possible
takeover. Acquiring its own stocks reduces the shares outstanding and it becomes more expensive to
individuals who plan to take over the company. The company may also repurchase shares for the purpose
of keeping them as treasury stock. When the time comes, these shares may also be available for re-issuance.
Dividend Theories
1. The residual theory holds that a firm may declare dividends only if there is an excess net income after tax
over the equity financing of the capital investment of the project. In other words, if the net income after tax
is less than the capital investment in the project, the firm may not declare dividends. The problem in the
application of this theory is that it may result in inconsistencies when it comes to the declaration of dividends.
The inconsistency arises from the fact that the firm who already established an optimal capital structure will

13
finance the capital investment based on its optimized capital structure. Thus, the capital investment has to
be financed first by debts followed by equity through retained earnings plowed back to the company. The
net income after tax must exceed the equity financing before the firm can declare dividends. Obviously,
the dividends to be declared are not directly associated with the earnings but rather with the excess of the
net income after tax over equity financing.
2. The indifference theory holds that investors do not really care whether a firm declares dividends or not. Thus,
dividends become irrelevant in the value of the stock and the cash inflows accruing to the stockholders are
considered relevant.
According to Miller and Modigliani, a firm’s value is determined solely by the earning power and risk of
its investment. The manner by which it splits its earnings stream between dividends and internally retained
earnings does not affect the value of the firm.
3. The bird-in-the-hand theory states that investors consider the declaration of dividends as relevant. Is suggests
that stockholders prefer to receive dividends now rather than reinvest the earnings of the company. It is not
that they are against the retention of earnings; rather, they believe there is an uncertainty as to whether the
retained portion will flow back in the form of a capital gain or dividends. And if there is any stream of cash
inflow in the future, the stockholders look at it at a discounted value. Thus, the stockholders’ wealth, as they
believe, is less in the future because of time consideration.
4. The clientele effect holds that a firm’s stockholders are influenced primarily by the dividend policy they
adopt. A firm that has a stable dividend payment and low capital investment may attract investors who are
risk-adverse and prefer to have a more stable dividend for their investment. However, if a firm suddenly
changes its policy to a lower payout ratio and shifts to more risky investments, the current stockholders will
end up selling stocks and will be replaced by a new set of stockholders who are willing to receive lower
dividends in exchange for higher capital gain and a higher risk for a better expected return.
Dividend Policy
A dividend policy is the guideline a firm uses regarding the declaration of dividends. Whether dividends
should be declared or not is discretionary, i.e., it depends on the management prerogative of the board of
directors. Some importance of a dividend policy includes:
 It influences the attitude of investors. For example, stockholders look unfavorably upon a corporation whose
dividends are cut, since they associate the cutback with corporate financial problems. Furthermore, in
setting a dividend policy, the management must ascertain and fulfill the objectives of the company
owner/s. Otherwise, the stockholders may sell their shares which may bring down the market price of the
stocks. In some cases, stockholder dissatisfaction may lead to the seizure of control of the company by an
outsider.
 It impacts the financing program and capital budget of the firm.
 It affects the cash flow position. A company with a poor liquidity position may be forced to restrict dividend
payment.
 It lowers the stockholders’ equity, since dividends are paid from the retained earnings. As such, the debt-
to-equity ratio will be higher.
Factors affecting Dividend Policy

1. Legal Constraints. These are legal prohibitions imposed on corporations from paying out dividends sourced
from the firm’s legal capital. The legal capital is the portion of the paid-in capital arising from the issuance of
capital stock which cannot be returned to the stockholders in any form during the lifetime of the corporation.
The legal capital is established to provide a sufficient equity base that will protect the interest of the creditors.
For a par value stock, the legal capital is the total par value of the stocks issued and subscribed while for a
no-par value stock, the legal capital is the total payments received from the stockholders including the
excess over the stated value.

14
2. Contractual Constraints. The ability to pay dividends is sometimes restricted by provisions or covenants that
form part of loan agreements. These are impositions made by banks or other financial institutions which limit
or avoid the declaration of dividends so as not to impair loan payments. In some cases, firms are only
prohibited from declaring dividends until a certain level of earnings has been reached or if the firm exceeds
certain ratios as stipulated in the contract.
3. Internal Constraints. The liquidity of the company is to be considered. The ability to pay dividends is
constrained by the amount of excess cash available rather than the level of retained earnings against which
they are charged. In this regard, companies are not restricted from paying dividends to stockholders as long
as the dividends to be declared will not exceed its retained earnings. However, declaring dividends through
borrowings may not be advisable due to cost of borrowing.
4. Growth Prospect. The financial requirements of the firm are directly related to the anticipated degree of
asset expansion. A greater amount of financing is needed to support its asset expansion by maintaining a
higher rate of reinvestment income. If a company is aspiring to achieve a certain growth rate, the most
effective way of attaining it is through payment of small dividends or non-declaration of dividends. The
retained earnings must be kept intact or have a high retention value to finance capital investments.
5. Owner Consideration. The dividend policy should have a positive effect on the wealth of the majority of the
owners. Some of the key considerations are the following:
a. The tax status of the owners. If the stockholders have a sizeable income, the firm may decide to have a
small dividend pay-out ratio to let the stockholders defer the payment of taxes until they sell their stocks.
Cash dividends are taxed based on the final tax; therefore, stockholders will benefit more from delaying
the tax payments rather than availing of a lower tax rate. However, low-income stockholders prefer a
high dividend-payout ratio.
b. The stockholders’ investment opportunities. Stockholders that have potential investment opportunities
outside the firm favor a high dividend-payout ratio. In this way, stockholders can maximize the growth
potential of their investment. However, if a firm can match the investment opportunities outside it by
having projects yielding a high return, a lower payout ratio is justified.
c. The potential dilution of ownership. A high dividend-payout ratio means that more external financing is
needed. If the firm issues new shares of stock, the shares will be diluted. By minimizing the dividend-
payout ratio, the possible dilution of ownership is limited. It is advisable that if external financing cannot
be avoided, the issuance of long-term liabilities should be done to avoid dilution.
d. Fears of a takeover. The stockholders who want to issue additional shares of stocks may opt to device a
dividend policy to retain either all or huge part of the retained earnings. The issuance of additional shares
of stock may lead to a possible takeover. To avoid this scenario, internal financing is done.
6. Market Considerations
a. Shareholder’s value fixed or increasing level of dividends as opposed to dividends whose amounts
fluctuate.
b. Shareholders also value a policy of continuous dividend payments.
c. Stable and continuous dividend payments (rather than fluctuating dividends over time) are a sign of
good financial health. A fluctuating dividend may send the wrong signal in the market, making investors
reluctant to invest.
d. A firm which does not have access to the financial market, tends to rely on its internal funding through
the retention of retained earnings.
Types of Dividend Policies

The dividend policy must consider how to maximize the stockholders’ wealth and how to finance future
investments. The most common types of dividend policies are the following:
1. Regular Dividend Policy. It is based on the payment of a fixed-peso dividend for each period. Risk-averse
investors prefer to receive regular dividends throughout the years to minimize uncertainty. Having regular
dividends plays a crucial role on the market’s assessment of the firm. A company that declares a regular

15
dividend gives the perception that the company is “doing fine” which is immediately reflected in the stock
market through its increased stock price. Hence, if the dividends are reduced, a decrease in the stock price
is also expected. Even if a company is incurring losses which are temporary in nature, it is imperative for it to
declare dividends to avoid creating a bad impression in the market. At times, firms that use this kind of policy
increase the regular dividends once there is a prolonged increase in the earnings.
2. Constant Payout Ratio Dividend Policy. It is computed by dividing the dividends per share by the earnings
per share. This policy is considered less superior than having a regular dividend. This dividend policy tends to
fluctuate in accordance with the net income of the company. If the net income is high, the dividends are
also high; if the earnings are low, the dividends are also low. Investors by nature prefer a more regular
dividend than a fluctuating dividend. Adopting this policy does not maximize the stockholders’ wealth
through the stock price since many investors still prefer a regular dividend.
3. Low-regular-and-extra Dividend Policy. It is based on paying a low regular dividend supplemented by
additional dividends when earnings are higher than normal. In this kind of policy, the firm establishes a regular
flow of dividends to build confidence among the stockholders and show that the company is doing well.
4. Residual Dividend Policy. It is relevant to the residual theory of dividends. It states that dividends will be
declared if and only if the net income after taxes is greater than the cost of debt and equity financing. The
dividends declared in this kind of policy primarily depend on the net income derived from the project and
the composition of the financing. If the financing came primarily from debt and practically from a smaller
amount of equity, chances are the dividends are higher. But if the financing came from equity and not so
much from debt, the dividends are lower.
Dividend Reinvestment Plan

The dividend reinvestment plan (DRIP) is a plan where the stockholders are allowed to use the dividends,
they receive to acquire additional shares of stock of the company without having to go to the process of buying
stocks from the stockbroker.
A DRIP helps enhance the market appeal of the firm’s shares. Moreover, the stockholder benefits from
reinvesting the dividends without incurring, or incurring only minimal, floatation cost since they can buy stocks
directly from the company. In this scheme, the stockholders can also acquire stocks at around 5% below the
prevailing market price.
Stock Repurchase as alternative to Cash Dividends

There are three basic ways to repurchase stocks. They are as follows:
1. Open-market stock repurchase. A firm may announce that it will repurchase some shares in the open
market from time to time as market conditions dictate. Moreover, the firm maintains the option of deciding
on whether, when, and how much to repurchase.
2. Fixed price tender stock repurchase. This offer specifies in advance a single purchase price, the number of
shares sought, and the duration of the offer with the public disclosure required. The offer may be made
conditional upon receiving tenders of a minimum number of shares, and may permit a withdrawal of the
tendered shares prior to the offer’s expiration date.
3. Public auction stock repurchase. A public auction offer specifies a price range within which the shares will
ultimately be purchased. Shareholders are invited to tender their stock, if they desire, at any price within the
stated range. The firm then complies these responses, creating a demand curve for the stock.
Motives to repurchase shares

 It reduces the number of shares outstanding, increasing the EPS, and thus, the share price.
 It sends a positive signal to the market, i.e., the management believes the share price is undervalued.
 It supports the share price in a declining market.
 Is adjusts the debt ratio to achieve the optimal capital structure.
 It is incorporated into the pay package for management.

16
 It protects against hostile takeovers by reducing the number of publicly traded shares in the market.

 Dividends are income distributed to investors.
 Dividends can be paid in the form of: cash, stock, stock split and stock repurchase.
 Dividends are supported by several theories including: residual theory, indifference theory, bird-in-the-hand
theory and clientele effect.
 A dividend policy is the guideline a firm uses regarding the declaration of dividends.
 Various factors can affect in formulating a dividend policy which includes: legal constraints, contractual
constraints, internal constraints, growth prospects, owner considerations, and market considerations.
 The most common types of dividend policy are: regular dividend policy, constant payout ratio dividend
policy, low-regular-and-extra dividend policy and residual dividend policy.
 The dividend reinvestment plan (DRIP) is a plan where the stockholders are allowed to use the dividends,
they receive to acquire additional shares of stock of the company without having to go to the process of
buying stocks from the stockbroker.
 Stock repurchase benefits the stockholders in several ways including: higher return when the market price
goes up, increase respective percentage share in the company, could benefit more from the premium
than from the dividend.
REFERENCES

17
LESSON 3: COST OF CAPITAL
LESSON OBJECTIVES:

 To understand the importance of computing the cost of capital and its estimation, and
 To calculate after-tax cost of debt and cost of capital under different models and approaches.
DISCUSSION AND APPLICATION:
Cost of Capital
It defines as the minimum rate of return or hurdle rate that must be made on an investment to maintain
the market value of the firm’s securities. The cost of capital has the same function as the firm’s cost of sales, i.e.,
the lower the cost of sales, the better the chances of generating net revenues; and the lower cost of capital, the
more investment activities a company can make. If a company cannot find profitable projects or projects with
an expected return that is at least equal to cost of capital, then the firm should distribute the retained earnings
to the stockholders as dividends instead. Investors should not engage in an investment activity where the
expected rate of return is less than the cost of capital; otherwise, they will not create wealth.
It is pointless for firms to make elaborate computations of expected profits on proposed investment
projects if they do not have an accurate estimate of the cost of money to be invested. Although the stockholders
and creditors may easily provide the needed funds for a proposed project, the firm should, nevertheless, be
realistic and consider if the expected return on the investment can cover the costs involved. The cost of capital
is one of the key criteria in project evaluation.
The cost of capital is computed either individually or as the weighted average of the components of
capital, namely retained earnings, common stocks, preferred stocks, and bonds.
Uses of Cost of Capital

1. Capital Budgeting Decisions. Investment decisions involving capital expenditure should ensure that the
expected return on a project proposal is greater than or at least equal to the cost of capital.
2. Establishing the Optimal Capital Structure. The firm’s capital structure refers to the firm’s debts, preferred
stocks, and common stocks in equity that provide the minimum overall cost of capital. The firm’s capital
structure is determined on the left side of the accounting equation, i.e., in the liabilities and equity section.
3. Making other financial decisions. The cost of capital helps evaluate the feasibility of refunding issued bonds,
refinancing long-term debts, and leasing assets (the cost of leasing is compared with the cost of borrowing
or owning). The concepts and techniques of the cost of capital are also applicable in situations related to
equity management, convertible securities, dividend-policy making, reorganization of a financially
distressed company, and mergers and consolidation.
Problems in Estimating Cost of Capital

1. Controversy regarding the dependence of cost of capital upon the method and level of financing--There is
a major controversy whether or not the cost of capital dependent upon the method and level of financing
by the company. According to the traditional theorists, the cost of capital of a firm depends upon the
method and level of financing. In other words, according to them, a firm can change its overall cost of
capital by changing its debt-equity mix. On the other hand, the modern theorists such as Modigliani and
Miller, the firm’s total cost of capital argue that is independent of the method and level of financing. In other
words, the change in the debt-equity ratio does not affect the total cost of capital. An important assumption
underlying MM approach is that there is perfect capital market. Since perfect capital market does not exist
in practice, hence the approach is not of much practical utility.

18
2. Computation of cost of equity--The determination of the cost of equity capital is another problem. In theory,
the cost of equity capital may be defined as the minimum rate of return that accompany must earn on that
portion of its capital employed, which is financed by equity capital so that the market price of the shares of
the company remains unchanged. In other words, it is the rate of return which the equity shareholders expect
from the shares of the company which will maintain the present market price of the equity shares of the
company. This means that determination of the cost of equity capital will require quantification of the
expectations of the equity shareholders. This is a difficult task because the equity shareholders value the
equity shares on the basis of a large number of factors, financial as well as psychological. Different authorities
have tried in different ways to quantify the expectations of the equity shareholders. Their methods and
calculations differ.
3. Computation of cost of retained earnings and depreciation funds--The cost of capital raised through
retained earnings and depreciation funds will depend upon the approach adopted for computing the cost
of equity capital. Since there are different views, therefore, a finance manager has to face difficult task in
subscribing and selecting an appropriate approach.
4. Future costs versus historical costs--It is argued that for decision-making purposes, the historical cost is not
relevant. The future costs should be considered. It, therefore, creates another problem whether to consider
marginal cost of capital, i.e., cost of additional funds or the average cost of capital, i.e., the cost of total
funds.
5. Problem of weights--The assignment of weights to each type of funds is a complex issue. The finance
manager has to make a choice between the risk value of each source of funds and the market value of
each source of funds. The results would be different in each case. It is clear from the above discussion that it
is difficult to calculate the cost of capital with precision. It can never be a single given figure. At the most it
can be estimated with a reasonable range of accuracy. Since the cost of capital is an important factor
affecting managerial decisions, it is imperative for the finance manager to identify the range within which
his cost of capital lies.
Cost of Debt Variables

1. The current level of interest rate. As the interest rate increases, the cost of debt also increases.
2. The default risk of the company. As the default risk of a firm increases, the cost of borrowing also increases.
One way of measuring default risk is by using the bond rating of the firm. A higher rating leads to a lower
interest rate and a lower rating leads to a higher interest rate.
The before-tax cost of debt is computed by determining the internal rate of return or its approximate yield
to maturity on the bond cash outflows. Thus, the formula for the cost of debt before tax is:
(FV − IP)
I+
ki = n
(FV − IP)
2
Where:
ki = approximate yield to maturity on a bond
I = annual interest payment (principal x interest rate x term)
FV = par value or face value of the bond (or the maturity value of the bond)
IP = value or proceeds for the bond
n = term of the bond
2 = constant (it is used to get the average of the FV and IP)
The tax benefit that accrues from paying interest makes the after-tax cost of debt lower than its pre-tax
cost. Thus, the formula in computing the after-tax cost of debt is as follows:

19
kd = ki (1 – t)
Where:
kd = cost of debt after tax
t = tax rate
Example:
Assume that Gol D Corp. issues a P1,000,000, 12%, 10-year bond whose net proceeds are P920,000. The
tax rate on the firm is 35%. To compute the cost of debt before tax:
(FV − IP)
I+
ki = n
(FV − IP)
2
(P1,000,000 − P920,000)
P120,000 +
= 10
(P1,000,000 − P920,000)
2
P120,000 + P8,000
=
P960,000
= 13.33%
Therefore, the after-tax cost of debt is:

kd = ki (1 – t)
= 13.33% (1 – 0.35)
= 8.66%
Cost of Preferred Stock

The cost of preferred stock measures the cost of financing through the issuance of preferred shares of
stock. It is similar to the cost of debt because payments are made annually, but it is different from it in that there
is no maturity date upon which the payment of the principal is made. Compared to the cost of debt, this is simpler
because the expected preferred stock dividends at year 1 are divided by the net proceeds from the sale of
preferred stock. Since the dividends are not tax-deductible expenses, a tax adjustment is not necessary.
kp = d1 1
P0 – F
Where:
d1 = dividends to be received at year 1
P0 = proceeds from the sale of preferred stock
F = flotation cost
Since new preferred stocks are involved, the difference of the market price of the preferred stocks and
the flotation cost it the proceeds. The flotation cost is the cost of issuing the new shares of stocks.
Example:
Gold D Corp. issued preferred stocks with an underwriting cost of 2% per share. The stocks are expected
to provide a P6 dividend per share at the time of issue. They are now selling in the market for P50 each. What is
the cost of the preferred stock?
kp = d1 1
P0 – F

20
= P6 6
P50 – (2% x P50)
= P6 6
P50 – P1
= 12.24%
The computed kp of 12.24% is no longer subject to tax adjustment since dividends declares are not tax-
deductible. Thus, issuing bonds is better than issuing preferred stocks to accumulate funds since the cost of capital
involved is much lower due to the tax shield on the interest payments on the bonds.
Cost of Common Stocks

Firms who want to raise capital may opt to issue common stocks instead of long-term bonds or preferred
stocks. However, before deciding to issue common stocks, a firm should consider if the return on such issuance
will at least compensate the cost incurred.
Like preferred stocks, dividends are expected to be given to the investors of common stocks. Investors
are forward-looking individuals. The future returns are what motivates them to invest in securities in the market.
Investors are willing to pay a certain price for a given security because they believe that the economic rights
they will obtain in the stream of cash flows are worth the cost.
Firms that issue securities such as common stocks must ascertain if the funds they accumulate are invested
in projects that can give them a return greater than the cost of equity. Proposed projects that are expected to
give a return lower than the cost of equity must be rejected.
Several techniques can be used to compute the cost of common-stock equity. These are follows:
1. Gordon’s Growth Model (GGM)
The formula for GGM (also known as the constant dividend growth model) is based on the current
market price of a common stock. The formula is derived from the valuation model of a common stock as
follows (which was also discussed in Module 2 Lesson 1, valuation of common stocks):
P0 = d1 1
ke – g
Where:
P0 = market price of a common stock
d1 = dividends received in 1 year
ke = cost of equity
g = constant growth rate in dividends [g = re (1 – dpo)] where re is the past rate of return
on the common stock and dpo refers to the dividend payout ratio
By applying algebra for the transposition:

ke = d1 1+ g
P0
The g represents the retained earnings reinvested in the firm. By looking at the formula carefully, it
will be seen that as the growth rate increases, k e also increases, leading to a higher expected return on
an investment. Likewise, with the increased growth rate, the market price of the stock also increases.
Therefore, the growth rate has a direct relationship to the cost of equity and the market price of the stock.

21
Example:
Assume that the stock of Gol D Corp. has a market price of P60. At the end of the year, dividends
are expected to be paid at P6 per share. The growth rate is also expected to be constant at an annual
rate of 5%. The cost of equity using GGM is as follows:
ke = d1 1+ g
P0
= P6 + 5%
P60
= 15%
2. Issuance of New Common Stock

If a firm decides to issue new shares of stock in the form of common stocks, a variable will be
added in what is termed as a flotation cost (f) which is the cost of issuing additional shares of stock. It
covers the expenses in paying the commission of the investment banker/s, fees of marketing specialist/s,
lawyer/s, accountant/s, and other costs directly associated with the issuance of new common stock.
The cost of the new common stock capital (ke) is:
ke = d1 1+ g
P0 (1 – f)
Example:
From the previous example of Gold D Corp. assume the new shares of common stocks with a
flotation cost of 5% of the market price of the stock are issued. The cost of the new common stock is
estimated as follows:
ke = P6 + 5%
P60 (1 – 0.05)
= 15.53%
Based on the two previous examples, the flotation cost in the formula augments the firm’s cost of
capital, making it more difficult to accept project proposals. In addition, an increased number of
common stocks without a corresponding increase in the firm’s earnings will dilute the earnings per share
(EPS). With a decline in the firm’s EPS, investors will think that the value of the common stock has
decreased.
3. Capital Asset Pricing Model (CAPM) – please refer discussion in Module 1 Lesson 3
4. Bond Plus Approach Model

Another model in estimating the cost of equity is the bond plus approach. It is applied by simply
adding a risk premium to the firm’s cost of debt after tax. This concept is supported by the fact that the
required rate of return by an investor is obtained through the cost of debt after tax and an additional
premium on the risk undertaken.
The cost of equity using this approach model may be estimated as follows:
ke = ki(1 – t) + risk premium

Example:
Gold D Corp. has issued a P1,000,000, 15%, 5-year bond whose net proceeds are P960,000. The
tax rate applicable to the firm is 35%. Compute the cost of equity using the bond plus approach with the
assumption that the risk premium is 5%.

22
(FV − IP)
I+
ki = n
(FV − IP)
2
(P1,000,000 − P960,000)
P150,000 +
= 10
(P1,000,000 − P960,000)
2
P150,000 + P8,000
=
P980,000
= 16.12%
Therefore, the after-tax cost of debt is:
kd = ki (1 – t)
= 16.12% (1 – 0.35)
= 10.48%
Applying the bond plus approach results in the following:
ke = ki(1 – t) + risk premium

= 10.48% + 5.0%
= 15.48%
The problem with applying this formula involves the determination of the risk premium. Based on
studies conducted in the past, the risk premium is normally estimated in terms of the average historical
returns of common stocks. Considered a little “off-bear”, this method relies heavily on the thesis that the
appropriate risk premium of a firm’s common stock is equivalent to that of an average stock during a
historical period.
Cost of Retained Earnings

Many firms regularly retain a portion of their net income for the purpose of reinvesting. Thus, this portion of
the net income is a source if internal financing. With a predetermined dividend policy, a part of these earnings is
reinvested with the expectation of a required rate of return to the stockholders. The cost of retained earnings (kr)
is said to be identical to that of the cost of common stock (ke). It is only appropriate that since a firm has retained
a portion of earnings rather than declaring them all as dividends, the existing stockholders can expect to receive
something in return for such reinvestment. Therefore, the cost of retained earnings is the required rate of return
that the investors expect for the reinvestment of the retained earnings. Since (kr) = (ke), then (kr) is estimated as
follows:
kr = d1 1+ g
P0
No flotation cost is involved if the retained earnings are used to finance the firm’s projects because it does
not have to go to the investment banker to obtain the needed funds. One advantage of using kr is that the cost
of capital is relatively lower as compared to ke. With the absence of the flotation cost in the model, the issue
price of the common stock (P0) is higher, resulting in lower ke.

23
Weighted Average Cost of Capital (WACC)

The weighted average cost of capital (WACC) is the overall cost a firm should consider before
undertaking an investment decision. Thus, to be acceptable, the expected rate of return on the investment must
not be lower than WACC. The WACC is estimated by giving weight to the cost of each type of capital in
proportion to the firm’s capital structure, i.e., long-term debts, common stocks, preferred stocks, and retained
earnings.
In computing a firm’s WACC, the formula used is as follows:
ka = (kd x wd)1+ (kp x wp) + (ke x we) + (kr x wr)

Where:
ka = the firm’s WACC
kd = cost of debt after tax
wd = weight of the cost of debt after tax
kp = cost of the preferred stock
wp = weight of the cost of preferred stock
ke = cost of common stock
we = weight of the cost of common stock
kr = cost of retained earnings
wr = weight of the cost of retained earnings
In developing the WACC, the firm should consider various alternatives to establish weights assigned to
the components of the capital structure. They may be based on the book values for each component, their
market value weights, or their target weights as presented below:
1. Book Value Weights

The use of book value weights in computing the firm’s WACC assumes that new finances will be
raised using the stated values on the firm’s current capital structure. The weights are determined by
obtaining the proportion of the book value of the long-term debts, preferred stocks, common stocks, and
retained earnings to the overall total book values of the long-term capital sources. The computation of
WACC using books value weight is as follows:
Example:
Assume that the overall capital structure of Gold Corporation uses the computed cost of capital
of each type of capital from the previous examples:
Book Value Per unit/share
Mortgage bonds (P1,000 par) P10,000,000 P1,050
Preferred stock (P100 par) 5,000,000 85
Common stock (P50 par) 15,000,000 70
Retained earnings 10,000,000
Total P40,000,000
The book value weights and the WACC are computed as follows:
Source Book Value Weights Cost Weighted Cost
Debt P10,000,000 25.0% 8.66% 2.17%
Preferred stock 5,000,000 12.5 12.24 1.53
Common stock 15,000,000 37.5 15.53 5.82
Retained earnings 10,000,000 25.0 15.00 3.75
Totals P40,000,000 100% 13.27%

24
Weighted cost of capital = ka = 13.27%
Advantages:
 it is stable and simple to use, and
 the figures for the capital structure are immediately available.
Disadvantages:
 It does not present the true economic value of the equity. The retained earnings are based on the
income statement which, in turn, is a product of several imperfect accounting practices. The methods
in determining the value of inventories and depreciation expenses somehow affect the true economic
value of the equity.
 It considers the WACC as the minimum expected rate of return of the firm based on the market
determination of these costs. If the firm is concerned with looking into market-determined costs, then
it cannot simply ignore market-determined weights if they are significantly different from those based
on the book values.
2. Market Value Weights

The market value weights are obtained by dividing the market value of each component of the
capital structure of the firm by its overall or total market value. Using market value weights in computing
the firm’s WACC is theoretically more sound as compared with using book value weights due to the fact
that market values of the securities once sold will approximate the actual amount of pesos to be
received.
The market value of the common stock equity of a publicly traded company is the price per share
multiplied by the number of shares outstanding. This is the easiest component to find. The market value of
the debt is easily found if the company has publicly traded bonds. Also frequently, companies have a
significant amount of bank loans whose market values are not easy to find. However, since the market
value of a debt tends to be pretty close to the book value (companies that have not experienced
significant changes in credit rating, at least), the book value of a debt is usually used in the WACC
computation. The market value of a preferred stock is usually found in the open market (same with
common stock) and determined by multiplying the price per share by the total number of shares
outstanding.
Example:
Using the previous example, the firm’s number of securities in each category is as follows:
Mortgage bonds = P10,000,000 = 10,000 P1,000

Preferred stock = P5,000,000 = 50,000 P100
Common stock = P15,000,000 = 300,000 P50
Therefore, the market values are:

Source No. of Securities Market Price Market Value
Debt 10,000 P1,050 P10,500,000
Preferred stock 50,000 85 4,250,000
Common stock 300,000 70 21,000,000
P35,750,000
The P21 million common stock market value must be pro-rated between the common stock and
retained earnings based on the original capital (book values on previous example: 15/25 for common

25
stock and 10/25 for retained earnings) since the market value of retained earnings was incorporated into
the common stock.
The firm’s WACC is as follows:
Source Market Value Weights Cost Weighted Average

Debt P10,500,000 29.37% 8.66% 2.54%
Preferred stock 4,250,000 11.89 12.24 1.46
Common stock 12,600,000 35.24 15.53 5.47
Retained earnings 8,400,000 23.50 15.00 3.52
P35,750,000 100% 13.00%
3. Target and Marginal Weights

If a firm has already settled or is able to determine what capital structure maximizes its value, the
use of the targeted capital structure with its corresponding weighs is appropriate.
The marginal weights play a significant role in maintaining the targeted capital structure of the
firm. In this scheme, the weight of each capital is compared against the overall capital of the firm. It also
helps the firm identify the specific cost of the various types of financing against the overall financing
expected to be optimal capital structure. In using marginal weights, the firm is concerned with the actual
peso amounts of each type of financing needed for a given investment project.
Example:
Gol D Corp. plans to raise P12 million for plant expansion. The firm want to maintain its present
capital structure, believing that such is its optimal structure. Assume that the cost of debt is 10%; the cost
of common stock is 12.60%; and the cost of retained earnings is 12%. Listed below are the components of
the firm’s balance sheet.
Gol D Corporation
Balance Sheet
December 31, 2020
Current Assets P 7,000,000 Current Liabilities P 5,000,000

Fixed Asset 18,000,000 Long-term Liabilities 10,000,000
Common Stocks 5,000,000
___________ Retained Earnings 5,000,000
Total Liabilities &
Total Assets P 25,000,000 Shareholders’ Equity P 25,000,000
The company’s cost of capital is computed as follows:
Source Marginal Weights Cost Weighted Cost

Debts 50% 10.00% 5.00%
Common stocks 25 12.60 3.15
Retained earnings 25 12.00 3.00
100% 11.15%

Note that in liabilities, only long-term was used in computing the marginal weights.

26

 Cost of capital is also known as the firm’s minimum required rate of return or hurdle rate.
 Cost of capital is used when a company is deciding on an investment opportunity. Other uses of cost of capital
includes capital-budgeting decisions, establishing the optimal capital structure and other financial decisions.
 Cost of capital is computed either individually or as weighted average (WACC) of the components of capital,
namely debts, preferred stocks, common stocks and retained earnings.
 Weighted average cost of capital (WACC) is the overall cost a firm should consider before undertaking an
investment decision.
 WACC is computed using different weights for each capital structure components which are: book value
weights, market value weights, and targeted and marginal weights.
REFERENCES
3. https://www.mbaknol.com/financial-management/problems-in-determination-of-cost-of-capital/

02FINMAN

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

02FINMAN

Uploaded by

Copyright:

Available Formats

FINMAN202

Financial Management [FINMAN202]

Financial Management [FINMAN202]

MODE OF STUDY AND ATTENDANCE

LEARNING MATERIALS AND REFERENCES

Financial Management [FINMAN202]

LEARNING MODULE INFORMATION

I. Course Code FINMAN202

II. Course Title FINANCIAL MANAGEMENT

III. Module Number 2

IV. Module Title CAPITAL SOURCING AND DIVIDEND

Financial Management [FINMAN202]

LESSON 1: LONG-TERM FINANCING

DISCUSSION & APPLICATION

Financial Management [FINMAN202]

Advantages of issuing long-term debts

Disadvantages of issuing a long-term debt

Debt-financing is advisable in the following situations

Financial Management [FINMAN202]

Features of a Bond Issue:

Financial Management [FINMAN202]

Credit Risk and Rating

Features of Common Stocks

Financial Management [FINMAN202]

Advantages of Issuing Common Stocks

Disadvantages of Issuing Common Stocks

Features of Preferred Stocks

Financial Management [FINMAN202]

Valuation of Common Stocks

Financial Management [FINMAN202]

The Growth Factor

P0 = D1 where P0 = price of the stock at year 0

Financial Management [FINMAN202]

Second, compute the price of the stock at year 3:

Valuation of Preferred Stocks

Financial Management [FINMAN202]

SUMMARY OF THE LESSON

Financial Management [FINMAN202]

LESSON 2: DIVIDEND POLICY

At the end of the lesson, the students are expected:

DISCUSSION & APPLICATION

Financial Management [FINMAN202]

Factors affecting Dividend Policy

Financial Management [FINMAN202]

Types of Dividend Policies

Financial Management [FINMAN202]

Dividend Reinvestment Plan

Stock Repurchase as alternative to Cash Dividends

Motives to repurchase shares

Financial Management [FINMAN202]

SUMMARY OF THE LESSON

Financial Management [FINMAN202]

LESSON 3: COST OF CAPITAL

At the end of the lesson, the students are expected:

DISCUSSION AND APPLICATION:

Uses of Cost of Capital

Problems in Estimating Cost of Capital

Financial Management [FINMAN202]

Cost of Debt Variables

Financial Management [FINMAN202]

Therefore, the after-tax cost of debt is:

Cost of Preferred Stock

Financial Management [FINMAN202]