MPA 10703

Financial Management

Cost of Capital
 Definition & Concept
Investors required rate of return
The minimum rate of return
necessary to attract an investor
to purchase or hold a security.
Not equal to Cost of Capital
because of
1. Taxes, and
2. Floatation Costs
 Taxes
When a firm borrows money, the
interest expenses is tax deductible.
Leads to lower cost of borrowing.
Eg: A firm borrows @ 9% interest,
and interest is deducted before
paying taxes. Assuming 34% tax
rate, for each Ringgit of interest it
pays, the firm reduces its taxes by
34.
Actual cost of borrowing is 5.94%.
= (I (1-T)) = 0.09 (1 0.34)
 Floatation cost
Refers to the cost associated with
issuing new securities. Eg: Legal fees,
printing prospectus, auditing, etc.
Example: A firm is issuing a new stock
@ RM25 per share, but incurs
transaction cost of RM5 per share.
Assume a required rate of return of
15%.
0.15 x RM25 = RM3.75 /year, the
amount needed to satisfy the
investors. However the firm only
 Floatation cost
Thus, the cost of capital (k) calculated
as the rate of return should be earned
on RM20 net proceeds, that will yield a
return of RM3.75 is
20k = RM25 x 0.15 = RM3.75
k = RM3.75 / RM20 = 0.1875 =
18.75%
The actual cost of capital is higher than
the required rate of return.
 Financial Policy
The firms policies regarding the
sources of financing and the particular
mix in which they will be used.
Weighted Average Cost of Capital
(WACC)
The average of the after-tax costs of
each of the sources of capital used by a
firm to finance a project. The weights
reflect the proportion of the total
financing raised from each source.
 Determining Cost of
Capital
For Investors, the rate of return on
a security is a benefit of investing.
For Financial Managers, that same
rate of return is a cost of raising
funds that are needed to operate
the firm.
In other words, the cost of raising
funds is the firms cost of capital.
 How can the firm raise
capital?
Bonds Amount of each
Preferred Stock source is determined
by the firms
Common Stock financial policy.

Each of these offers a rate of return

to investors.
This return is a cost to the firm.
Cost of
Debt
 Cost of Debt

For the issuing firm, the cost of

debt is:
the rate of return required by
investors,
adjusted for flotation costs
(any costs associated with
issuing new bonds), and
adjusted for taxes.
Example: Tax effects of financing with
debt
with stock with
debt
EBIT 400,000
400,000
- interest expense 0
(50,000)
EBT 400,000 350,000
- taxes (34%) (136,000)
(119,000)
 Example: Tax effects of financing
with debt
With Stock With
Debt
EBIT 400,000
400,000
- interest expense 0
(50,000)
EBT 400,000
350,000
- taxes (34%) (136,000)
(119,000)
 After-tax Before-tax
Marginal
1
=
-
% cost of % cost of x tax
Debt Debt rate

Kd = kd (1 - T)

.066 = .10 (1 - .34)

 Example: Cost of
Debt
Prescott Corporation issues a RM1,000
par, 20 year bond paying the market
rate of 10%. Coupons are semiannual.
The bond will sell for par since it pays
the market rate, but flotation costs
amount to RM50 per bond.
What is the pre-tax and after-tax cost
of debt for Prescott Corporation?
 Cost of Debt
Pre-tax cost of debt: After-tax cost of debt:
(using TVM) Kd = kd (1 - T)
P/Y = 2 Kd = .1061 (1 -
N = 40 .34)
PMT = -50 Kd = .07 = 7%
FV = -1000
So, a 10% bond costs the
PV = 950 firm only 7%(with
solve: floatation costs) since the
I = 10.61% = kd interest is tax deductible
 Cost of Debt
Example:
Seri Pagi Bhd plans to issue a new 8%
coupon bond that will mature in 10
years. The bond will have a face
value of RM1000 and will be sold at
discount, i.e. RM950. In issuing this
bond, a floatation cost of RM50 per
bond must be included. Assuming a
tax bracket of 35%, what will the cost
of debt?
 Cost of Debt
Equation of Bond Valuation;
NPd* = I /(1+kd)t + M /(1+kd)n

Can be written as;

NPd = I (PVIFAkd,n) + M (PVIFkd,n)
kd is the discount rate, determined by
YTM formula.

NPd* = Net proceeds per bonds

NPd* = (Market Price Floatation cost
discounts)
 NP = RM950 RM50
YTM = RM80 + [(1000-900)/10)]
[(1000 + 900)/2]
= 0.09474
= 9.5%
9.5% is cost before tax.
After tax cost of debt = kd ( 1- T )
= 9.5 ( 1-0.35)
=
6.175%
 Cost of Preferred
Stock
Finding the cost of preferred
stock is similar to finding the
rate of return, except that we
have to consider the flotation
costs associated with issuing
preferred stock.
 Cost of Preferred
Stock
Recall:

D k = Dividend
p
Po Price
=

From the firms point of view:

D Dividend
NPo* Net Price
kp =
=
 Example: Cost of
Preferred
If Prescott Corporation issues
preferred stock, it will pay a
dividend of RM8 per year and
should be valued at RM75 per
share. If flotation costs
amount to RM1 per share,
what is the cost of preferred
stock for Prescott?
 Cost of Preferred Stock

D Dividend
kps =
NPo Net Price
=

8.00__
(75 1 )
=
= 10.81%
 Exercise
DCS Bhd had an issue of preferred
stock that had a market price of
RM26.25 and paid annual dividend
of RM2.06 per share. Assuming the
firm were to sell an identical issue of
preferred stock, it would incur
floatation costs of RM2.00 per share
using todays price. What is DCS
Bhds cost of preferred stock?
 Cost of Common Equity

Difficult to estimate as the required

rate of return is not observable.
Unlike bonds & preferred, C/S
Dividends payment is uncertain
Residual owner, so they get what is
left of the firms earnings.
 Cost of Common
Stock
Two sources :
1) Internal common equity (retained earnings).
2) External common equity (new common stock
issue).
Do these two sources have the same cost?
No. (Internal common equity has no floatation
cost)
(External common equity has floatation cost)
 Two methods for estimating the
cost of equity:

1. The Dividend Growth Model

2. Capital Asset Pricing
Model,CAPM
 The Dividend Growth
Model
For common equity with constant
dividend growth, price of the stock
can be determined by:
Pcs = D1 / kcs - g
Further adjustment gives formula for
the cost of common equity as:
To calculate cost of
+g using retained
kcs = D1 earnings
Pcs
 To estimate the cost of acquiring new
equity capital, a minor adjustment
(that is to use net proceeds per share,
NPcs) is required.
The cost of new common stock is
+ g
kncs = D1
NPcs
 Example:
Dwelling Inc. Stock is sold @RM49.00 per
share, and dividend of RM0.22 per share
has been paid. If the dividend is expected
to grow @ a rate of 14.6% per year in the
future, What will be the investors
required rate of return i.e the Dwellings
cost of retained earnings.
kcs = (D1/Pcs) + g
= (0.25/49.00) + 0.146
= 0.1511 @ 15.11%
 Example:
Now, Dwelling Inc. plans to issue
new stocks, and the cost that it has
to incur is RM3.00 per share.
Assuming the price stays @
RM49.00, what will the cost of this
new equity capital?
kncs = (D1/NPcs) + g
= (0.25/49.00 3.00) + 0.146
= (0.25/46.00) + 0.146
= 0.1514 @ 15.14%
 Exercise
Kejora Berhad plans to pay RM1.50 per
share for next year dividend. The
dividend has been growing at a constant
rate of 4% every year. Currently Kejora
Berhads share is selling @ RM12. If the
company plans to issue a new batch of
common equity, which has floatation cost
of RM1.20 per share, what will be the
cost of retain earnings and cost of new
common equity?
 Cost of retained earnings = 16.5%
Cost of new common stock =
17.89%.
Remember!!!!
Cost of new common share will
always be greater than the cost
of retained earnings because of
floatation cost.
Capital Asset Pricing Model (CAPM)
Basic formula in determining
investors expected/required rate of
return from an investment.
Has 3 components.
kc = krf + (km krf)

where , krf = risk free rate

km= market return
= beta
 CAPM has 2 advantages:
Simple & easy to understand
Doesnt rely on companys dividend
When applying CAPM in calculating the
cost of new stock, floatation cost should be
considered:
Kncs = kc
1F
where ,
F = floatation cost ( in % of the stocks price)
kc = cost of retained earnings
 Example
Rate of return for Treasury Bills is
estimated at 4% while market index is
currently at 9%. Utama Berhads
common stock is currently sell at
RM15.00 and has a beta coefficient of
1.5. If new stock are issued, floatation
costs are RM1.40 per share. Using
CAPM, what is retained earning cost
and new issue of common stock for
Utama Berhad?
 Cost of retained earnings
Kc = 0.04 + 1.5 (0.09 0.04)
= 11.5%
Cost of new shares,
F = RM 1.40 / RM15.00
= 0.093
So kncs = 0.115/ (1 0.093)
= 0.115 / 0.907
= 12.68%
Weighted Average Cost of Capital

WACC is the weighted average cost

of all the financing sources.
Calculation should include the weight
given to each component of capital.
(The capital structure of each
company usually different from one
to another.
 Weighted Average Cost of
Capital
Weight in WACC can be based on
Securities book value
Securities market value
 Weighted Average Cost of
Capital
Source Cost Capital
Structure
Debt 6%
20%
Preferred Stock 10% 10%
WACC equity
Common 16% 70%
= wd.kd (1-T) + wps.kps + wcs.kcs
= 0.20 (6%) + 0.10 (10%) + 0.70 (16%)
= 13.4%
 Example: WACC
The capital structure of Arjuna Bhd is as follows:
40% common equity,10% preferred share dan 50%
debt. If the cost of common equity is 18%, cost of
preferred share is 10% cost of debt is 8%, calculate
the weighted average cost of capital for Arjuna.
(Assume a tax rate of 35%)

WACC = wd.kd (1-T) + wps.kps + wcs.kcs

= 0.5 x 8% (0.65) + 0.1 x 10% + 0.4 x
18%
= 0.026 + 0.01 + 0.072 = 10.8%