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The Cost of Capital: Chema C. Paciones

This document discusses the cost of capital and how to calculate a company's weighted average cost of capital (WACC). It defines cost of capital and outlines different capital sources like debt, preferred stock, and common equity. It then explains how to calculate the costs of long-term debt, preferred stock using the dividend yield method, and common equity using the dividend growth model and capital asset pricing model. The document concludes by defining WACC as the weighted average of different capital costs based on each source's proportion of the total capital structure, and provides an example calculation.

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94 views13 pages

The Cost of Capital: Chema C. Paciones

This document discusses the cost of capital and how to calculate a company's weighted average cost of capital (WACC). It defines cost of capital and outlines different capital sources like debt, preferred stock, and common equity. It then explains how to calculate the costs of long-term debt, preferred stock using the dividend yield method, and common equity using the dividend growth model and capital asset pricing model. The document concludes by defining WACC as the weighted average of different capital costs based on each source's proportion of the total capital structure, and provides an example calculation.

Uploaded by

Chema Paciones
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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FINANCIAL MANAGEMENT – MBA 206A

THE COST OF
CAPITAL
Prepared by:
CHEMA C. PACIONES
TOPIC OUTLINE

Basic concepts
Cost of Long term Debt
Cost of preferred sticks
Cost of common equity – Dividend Growth
Model
Cost of common equity – capital asset pricing
model
Weighted Average Cost of the Capital (WACC)
BASIC CONCEPTS
Cost of Capital is also known as:

CAPITAL STRUCTURE

Capital structure refers to the mix of debt, preferred


stocks and common equity that the firm uses to finance
its assets and resources.

Accounting Equation

Assets = Liabilities + Equity


Objective

 To maximize the market value of


the firm through an appropriate
mix of long- term sources of
funds
BASIC CONCEPTS

SOURCE CAPITAL COST OF CAPITAL

Long-term Debt After-tax Cost of


Creditors
Debt

Preferred
Stockholders
Preferred shares Dividend Per
Share ÷ Net
Issue price

Common
Stockholders Common
CAPM or DGM
Shares
BASIC
COSTCONCEPTS
OF LONG-TERM DEBT

The before-tax cost of debt is computed by using


yield to maturity formula:

+ Face Value – Issue Price


Coupon
Yield to Yield to Maturity
Maturity =
(Issue Price x 60%) + (Face Value X 40%)
COST OF PREFERRED STOCKS

The cost of preferred stock to a company is effectively the price it pays in return for
the income it gets from issuing and selling the stock. In other words, it’s the amount
of money the company pays out in a year, divided by the lump sum they got from
issuing the stock.

Cost of preferred shares is computed as:

Dividend per share ÷ (Issue price –floatation cost)


DIVIDEND GROWTH MODEL
This is known as GORDON GROWTH MODEL name
Myron Gordon

This model assumes that dividends grow either at a stable rate in perpetuity or at
different rate during the period.

Cost of retained earnings:  Cost of new ordinary shares:

Ke = (DI ÷ P0) + GR Kn = [D1 (P0-FC)] + GR

 How to convert D0 to D1

D1 = {D0 x (1
CAPITAL ASSET PRICING MODEL

This model describes the relationship between systematic risk and expected
return. This model assumes the expected return of a particular stock depends
on its volatility (beta) relative to the overall stock market.

Cost of capital

Risk free rate + [ Beta x (market return – Risk free rate)]


Weighted Average Cost of Capital (WACC)

This is the calculation of the firm’s effective cost of capital, taking into
account the portion of its capital that was obtained from various
sources.

To compute for the WACC, multiply the cost of each type of


capital by their respective weights (percentage of each
source to the firm’s total capital structure) and add up the
individual weighted cost of capital.
Weighted Average Cost of Capital (WACC)

SAMPLE OF EXERCISE:

XYZ corp’s capital structure is as follows:

Debt 35%
Preferred Stock 15%
Common equity 50%

The after –tax cost of debt is 6.5 percent; the cost of preferred stock is 10
percent; and the cost of common equity (in the form of retained earnings)
is 13.5 percent)

Requirement : Calculate XYZ’s weighted average cost of capital.


THANK YOU!

STAY SAFE.
Weighted Average Cost of Capital (WACC)

SOLUTION:

SOURCE COST WEIGHT WACC

DEBT 6.50% 35% 2.275%

Preferred Stock 10.0% 15% 1.500%

Common Stock 13.5% 50% 6.750%

100% 10.525%

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