ACC412
Management Accounting I
Module 4 (B)
Cost of Capital
By:
E. P. Enyi, Ph.D, MBA, ACA, FAAFM, RFS, MFP, FIIA
Head, Dept of Accounting, Covenant University,
Ota, Nigeria
Cost of Capital
• Business and economic decisions can only be accurate
when all elements of costs and benefits have been
correctly considered.
• Capital like any other variable in business decision has a
cost attached to it. It is not free even when provided by
the business owner(s).
• Cost of Capital is defined as the required rate of return
necessary to make a capital budgeting project
considerable.
• It is the rate of return on investment that is necessary to
maintain the market value of a firm.
• It is known as hurdle rate, cut-off rate or simply as the
minimum required rate of return (RRR).
Components of Cost of Capital
• Every composition of a firm’s capital has a cost
associated with it. For instance, ordinary shares
and retained earnings have their own cost to the
firm, so also are preferred stock and debts.
• The cost of debt is the interest rate payable after
adjusting for tax.
• The cost of preference shares is the fixed annual
dividend rate.
• The cost of equity and retained earnings are the
opportunity cost of not investing the money
elsewhere.
The reason why ordinary shares and retained income carry costs
despite their ownership by the firm is that providers of capital have to
be compensated for the time and risk in giving away their money.
Cost of Debt
• Cost of debt is the yield or return which lenders
expect from their investment.
• It is tax deductible.
• The formula is given as follows:
Kd = r(1-T)
Where;
Kd = Cost of debt;
r = pre-tax interest rate
T = tax rate
Cost Equity
• This is the rate of return required by shareholders on
stocks of comparable risk.
• It is a price which the firm must pay to attract capital from
shareholders.
• Because shareholders expect to receive both dividends
and capital gains on their investments, the cost of equity
includes the expected dividend yield and a percentage of
capital appreciation.
• A simple formula for equity cost is given as:
Ke = (d/p) + g
Where;
Ke = Cost of Equity
d = Dividend yield per share
p = Current Market Price of the share
g = expected annual dividend growth rate.
Other Methods of Measuring Equity Cost
• The cost of equity can also be determined by
using the Capital Assets Pricing Model (CAPM)
introduced by Modigliani and Miller.
• The CAPM formula is as follows:
Ke = Rf + β(Rm – Rf)
Where;
Rf = Risk free rate (rates of government bonds)
Rm = Market Risk Premium
β = the beta factor of the firm
Ke = Cost of equity
Cost of Retained Earnings
• The cost of retained earnings is the same as the cost of
ordinary shares.
• When a company issues new share capital at a price
less than the prevailing market price, the cost of retained
earnings will be less than the cost of new equity share
issue. E.g. if d=25, p=75 and g=0.07;
then
Ke = Kr = (25/75) + 0.07 = 0.4 or 40%.
But if p is offered at 50 (new issue at lower price)
then
Ke(new issue)=(25/50) + 0.07 = 0.57 or 57%
while Kr still remains at 40%. (As previously computed)
(Here, Kr = Cost of retained earnings).
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Cost of Preference Shares
Preference share is regarded as a debt
and, therefore, has no characteristics
found in ordinary share holding.
It has a fixed dividend rate which must be
paid before the ordinary shareholders get
their own.
Because the dividend is pre-agreed like an
interest rate, it has no growth rate.
The formula is:
Kp = d/p
(With d and p as previously defined).
Weighted Average Cost of Capital (WACC)
• The WACC is the firm’s true cost of capital.
• It is the average or overall cost of capital which
has taken all aspects of the costs from all
sources of finance into account.
• The WACC is the firm’s Required Rate of Return
(RRR) which must be taken into account when
discounting or when making critical investment
and financing decisions.
• It is highly complicated and a bit cumbersome to
calculate in real life because of many factors to
be taken into consideration such as beta factors,
market risk premium etc.
Computing the Weighted Average Cost of
Capital (WACC)
• Three steps are involved in computing the
WACC.
Step1 – Calculate the capital component
costs for each category;
Step2 – Assign weights to each component
according to its balance sheet value;
Step3 – Multiply the weights by computed
component costs and sum up to get the
WACC.
Illustration
Dominion Ventures Ltd., intends to embark on a long
term investment in capital assets. The current capital
structure of the company is as follows:
Ordinary Share Capital
N20,000,000
Preference Share Capital
5,000,000
15% Debenture Stock
20,000,000
Retained Earnings
5,000,000
The current rate of corporation tax is 30%. The
company’s dividend yield which has maintained a
constant growth of 5% per annum is 12kobo per share.
The current market price of the company’s share is put
at N1.35 while the agreement on the preference dividend
is 15kobo on the par value of N1.10 per share.
Required: Calculate the Weighted Average Cost of
Capital (WACC) for Dominion Ventures Ltd.
SOLUTION
Step1: Calculate the cost of components
Kd = 15(1- 0.3) = 10.5%
Ke = ((12/135) + 0.05) x 100 = 13.89%
Kp = (15/110) x 100 = 13.64%
Kr = Ke
Step2: Assign weights
Type of Capital
Amount
Ordinary Share 20,000,000
Preference Share 5,000,000
15% Debenture 20,000,000
Retained Earnings 5,000,000
TOTAL
50,000,000
Weight
0.4 (20/50)
0.1 (5/50)
0.4 (20/50)
0.1 (5/50)
1.0
Step3: Compute WACC
Weighted
Capital Type
Weight
Ordinary Share
0.4
Preference Share
0.1
15% Debenture
0.4
Retained Earnings
0.1
TOTAL
i.e. WACC = 12.51%
Cost
13.89
13.64
10.50
13.89
Cost
5.556
1.364
4.200
1.389
12.509
Class Work
Assuming that Dominion Ventures Ltd.,
decided to issue additional N10million
ordinary shares and N5million preferred
stock at N1.15 and N1.10 per share
respectively before embarking on the new
capital project; with all other information as
before, compute the company’s cost of
capital to be used in the appraisal of the
new project.