Financial management

1. Chapter 4: Cost of Capital
• Cost-of-capital refers the minimum rate of
return that the firm must earn on its invested
capital if the market value of the firm is to
remain unchanged.
Debt
(Bond)
Preferred
stock
Common
stock
Retained
Earning
Capital Components

2. CONT’D
The cost of each component of capital is
called component/specific cost of
capital.
The overall cost of capital is called
weighted average cost of capital which
a minimum rate of return that must be
earned on the entire investments.

3. Specific cost of Debt
• Computation of the cost of debt capital is based on
the characteristics of bonds.
• The computation of the specific cost of debt (bond)
involves three steps
1. Determine the net proceeds per bond
(Par Value - Selling /flouting costs )
2. Determine the effective before-tax cost-of- debt (Kd)
3. Compute after-tax specific cost of debt
It is computed as T= Tax rate
Kd (1-T)

4. CONT’D
Example : The corporation is to issue a bond
with a par value of $ 1000,carries a coupon
interest amount of $120 and is expected to
mature in 25 years of time as well as the tax
rate is 30%.

5. The Specific Cost of Preferred Stock
• When a business firm sells preferred stock, it
expects to pay fixed dividends to investors
(preferred stock holders) in the return for their
investment.
• specific cost of Preferred share(Kps) =
Dps= Dividend per share
Pn= Net proceed

6. Example
The firm sells the preferred stock for $ 110 per
share and pays a $10 selling (flotation costs)
per share. Compute the specific (component)
cost of capital of preferred stock.
Dividend amount is known to be$ 5

7. Specific cost of common stock
The specific cost of capital of common stock is
the minimum rate of return that the business
firm must earn for its common shareholders
investment.
g=annual compound rate growth of dividend
D= Dividend
Pn= net proceed
Ke = Do (1+g) + g
Pn

8. Example
Assume that the firm is selling common
stock to potential investors in the
country. The price of the common
stock is $ 110 with flotation cost of $
10. The current dividend of the firm’s
common share is $ 10 per year and it is
expected to grow at 10 % annual
compound rate. Compute the specific
cost of capital for common stock

9. Specific Cost of Retained Earnings
The nature of the retained
earnings brings two
difficulties to compute the
cost of capital
Retained earnings are not
securities
A tendency to equate the
specific cost of retained
earnings with zero

10. CONT’D
Kr = Do (1+g) + g g=annual compound rate
Po growth of dividend
D= Dividend
Po= par value

11. Example
Assume that the firm is selling common
stock to potential investors in the
country. The price of the common
stock is $ 110 with flotation cost of $
10. The current dividend of the firm’s
common share is $ 10 per year and it is
expected to grow at 10 % annual
compound rate. Compute the specific
cost of capital for common stock

12. Weighted Average Cost-of-Capital (WACC)
A minimum rate of return that must be
earned on the entire investments of the
firm.
WACC is calculated either based on the
book values or market values of the
sources of capital.

13. 1. Book Value Method
• This method uses the financial records of the company.
• The following three steps are needed to compute WACC
based on book value method
1. Find the percentage of each long-term capital provided
by each financing source (Book value %).
2. Multiply each capital percentage by its specific
(component) cost of capital.
3. Add the products you have computed under step 2.

14. Example
ABC Company
Source of capital Book value Specific cost of capital
9% Bonds, $1000 par $30,000,000 5%, or 0.05
100,000 Shares, $ 100 par $ 10,000,000 8.0%, or 0.080
Preferred Stock
Common stock, 800,000 $40,000,000 11.0% or 0.110
Shares, $ 50 par
Retained earnings $20,000,000 10 %, or 0.10
$ 100,000,000
Required
Compute WACC based on book value method

15. 2. Market Value Method
WACC in this method reflects the rate of
return currently required by investors rather
than the historical rate.
Example: Consider the previous illustration to
compute WACC using Market value method.
The market value of the bond is 90% of its book
value, the preferred stocks and common stocks
are being sold for $110 and $ 80 respectively.

16. Marginal Cost of Capital (MCC)
When the additional capital comes from more
than one source , the weighted average cost of
capital of the new fund is called the weighted
marginal cost of capital ( WMCC)
The cost of capital of the additional fund is
called Marginal Cost of Capital (MCC)

17. Example
XYZ Company
Source of capital Book value Specific cost of capital
Bonds $30,000,000 7 %, or 7
Common stock $50,000,000 12.0% or 0.12
Retained earnings $20,000,000 11%, or 0.11
$ 100,000,000
Required
Suppose the firm plans to raise an additional fund of $50
million to finance its new project: $ 20 million from bond
selling, $20 million from common stock and $ 10 million from
retained earning. The specific cost of capital for the bond,
common stock and retained earning are, 7%, 13% and 12%
respectively.

18. CONT’D
Required
Calculate WACC
based on Book
value method
Calculate the
WMCC for
additional fund
Calculate the WACC
after acquiring the
additional fund

19. Exercise
XYZ Company
Source of capital Book value Specific cost of capital
Bonds $30,000,000 6.4%, or 0.064
Common stock $50,000,000 12.0% or 0.12
Retained earnings $20,000,000 11.5%, or 0.115
$ 100,000,000
Required
Suppose the firm plans to raise an additional fund of $10
million to finance its new project: $ 3 million from bond selling,
$5 million from common stock and $ 2 million from retained
earning keeping the specific cost of capital constant.

20. CONT’D
Required
Calculate WACC based on
Book value method
Calculate the WMCC for
additional fund
Calculate the WACC after
acquiring the additional fund

21. End of Chapter 4