FIN100: Cost of Capital and Long-term Financial Policy

Cost of Capital
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It refers to the cost of using long-term financing money.

It is the expected returns of investments without impairing the principal value of money
invested.
It is the return that investors demand for a given level of risk.
It serves as a benchmark in evaluating proposed engagements.

Cost of capital according to sources:

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Cost of debt;
Cost of preference share;
Cost of ordinary share; and
Cost of Retained Earnings;

Weighted Average Cost of Capital (WACC)

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It is the minimum return a company needs to satisfy all of its investors, including
stockholders, bondholders, and preferred stockholders.
This is the cost of capital for the firm as whole, and it can be interpreted as the required
return on the overall firm.
Required Rate of Return vs. Cost of Capital

Cost of Common Equity

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It is the return that equity investors require on their investment on a firm.

Approaches in computing cost of equity;
o Dividend Growth Model (DGM) Approach
o Capital Asset Pricing Model (CAPM)

Dividend Growth Model (DGM)

Sometimes referred to as the Gordon Growth Model, Cost of equity is determined by

getting the sum of the yield rate and the growth rate.
Cost of equity is computed as follows:

Where:

COCE = Cost of Common Equity

MPPS (net) = Market Price per share, net of flotation costs
GR = Growth Rate

Flotation Cost
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These are costs incurred in issuing the shares of stock in the capital market such
as underwriting fees, agency costs, printing, advertising, and taxes.

FIN100: Cost of Capital and Long-term Financial Policy

Advantages and Disadvantages of DGM

Capital Asset Pricing Model

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This approach computes the cost of common equity by the market rate composed of riskfree rate and the adjusted risk-premium rate.

Cost of common equity is computed as follows:

Where:

COCE = Cost of Common Equity

RF = Risk-free rate

Adjusted Risk Premium Rate = (Market Rate RF)

Elements of CAPM
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Risk-free rate
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Risk Premium Rate

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Represents the business risk attendant to a given project or undertaking.

Adjusted Risk-premium
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Represents the rate of return in a relatively risk-free or riskless investments.

It is the basic risk-premium adjusted by a companys beta coefficient.

Beta coefficient ()
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It is a measure that describes the risk of an investment relative to other

investments in general.

It is the correlation between the volatility (price variation) of the individual stock
price with the composite price of the stock market.

FIN100: Cost of Capital and Long-term Financial Policy

Advantages and Disadvantages of CAPM

Cost of Debt
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It is the return a firms creditors demand on new borrowings.

It is computed as follows:

Where:

EIR = Effective Interest Rate

tr = Tax Rate

Or, alternatively, it can also be computed as follows

Where: Market value is net of all flotation costs

Cost of Preference Equity

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Sometimes referred to as the preferred stock yield rate, it is the return that
preference equity investors require on their investment on a firm.

It is computed as follows:

Where:

COPE = Cost of Preference Equity

DPS = Dividends per share

MPPS = market price per share , net of floatation cost

FIN100: Cost of Capital and Long-term Financial Policy

The Weighted Average Cost of Capital
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After computing the cost of capital from different sources, a firm must compute
for its weighted average Cost of capital to compute for the overall required rate
of return.

This is done by assigning weight to each of the sources depending on its capital
structure or capital mix.

It should be noted that in the computation, the correct way to proceed is to use
the market values of the debt and the equity.

Trading On Equity
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It is the reduction of the weighted cost of capital by strategically balancing the

proportional mix of debt and owners equity.

An intelligent way to do this is by increasing the proportional mix of long-term

debt over other sources of capital. This is because debt has the lowest cost of
capital.

If a business uses more debt to finance its operations, we can say that a
business is highly leveraged. It means more debt, lower cost if capital, higher
exposure to the risk of insolvency, and expectedly, higher return on common
equity.