COST OF CAPITAL

COST OF ORDINARY SHARES (COMMON STOCK)

The cost of ordinary shares, (re), usually referred to simply as the cost of
equity, is the rate of return required by a companys common
shareholders.
A company may increase common equity through the reinvestment of
earnings that is, retained earnings or through the issuance of new
shares of stock.

TWO METHODS OF COMPUTING THE COST OF ORDINARY SHARES

1. CAPITAL ASSET PRICING MODEL (CAPM)
Re = rf + (rm rf) *
Where:
Re = the required rate of return on equity
rf = the risk free rate
rm rf = the market risk premium
= beta coefficient = unsystematic risk
EXAMPLE:
Valence Industries want to know its ost of equity. Its CFO believe the
risk-free rate is 5 percent, equity risk premium is 7 percent, and
Valences equity beta is 1.5. What is Valences cost of equity using the
CAPM approach?
Cost of common stock = 5 percent + 1.5(7 percent) = 15.5
percent.
2. DIVIDEND CAPITALIZATION/GROWTH MODEL
The dividend capitalization model bases the cost of equity primarily
on the dividends issued by a company. The formula is:

EXAMPLE:
The expected dividend to be paid out next year by ABC Corporation is
$2.00 per share. The current market value of the stock is $20. The
historical growth rate for the dividend payments has been 2%. What is
the cost of equity using the Dividend Capitalization model?

($2.00 Dividend / $20 Current market value) + 2% Dividend

growth rate
= 12% Cost of equity
ADVANTAGES/DISADVANTAGES
The dividend growth model is simple and straightforward, but it does not
apply to companies that don't pay dividends, and it assumes that
dividends grow at a constant rate over time. The dividend growth model
also quite sensitive to changes in the dividend growth rate, and it does not
explicitly consider the risk of the investment.
CAPM is useful because it explicitly accounts for an investment's riskiness
and can be applied by any company, regardless of its dividend size or
dividend growth rate. However, the components of CAPM are estimates,
and they generally lead to a less concrete answer than the dividend
growth model does. The CAPM method also implicitly relies on past
performance to predict the future.

WEIGHTED AVERAGE COST OF CAPITAL (WACC)

Weighted average cost of capital (WACC) is a calculation of a firm's cost of
capital in which each category of capital is proportionately weighted.
It is the average rate of return a company expects to compensate all its
different investors.
FORMULA:

Where:
Re = cost of equity

Rd = cost of debt

E = market value of the firm's equity

D = market value of the firm's debt

V = E + D = total market value of the firms financing (equity

and debt)
E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

Tc = corporate tax rate

WEIGHTED MARGINAL COST

 Small and large businesses need to raise capital to finance growth plans.
There is a cost associated with different forms of capital, such as debt,
common stock and preferred stock. The weighted marginal cost of capital
is the cost to raise one additional dollar of each one of these different
forms of capital.

MARGINAL COST OF DEBT

The marginal cost of debt capital is the interest rate demanded by
investors, adjusted for taxes. For example, if a small business needs to
raise new debt at 8 percent interest and its tax rate is 15 percent, the
marginal cost of debt capital is 0.08 multiplied by (1 minus 0.15),
which is 0.068, or 6.8 percent.
MARGINAL COST OF EQUITY
The marginal cost of common stock capital is the expected dividend
growth rate plus the ratio of next year's dividend payments to the
stock price, adjusted for stock issuance costs.
EXAMPLE:
If a company's stock issuance costs are 10 percent of its current
stock price of $20, the adjusted stock price is $20 multiplied by (1
minus 0.10), or $18. If next year's dividends are $2 and the
expected dividend growth rate is 5 percent, the marginal cost of
common stock capital is ($2 divided by $18) plus 5 percent,
which is about 0.161, or 16.1 percent.