COST OF CAPITAL
Capital Component
“The cost of capital is calculated as a weighted average, or composite, of the various types of funds
used over time, regardless of the specific financing used in a given year.”
Debt (rd)
Component Cost
Valuation
After-tax interest
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑌𝑇𝑀 𝑜𝑟 𝑌𝑇𝐶
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 (1 − 𝑇𝑎𝑥 𝑟𝑎𝑡𝑒)
Target Capital Structure
- the mix of debt, preferred stock, retained earnings, and common equity to be used
Target Capital Structure =
40% Debt + 10% Preference Shares + 30% Retained Earnings + 20%
Ordinary Shares
𝑟𝑃 =
Preference shares
(rp)
Required rate of return on
preference shares
(Capital Asset Pricing Model)
Required rate of return / Expected
rate of return on ordinary shares
(these two are assumed equal due to
market equilibrium)
Factors that Affect WACC
Uncontrollable
1. Interest rates
2. Stock prices
3. Tax rates
115
102
Expected rate of return
(Discounted Cash Flow (DCF) Model)
𝑟̂𝑠 =
Retained earnings
(rs)
Bond Yield plus Risk Premium
Approach
𝑟𝑆 = 𝐵𝑜𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 + 𝑅𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚
− 1 = 12.75%
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑛𝑒𝑥𝑡 𝑦𝑒𝑎𝑟
+ 𝐺𝑟𝑜𝑤𝑡ℎ
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒
𝐷1
𝑟̂𝑠 =
+𝑔
𝑃0
Based on studies, the premium on a firm’s
stock over its own bonds ranges from 3%
to 5%.
The cost of retained earnings may be:
1. The result the method to which the management Is confident
2. Average of the results of the different methods
3. Average of the various results with corresponding weights
Controllable
1. Capital structure
2. Dividend payout ratio
3. Capital budgeting decision rules
Other Problems with Cost of Capital Estimates
1. Depreciation-generated funds
2. Obtaining input data for privately owned firms
3. Measurement problems (growth rate, risk premium)
4. Costs of capital for projects of differing risks
5. Capital structure weights
𝑟𝑠 = 𝑟𝑖𝑠𝑘 free rate + (risk premium)beta
𝑟𝑠 = 𝑟𝑅𝐹 + (𝑟𝑀 − 𝑟𝑅𝐹 )β
𝑟𝑠 = 𝑟̂𝑠
100
With flotation cost: 𝑟𝑒𝑡𝑢𝑟𝑛 =
Preferred dividend
Stock’s current price (1 − Flotation)
𝐷𝑃
=
𝑃𝑃 − (1 − 𝐹)
Required rate of return
WACC =
40% (Debt’s component cost) + 10% (Pref. Sh.’s component cost) +
30% (RE’s component cost) + 20% (Ord. Sh.’s component cost)
Flotation Cost
Flotation cost can be accounted for using two approaches:
1. Increase the cost of capital (as illustrated in the computations of the cost of capital)
2. Increase the project cost
Example:
Initial cost: P100 million
Future inflow: P115 million
Flotation cost: P2 million
115
Without flotation cost: 𝑟𝑒𝑡𝑢𝑟𝑛 =
− 1 = 15%
or, if there is flotation cost involved:
𝑟𝑃 =
Weighted Average Cost of Capital (WACC)
Preferred dividend
𝐷𝑃
=
Stock’s current price 𝑃𝑃
Required return plus flotation cost
(FC)
Ordinary shares (re)
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑛𝑒𝑥𝑡 𝑦𝑒𝑎𝑟
+ 𝐺𝑟𝑜𝑤𝑡ℎ
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 (1 − 𝐹𝑙𝑜𝑡𝑎𝑡𝑖𝑜𝑛 )
𝐷1
𝑟̂𝑠 =
+𝑔
𝑃0 (1 − 𝐹)
Q: When to issue new common stocks?
A: When the capital budget exceeds the retained earnings breakpoint
𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛 𝑡𝑜 𝑅𝐸 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟
𝑅𝐸 𝐵𝑟𝑒𝑎𝑘𝑝𝑜𝑖𝑛𝑡 =
𝐸𝑞𝑢𝑖𝑡𝑦 𝑓𝑟𝑎𝑐𝑡𝑖𝑜𝑛