1

MANAGEMENT ADVISORY SERVICES jjaurojrtcbic

7 Cost of Capital October 2013
2
An Overview of the Cost of
Capital
The cost of capital acts as a link between the
firms long-term investment decisions and the
wealth of the owners as determined by investors
in the marketplace.
It is the magic number that is used to decide
whether a proposed investment will increase or
decrease the firms stock price.
Formally, the cost of capital is the rate of return
that a firm must earn on the projects in which it
invests to maintain the market value of its stock.
3
The Firms Capital Structure
4
Some Key Assumptions
Business Riskthe risk to the firm of being unable to
cover operating costsis assumed to be unchanged.
This means that the acceptance of a given project does
not affect the firms ability to meet operating costs.
Financial Riskthe risk to the firm of being unable to
cover required financial obligationsis assumed to be
unchanged. This means that the projects are financed in
such a way that the firms ability to meet financing costs
is unchanged.
After-tax costs are considered relevantthe cost of
capital is measured on an after-tax basis.
5
1.Chubby Company has on its books the following:

Source of Capital Book Value(P) After-tax Cost
Long-term debt 6,000,000 5%
Preferred stock 1,000,000 10%
Common stock 3,000,000 15%

a. Calculate the firms weighted average cost of capital.
b. Describe the importance of the weighted average
cost of capital in the investment activities of Chubby
Company.
c. Explain why debt cost less than preferred and
common stocks.
6
1a
Liabilities Capital Capital After
And Equity Structure Structure Tax Weight
Assets Source of Capital Book Value Weight Weight Costs Costs
Current Assets - Cash 10,000,000.00 Long Term Debt 6,000,000.00 6/10 0.60 5.00% 3.00%
Fixed Assets Preferred Stock 1,000,000.00 1/10 0.10 10.00% 1.00%
Common Stock 3,000,000.00 3/10 0.30 15.00% 4.50%
TOTAL ASSETS 10,000,000.00 TOTAL 10,000,000.00 1.00 8.50% WACC
7
WACC = k
a
= w
i
k
i
+ w
p
k
p
+ w
s
k
r or n

The weights in the above equation are intended to
represent a specific financing mix (where w
i
= % of
debt, w
p
= % of preferred, and w
s
= % of common).
Specifically, these weights are the target percentages
of debt and equity that will minimize the firms overall
cost of raising funds.
The Weighted Average Cost of
Capital
Capital Structure Weights
8
WACC = k
a
= w
i
k
i
+ w
p
k
p
+ w
s
k
r or n

The Weighted Average Cost of
Capital
Capital Structure Weights
One method uses book values from the firms balance
sheet. For example, to estimate the weight for debt,
simply divide the book value of the firms long-term debt
by the book value of its total assets.
To estimate the weight for equity, simply divide the total
book value of equity by the book value of total assets.
9
WACC = k
a
= w
i
k
i
+ w
p
k
p
+ w
s
k
r or n

The Weighted Average Cost of
Capital
Capital Structure Weights
Using the costs previously calculated along with the
market value weights, we may calculate the weighted
average cost of capital as follows:
WACC = .60(5%) + .10(10%) + .30(15%)
= 8.5%
This assumes the firm has sufficient retained earnings to
fund any anticipated investment projects.
10
1b
WACC dictates that all investments should have an internal rate of return above 8.5%.
1c
Debt is less costly because it is less risky from an investor's standpoint thus a lower
return is demanded by investors. Moreover, interest expense is deductible for tax
purposes creaing cash savings from tax payment reduction.
11
2. Chubby Company has on its books the following:

Source of Capital Book Value(P) After-tax Cost
Long-term debt 3,000,000 5%
Preferred stock 1,000,000 10%
Common stock 6,000,000 15%

a. Calculate the firms weighted average cost of capital.
b. Differentiate the weighted average cost of capital in No.1
and No. 2, and discuss the significance in terms of risks and
returns trade-off.
12
2a
Capital Capital After
Structure Structure Tax Weight
Source of Capital Book Value Weight Weight Costs Costs
LTD 3,000,000.00 3/10 0.30 5.00% 1.50%
PS 1,000,000.00 1/10 0.10 10.00% 1.00%
CS 6,000,000.00 6/10 0.60 15.00% 9.00%
TOTAL 10,000,000.00 1.00 11.50% WACC
WACC = (WdxKi) +( WpxKp )+(WeKe)
11.5% = (.30x5%) + ( .10x10%) +(.60x15%)
2b
There was an increase in WACC in No. 2 at 11.5% from No. 1 which is 8.5% this means that
it has become less profitable however, with lesser debt it has become less risky. This is the
trade off between risks and returns.
13
3. Chubby Company has gathered the following data:

Source of Capital Book
Value(P)

Market
Value(P)

After-tax Cost
Long-term debt 3,000,000 2,500,000 5%
Preferred stock 1,000,000 1,500,000 10%
Common stock 6,000,000 9,000,000 15%

a. Calculate the firms weighted average cost of capitals based
on book values.
b. Calculate the firms weighted average cost of capitals based
on market values.
c. Differentiate the weighted average cost of capital in a and b,
which figure is more reliable in making an investment
decision.
d. Demonstrate the implications of a wrong economic decision
as a result of reliance on a wrong weighted average cost of
capital.
14
3a
Capital Capital After
Structure Structure Tax Weight
Source of Capital Book Value Weight Weight Costs Costs
LTD 3,000,000.00 3/10 0.30 5.00% 1.50%
PS 1,000,000.00 1/10 0.10 10.00% 1.00%
CS 6,000,000.00 6/10 0.60 15.00% 9.00%
TOTAL 10,000,000.00 1.00 11.50% WACC
3b
Capital Capital After
Structure Structure Tax Weight
Source of Capital Market Value Weight Weight Costs Costs
LTD 2,500,000.00 0.19 0.19 5.00% 0.96%
PS 1,500,000.00 0.12 0.12 10.00% 1.15%
CS 9,000,000.00 0.69 0.69 15.00% 10.38%
TOTAL 13,000,000.00 1.00 12.50% WACC
3c
Market values are more reliable as they reflect the true value of the net assets.
3d
Investments with IRR of 12% will be wrongfully accepted by using book values.
15
10. Floyd Co. made the following investment decision:

Particulars Project Apple Project Mona
Required investment P60,000 P40,000
Life 15 Years 15 Years
Internal Rate of
Return
8% 15%
Source of Financing Debt Equity
Cost of Financing 7% 16%
Decision Accept Reject
Reason IRR8%>7%Cost of
financing
IRR15%<16%Cost of
financing

a. Explain why the decision to accept project apple and reject
project mona might not have been to the best interest of the
stockholders.
b. Compute weighted average cost of capital and determine
which project should be rejected and which should be
accepted.
16
10b
Capital Capital After
Structure Structure Tax Weight
Source of Capital Book Value Weight Weight Costs Costs
LTD 60,000.00 6/10 0.60 7.00% 4.20%
PS - 0 0.00 0.00% 0.00%
CS 40,000.00 4/10 0.40 16.00% 6.40%
TOTAL 100,000.00 1.00 10.60% WACC
Project Apple IRR 8%<10.6%WACC Reject
Project Mona IRR 15%>10.6%WACC Accept
17
The Basic Concept Problem 10
Why do we need to determine a companys overall
weighted average cost of capital?
As Problem 10 clearly illustrates, using this piecemeal
approach to evaluate investment opportunities is clearly
not in the best interest of the firms shareholders the
company the company accepted Apple with an IRR 0f
8% and rejected Mona with an IRR of 15%.
Over the long haul, the firm must undertake investments
that maximize firm value.
This can only be achieved if it undertakes projects that
provide returns in excess of the firms overall weighted
average cost of financing (or WACC) as illustrated in
10b.
18
Specific Sources of Capital:
The Cost of Long-Term Debt
The pretax cost of debt is equal to the the yield-to-
maturity on the firms debt adjusted for flotation costs.
Recall that a bonds yield-to-maturity depends upon a
number of factors including the bonds coupon rate,
maturity date, par value, current market conditions, and
selling price.
After obtaining the bonds yield, a simple adjustment
must be made to account for the fact that interest is a
tax-deductible expense.
This will have the effect of reducing the cost of debt.
19
4. Chubby Company can sell 15-year, P1,000 par value bonds
paying annual interest at a 12% coupon rate. Because of rising
interest rates, the bonds can be sold for P1,010 each. However,
P30 floatation cost per bond will be incurred. Chubby is in the
40% tax bracket.

a. Find the net proceeds from the sale of the bonds.
b. Show the cash flows of the bonds from Chubbys
standpoint.
c. Use the approximation formula to estimate the before and
after tax cost of debt.
d. Use the internal rate of return approach to compute the
before and after tax cost of debt.
e. Contrast and compare the cost of debt under the
approximation method and internal rate of return approach.
f. Explain the relationship between the value of the bonds and
current interest rates.
g. Use the approximation formula to estimate the before and
after tax cost of debt if the bonds can be sold for P1,030
each instead of P1,010, assuming all things being equal.
h. Use the approximation formula to estimate the before and
after tax cost of debt if the bonds can be sold for P1,050
each instead of P1,010, assuming all things being equal.
i. Contrast and explain the answers in c, g and h.
20
Before-Tax Cost of Debt
The before-tax cost of debt can be
calculated by:
Approximating the cost
Internal Rate of Return
Specific Sources of Capital:
The Cost of Long-Term Debt
21
Before-Tax Cost of Debt
Approximating the Cost
Specific Sources of Capital:
The Cost of Long-Term Debt
(cont.)
22
Appproximation cost of debt formula:
kd = I + P1,000-Nd/n ki = kd x (1-tax rate)
Nd + P1,000
'2
kd = before tax cost of debt
I = stated interest
Nd = Net proceeds
n = term of the bond
P1,000 = assuimed face value of the bonds
2 = constant
ki - after tax cost of debt
23
4a
Selling price 1,010.00
Less
Floatation cost 30.00
Net proceeds, Nd 980.00
4b
t0 t1 t2 t15
980.00 (120.00) (120.00) (120.00)
(1,000.00)
24
4c
Appproximation cost of debt formula:
kd = I + P1,000-Nd/n ki = kd x (1-tax rate)
Nd + P1,000
'2
kd = before tax cost of debt
I = stated interest
Nd = Net proceeds
n = term of the bond
P1,000 = assuimed face value of the bonds
2 = constant
ki - after tax cost of debt
kd= P120 + P1,000 - P980/15 years ,= P120 + 1.3333333 0.122556
P980 + P1,000 990 12.26%
'2
ki= 12.26% x 1-.40 = 0.073533
7.35%
25
Find the after-tax cost of debt for Duchess
assuming it has a 40% tax rate:
k
i
= 12.26% (1-.40) = 7.35%
This suggests that the after-tax cost of raising
debt capital is 7.35%.
Specific Sources of Capital:
The Cost of Long-Term Debt
26
4g
kd= P120 + P1,000 - P1,000/15 years ,= P120 + 0 0.12
P1,000 + P1,000 1000 12.00%
'2
ki= 12.00% x 1-.40 = 0.072
7.20%
4h
kd= P120 + P1,000 - P1020/15 years ,= P120 + -1.333333 0.117492
P1020 + P1,000 1010 11.75%
'2
ki= 11.75% x 1-.40 = 0.070495
7.05%
27
n
o
t n
t 1
I M
B
(1 k) (1 k)
=
( (
= +
( (
+ +

15
t 15
t 1
$120 $1,000
$980
(1 k) (1 k)
=
( (
= +
( (
+ +

28
t
0
t
1
t
2
t
3
t
4
t
5
t
6
t
7
t
8
t
9
t
10
t
11
t
12
t
13
t
14
t
15
B
0
980.00 (120.00) (120.00) (120.00) (120.00) (120.00) (120.00) (120.00) (120.00) (120.00) (120.00) (120.00) (120.00) (120.00) (120.00) (120.00)
(120)/1.IRR
(120)/1.IRR/1.IRR
x 1/1.IRR
3
x 1/1.IRR
4
x 1/1.IRR
5
x 1/1.IRR
6
x 1/1.IRR
7
x 1/1.IRR
8
x 1/1.IRR
9
x 1/1.IRR
10
x 1/1.IRR
11
x 1/1.IRR
12
x 1/1.IRR
13
x 1/1.IRR
14
x 1/1.IRR
15
1/1.IRR
15
x
(1,000.00)
PVFCF (980.00) IF THE 16 FUTURE CASHFLOWS BE ADDED IT MUST BE EQUAL TO B
0
WHICH IS 980.00
NPV - THIS BECOMES 0 IF THE SUM OF THE 16 FUTURE CASHFLOWS IS EQUAL TO B
0
WHICH IS 980.00
29
t
0
t
1
t
2
t
3

t
15
B
0
980.00 (120.00) (120.00) (120.00) (120.00)
(120)/1.IRR
(120)/1.IRR/1.IRR
x 1/1.IRR
3
x 1/1.IRR
15
1/1.IRR
15
x
(1,000.00)
PVFCF (980.00)
IF THE 16 FUTURE CASHFLOWS BE ADDED IT MUST BE EQUAL TO B
0
WHICH IS 980.00
NPV -
THIS BECOMES 0 IF THE SUM OF THE 16 FUTURE CASHFLOWS IS EQUAL TO B
0
WHICH IS 980.00
30
t
0
t
1
t
2
t
3

t
15
B
0
980.00 (120.00) (120.00) (120.00) (120.00)
(120)/1.12
(120)/1.12/1.12
x 1/1.12
3
x 1/1.12
15
1/1.12
15
x
(1,000.00)
PVFCF (1,000.32)
THE 16 FUTURE CASHFLOWS IS NOT EQUAL TO B
0
WHICH IS 980.00
NPV (20.32) SINCE THIS IS NOT 0 12% IS NOT THE INTERNAL RATE OF RETURN
31
t0 t1 t2 t3 t15
B
0
980.00 (120.00) (120.00) (120.00) (120.00)
12% (817.32) 6.811 X
(183.00) 0.183 X (1,000.00)
(1,000.32)
(20.32)
32
t
0
t
1
t
2
t
3

t
15
B
0
980.00 (120.00) (120.00) (120.00) (120.00)
(120)/1.13
(120)/1.13/1.13
x 1/1.13
3
x 1/1.13
15
1/1.13
15
x
(1,000.00)
PVFCF (935.44)
THE 16 FUTURE CASHFLOWS IS NOT EQUAL TO B
0
WHICH IS 980.00
NPV 44.56 SINCE THIS IS NOT 0 13% IS NOT THE INTERNAL RATE OF RETURN
33
t0 t1 t2 t3 t15
B
0
980.00 (120.00) (120.00) (120.00) (120.00)
13% (775.44) 6.462 X
(160.00) 0.160 X (1,000.00)
(935.44)
44.56
34
t0 t1 t2 t3 t15
B
0
980.00 (120.00) (120.00) (120.00) (120.00)
12% (817.32) 6.811 X
(183.00) 0.183 X (1,000.00)
(1,000.32)
(20.32)
t0 t1 t2 t3 t15
B
0
980.00 (120.00) (120.00) (120.00) (120.00)
13% (775.44) 6.462 X
(160.00) 0.160 X (1,000.00)
(935.44)
44.56
35
Step 1: Try 12%
V = 120 (6.811) + 1,000 (0.183)
V = 817.32 + 183
V = $1,000.32
(Due to rounding of the PVIF, the value of the bond is 32 cents greater than expected.
At the coupon rate, the value of a $1,000 face value bond is $1,000.)
Try 13%:
V = 120 (6.462) + 1,000 (0.160)
V = 775.44 + 160
V = $935.44
The cost to maturity is between 12% and 13%.
Step 2: $1,000.32 - $935.44 = $64.88
Step 3: $1,000.32 - $980.00 = $20.32
Step 4: $20.32 $64.88 = 0.31
Step 5: 12 + 0.31 = 12.31% = before-tax cost of debt
12.31 (1 - 0.40) = 7.39% = after-tax cost of debt
n
o
t n
t 1
I M
B
(1 k) (1 k)
=
( (
= +
( (
+ +

15
t 15
t 1
$120 $1, 000
$980
(1 k) (1 k)
=
( (
= +
( (
+ +

36
The cost to maturity is between 12% and 13%.
Step 2: $1,000.32 - $935.44 = $64.88
Step 3: $1,000.32 - $980.00 = $20.32
Step 4: $20.32 $64.88 = 0.31
Step 5: 12 + 0.31 = 12.31% = before-tax cost of debt
12.31 (1 - 0.40) = 7.39% = after-tax cost of debt
37
12% ? 13%
1,000.32 980.00 935.44
100% OR 1 64.88 1,000.32 - 935.33 STEP2
20.32 1,000.32 - 980.00 STEP3
20.32/64.88= 1-.31 20.32/64.88 STEP4
0.31 0.69
38
4e
12.26% and 12.31% after tax is 7.35% and 7.39% for approximation and IRR respectively, difference is
negligible.
4f
The value of bonds and interest rate have an inverse relationship.
39
K
P
= D
P
/N
p
OR K
P
= D
P
/Po-FC
Kp=Cost of Preferred Stock Dp= Dividends of
Preferred Stock Po=Price or Market Value of
Preferred Stock FC= Floatation Costs
K
P
= D
P
/N
p
= P100X11%/P101-P9 =
P11/P92 = 11.96%
Specific Sources of Capital:
The Cost of Preferred Stock
40
k
p
= D
p
N
p=
Preferred
Stock
Calculation
Floyd k
p
11.00 92.00 = 11.96%
Louie k
p
3.20 34.50 = 9.28%
Paul k
p
5.00 33.00 = 15.15%
Cahayon k
p
3.00 24.50 = 12.24%
Villamin k
p
1.80 17.50 = 10.29%

41
6. Data of the common stock of the following companies are listed below:

Company Market
Value(P)
Dividend
Growth Rate
(%)
Projected
Dividends
Underpricing
Per Share (P)
Floatation
Cost Per
Share(P)
Ofel Co. 50 8 2.25 2 1
Tabag Corp. 20 4 1 0.50 1.50
DelaCruz, Co 42.50 6 2 1 2
Cecilia Co. 19 2 2.10 1.30 1.70

a. Compute the cost of retained earnings or common stocks using the constant growth
valuation model or the Gordon model.
b. Compute the cost of new common stocks using the constant growth valuation
model or the Gordon model.
c. Why is the cost of new common stocks more costly than cost of retained earnings?.
d. Why is the cost of common stocks the same as the cost of retained earnings?.
e. Why is it necessary to underprice new common stocks?.
42
Specific Sources of Capital:
The Cost of Common Stock
There are two forms of common stock financing:
retained earnings and new issues of common stock.
In addition, there are two different ways to estimate the
cost of common equity: any form of the dividend
valuation model, and the capital asset pricing
model (CAPM).
The dividend valuation models are based on the premise
that the value of a share of stock is based on the present
value of all future dividends.
43
k
S
= (D
1
/P
0
) + g
k
E
= r
F
+ b(k
M
- R
F
).
Using the constant growth model, we have:
We can also estimate the cost of common equity
using the CAPM:
The Cost of Common Stock
44
The CAPM differs from dividend valuation
models in that it explicitly considers the firms
risk as reflected in beta.
On the other hand, the dividend valuation model
does not explicitly consider risk.
Dividend valuation models use the market price
(P
0
) as a reflection of the expected risk-return
preference of investors in the marketplace.
The Cost of Common Stock
45
Although both are theoretically equivalent,
dividend valuation models are often preferred
because the data required are more
readily available.
The two methods also differ in that the dividend
valuation models (unlike the CAPM) can easily
be adjusted for flotation costs when estimating
the cost of new equity.
This will be demonstrated in the examples
that follow.
The Cost of Common Stock
46
k
s
= D
1
/P
0
+ g
Ks = Cost of Retained Earnings or
Common Stock; D
1
= Dividends as
forecasted or expected; Po= Price or
Market Value of Common Stocks; g=
Growth Rate.
k
S
= (P2.25/P50.00) + .08 = 12.5%.
The Cost of Common Stock
Cost of Retained Earnings (k
E
)
Constant Dividend Growth Model

47
t
-1
Past
2012
t
0
Present
2013
t
1
Future
2014
P
-1
Price 2012
P
0
Price 2013

P
1
Price 2014

D
-1
Dividends
2012

D
0
Dividends
2013

D
1
Dividends
2014
Paid for
2013
Investment
P
-1


Paid for
2013
Investment
P
0

48
k
n
= D
1
/N
n
+ g or
K
n
= D
1
/Po-FC-U + g

Kn= Cost of New Common Stock; D
1
= Dividends as
forecasted or expected; Nn= Net Proceeds (Price or
Market Value of Common Stock Floatation Cost
Underpricing); g=Growth Rate?
k
n
= [P2.25/(P50.00 P1.00-P2.00) + .08= 12.79%
Cost of New Equity (k
n
)
Constant Dividend Growth Model
The Cost of Common Stock
49
Firm Calculation
Ofel
k
r
= (P2.25 P50.00) + 8% = 12.50%
k
n
= (P2.25 P47.00) + 8% = 12.79%
Tabag
k
r
= (P1.00 P20.00) + 4% = 9.00%
k
n
= (P1.00 P18.00) + 4% = 9.56%
Dela Cruz
k
r
= (P2.00 P42.50) + 6% = 10.71%
k
n
= (P2.00 P39.50) + 6% = 11.06%
Cecilia
k
r
= (P2.10 P19.00) + 2% = 13.05%
k
n
= (P2.10 P16.00) + 2% = 15.13%

50
6c
Because of floatation costs and underpricing
6d
Retained earnings rightfully belongs to common stockholders.
6e
Signalling theory - investors takes issuance of equity as a sign of companies poor prospects.
51
7.JJ Co. common stock has a beta of 1.2. The risk free rate is 6% and the market return is 11%.
a. Determine the cost of common stock using the capital asset pricing model or M and M
model.
b. Determine the required return the common stock should provide to investors.
c. What is the risk premium of the common stock?
d. Determine the cost of common stock using the capital asset pricing model or M and M
model assuming a beta of 1 instead of 1.2, assuming all things being equal.
e. Determine the cost of common stock using the capital asset pricing model or M and M
model assuming a beta of .90 instead of 1.2, assuming all things being equal.
f. Explain the concept of risk free rate, market return and beta.
52
k
s
= R
F
+ b(k
M
- R
F
).
K
s
=Cost of Retained Earnings; R
F
=Risk Free

Rate =nth
T-bill rate Or Govt. Bond rate; K
m
= Average Market
Return; b = beta a measure of stock price volatility:
k
s
= 6.0% + 1.2 (11.0%-6.0%) = 12.0%.
Cost of Retained Earnings (k
E
)
Security Market Line Approach


(The Cost of Common Stock)
53
k
s
= R
F
+ [b (k
m
- R
F
)]
k
s
= 6% + 1.2 (11% - 6%)
k
s
= 6% + 6%
k
s
= 12%
(c) Risk premium = 6%
(b) Rate of return = 12%
(a) After-tax cost of common equity using the CAPM = 12%
54
k
s
= R
F
+ [b (k
m
- R
F
)]
k
s
= 6% + 1 (11%- 6%)
k
s
= 6% + 5%
k
s
= 11%
55
k
s
= R
F
+ [b (k
m
- R
F
)]
k
s
= 6% + .90 (11% - 6%)
k
s
= 6% + 4.5%
k
s
= 10.5%
56
7f
Risk free rate is the rate from t-bills or govt. bonds, market return is the return paid by the market which
is higher than the risk free rate and beta is a measure of volatility of the stock price which is measure of
risk.
57
8.Chubby Companys common stock is currently selling for P57.50. The firm
expects to pay a P3.40 dividends at the end of 2007. After underpricing
and floatation cost, Chubby expects to net P52 per share on new
issuance of common stocks. Dividends paid for the last 5 years are as
follows:

Year 2002 2003 2004 2005 2006
Dividends 2.12 2.30 2.60 2.92 3.10

a. Compute for the dividend growth rate.
b. Determine the net proceeds on the common stocks.
c. Compute the cost of retained earnings using the constant growth
valuation model or the Gordon model.
d. Compute the cost of new common stocks using the constant growth
valuation model or the Gordon model.
58
A. USING FUTURE VALUE TABLE ANSWER IS 10% USING EXCEL ANSWER IS 9.97%
D
2006
3.10 = 1.462 FACTOR
D
2002
2.12
USING THE TABLE OF FUTURE VALUES FOR 4 PERIODS 1.462
IS NEAREST TO 1.464 WITH A RATE OF 10%
B.
Nn P52 Given in the problem
59
GEOMETRIC GROWTH RATE
YEARS 1 2 3 4 5 = 5 YEARS
PERIODS 1 2 3 4 = 4 PERIODS
FUTURE
t
1
2002 2003 2004 2005 2006 2007
2.12 2.30 2.60 2.92 3.10 3.40
GROWTH P 0.18 0.30 0.32 0.18 D
1
=P3.40
GROWTH% 8% 13% 12% 6%
9.97% 2.12 X 1.462 = 3.0994 FACTOR RATE
2.12 X1.0997 X1.0997 X1.0997 X1.0997 3.1005 1.462 9.97%
10% 2.12 X 1.464 = 3.1037 FACTOR RATE
2.12 X1.10 X1.10 X1.10 X1.10 3.1039 1.464 10.00%
60
C.
Kr
D
1
+ g P3.40 + .10 15.91%
P
0
P57.50
D.
Kn
D
1
+ g P3.40 + .10 16.54%
Nn P52.00
61
9.Aristorenas Inc., reported earnings available to common stockholders of P4,200,000 last year. From
these earnings dividends were paid for P1.26 per share on its 1,000,000 common outstanding
shares. The company has a 40% debt ratio, 10% preferred stock and 50% common stocks in
its capital structure. It is in the 40% tax bracket.
a. If the market value of the companys common stock is P40 and dividends are expected to
grow at a rate of 6% per year, what is the companys cost of financing with retained
earnings.
b. If the underpricing and floatation costs on new shares of common stocks amounts to P7
per share, what is the companys cost of nnew common stock financing?
c. If the company can issue P2 dividend preferred stock for a market price of P25 per share
with floatation costs of P3 per share. What is the cost of preferred stock financing?
d. The company can issue P1,000 par value, 10% coupon, 5-year bonds that can be sold for
P1,200 each. Floatation costs would amount to P25 per bond. What is the approximate
cost of debt?.
e. What is the maximum investment that the company can make before issuing new common
stocks?.
f. What is the weighted average cost of capital for projects at a cost at or below the amount
computed in e?
g. What is the weighted average cost of capital for projects at a cost higher the amount
computed in e?
62
a. Cost of Retained Earnings
Kr
D
1
+ g P1.26 (1+.06) + .06 9.35%
P
0
P40.00
OR
D
0
(1+g)
+ g
P
0
b. Cost of New Common Stocks
Kn
D
1
+ g P1.26 (1+.06) + .10 10.06%
Nn P40.00 - P7.00
OR
D
0
(1+g)
+ g
Nn
63
c. Cost of Preferred Stocks
Kp
D
p
P2.00 + .10 9.09%
Np P25.00 - P3.00
d. Cost of Debt
kd= P100 + P1,000 - P1,175/5 years 65 0.05977
P1,175 + P1,000 1087.5 5.98%
'2
ki= 5.98% x 1-.40 = 0.035862069
3.59%
64
e.
BREAKPOINT
COMMON EQUITY
Amount of Funds Available at a given cost
Target Capital Structure Weight for source
BP
COMMON EQUITY
A F
COMMON EQUITY
W
COMMON EQUITY
BP
COMMON EQUITY
P4,200,000 - (P1.26 x 1,000,000 common shares)
50%
BP
COMMON EQUITY
P2,940,000 5,880,000.00
0.5
Liabilities Capital After
And Equity Structure Tax Weight
Assets Source of Capital Book Value Weight Costs Costs
Current Assets - Cash Long Term Debt 0.40 3.59% 1.44%
Fixed Assets Preferred Stock 0.10 9.09% 0.91%
Retained Earnings 2,940,000.00 0.50 9.35% 4.68%
TOTAL ASSETS 5,880,000.00 TOTAL 5,880,000.00 1.00 7.02% WACC
2,940,000/50%
65
f. WACC with projects of cumulative costs of P5,880,000
WACC = (WdxKd) (1-T) + ( WpxKp ) + (WeKe)
WACC = (.40x5.98%) (1-.40) + ( .10x9.09% ) + (.50x9.35%)
WACC = (.02392%) (60%) + ( 0.909%) + (4.675%)
WACC = (1.435%) + ( 0.909%) + (4.675%)
WACC = 7.02%
Liabilities Capital After
And Equity Structure Tax Weight
Assets Source of Capital Book Value Weight Costs Costs
Current Assets - Cash Long Term Debt 2,352,000.00 0.40 3.59% 1.44%
Fixed Assets Preferred Stock 588,000.00 0.10 9.09% 0.91%
Retained Earnings 2,940,000.00 0.50 9.35% 4.68%
TOTAL ASSETS 5,880,000.00 TOTAL 5,880,000.00 1.00 7.02% WACC
2,940,000/50%
66
f. WACC with projects of cumulative costs above P5,880,000
WACC = (WdxKd) (1-T) + ( WpxKp ) + (WeKe)
WACC = (.40x5.98%) (1-.40) + ( .10x9.09% ) + (.50x10.06%)
WACC = (.02392%) (60%) + ( 0.909%) + (5.03%)
WACC = (1.435%) + ( 0.909%) + 5.03%)
WACC = 7.375%
Liabilities Capital After
And Equity Structure Tax Weight
Assets Source of Capital Book Value Weight Costs Costs
Current Assets - Cash Long Term Debt 2,400,000.00 0.40 3.59% 1.44%
Fixed Assets Preferred Stock 600,000.00 0.10 9.09% 0.91%
Retained Earnings 2,940,000.00
New Common Stock 120,000.00 0.50 10.06% 5.03%
TOTAL ASSETS 6,000,000.00 TOTAL 6,000,000.00 0.50 7.375% WACC