COST OF CAPITAL
Cost of Capital
Also known as the firm’s minimum required rate of return or hurdle rate, Cost of capital is defined as the minimum rate of return that
must be made on an investment to maintain the market value of the firm’s securities. The cost of capital has been 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 the cost of
capital, the more investment activities company can make. If a company cannot find profitable projects or projects with an expected
return that is at least equal to the 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 not create wealth.
It is pointless for firms to make elaborate computations of expected profit 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 individual or as the weighted average of the components of capital, namely retained earnings,
common stocks, preferred stocks, and bonds.
Uses of Cost of Capital
The cost of capital has many uses. Listed below are some of its possible applications when making financial decisions.
1. Capital-budgeting decisions. Investment decisions involving capital expenditures should not 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 debt , 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.
Individual Cost of Capital
How the cost of capital is computed depends on which kind of financing is available to the company. It may be use single financing or
the weighted average of two or more sources of financing.
Cost of Debt
The cost of debt measure the current cost of the firm to finance its projects. In general, it is determined by the following 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 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 bond cash
outflows. Thus, formula for the cost of debt before tax is:
(FV-IP)
I+ -----------
N
Ki = -----------------------
(FV+IP)
------------
2
Where:
Ki = approximate yield to maturity on bond
I = annual interest payment (PxRxT)
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:
Kd = ki (I-t)
Where:
Kd = cost of debt after tax
t = the tax rate
Example
Assume that Pau Corp issues a Php1,000,000, 12%, 10-year bond whose net proceeds are Php920,000. The tax rate on the firm is
35%. To compute the cost of debt before tax:
(Php1,000,000-Php920,000)
Php120,000 +----------------------------------------
10
Ki = ------------------------------------------------------------------------
(Php1,000,000+Php920,000)
---------------------------------------
2
Php120,000 + Php8,000
= ---------------------------------------------
Php960,000
= 13.33%
Therefore, the after tax cost of debt is:
Kd = 13.33% (1-0.35)
= 8.66%
If the interest on the bonds is paid semi-annually, as with most bonds issued , the formula for the cost of debt before and after tax will
still be applicable. The difference will lie on n (term of the bond). In this formula, n will be computed as the term of the bond multiplied
by the number of interest payments in a year. Thus, if the term of the bonds is 10 years that pays semi-annual interest, n will become
20 (20x2). Moreover, if the term of the bond is 10 years that pays a quarterly interest, n will become 40 (10x4).
Example
Use the same example of Pau Corporation, but assume that the interest is paid semi-annually. The computations for the cost of debt
before and after taxes are as follows:
(Php1,000,000 – Php920,000)
Php60,000+ ------------------------------------------
20
Ki = --------------------------------------------------------------------------
(Php1,000,000 + Php920,000)
-----------------------------------------
2
Php60,000 + Php4,000
= ---------------------------------------
Php 960,000
= 6.67%
Therefore, the after-tax cost of debt is:
Kd = 6.67% (1-0.35)
= 6.67 (0.65)
= 4.34%
Note that the cost of debt before tax of 6.67% and the cost of debt after tax of 4.34% are based on the semi-annual payment of interest
To compute the annual rate or effective rate per year, the computed percentages are multiplied by 2.
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 dividends are not tax-deductible expenses, a tax adjustment is not necessary.
D1
Kp = -----------------
Po - F
Where:
D1 = dividends to be received in 1 year
Po = proceeds from the sale of the preferred stock
F = flotation cost
Since new preferred stocks are involved, the difference of the market price of the preferred stocks and the floatation cost is the
proceeds. The floatation cost is the cost of issuing the new shares of stock.
Example
Pau Company issued preferred stocks with an underwriting cost of 2% per share. The stocks are expected to provide a Php6.00
dividend per share at the time of issue. They are now selling in the market for Php50.00 each. What is the cost of the preferred stock?
Php6.00
Kp = -----------------------------------
Php50.00-(Php50.00x2%)
Php6.00
= --------------------------
Php50.00-Php1.00
Php6.000
= ---------------------------
Php49.00
= 12.24%
The computed Kp of 12.24% is no longer subject to tax adjustment since dividends declared 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 Stock
Firms who want to raise capital may opt to issue common stocks instead of long-term bonds and preferred stocks. However, before
deciding to issue common stocks, a firm should consider if the return on such an issuance or issuances will at least compensate the
cost incurred.
Like preferred stocks, dividends are expected to be given to the investors of common stocks. Investors are forwarded-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. There are as follows:
Gordon’s Growth Model
The formula for Gordon’s growth model (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. The valuation model is as follows:
D1
Po = -----------
Ke-g
Where:
Po = market price of a common stock
D1 = dividends received in 1 year
Ke = cost of equity
g = constant growth rate (g=Re[1-dpo]) where Re is the past rate of return on the common stock and
dpo refers to the dividend payout ratio
Applying algebra for the transposition:
D1
Ke = ---- + g
Po
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, Ke 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.
Example
Assume that the stock of Pau Corporation has a market price of Php60.00. At the end of the year, dividends are expected to be paid at
Php6.00 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:
D1
Ke = --------- +g
Po
Php6.00
= ------------------ + 5%
Php60.00
= 15%
Issuance of 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 floatation
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 (k) is:
D1
Ke = --------------------- +g
Po (1-f)
Example
From the previous example of Pau Corp, assume that new shares of common stocks with a floatation cost of 5% of the market price of
the stock are issued. The cost of the new common stock is estimated as follows:
Php6.00
Ke = -------------------------- + 5%
Php60.00 (1-0.05)
= 15.53%
Based on the two previous examples, the floatation n 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’ 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.
Capital Asset pricing Model (CAPM)
The capital asset pricing model (CAPM) is used in finance to theoretically determine the appropriate required rate of return of an asset.
The CAPM formula considers the asset’s sensitivity to non-diversifiable risk (also known as systematic risk or market risk). In number of
cases, it is referred to as beta (B) in the financial industry, as well as the expected return of the market, and expected return of a
theoretical risk-free asset.
The beta measures the volatility of an asset return in relation to the market portfolio. It measures the systematic risk of a single
instrument or an entire portfolio. Sharpe (1964) first used the idea in hi landmark paper introducing CAPM. The term beta was
introduced later.
Beta describes the sensitivity of an instrument or portfolio to broad marker movements. For instance, if the beta of a firm is 1.0, then it
has a direct relationship with the market. And if the firm’s beta is -1.0, then it means that the firm’s expected return has an adverse
relationship with the market . Furthermore, if the firm’s beta is 1.20, then the asset’s return is 20% more volatile than the market. The
expected return on the market (Rm) can be estimated by the return on the market portfolio such as the All-Shares Index or the
Philippine Stock Exchange Composite Index (previously termed Philsix, and now known as PSEi).
The risk-free rate of return to be used is estimated by using the treasury bill rate (90 day T-bill) or the estimated return on other short-
term government securities.
The CAPM approach in measuring the cost of equity estimated as:
Ke = Rf+b(Rm-Rf)
Where:
Ke = cost of equity
Rf = risk-free rate of return
B = beta, which is the sensitivity of the rate of return on the firm’s common
stock in relation to the market return
Rm = required rate of return on the market portfolio
Example
Assume that Pau Corporation uses the CAPM to estimate its cost of equity. The treasury bill rate at the time of estimation is 8% with a
beta of 1.2 and the expected return on the market is 15%. What is the firm’s cost of equity?
Ke = Rf + b (Rm -Rf)
= 8% + 1.2(15%-8%)
= 16.4%
The 16.4% cost of equity can be viewed as consisting of an 8% risk-free rate in addition to an 8.4% risk premium, which reflects that the
firm’s stock price is 1.2 times more volatile than the market portfolio.
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 the bond plus approach model may be estimated as follows:
Ke = Ki(1-t) + risk premium
Example
Pau Corporation has issued a Php1,000,000, 155, 5-year bond whose net proceeds are Php960,000. The ta 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 at 5%.
(FV-IP)
1+---------------
n
Ki = -----------------------------------
(FV+IP)
--------------------
2
(Php1,000,000-Php960,000)
Php150,000 + -----------------------------------------------
5
Ki = ---------------------------------------------------------------------------------
(Php1,000,000 + Php960,000)
-----------------------------------------
2
Php150,000 + Php8,000
= ---------------------------------
Php980,000
= 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-best”, 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 investing. Thus, this portion of the net income is a source of
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 (K) is said to be identical to that of the cost of common stock (K). It is only
appropriate that since a firm has retained a portion of its 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 investor expects for the reinvestment of the retained
earnings. Since (Kr=(Ke)), then (Kr) is estimated as follows:
D1
Kr = -------------- + g
Po
No floatation cost is involved if the retained earnings are used to finance the firm’s projects because the firms does not have to g 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 floatation cost in the model, the issue price of the common stock (Po) is higher, resulting in a lower Kr.
Weighted Average Cost of Capital (WACC)
The weighted average cost of capital (WACC) is the overall cost of 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 the 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) + (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 preferred stock
Wp = weight of the cost of preferred stock
Ke = cost of common stock
We = weight of the common stock
Kr = cost of retained earnings
Wr = weight of the cost of retained earnings
In developing WACC, the firm should consider various alternatives to establish the 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.
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 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 of the book values of all the long-term capital resources. The computation of
WACC using the book value weights is as follows:
Example
Assume that the overall capita structure of pau Corporation uses the computed cost of capital for each type of capital from the previous
examples:
Market Value
Book Value Per Unit/Share
Mortgage bonds (Php,1,000 par) Php10,000,000 Php 1,050
Preferred stock (Php100 par) 5,000,000 85
Common stock (Php50 par) 15,000,000 70
Retained earnings 10,000,000
---------------------
Total Php40,000,000
============
The book value weights and the WACC are computed as follows:
Source Book Value Weights Cost Weighted Cost
Debt Php 10,000,000 25.0% 8.66% 2.54%
Preferred stock 5,000,000 12.5 12.24 1.46
Common stock 15,000,000 37.5 15.53 5.47
Retained earnings 10,000,000 25.0 15.00 3.53
-----------------------------------------------------------------------------------
Total Php40,000,000 100% 13.00
===============================================
The use of the book value weights is advantageous for two reasons: (1) it is stable and simple to use, and (2) the figures for the capital
structure are immediately available.
A disadvantage in using book value weights, however, is that 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 the inventories and depreciation expenses somehow affect the true economic value of the equity. Another
disadvantages with tis method is that 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.
Market Value Weights
The market value weights are obtained by dividing the market value of each of component of the capital structure of the firm by its
overall or total market value. Using market value weights in computing the firm’s weighted average cost of capital is theoretically more
sound as compared with using book value weights due to the fact that the market values of the securities once sold will approximate
the actual amount of pesos to be received.
The market value of 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 formula. Again, the market value of a preferred stock is
usually and easily found in the open market and determined by multiplying the cost per share by the number of shares outstanding.
Example
Using the previous example, the firm’s number of securities in each category is as follows:
Php10,000,000
Mortgage bonds = ------------------------ = 10,000
Php1,000
Php5,000,000
Preferred stock = ------------------------ = 50,000
Php100
Php15,000,000
Common stock = ------------------------- = 300,000
Php50
Therefore, the market value are:
Number Market Market
Source of Securities Price Value
Debt 10,000 Php1,050 Php10,500,000
Preferred stock 50,000 85 4,250,000
Common stock 300,000 70 21,000,000
----------------------
Php35,750,000
============
The Php21million-common stock value must be pro-rated between the common stock and retained earnings based on the original
capital (Php21,000,000 x 15/25 for the common stock and Php21,000,000 x 10/25 for the retained earnings) since the market value of
the retained earnings was incorporated into common stock.
The firm’s weighted average cost of capital is as follows:
Source Market Value Weights Cost Weighted Average
Debt Php 10,500,000 29.37% 8.66% 1.99%
Preferred stock 4,250,000 11.89 12.24 1.14
Common stock 12,600,000 35.24 15.53 7.13
Retained earnings 8,400,000 23.50 15.00 3.28
Weighted cost of capital = Ka = 13.00%
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 weights is appropriate.
The marginal weights play a significant role in maintaining the targeted capital structure of the firm. In this scheme, the weights of each
capital is compared against the overall capital of the firm. It also helps the firm identity the specific costs 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
Pau Corp plans to raise Php12million for plant expansion. The firm wants to maintain its present capital structure, believing that such is
its optimal structure. Assume that the cost of debt is 10% ; the cost of the common stock is 12.60%; and the cost of retained earnings is
12%. Listed below are the components of the firm’s balance sheet.
Pau Corporation
Statement of Financial Position
December 31, 2015
Current asset Php 7,000,000
Property, plant and equipment 18,000,000
-------------------------
Total Assets Php 25,000,000
==============
Current liabilities Php 5,000,000
Long-term debt 10,000,000
Common stock 5,000,000
Retained earnings 5,000,000
--------------------------
Total Liabilities and Stockholder’s Equity Php 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 stock 25 12.60 3.15
Retained earnings 25 12.00 3.00
------------------------------------------------------------------------
100% 11.15%
==========================================
Weighted cost of capital = Ka = 11.15%
