COST OF CAPITAL

S r. J e a n e t t e M . F o r m e n t e r a
 OVERVIEW
COST OF CAPITAL
INTRODUCTION
Cost of capital is an integral part of investment decision as
it is used to measure the worth of investment proposal
provided by the business concern.
It is used as a discount rate in determining the
present value of future cash flows associated with capital
projects. It is also called as cut-off rate, target rate,
hurdle rate and required rate of return.

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 Meaning of Cost of Capital
Cost of capital is the rate of return that a firm
must earn on its project investments to
maintain its market value and attract funds.

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IMPORTANCE OF COST OF
CAPITAL
Computation of cost of
capital is a very important
part of the financial
management to
decide the capital
structure
of the business concern.
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 Cost of Long-Term Debt
What is Long-Term Debt?

Long-term debt is debt due in

one year or more. It is a key item that
appears on a company's balance sheet.

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 Long-Term Debt Example

Let's assume Company XYZ borrowed P12

million from the bank and now must repay
P100,000 of the loan every month for the
next 10 years. Here is Company
XYZ's balance sheet before borrowing the
P12 million:

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Before Borrowing P12M After Borrowing P12M
Cash P100,000 Cash P12,100,000
Accounts Receivable 50,000 Accounts Receivable 50,000
Inventory 30,000 Inventory 30,000
Total Current Assets 180,000 Total Current Assets P12,180,000

Fixed Assets, Net 500,000 Fixed Assets, Net 500,000

Total Assets P680,000 Total Assets P12 680,000

Accounts Payable P130,000 Accounts Payable P130,000

Accrued Liabilities 150.000 Accrued Liabilities 150,000
Current Portion Of Lt Debt 0 Current Portion Of Lt Debt 1,200,000
Total Current Liabilities P280,000 Total Current Liabilities P1,480,000

Long-Term Debt 0 Long-Term Debt 10,800,000

Shareholder’s Equity 400,000 Shareholder’s Equity 400,000
Total Liab. & Shareholder’s Equity P680,000 Total Liab. & Shareholder’s Equity P12,680,000
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 A company's long-term debts are ranked
on the balance sheet in the order
they will be repaid if the company is
liquidated. A company must record
the market value of its long-term debt on
the balance sheet, which is the amount
necessary to pay off the debt as of the date
of the balance sheet.
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 Why Long-Term Debt Matters?
Analysts evaluate a company's long-term debt to
see how much leverage a company has and how
solvent the company is.

Interest rate changes can motivate companies to repay

long-term debt before it is actually due. If a company notices that
interest rates have fallen below the rate the company is currently
paying on its debt, the company may choose to pay off the high-
rate debt with new, lower-rate debt.

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 Cost of Preference Share
(Preferred Stock)
The cost of preference share capital is apparently the
dividend which is committed and paid by the company.
This cost is not relevant for project evaluation because
this is not the cost at which further capital can be
obtained. To find out the cost of acquiring the marginal
cost, we will be finding the yield on the preference
share based on the current market value of the
preference share.
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 The preference share is issued at a
stated rate of dividend on the face value of
the share.

Therefore, without paying the dividend

to preference shares, they cannot pay
anything to equity shares.

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 Cost of preference shares can be calculated
as follows:

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 EXAMPLE:
A firm issued a 10% preference stock of P1000
which has a current market price of P900. Cost can be
calculated as below:

Kp = 100/900
Solving the above equation, we will get 11.11%. This
is the cost of redeemable preference share capital.
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 Cost of Ordinary Shares (Common Stock)

Ordinary Shares Capital is defined as the amount of money

which is raised by the companies from the issue of the
common shares of the company from the public and the
private sources and it is shown under owner’s equity in the
liability side of the balance sheet of the company. 15
 Ordinary Shares Capital Formula:
Ordinary Share Capital = Issue Price of Share * Number of Outstanding Shares
where,
•Issue price of the share in the face of the
value of the share at which it is available to
the public

•The number of outstanding shares is the

number of shares available to raise the
required amount of capital.

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Example
Suppose ABC is a US-based company. If
the company sells 1000 shares having a face
value of $ 1 per share.

Calculation of ordinary shares capital can be done

as follows:
Solution:
Issued share capital= $(1000*1)
Issued Share Capital = $1000 of ABC

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Important Points
• As it is a major source of financing incorporation, Ordinary
shares must be part of the stock of all companies.
• Ordinary shareholders are generally considered unsecured
creditors. They face greater economic risk than creditors
and preferred shareholders of a company.
• Ordinary shares rank after preference shares for the
purpose of dividends and returns of capital but carry voting
rights.

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Conclusion
We can conclude that there are many possible
ways to raise capital. Out of this, the company can raise
capital by issue of shares to the public. This can be more
suitable and appropriate as compared to other
methods.

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 Weighted Average Cost of Capital
Definition of WACC
 A firm’s Weighted Average Cost of Capital (WACC)
represents its blended cost of capital across all sources,
including common shares, preferred shares, and debt.

 The cost of each type of capital is weighted by its

percentage of total capital and they are added together.

 WACC is used in financial modeling as the discount rate

to calculate the net present value of a business.

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 What is the WACC Formula?
As shown below, the WACC formula is:
WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))
Where:
E = market value of the firm’s equity (market cap)
D = market value of the firm’s debt
V = total value of capital (equity plus debt)
E/V = percentage of capital that is equity
D/V = percentage of capital that is debt
Re = cost of equity (required rate of return)
Rd = cost of debt (yield to maturity on existing debt)
T = tax rate

extended version of the

WACC formula:
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WACC Part 1 – Cost of Equity

The cost of equity is calculated using the Capital Asset Pricing

Model (CAPM) which equates rates of return to volatility (risk vs
reward). Below is the formula for the cost of equity:

Re = Rf + β × (Rm − Rf)
Where:
Rf = the risk-free rate (typically a 10-year Treasury bond yield)
β = equity beta (levered)
Rm = annual return of the market

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• The cost of equity is an implied cost or an
opportunity cost of capital.
It is the rate of return shareholders require, in
theory, in order to compensate them for the risk of
investing in the stock.
• Risk-free Rate
The risk-free rate is the return that can be
earned by investing in a riskless security, e.g., Treasury
bonds. Typically, the yield of the 10-year Treasury is used
for the risk-free rate.

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WACC Part 2 – Cost of Debt and Preferred Stock

Determining the cost of debt and preferred stock is

probably the easiest part of the WACC calculation. The
cost of debt is the yield to maturity on the firm’s debt and
similarly, the cost of preferred stock is the yield on the
company’s preferred stock.

Simply multiply the cost of debt and yield on preferred

stock with the proportion of debt and preferred stock in a
company’s capital structure, respectively.

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 Since interest payments are tax-deductible, the cost
of debt needs to be multiplied by (1 – tax rate), which is
referred to as the value of the tax shield.
This is not done for preferred stock because
preferred dividends are paid with after-tax profits.

Take the weighted average current yield to maturity of all

outstanding debt then multiply it one minus the tax rate
and you have the after-tax cost of debt to be used in the
WACC formula.

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What is WACC used for?

The Weighted Average Cost of Capital serves as the

discount rate for calculating the Net Present Value (NPV) of a
business. It is also used to evaluate investment opportunities, as
it is considered to represent the firm’s opportunity cost. Thus, it is
used as a hurdle rate by companies.

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 Marginal Cost and Investment Decision
Marginal Costs
In economics, marginal cost is the change in the total cost that
arises when the quantity produced is incremented by one unit, that
is, it is the cost of producing one more unit of a good.

In practice, this analysis is segregated into short and long-run cases,

so that, over the longest run, all costs become marginal. At each level
of production and time period being considered, marginal costs
include all costs that vary with the level of production, whereas
other costs that do not vary with production are considered fixed.

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Marginal Cost and Investment Decision
The concepts of a marginal cost of
capital and an investment opportunities
schedule provide the mechanisms
whereby financing and investment
decisions can be made simultaneously.

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 The Marginal Cost of Capital (MCC)
As the volume of financing increases, the costs of
various types of financing will increase, raising the
firm’s weighted average cost of capital. Therefore, it is
useful to calculate the marginal cost of capital
(MCC),which is the firm’s weighted average cost of
capital associated with its next total new financing.
• This cost is relevant to decisions regarding
investment projects

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Marginal Cost Of Capital And Investment
Schedule

A company's marginal cost of capital (MCC) may

increase as additional capital is raised, whereas
returns to a company's investment opportunities are
generally believed to decrease as the company
makes additional investments, as represented by the
Investment Opportunity Schedule (IOS).

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The following graph demonstrate the relationship between
cost of capital and investment returns.

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 In the context of a company's investment
decision, the optimal capital budget is that
amount of capital raised and invested at which the
marginal cost of capital is equal to the marginal return
from investing.

In other words, the optimal capital budget occurs

when the marginal cost of capital intersects with
the investment opportunity schedule.

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 The relation between the MCC and the Investment
Opportunity Schedule (IOS) provides a broad picture of
the basic decision-making problem of a company.

However, we are often interested in valuing an

individual project or even a portion of a company, such
as a division or product line. In these applications, we
are interested in the cost of capital for the project,
product, or division as opposed to the cost of capital for
the company overall.

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