The Significance of Knowing the Cost of Capital and Its Effect on Business Decisions

The cost of capital represents the minimum return a company must earn on its investments to
satisfy its investors (both lenders and shareholders). It is important because it serves as a
minimum required performance: if a business project earns more than the cost of capital, it
adds value to the company; if it earns less, it weakens the company’s financial health.

According to corporate finance textbooks like "Principles of Corporate Finance" by Brealey,

Myers, and Allen, the cost of capital is considered the minimum acceptable rate of return —
meaning businesses should only invest in projects that can at least meet or exceed this rate.

Here’s why it’s important and how it affects decisions:

1. Investment Decisions (Capital Budgeting)

○ When evaluating new projects (like launching a new product, buying equipment,
or expanding operations), the company compares the project’s expected return
to the cost of capital.

○ If the expected returns are greater than the cost of capital, the project is
considered beneficial because it will increase shareholder wealth.

○ If returns are lower, the project is rejected because it would reduce overall
company value.

2. Financing Decisions

○ Companies must decide whether to use debt (loans) or equity (issuing shares) to
fund projects.

○ Knowing the cost of capital helps companies choose the most cost-effective way
to raise money while keeping profits high.

3. Valuation and Growth Decisions

○ When determining the value of the company, future earnings are discounted
using the cost of capital.

○ An inaccurate estimate can cause wrong decisions, such as overpaying for

investments or missing valuable opportunities.

4. Risk Management
 ○ Higher-risk projects need to offer higher potential returns.

○ By considering the cost of capital, companies ensure they only pursue

projects that fairly compensate for the risk taken.

Simple way to think about it:

"The cost of capital tells a business the minimum return it must aim for.
If a project can't achieve that return, it's better not to proceed."

Trusted Sources for this explanation:

● Brealey, Myers, and Allen - Principles of Corporate Finance

● Ross, Westerfield, and Jordan - Fundamentals of Corporate Finance

Brigham and Houston - Financial Management: Theory and Practice Chapter 15:
Calculating the Cost of Capital (Simplified)
Expected Learning Outcomes:
By the end of this chapter, you should be able to:

● Understand why it’s important to know how much it costs a firm to get funds for its
projects.

● Learn about the different sources of funds like:

○ Debt (loans)

○ Preferred shares (special stocks with fixed dividends)

○ Ordinary shares (regular stocks)

● Learn how to compute:

○ After-tax cost of debt (how much debt really costs after tax savings)

○ Cost of preferred shares

○ Cost of ordinary equity using different methods:

 ■ CAPM (Capital Asset Pricing Model)

■ Bond-Yield + Risk Premium Approach

■ Dividend Yield + Growth Rate Approach

■ Discounted Cash Flow Approach

■ Earnings-Price Ratio Method

○ Cost of retained earnings (profits kept in the company instead of paid as

dividends)

● Know when a company should issue new shares.

● Understand the challenges in estimating these costs.

● Calculate the Weighted Average Cost of Capital (WACC) using:

○ Historical weights (based on past financing)

○ Target weights (based on planned financing)

Introduction (Simplified)
In Chapter 6, you learned how investors expect a certain return based on risk. Now, we’re
switching perspectives — this time we ask:
How much does a company need to pay to get funds from debt and equity sources?

● Companies usually use a mix of loans (debt) and stocks (equity) to raise money for their
business needs.

● In Chapter 18, you’ll study how managers decide on the best mix. For now, let’s assume
the mix is already chosen, and our job is to figure out the total cost of using those funds.

● Different types of investors (debt holders, preferred shareholders, ordinary shareholders)

expect different returns because they face different risks. So, a company needs to
compute an average cost of capital — usually by taking a weighted average based on
how much of each type it uses.

● Why weighted? Because companies hardly ever use equal amounts of debt and equity.

○ For example, if a company is 70% financed by debt and 30% by equity, you can’t
just average their costs equally — you have to weigh them according to their
 proportions.

Important Note:

● Interest paid on debt lowers taxable income (tax-deductible), so its actual cost is lower
after tax.

● Dividends paid to shareholders (both ordinary and preferred) aren’t tax-deductible,

meaning the company pays those in full, making them more expensive compared to debt
after tax savings.

📖 Specific Capital Component Costs (Simplified)

When a company needs money, it can get it from three main sources:

1. Debt (loans, bonds)

2. Preferred shares (special stocks with fixed dividends)

3. Ordinary shares (regular stocks)

These are called capital components.

Example:

● If XYZ Corporation can borrow at 10% (after tax) — then that’ no s their cost of debt.

● When you combine the costs of these different sources, you get something called the
Weighted Average Cost of Capital (WACC), which tells the company how much it
needs to pay on average to get funds.

Important:
Not all money used by a company comes from investors. Things like accounts payable (money
owed to suppliers) or accrued expenses aren’t counted here because they aren’t direct
investments from people or banks.

A. Cost of Debt (Kd) (Simplified)

This is the minimum return lenders want for giving a company money.

● Before-tax cost of debt = the interest rate the company pays on loans or bonds.
Example: If a company borrows at 12%, its before-tax cost of debt is 12%.
 ● But for company decisions, we use the after-tax cost of debt because interest
payments reduce taxable income (the government shares the burden by lowering the tax
bill).

📊 How to Compute the Cost of a New Bond Issue (Simplified)

When a company issues new bonds (borrows money from the public), it follows these steps:

1. Figure out how much money it actually gets after selling the bond and paying costs (like
fees to banks).
Net Proceeds = Market Price of Bond − Flotation Costs

2. Calculate the before-tax cost of the bond.

If there’s no flotation cost and the bond sells at face value (par), this is just the coupon
rate (the interest paid yearly).
But usually, we compute it based on current market borrowing rates (the yield to
maturity) since that's more accurate.

Formula:
To get the before-tax cost, you need to find the rate (kd) that makes the present value of all
future interest payments plus the final repayment equal to the net proceeds the company got
from selling the bond.

✏️ Handwritten Notes (based on your style):

● PV = Net of Marginal Tax Rate

● WACC (Weighted Average Cost of Capital) uses the after-tax cost of debt.

● Flotation costs lower net proceeds, thus increasing the effective interest rate slightly.

● Trial-and-error is needed when bond periods are long (like 25 years).

B. Cost of Preferred Share (Kₚ)

Preferred shares are part of a firm’s permanent financing, but they are not issued as often as
bonds or common stock. They are hybrid securities — showing features of both:

● Debt (because they pay fixed dividends)

● Equity (because they have no fixed maturity, and dividends can sometimes be deferred)
 Note:
Under Philippine Financial Reporting Standards (PFRS), if preferred shares are classified as
debt, they follow a different computation. Here, we assume they are treated like equity preferred
shares (typical for finance cost computations).

Handwritten Notes Summary:

● Preferred shares = hybrid (debt + equity)

● Use net proceeds when shares are newly issued.

● Flotation costs reduce the selling price → making the cost higher.

● If existing shares, use the market price instead of net proceeds.

C. Cost of Ordinary Equity Share

Ordinary equity shares do not represent a contractual obligation to make specific payments,
making it more difficult to measure their cost compared to bonds or preferred shares. Business
firms raise equity capital:

● Externally through the sale of new ordinary equity shares.

● Internally through retained earnings.

Retained earnings represent the portion of accumulated after-tax profits that the firm has
reinvested into the business rather than distributed to shareholders.

The cost of existing ordinary equity shares is the same as the cost of retained earnings, with no
flotation costs considered. However, the cost of new ordinary equity shares is higher because of
flotation costs that reduce net proceeds. Thus, firms usually prefer to use retained earnings first
before issuing new ordinary equity shares.

A. Cost of Equity

1. The CAPM Approach The Capital Asset Pricing Model (CAPM) is the most widely used
method to estimate the cost of ordinary equity shares. The CAPM steps are:

Step 1:
Estimate the risk-free rate— usually measured by the 10-year Treasury bond rate or short-
term Treasury bill rate.
Step 2:
Estimate the beta coefficient — Beta measures how sensitive the stock’s returns are relative
to market movements.

Step 3:
Estimate the expected market risk premium — the difference between the expected return
on the market portfolio and the risk-free rate.

Step 4
Use the CAPM formula:

Thus, the CAPM estimate of rsr_s equals the risk-free rate plus a risk premium based on the
stock’s beta.

2. Bond Yield Plus Risk Premium Approach

In situations where reliable inputs for the CAPM approach are not available (such as for
closely held companies), analysts use a more subjective procedure to estimate the cost
of equity. The formula is:

The risk premium for a firm’s stock over its own bonds is typically determined judgmentally and
ranges from 3 to 5 percentage points above the base rate.

5. Earnings – Price Ratio Method

This method is used to estimate the cost of ordinary equity based on the inverse of the firm's
price-earnings ratio (P/E ratio). It's simple to compute but lacks strong economic logic.

B. Cost of New Ordinary Equity Shares

When a company issues new shares, it must account for extra costs, such as flotation costs
(fees for marketing the shares and selling them at a lower price to attract investors). These
additional costs make the cost of new equity higher than the cost of using retained earnings.

Why is the Cost of New Shares Higher?

The cost of new shares is higher than using retained earnings because of:

● Underpricing: Selling shares at a lower price to attract investors.

● Underwriting Fees: Costs for marketing and selling the new shares.

The Constant Growth Model helps estimate how much the company needs to earn from the
new shares, considering the expected dividend growth and flotation costs.
📈 When Must External Equity Be Used? (Simplified)

A company uses external equity (like selling new shares) when its internal funds — such as
retained earnings (profits kept in the business) — aren’t enough to cover planned investments.

The point where retained earnings run out is called the Retained Earnings Breakpoint.

⚠️ Problems to Consider with Estimates of Cost of Capital (Simplified)

Estimating a company’s cost of capital isn’t always easy. Here’s why:

1. Privately Owned Firms:

No stock market data is available for these companies, making it tricky to estimate how
much their equity really costs.

2. Measurement Problems:
It’s hard to accurately predict future profits, growth rates, and market risk premiums.

3. Capital Structure Weights:

The company needs reliable and realistic target percentages for debt, preferred shares,
and equity — otherwise, the calculations won’t be meaningful.

4. Different Project Risks:

Not all projects have the same risk. A riskier project might need a higher return than the
company’s usual rate.

Bottom line:
Firms must carefully handle these issues so their cost of capital estimates remain accurate and
helpful when making decisions about investments and funding.

What is WACC?

WACC stands for Weighted Average Cost of Capital, and it shows how much a company is
paying on average to raise money from debt, preferred shares, and equity.

Important Points:

● Debt is cheaper because the company can deduct interest from taxes.

● Preferred shares and equity (like dividends) don’t have this tax benefit.

● WACC can be calculated for the current or new financing.

How WACC is Calculated:

There are two ways to calculate WACC, using Historical Weights or Target Weights.

A. Historical Weights:

● Book Value Weights: Uses the company’s balance sheet values to find the proportions
of debt and equity. It might be inaccurate because it doesn't reflect market price
changes. It’s less useful for current decisions since balance sheet values can become
outdated.

● Market Value Weights: Uses the current market prices of the company’s debt and
equity. More accurate because it reflects investor expectations, but it can change
frequently because market prices fluctuate.

B. Target Weights:

Target weights are based on a company’s desired capital structure — the ideal mix of debt,
preferred shares, and equity that the company wants to achieve. Firms using target weights aim
to raise funds in a way that aligns with this optimal structure. They adjust their financing to stay
in line with this goal.

It’s better to use market values (current prices) for target weights because:

● It helps maximize the company’s share price.

● It helps minimize the cost of capital.