FINANCIAL MANAGEMENT – MBA 206A

THE COST OF
CAPITAL
Prepared by:
CHEMA C. PACIONES

Dr . Rubi Ana Saludario

Professor
 TOPIC OUTLINE

Basic concepts
Cost of Long term Debt
Cost of preferred stocks
Cost of common equity – Dividend Growth
Model
Cost of common equity – capital asset pricing
model
Weighted Average Cost of the Capital (WACC)
 BASIC CONCEPTS
Cost of Capital is all about:

CAPITAL STRUCTURE

Capital structure refers to the mix of debt, preferred

stocks and common equity that the firm uses to finance
its assets and resources.

Accounting Equation

Assets = Liability + Equity

 Objective

 To maximize the market value of

the firm through an appropriate
mix of long- term sources of
funds
 BASIC CONCEPTS

SOURCE CAPITAL COST OF CAPITAL

Long-term Debt After-tax Cost of

Creditors
Debt

Preferred
Stockholders
Preferred shares Dividend Per
Share ÷ Net
Issue price

Common
Stockholders Common
CAPM or DGM
Shares
 Preferred Stock vs Common Stock

 PS owners gets paid  Common Stock owners invited to

dividend first. shareholders meetings.

 Are pain individuals after

 Less risk than common preferred stocks holders
stock.
 Common stock holders have more
 No voting rights in potential to make money higher
risk….higher earnings.
corporation
 BASIC
COSTCONCEPTS
OF LONG-TERM DEBT

The before-tax cost of debt is computed by using

yield to maturity formula:

+ Face Value – Issue Price

Coupon
Yield to Yield to Maturity
Maturity =
(Issue Price x 60%) + (Face Value X 40%)
 COST OF PREFERRED STOCKS

The cost of preferred stock to a company is effectively the price it pays in return for
the income it gets from issuing and selling the stock. In other words, it’s the amount
of money the company pays out in a year, divided by the lump sum they got from
issuing the stock.

Cost of preferred shares is computed as:

Dividend per share ÷ (Issue price –floatation cost)

 DIVIDEND GROWTH MODEL
This is known as GORDON GROWTH MODEL name
Myron Gordon

This model assumes that dividends grow either at a stable rate in perpetuity or at
different rate during the period.

Cost of retained earnings:  Cost of new ordinary shares:

Ke = (DI ÷ P0) + GR Kn = [D1 (P0-FC)] + GR

 How to convert D0 to D1

D1 = {D0 x (1
 CAPITAL ASSET PRICING MODEL

This model describes the relationship between systematic risk and expected
return. This model assumes the expected return of a particular stock depends
on its volatility (beta) relative to the overall stock market.

Cost of capital

Risk free rate + [ Beta x (market return – Risk free rate)]

 Weighted Average Cost of Capital (WACC)

This is the calculation of the firm’s effective cost of capital, taking into
account the portion of its capital that was obtained from various
sources.

To compute for the WACC, multiply the cost of each type of

capital by their respective weights (percentage of each
source to the firm’s total capital structure) and add up the
individual weighted cost of capital.
 Weighted Average Cost of Capital (WACC)

SAMPLE OF EXERCISE:

XYZ corp’s capital structure is as follows:

Debt 35%
Preferred Stock 15%
Common equity 50%

The after –tax cost of debt is 6.5 percent; the cost of preferred stock is 10
percent; and the cost of common equity (in the form of retained earnings)
is 13.5 percent)

Requirement : Calculate XYZ’s weighted average cost of capital.

 Weighted Average Cost of Capital (WACC)

SOLUTION:

SOURCE COST WEIGHT WACC

DEBT 6.50% 35% 2.275%

Preferred Stock 10.0% 15% 1.500%

Common Stock 13.5% 50% 6.750%

100% 10.525%
 SUMMARY

The cost of capital is simply the return expected by

those who provide capital for the business,”
There are two groups of people who may put up the
capital needed to run a business:

1. investors who purchase stock

2. debt holders who buy bonds or issues loans to the
company
THANK YOU!

STAY SAFE.