Cost of Capital

Professor: JOHN ANTHONY M. LABAY, CPA, MBA

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TITLE: Cost of Capital

I. Discussion
RISK AND RETURN
Generally, the higher the potential return of an investment, the higher the risk. There is no
guarantee that you will actually get a higher return by accepting more risk. The risk is the
chance that an investment's actual return will be different than expected. Risk means you
have the possibility of losing some, or even all, of your original investment. Returns are
the gains or losses from a security in a particular period and are usually quoted as a
percentage. Low levels of uncertainty (low risk) are associated with low potential returns.
High levels of uncertainty (high risk) are associated with high potential returns.

COST OF CAPITAL
The cost of capital is a term used in the field of financial investment to refer to the cost of
a company's funds (both debt and equity), or, from an investor's point of view "the
shareholder's required return on a portfolio of all the company's existing securities". It is
used to evaluate new projects of a company as it is the minimum return that investors
expect for providing capital to the company, thus setting a benchmark that a new project
has to meet.

For an investment to be worthwhile, the expected return on capital must be greater than
the cost of capital. The cost of capital is the rate of return that capital could be expected
to earn in an alternative investment of equivalent risk. If a project is of similar risk to a
company's average business activities it is reasonable to use the company's average cost
of capital as a basis for the evaluation. A company's securities typically include both debt
and equity; one must therefore calculate both the cost of debt and the cost of equity to
determine a company's cost of capital. However, a rate of return larger than the cost of
capital is usually required.

Cost of Debt
The cost of debt is relatively simple to calculate, as it is composed of the rate of interest
paid. In practice, the interest-rate paid by the company can be modeled as the risk-free
rate plus a risk component (risk premium), which itself incorporates a probable rate of
default (and amount of recovery given default). For companies with similar risk or credit
ratings, the interest rate is largely exogenous (not linked to the company's activities).

The cost of debt is computed by taking the rate on a risk free bond whose duration
matches the term structure of the corporate debt, then adding a default premium. This
default premium will rise as the amount of debt increases (since, all other things being
equal, the risk rises as the amount of debt rises). Since in most cases debt expense is a
deductible expense, the cost of debt is computed as an after tax cost to make it
comparable with the cost of equity (earnings are after-tax as well). Thus, for profitable
firms, debt is discounted by the tax rate. The formula can be written as:

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After-tax cost of debt = (Rf + credit risk rate) (1-T)

Where:
T is the corporate tax rate
Rf is the risk-free rate

The yield to maturity can be used as an approximation of the cost of capital. Yield to
maturity (YTM) is the annual return that a bond is expected to generate if it is held till its
maturity given its coupon rate, payment frequency and current market price.

Yield to maturity is essentially the internal rate of return of a bond i.e. the discount rate at
which the present value of a bond’s coupon payments and maturity value is equal to its
current market price.
Yield to maturity can also be calculated using the following approximation formula:
YTM = C + (F – P)/n
(F + P)/2
Where:
C is the annual coupon amount
F is the face value of the bond
P is the current bond price
n is the total number of years till maturity

After-tax cost of debt can be determined using the following formula:

After-Tax Cost of Debt = Pre-Tax Cost of Debt × (1 – Tax Rate)
The gross or pre-tax cost of debt equals yield to maturity of the debt. The applicable tax
rate is the marginal tax rate.

Cost of Equity
The cost of equity is more challenging to calculate as equity does not pay a set return to
its investors. Similar to the cost of debt, the cost of equity is broadly defined as the risk-
weighted projected return required by investors, where the return is largely unknown. The
cost of equity is therefore inferred by comparing the investment to other investments
(comparable) with similar risk profiles to determine the "market" cost of equity. It is
commonly equated using the Capital Asset Pricing Model (CAPM) formula.
Cost of equity = Risk free rate of return + Premium expected for risk
Cost of equity = Risk free rate of return + Beta x (market rate of return- risk free
rate of return)

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Es = Rf + βs (RM-Rf)

Where:
Es - The expected return for a security
Rf - The expected risk-free return in that market (government bond yield)
βs - The sensitivity to market risk for the security
RM - The historical return of the stock market/ equity market
(RM-Rf) - The risk premium of market assets over risk free assets.
The risk free rate is taken from the lowest yielding bonds in the particular market, such as
government bonds

The Capital Asset Pricing Model (CAPM) describes the relationship between systematic
risk and expected return for assets, particularly stocks. CAPM is widely used throughout
finance for pricing risky securities and generating expected returns for assets given the
risk of those assets and cost of capital. The goal of the CAPM formula is to evaluate
whether a stock is fairly valued when its risk and the time value of money are compared
to its expected return.

Once cost of debt and cost of equity have been determined, their blend, the weighted-
average cost of capital (WACC), can be calculated. This WACC can then be used as a
discount rate for a project's projected cash flows.

Cost of Retained Earnings/Cost of Internal Equity

Note that retained earnings are a component of equity, and therefore the cost of retained
earnings (internal equity) is equal to the cost of equity as explained above. Dividends
(earnings that are paid to investors and not retained) are a component of the return on
capital to equity holders, and influence the cost of capital through that mechanism.

Expected Return
The expected return (or required rate of return for investors) can be calculated with the
"dividend capitalization model", which is
DividendPayment/Share
Kcs = + GrowthRate
PriceMarket

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Weighted Average Cost of Capital

The weighted average cost of capital (WACC) is the rate that a company is expected to
pay on average to all its security holders to finance its assets. The WACC is the minimum
return that a company must earn on an existing asset base to satisfy its creditors, owners,
and other providers of capital, or they will invest elsewhere. Companies raise money from
a number of sources: common equity, preferred equity, straight debt, convertible debt,
exchangeable debt, warrants, options, pension liabilities, executive stock options,
governmental subsidies, and so on. Different securities, which represent different sources
of finance, are expected to generate different returns. The WACC is calculated taking into
account the relative weights of each component of the capital structure. The more complex
the company's capital structure, the more laborious it is to calculate the WACC.
Companies can use WACC to see if the investment projects available to them are
worthwhile to undertake.

The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm's cost
of capital. The total capital for a firm is the value of its equity (for a firm without outstanding
warrants and options, this is the same as the company's market capitalization) plus the
cost of its debt (the cost of debt should be continually updated as the cost of debt changes
as a result of interest rate changes). Notice that the "equity" in the debt to equity ratio is
the market value of all equity, not the shareholders' equity on the balance sheet. To
calculate the firm’s weighted cost of capital, we must first calculate the costs of the
individual financing sources: Cost of Debt, Cost of Preference Capital and Cost of Equity
Capital. Calculation of WACC is an iterative procedure which requires estimation of the
fair market value of equity capital.

A calculation of a firm's cost of capital in which each category of capital is proportionately

weighted. All capital sources - common stock, preferred stock, bonds and any other long-
term debt - are included in a WACC calculation. All else equal, the WACC of a firm
increases as the beta and rate of return on equity increases, as an increase in WACC
notes a decrease in valuation and a higher risk.

The WACC equation is the cost of each capital component multiplied by its proportional
weight and then summing:
E D
WACC = x Re + x Rd x (1 - Tax)
T T

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Where:
Re - cost of equity
Rd - cost of debt
E - market value of the firm's equity
D - market value of the firm's debt
T-E+D
E/T - percentage of financing that is equity
D/T - percentage of financing that is debt
Tax - corporate tax rate

Capital Structure
Because of tax advantages on debt issuance, it will be cheaper to issue debt rather than
new equity (this is only true for profitable firms, tax breaks are available only to profitable
firms). At some point, however, the cost of issuing new debt will be greater than the cost
of issuing new equity. This is because adding debt increases the default risk - and thus
the interest rate that the company must pay in order to borrow money. By utilizing too
much debt in its capital structure, this increased default risk can also drive up the costs
for other sources (such as retained earnings and preferred stock) as well. Management
must identify the "optimal mix" of financing – the capital structure where the cost of capital
is minimized so that the firm's value can be maximized.

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Illustrative Problem:
The Company went public by issuing 1,000,000 shares of common stock at P25 per share.
The shares are currently trading at P30 per share. Current risk-free rate is 4%, market risk
premium is 8% and the company has a beta coefficient of 1.2.

During last year, it issued 50,000 bonds of P1,000 par paying 10% coupon annually
maturing in 20 years. The bonds are currently trading at P950. The tax rate is 30%.

Required:
a. Calculate the proportion of equity and debt in capital structure.
b. Calculate the cost of equity
c. Calculate the after-tax cost of debt
d. Calculate the weighted average cost of capital

Solution:
a. Calculating Capital Structure Weights
Current Market Value of Equity
= 1,000,000 × P30
= P30,000,000
Current Market Value of Debt
= 50,000 × P950
= P47,500,000

Total Market Value of Debt and Equity

= P30,000,000 + P47,500,000
= P77,500,000

Weight of Equity
= P30,000,000 ÷ P77,500,000
= 38.71%

Weight of Debt
= P47,500,000 ÷ P77,500,000 (or 100% − 38.71%)
= 61.29%

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b. Use either the dividend discount model (DDM) or capital asset pricing model (CAPM).
In the current example, the data available allow us to use only CAPM to calculate cost of
equity.

Cost of Equity
= 4% + (1.2 × 8%)
= 13.6%

c.
YTM = 100 + (1,000 – 950)/20
(1,000 + 950)/2
= 10.51%

After-tax cost of debt = 10.51% × (1 − 30%)

= 7.36%

d. Calculating WACC
WACC = (38.71% × 13.6%) + (61.29% × 7.36%)
= 5.26% + 4.51%
= 9.77%

II. Learning Exercises

1. Suppose today is January 1, 2020; on January 1, 2010, ACC Industries issued a 30-
year bond with a 9% coupon and a P1,000 face value, payable on January 1, 2040. The
bond now sells for P915. Use this bond to determine the firm's after-tax cost of debt.
(Assume a 34% tax rate.)

2. Suppose ACC Industries (see Problem 1) also issued a 30-year bond five years ago; it
has a P1,000 face value and a 10% coupon. If the bond currently sells for P1,000, what
is the after-tax cost of debt capital, as indicated by the market value of this outstanding
bond?

3. Suppose five years from now the ACC bond described in the Problem 2 has a market
price of P1,100. What is the after-tax cost of debt capital at that time?

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4. ACC Industries just declared a dividend of P3.50 per share of common stock. The
current stock price is P25 per share, and the dividend is expected to increase at a rate of
4% per year for the foreseeable future. Use the dividend growth model approach to
compute the cost of equity capital.

5. Suppose the market risk premium is 8.5%, the risk-free rate is 7.0%, and ACC Industries
has ß equal to 1.35. Use the Security Market Line (SML)/Capital Asset Pricing Model
(CAPM) to compute the firm's cost of equity capital.

6. Assume the debt-equity ratio for ACC is .50. Use the data of Problems 1 through 5 to
compute the WACC for ACC Industries.

7. ACC Industries has a preferred stock issue outstanding which pays an annual dividend
of P3.25 per share and currently has a market price of P25 per share. Compute the cost
of preferred stock.

8. Suppose ACC's capital structure is 30% debt, 10% preferred stock and 60% equity.
Assume all other data as presented in Problems 1 through 7; compute the WACC.

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III. Assessment

MULTIPLE CHOICE QUESTIONS

1. The company’s average cost of capital is ________.
A. the average cost of equity shares and debentures
B. the average cost of equity preference shares
C. the average cost of shares and all sources of long-term funds
D. the average cost of short-term funds

2. Most investors are risk averse which means____________.

A. they will assume more risk only if they are compensated by higher expected return
B. they will always invest in the investment with the lowest possible risk
C. they will always invest in the investment with the lowest possible risk
D. they avoid the stock market due to the high degree of risk

3. The company's cost of capital is called ________.

A. Leverage
B. Hurdle rate
C. Risk rate
D. Return rate

4. Cost of retained earnings is equal to _______.

A. Cost of equity
B. Cost of debt
C. Cost of bank loan
D. Cost of term loans

5. Beta measures the ___________.

A. Investment risk rate
B. Financial risk
C. Market risk
D. Market and finance risk

6. The coupon rate is another name for the__________.

A. market interest rate
B. current yield
C. stated interest rate
D. yield to maturity

7. Which of the following statements is most correct?

A. The WACC measures the after-tax cost of capital.
B. The WACC measures the marginal cost of capital.
C. There is no cost associated with using retained earnings.
D. Statements a and b are correct.

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8. A company has a capital structure that consists of 50 % debt and 50 % equity. Which of the
following statements is most correct?
A. The cost of equity financing is greater than or equal to the cost of debt financing.
B. The WACC exceeds the cost of equity financing.
C. The WACC is calculated on a before-tax basis.
D. The cost of retained earnings exceeds the cost of issuing new common stock.

9 – 12. The company has a target capital structure that calls for 40% debt, 10% preferred stock,
and 50% common equity. The firm’s current after-tax cost of debt is 6%, and it can sell as much
debt as it wishes at this rate. The firm’s preferred stock currently sells for P90 a share and pays
a dividend of P10 per share; however, the firm will net only P80 per share from the sale of new
preferred stock. Ross’ common stock currently sells for P40 per share, but the firm will net only
P34 per share from the sale of new common stock. The firm recently paid a dividend of P2 per
share on its common stock, and investors expect the dividend to grow indefinitely at a constant
rate of 10% per year. Assume the firm has sufficient retained earnings to fund the equity portion
of its capital budget.

9. What is the firm’s cost of retained earnings?

A. 10.0%
B. 12.5%
C. 15.5%
D. 16.5%

10. What is the firm’s cost of newly issued common stock?

A. 10.0%
B. 12.5%
C. 15.5%
D. 16.5%

11. What is the firm’s cost of newly issued preferred stock?

A. 10.0%
B. 12.5%
C. 15.5%
D. 16.5%

12. What is the firm’s weighted average cost of capital?

A. 9.5%
B. 10.3%
C. 10.8%
D. 11.4%

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13 – 18. The Corporation has a target capital structure consisting of 20% debt, 20% preferred
stock, and 60% common equity. Assume the firm has insufficient retained earnings to fund the
equity portion of its capital budget. Its bonds have a 12% coupon, paid semiannually, a current
maturity of 20 years, and sell for P1,000. The firm could sell, at par, P100 preferred stock that
pays a 12% annual dividend, but flotation costs of 5% would be incurred. Corporation’s beta is
1.2, the risk-free rate is 10%, and the market risk premium is 5%. The corporation is a constant
growth firm that just paid a dividend of P2.00, sells for P27.00 per share, and has a growth rate
of 8%. The firm’s policy is to use a risk premium of 4% age points when using the bond-yield-
plus-risk-premium method to find ks. Flotation costs on new common stock total 10%, and the
firm’s marginal tax rate is 40%.

13. What is the Corporations’ component cost of debt?

A. 10.0%
B. 9.1%
C. 8.6%
D. 7.2%

14. What is the Corporations’ cost of preferred stock?

A. 10.0%
B. 11.0%
C. 12.0%
D. 12.6%

15. What is the Corporations’ cost of retained earnings using the CAPM approach?
A. 13.6%
B. 14.1%
C. 16.0%
D. 16.6%

16. What is the Corporation’s cost of retained earnings using the dividend capitalization
approach?
A. 13.6%
B. 14.1%
C. 16.0%
D. 16.9%

17. What is the Corporations’ cost of retained earnings using the bond-yield-plus-risk-premium
approach?
A. 13.6%
B. 14.1%
C. 16.0%
D. 16.6%

18. What is the Corporations’ WACC, if the firm has insufficient retained earnings to fund the
equity portion of its capital budget?
A. 13.6%
B. 14.1%
C. 16.0%
D. 16.6%

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19. The Company wants to calculate its weighted average cost of capital (WACC). The
company’s Finance Manager has collected the following information:
• The company’s long-term bonds currently offer a yield to maturity of 8%.
• The company’s stock price is P32 a share (P0 = P32).
• The company recently paid a dividend of P2 a share (D0 = P2.00).
• The dividend is expected to grow at a constant rate of 6 % a year (g = 6%).
• The company pays a 10% flotation cost whenever it issues new common stock (F = 10%).
• The company’s target capital structure is 75% equity and 25% debt.
• The company’s tax rate is 40%.
• The firm will be able to use retained earnings to fund the equity portion of its capital budget.

What is the company’s WACC?

A. 10.67%
B. 11.22%
C. 11.47%
D. 12.02%

20. The Industry finances its projects with 40% debt, 10% preferred stock, and 50% common
stock.
• The company can issue bonds at a yield to maturity of 8.4%.
• The cost of preferred stock is 9%.
• The risk-free rate is 6.57%.
• The market risk premium is 5%.
• The Industry beta is equal to 1.3.
• Assume that the firm will be able to use retained earnings to fund the equity portion of its
capital budget.
• The company’s tax rate is 30 %.

What is the company’s weighted average cost of capital (WACC)?

A. 8.33%
B. 8.95%
C. 9.79%
D. 10.92%

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