Explain: The Cost of Capital

What sources of capital do firms use?

There are several sources of capital by the firms. These are:

1. These are obligations to third parties incurred by firms and are normally interest bearing. These liabilities may be long term or
short term. Examples of these are bonds payable, notes payable, bank loans, and other loans from financing companies.
2. Preferred Stock. These are hybrid securities that limit the exposure of holders thereof. They are hybrid in a sense because
technically they are considered equity instruments (limiting the liabilities of the holders only to the extent of their contribution) but
the issuers are required to pay a fixed amount of return (dividends), making it have the feature of a debt instrument. Some
preferred shares/stocks contain conversion options which may entitle the holders thereof the right to convert these shares into
common or ordinary shares. Preferred shares are non-voting shares but are entitled to receive fixed amount of dividends.
3. Common Equity / Ordinary Shares. Common equity represents ownership of the company. While holders of these type of
shares do not receive fixed amount of dividends, they receive all that is left of what is declared by the corporation after settling
the preferred dividends and the interest expense. Representing ownership, common equity holders have voting rights and may
participate in major decision making of the corporation. The compensation received by the common equity holders is the
dividends. Common equity can be internal of external. Internal source common equity capital is the retained earnings which is
actually due to them. External source is the issuance of additional/new common equity. The compensation required by internal
and external source of common equity capital differs, the latter being more costly in most cases.

Calculating the Weighted Average Cost of Capital

A company's weighted average cost of capital is how much it pays for the money it uses to operate, stated as an average. It is also
the minimum average rate of return it must earn on its assets to satisfy its investors.1 In other words, the amount the company pays
to operate must approximately equal the rate of return it earns.

The WACC is based on a business firm's capital structure. The capital structure of a business firm is essentially the right-hand side
of its balance sheet where its financing sources are listed. On the right-hand side of the balance sheet, there is a list of the debt and
equity accounts of the firm.

Included in the cost of capital calculation is some combination of the liability, or debt accounts, except for current liabilities such as
accounts payable. Also included are the shareholder's equity accounts including retained earnings and new common stock. When a
business raises money by selling shares and receiving cash from investors, that is equity financing. Existing shareholder's equity
may also be used for financing operations. Raising money by borrowing from a bank or issuing bonds qualifies as debt and the cost
is interest charges to the business firm.

Most of the time, WACC is used by investors as a measurement to indicate whether they should invest in a company.

Source: https://www.thebalancesmb.com/calculate-weighted-average-cost-of-capital-393130
(https://www.thebalancesmb.com/calculate-weighted-average-cost-of-capital-393130) (https://www.thebalancesmb.com/calculate-
weighted-average-cost-of-capital-393130)

Formula:

WACC = wdrd(1 – T) + wprp + wcrs

The w’s refer to the firm’s capital structure weights.

The r’s refer to the cost of each component.

Specifically:

wd – weight of debt

rd – cost of Debt (normally interest rate or yield to maturity of bonds)

T – tax rate

wp – Weight of preferred Stock

rp – cost of preferred stock (normally the percent of dividend it earns)

wc – Weight of common equity

rs – Cost of equity (normally cost of retained earnings)

Note: In certain cases, issuance of new common stock is needed, thus the cost of issuance of the common stock will also have to
be estimated.

Should our analysis focus on before-tax or after-tax capital costs?

Stockholders focus on after-tax CFs. Therefore, we should focus on after-tax capital costs; i.e., use after-tax costs of capital in
WACC. Only rd needs adjustment, because interest is tax deductible.

Should our analysis focus on historical (embedded) costs or new (marginal) costs?

The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on today’s marginal costs (for
WACC).
How are the weights determined?

The Market value of the capital must be used to determine the weight. In its absence, book values will be used. In cases
where there are plans for future expansion or projects that need capitalization, target capital structure takes precedence over the
actual or recorded values. In summary, the weights shall be determined in the following order of priority:

1. Target Capital Structure

2. Market Value of the capital component
3. Book Value (Accounting records value)

Example:

Coleman Technologies Inc. is calculating cost of capital for major expansion program. The following are the information given:

Tax rate = 40%.

15-year, 12% coupon, semiannual payment noncallable bonds sell for $1,153.72. New bonds will be privately placed with no
flotation cost.
10%, $100 par value, quarterly dividend, perpetual preferred stock sells for $111.10.
Common stock sells for $50. D0 = $4.19 and g = 5%.
b = 1.2; rRF = 7%; RPM = 6%.
Bond-Yield Risk Premium = 4%.
Target capital structure: 30% debt, 10% preferred, 60% common equity.

Review of Coleman’s Capital Structure reveal the following:

Component Cost of Debt

WACC = wdrd(1 – T) + wprp + wcrs

rd is the marginal cost of debt capital.

The yield to maturity on outstanding L-T debt is often used as a measure of rd.

Why tax-adjust; i.e., why rd(1 – T)? – This is because interest paid to creditors are tax deductible expenses. Hence, it offers “tax
shield”, effectively lowering the taxes paid by firms. This tax reduction/benefit therefore is lowering the cost of debt.

In the case of Coleman Technologies Inc. it’s debt component has the following details:

A 15-year, 12% semiannual coupon bond sells for $1,153.72.

The cost of debt for this bond will be its YTM or yield to maturity. The concept of time value of money is applied in order to compute
for the YTM. YTM is the rate of interest that will discount all future cash flows associated with the bond to its present value. The
present value of the bond will be its current selling price. Par value of bonds, in the absence of any statement will be $1,000.

To calculate for YTM, the following details must be obtained:

Price of the Bond – 1,153.72

Cash Flows
 Interest: $1,000 (0.12) x ½ = $60. The $60 interest is paid every 6 months, meaning twice a year. Since the bond is having a
15-years maturity, there will be 30 (15 x 2) payments of interest (each at $60).

Principal – at the end of the 15th year, the face value of the bond of $1,000 will be paid, undergoing semi-annual
compounding.

Compounding period – 30 (15 years x 2 payments per year)

Using time value of money, the following equation will be used to compute for YTM: (Notice that YTM will take the place of interest):

YTM = 10%

What is the cost of debt (rd)? The cost of debt is the computed YTM, 10%.

Component Cost of Debt

Interest is tax deductible, so

A-T rd = B-T rd(1 – T)

= 10%(1 – 0.40) = 6%

Use nominal rate.

Flotation costs are small, so ignore them.

Component Cost of Preferred Stock

WACC = wdrd(1 – T) + wprp + wcrs

rp is the marginal cost of preferred stock, which is the return investors require on a firm’s preferred stock.
Preferred dividends are not tax-deductible, so no tax adjustments necessary. Just use nominal rp.
Our calculation ignores possible flotation costs.

What is the cost of preferred stock?

Using the same illustration, the cost of preferred stock can be solved by using this formula:

rp = Dp/Pp

= $10/$111.10

= 9%

Where:

Dp = Dividends on Preferred Stock

Pp = Price of the Preferred Stock

In certain cases, the price of the preferred stock may not be given because it is not traded. If such is the case, the cost of
preferred stock can be assumed as the dividend rate it is entitled to receive. In the problem given, it will be 10%.
Is preferred stock more or less risky to investors than debt?

More risky; company not required to pay preferred dividend.

However, firms try to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds,
(3) preferred stockholders may gain control of firm.

Why is the yield on preferred stock lower than debt?

Preferred stock will often have a lower Before-tax yield than the Before tax yield on debt.
Corporations own most preferred stock, so 70% of preferred dividends are excluded from corporate taxation.
The After tax yield to an investor, and the After tax cost to the issuer, are higher on preferred stock than on debt. Consistent with
higher risk of preferred stock.

Component Cost of Equity

WACC = wdrd(1 – T) + wprp + wcrs

rs is the marginal cost of common equity using retained earnings.

The rate of return investors require on the firm’s common equity using new equity is re.

Why is there a cost for retained earnings?

Earnings can be reinvested or paid out as dividends.

Investors could buy other securities, earn a return.
If earnings are retained, there is an opportunity cost (the return that stockholders could earn on alternative investments of equal
risk).
Investors could buy similar stocks and earn rs.
Firm could repurchase its own stock and earn rs.

Three Ways to Determine the Cost of Common Equity, rs

1. CAPM: rs = rRF + (rM – rRF)b

Where :

CAPM = Capital Asset Princing Model

rs = Cost of equity

rRF = Risk free rate; Normally represented by the rate of Treasury Bonds / Bills

rM = Market Risk; This is the return on average stock in the market, usually represented by average rate of return for that
industry.

b = Beta; This is a measure of the firm’s sensitivity to changes in the average stock in the market. A beta of 1 means the firm
moves in complete unison with the market. A positive value means the firm’s returns move in the same direction with the market
while the negative beta means that the firm’s returns move in the opposite direction with the market. The greater is the absolute
value of the beta, the more sensitive is the firm’s return with the changes if market conditions affecting the industry.

(rM – rRF) = Market risk premium.

2. DCF: rs = (D1/P0) + g

This is approach is based on the premise that the firm’s cost is determined by the value of its stock price. The formula is derived
from Gordon Model of estimating the intrinsic value of a stock, stated as follows:
P0 = D1 / (rs – g)

Where:

DCF = Discounted Cash Flow

rs = Cost of equity

D1 = Expected Dividends/ Dividends one year from Now

P0 = Price of the stock now.

g = growth rate (remember IGR and SGR)

3. Bond-Yield-Plus-Risk-Premium.

rs = rd + RP

Where:

rs = Cost of equity

rd = Cost of Debt

RP = Risk Premium

This is based on the premise that the cost of equity is based on the cost of debt plus a certain value for risk premium. The risk
premium is added because in so far as the investors are concerned, equity instruments are more risky than debt, hence to entice
them to hold equity investments, they have to be lured by giving higher returns. On the part of the issuer, these returns are the costs
of capital.

Find the Cost of Common Equity Using the CAPM Approach

The rRF = 7%, RPM = 6%, and the firm’s beta is 1.2.

rs = rRF + (rM – rRF)b

= 7.0% + (6.0%)1.2 = 14.2%

Find the Cost of Common Equity Using the DCF Approach

D0 = $4.19, P0 = $50, and g = 5%.

D1 = D0(1 + g)

= $4.19(1 + 0.05)

= $4.3995

rs = (D1/P0) + g

= ($4.3995/$50) + 0.05

= 13.8%

Can DCF methodology be applied if growth is not constant?

Yes, nonconstant growth stocks are expected to attain constant growth at some point, generally in 5 to 10 years.
May be complicated to calculate. (We will discuss this in Stock valuation topic)
Find rs Using the Bond-Yield-Plus-Risk-Premium Approach

rd = 10% and RP = 4%.

This RP is not the same as the CAPM RPM.

This method produces a ballpark estimate of rs, and can serve as a useful check.

rs = rd + RP

rs = 10.0% + 4.0% = 14.0%

What is a reasonable final estimate of rs?

Range = 13.8%-14.2%, might use midpoint of range, 14%.

Why is the cost of retained earnings cheaper than the cost of issuing new common stock?

When a company issues new common stock they also have to pay flotation costs to the underwriter.
Issuing new common stock may send a negative signal to the capital markets, which may depress the stock price.

Approaches for Flotation Adjustment

1. Include costs as part of the project’s upfront cost.

This reduces the project’s estimated return.

1. Adjust cost of capital to include flotation in DCF model.

Commonly done by incorporating flotation in DCF model. In this case, the floatation cost is deducted from the price of the stock,
thereby reducing the amount to be realized from selling the stock.

Example:

If new common stock issue incurs a flotation cost of 15% of the proceeds, what is re?

Flotation Costs

Flotation costs depend on the firm’s risk and the type of capital raised.
Flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly
small.
We will frequently ignore flotation costs when calculating the WACC.

What is the firm’s WACC (ignoring flotation costs)?

WACC = wdrd(1 – T) + wprp + wcrs

= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)

= 1.8% + 0.9% + 8.4%

 = 11.1%

What factors influence a company’s composite WACC?

1. Factors the firm cannot control:

Market conditions such as interest rates and tax rates.
1. Factors the firm can control:
Firm’s capital structure.
Firm’s dividend policy.
The firm’s investment policy. Firms with riskier projects generally have a higher WACC.

Use of WACC

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.

In project evaluation, the WACC is compared with the project’s expected/projected return. Any project whose return is higher than
WACC is deemed acceptable and therefore maybe accepted. Projects with returns lower than WACC is likely to be rejected.

Should the company use the composite WACC as the hurdle rate for each of its projects?

NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents
the “hurdle rate” for a typical project with average risk.
Different projects have different risks. The project’s WACC should be adjusted to reflect the project’s risk.

Divisional Cost of Capital (Risk Adjusting Cost of Capital)

Considering the following scenario. Firm A has determined its composite WACC (for the entire firm, of average risk projects) at 10%.
It has two divisions that proposed two different projects. Division H proposed a high risk project with returns of 11%. Division H’s
WACC for this type of project is 13%. Project L on the other hand is a low risk project, with expected return of 9%. The proponent of
Project L, Division L has determined its division’s WACC at 7%.

The following table will present the result of decision based on the firm’s composite WACC:

Evaluating the projects using the composite WACC will result to the acceptance of Project H and rejection of Project L.

Considering the riskiness of the projects, the Divisional WACC is determined and the following summarizes the results:

Note, if the company correctly risk-adjusted the WACC, then it would select Project L and reject Project H. Alternatively, if
the company didn’t risk-adjust and instead used the composite WACC for all projects, it would mistakenly select Project H and reject
Project L.