Group 9
Cost of
Capital
BSACC 3A GROUP 9
Lesson Objectives
Identify the important characteristics, key
assumptions, and basic concepts relative to
the cost of capital;
Compute the cost of capital using common
stocks, debts, preferred stocks, and retained
earnings;
Explain how the cost of capital is used in
making investment decision; and
Determine the Weighted cost of using book-
value weights and market-value weights.
What is cost of
Capital
Capital Structure
Also called minimum required
rate of return or hurdle rate
Have the same function as the
firm’s cost of sale
Capital structure
Refers to the mix of debt, preferred
stock and common equity, that the firm
uses to finance its assets and
resources.
At the end of the day it shows who is
the owner of the asset of the company.
Hurdle rate
It is the minimum rate of return
that must be made on an
investment to maintain the
market value of the firm’s
security.
Same Function as
COGS
The LOWER the cost The HIGHER the cost
of capital the lower of capital the lesser
the more investment the investment the
the company can company can make.
make.
Inversely Proportional
Use of Cost of
Capital
1. Capital budgeting
decision
2. Optimizing Capital
Structure
3. Making Financial
Decision
Capital Budgeting
Decision
Invest Do not invest
Rate of return = cost
of capital Rate of return < cost
Rate of return > cost of capital.
of capital
Establishing the Optimal
Capital Structure
The firm’s capital structure refers
to the firm’s debt, preferred
stock and common stock
Optimal mixture of debt and
euity
Making Financial
Decision
The cost of capital evaluates the
feasibility of refunding, issuing bonds,
refinancing debts, and leasing assets by
comparing borrowing, leasing, or owning
costs. It also applies to equity
management, convertible securities,
dividend policy, identifying financially
distressed companies, and mergers or
consolidations
Computation of Cost of
Capital
Cost of Capital can be computed either:
Individually WACC
Individual Cost of Capital
SOURCES CAPITAL COST
Creditors Long term debt After-tax cost of debt
Preferred Stockholders Preferred Shares Dividends
Common Stockholders Common Shares Dividends
Retained Earnings Retained Earnings Opportunity Cost
Kinds of Financing
SINGLE WEIGHTED
FINANCING AVERAGE
COST OF DEBT
measures the current cost of the firm to finance its projects
1. Compute the before tax cost of debt first using the yield to maturity
formula
I = annual interest payment
FV = face value of the bond
IP = value or proceeds of the bond
n = term of the bond
2 = used to get the average of the FV
and IP
2. Compute the after-tax cost of debt.
After-tax cost of debt = before-tax cost of debt (1-tax rate)
APPLICATION:
Company X plans to open a new
manufacturing plant and needs to
borrow funds. Assume that Company X
issues a P1,000,000, 12%, 10-year
bond whose net proceeds are
P920,000. The tax rate on the firm is
35%.
1. Compute the cost of debt before
tax using the yield to maturity
formula.
2. Compute the after-tax cost of debt.
3. Implication
Cost of Preferred Stock
measures the cost of financing through the issuance of preferred
shares of stock.
similar to cost 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 was made.
dividends are not tax deductible expenses, therefore a tax adjustment
is not necessary.
Cost of Preferred Stock
Application:
Sprinkle Doo Corp issued preferred stocks with an underwriting cost of 2% per share. The
stocks are expected to provide a P6 dividend per share at the time of issue. they are now
selling in the market for P50 each. What is the cost of preferred stocks.
Cost of Common Stock
Several techniques can be used to compute the cost of
common-stock equity.
1. Gordon’s Growth Model (GGM)
2. Capital Asset Pricing Model (CAPM)
Cost of Common Stock
1. Gordon’s Growth Model (GGM)
it is also called constant dividend growth model.
the formula is based on the current market price of a
common stock.
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.
Cost of Common Stock
1. Gordon’s Growth Model (GGM)
Application:
Weighted Average Cost
of Capital (WACC)
What is weighted
average cost of Capital
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.
It is the overall cost a firm should
consider before undertaking an
investment decision.
To compute for WACC,
simply 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.
Book value Weights
Market value Weights
Target and Marginal Weights
Salford & Co
Thank You
To everyone who is present here
