COST OF CAPITAL

GROUP 4
Ma. Teresa Lhyn Respicio Darry Katie Mae Pascua
Kwinzy Anne Remular Bianca Sadorra
Judy Ann Natividad Gheizel Baniaga
Erika Jamile Pascua Alliah Vina Galam
Janel Nicole Gambeng
 1 Cost of Capital

MAIN TOPIC 2 Leverage

3 Capital structure
COST OF
CAPITAL
Represents the overall cost of long-term financing
to the firm.
It is the minimum required rate of return for an
investor to put money in a project
It is the combination of both debt and equity
financing.
also known as hurdle rate, target rate, minimum
acceptable rate, and minimum ROI.
COST OF CAPITAL IS USED FOR:
1. Capital budgeting decisions

2. Helping establish the optimal capital structure

3. Making decisions
DEBT FINANCING EQUITY FINANCING

Debts or bonds are borrowed funds The exchange of money for a stake
that must be repaid with interest. in a company’s ownership is known
The explicit cost of capital or as equity financing.
interest expense on the debt is This type of financing enables a
considered a cost of doing business company to obtain funds without
and is thus tax deductible. incurring debt.
 1. LONG-TERM DEBT

2. PREFERRED STOCK
SOURCES OF
LONG-TERM
CAPITAL
3. COMMON STOCK

4. RETAINED EARNINGS
COMPUTATION OF
COST OF CAPITAL
CAPITAL COST

Long-Term Debt (Kd) Yield Rate (100% - Tax Rate)

Preferred Stock (Kp) Yield Rate

Common Stock and Retained earnings (Ke) Yield Rate + Growth Rate
Cost of
ILLUSTRATION:
Long-Term Debt (Kd)
Yield rate is based on a debt
Jervi Corporation is planning to issue P20M
instrument’s EFFECTIVE interest
rate, rather than its nominal interest bonds at an effective interest rate of 10%.
rate. The company pays income tax at a rate of
30%. What is the cost of debt capital?
Cost of long-term debt is expressed
as “after-tax” since interest charges
are tax-deductible expenses. Cost of debt = interest ( 1 - Tax rate)
= 10% x (1 - 0.30)
Formula:
= 7%
Yield Rate (100% - Tax Rate)
 Cost of Preferred ILLUSTRATION:
Stock (PS) or “KP” Sam Corporation is planning to issue 100,000
shares of 10%, P50 par value preferred stocks
for P80 per share. The company pays income
Dividends distributed to
tax at a rate of 30%.
preferred shareholders.
Preferred stock has features of
both common stock and bonds Cost of preferred stock:
hence they are more attractive
to investors

10% * 50
Formula: 80
Dividend per
- share
Market Price per share- Flotation Cost .0625 or 6.25 %
COST OF COMMON STOCK (CS)
Rate at which investors discount the expected dividends of the firm to
determine its share value

Two common forms of common stock financing:

1. RETAINED EARNINGS COST OF NEW ORDINARY SHARES

WAYS TO DETERMINE COST OF EQUITY
These are independent methods that can be used for Preferred Stocks,
Common Stocks, or Retained earnings

1. DIVIDEND GROWTH MODEL, or

DIVIDEND- YIELD-PLUS-GROWTH- 2. CAPITAL ASSET PRICING MODEL
RATE
Dividend Growth ILLUSTRATION:
Model Compute Ke and Kn under the following
circumstances:
This model assumes that
dividends grow either at a Case A:
stable rate in perpetuity or at a D1 = P4.50, P0 = P60, G = 6%, F = P4.00
different rate during the period.

Case B:
Formulas:
E1 = P12, Payout ratio = 20%, P0 = P36, G=5%, F= 12
Cost of retained earnings (Ke):
D1
+G Case C:
P0
D0 = P3, G = 9%, P0=P60, F = P3.50
Cost of new ordinary
- shares (Kn):
D1
+G
(P0 - FC)
SOLUTION: CASE A

Cost of retained earnings:

Formulas:
Cost of retained earnings (Ke):
D1
+G
P0

Cost of new ordinary shares (Kn):

D1 Cost of new ordinary shares:

+G
(P0 - FC)

-
SOLUTION: CASE B

Cost of retained earnings:

Formulas:
Cost of retained earnings (Ke):
D1
+G
P0

Cost of new ordinary shares (Kn):

D1 Cost of new ordinary shares:

+G
(P0 - FC)

-
SOLUTION: CASE C

Cost of retained earnings:

Formulas:
Cost of retained earnings (Ke):
D1
+G
P0

Cost of new ordinary shares (Kn):

D1 Cost of new ordinary shares:

+G
(P0 - FC)

-
 CAPITAL ASSET PRICING MODEL(CAPM)
A RISK-BASED APPROACH

DIVERSIFIABLE RISK NON- DIVERSIFIABLE RISK

is the risk that can be eliminated by

are the risks that cannot be diversified away
diversification

Types of risk

BUSINESS RISK MARKET RISK

LIQUIDITY RISK INTEREST RISK
DEFAULT RISK PURCHASE RISK
Capital Asset FORMULA:
Pricing Model KE= KRF +β (KM+KRF)

CAPM is graphically represented by “KE” is the EXPECTED or REQUIRED RATE OF

drawing the SECURITY MARKET RETURN used as cost of equity capital.
LINE, which shows the amount of
returns an investor can expect from
the market with regard to the
“KRF” is the RISK-FREE RATE that is usually
different levels of systematic risk based on treasury bill (T-bill) rate.

CAPM, a model developed by “β” is the BETA COEFFICIENT.

American econo,ist William Sharpe,
“KM” is the MARKET RETURN while “(KM - KRF)”
deals with the relationship between
no-diversifiable/systematic risk and is the MARKET RISK PREMIUM.
expected return for assets,
particularly stocks. “β (KM - KRF)” is the RISK PREMIUM, the
additional return required to compensate for
assumed risks.
 ILLUSTRATION:

The return on market portfolio is 12% and

the risk-free rate is 5%. The beta coefficient
Capital Asset Pricing is 1.4. Using the capital asset pricing model,
what is the cost of capital (or required rate of
Model
return)?

Required rate of return= Rf + β(Rm-Rf)

= 5%+ 1.4(12%-5%)
= 14.8%
LEVERAGE
is an investment strategy of
using borrowed funds, to
improve overall company
profitability.
THREE TYPES OF
LEVERAGE

1. OPERATING LEVERAGE

2. FINANCIAL LEVERAGE

3. TOTAL LEVERAGE
LEVERAGE

Financial leverage in general refers to an investment

strategy of using borrowed funds to improve overall
company profitability. Effective leveraging is attained
if the return is greater than the financing cost.

Operating leverage is a strategy of increasing overall

profitability by increasing sales units.
LEVERAGE
OPERATING LEVERAGE FINANCIAL LEVERAGE

• concerned with the relationship • concerned with the relationship

between sales revenue and between EBIT and EPS
earnings before interest and taxes

• use of fixed operating cost to • use of fixed financing cost to

magnify the effects of changes in magnify the effects of changes in
sales on the firm's earnings before EBIT on EPS
interests and taxes.
OPERATING LEVERAGE
FORMULA:

Single year leverage

= Contribution Margin / Earnings Before Interest and Taxes

Two year leverage

= percentage change in EBIT/ percentage change in sales
FINANCIAL LEVERAGE
FORMULA:
Single year leverage
= Earnings Before Interest and Taxes / Earnings Before Tax

Two year leverage

= percentage change in EPS / percentage change in EBIT

Financial leverage with preferred shares

= EBIT = {EBIT - Interest - (Preferred Dividends / (1 - T)I
ILLUSTRATION Degree of Financial Leverage
Two companies have the same

of Company Y
EBIT of P3,000,000 but different

capital structure. Formula : EBIT / EBIT - 1

- (D/ 1 - T)
Company Y is mostly focused on

equity financing using both

common and preferred equity. P3,000,000

Its preferred dividend payment —————————————————————————————————
P3,000,000 - P250,000 - (P150,000/ 1 - 0.30)
is P150,000, and the interest

payment is P250,000.

By contrast, Company Z tends to

= 1.18
use debt financing and has onlv

common equity. Its interest

payment is P1,250,000. The tax

rate for both companies is 30%

ILLUSTRATION Degree of Financial Leverage

Two companies have the same of Company Z

EBIT of P3,000,000 but different

capital structure. Formula : EBIT / EBIT - 1

Company Y is mostly focused on

equity financing using both

common and preferred equity. P3,000,000

Its preferred dividend payment —————————————————————————
P3,000,000 - P1,250,000
is P150,000, and the interest

payment is P250,000.
= 1.71
By contrast, Company Z tends to

use debt financing and has onlv

common equity. Its interest

payment is P1,250,000. The tax

rate for both companies is 30%

M-M PROPOSITION AND LEVERAGE

Consider the Modigliani-Miller proposition for taking

advantage of leveraging as discussed under Long-term
financing.
Degree of Total
Leverage
ILLUSTRATION:
is a measure of total risk, determines Assume that Company ABC's current EPS is 3
how Earnings per share (EPS) is
affected by a chnage in sales.
and it is trying to determine what its new EPS
will be in the event that is experiences a 10%
increase in sales revenue.
The degree of total leverage can
Also assume the following for Company ABC:
also be referred to as the “degree of
combined leverage” because it
considers the effects of both Contribution Margin - 15,000,000
operating leverage and financial Fixed Costs - 3,000,000
leverage Interest Expenses - 1,500,000
Formula:
DTL = CM / EBIT - FFC* OR;
DTL = % changes in EPS
% changes in Sales

SOLUTION:
DTL = CM / EBIT - FC* OR;
DTL = % changes in EPS
% changes in Sales

DTL = 15,000,000 15M - 3M

15M - 3M 15M - 3M - 1.5m
= 1.25 = 1.14
= 1.25 x 1.14
DTL = 1.43%

The figure can then be used to help the company determine what its new EPS will be if it sees a 10%
increase in sales revenue.

Calculation of EPS ;
= 3 x (1 + 1.43 x 10%)
= 3.29
CAPITAL
STRUCTURE
Capital structure is the composition of a
company’s sources of funds, a mix of the
owner’s capital (equity) and loan (debt) from
outsiders.
 1. ASSESSING COMPANY GROWTH
WHY IS
CAPITAL
STRUCTURE 2. OWNERSHIP AND INTEREST
IMPORTANT?

3. SEEKING INVESTORS
FACTORS AFFECTING THE CAPITAL
STRUCTURE
INTERNAL FACTORS
1. - The capital structure of a business or a startup
depends upon its size, theme, and nature.

EXTERNAL FACTORS
2. - The external factors consist of those policies and
documentation, that the owner cannot control
 1. NET INCOME THEORY

2. NET OPERATING INCOME THEORY

THEORIES OF
CAPITAL
STRUCTURE
3. TRADITIONAL THEORY

4. MODIGLIANI-MILLER THEORY
HOW IS CAPITAL STRUCTURE
CALCULATED?
You can calculate your company’s capital structure by examining your
debt-to-equity ratio, which you determine by dividing your liabilities
(level of debt) by your total equity. The difference between your assets
and liabilities determines your working capital or the amount of
liquidity (current cash flow) you have.
 CONCLUSION

The capital structure of a company determines the best

proportion of the debt and equity of that company. Capital structure
is very much required for the successful running of a business and to
ensure profitable growth in the market. Without a proper capital
structure, a company might face several hurdles in the market.
THEORIES
AND
PROBLEMS
THEORIES

1. Which of the following is not a source of long-term financing?

a) Common stocks

b) Bonds

c) Preferred stocks

d) Floating lien
THEORIES

1. Which of the following is not a source of long-term financing?

a) Common stocks

b) Bonds

c) Preferred stocks

d) Floating lien
THEORIES

2. Which of the following brings in additional capital to the firm?

a) Issuance of stock dividend

b) Two-for-one stock split

c) Exercise of warrants

d) Conversion of convertible bonds to common stocks

THEORIES

2. Which of the following brings in additional capital to the firm?

a) Issuance of stock dividend

b) Two-for-one stock split

c) Exercise of warrants

d) Conversion of convertible bonds to common stocks

THEORIES
Warrants are long-term options that give holders the right to buy
common stocks in the future at a specified price. Issuers of debt
3.
sometimes attach stock purchase warrants to debt instrument as an
inducement to investors. A major use of warrants in financing is to

a) Increase the return on debt

b) Lower the cost of debt

c) Avoid dilution in earnings per share

d) Maintain managerial control

THEORIES
Warrants are long-term options that give holders the right to buy
common stocks in the future at a specified price. Issuers of debt
3.
sometimes attach stock purchase warrants to debt instrument as an
inducement to investors. A major use of warrants in financing is to

a) Increase the return on debt

b) Lower the cost of debt

c) Avoid dilution in earnings per share

d) Maintain managerial control

THEORIES

To acquire additional capital while attempting to maximize

4.
earnings per share, a company should normally

a) Select debt over equity initially

b) Select equity over debt initially

c) Issue both bonds and stocks in equal proportion

d) Discontinue paying dividends and use current cash flows to

raise capital funds
THEORIES

To acquire additional capital while attempting to maximize

4.
earnings per share, a company should normally

a) Select debt over equity initially

b) Select equity over debt initially

c) Issue both bonds and stocks in equal proportion

d) Discontinue paying dividends and use current cash flows to

raise capital funds
THEORIES

If firm’s degree of operating leverage is higher than the

5.
industry average, such firm

a) Is more profitable

b) Is less risky

c) Has profits that are more sensitive to changes in sales

volume

d) Has higher sales

THEORIES

If firm’s degree of operating leverage is higher than the

5.
industry average, such firm

a) Is more profitable

b) Is less risky

c) Has profits that are more sensitive to changes in sales

volume

d) Has higher sales

THEORIES

Which of the following statements about cost of capital is

6.
false?

a) Cost of capital is based on what the company pays for its capital, not
the return earned on the capital employed.

b) The overall cost of capital is the minimum rate a firm must earn on all
investments to cover capital costs.

c) The overall cost of capital is the cost of the firm’s equity capital at
which the market value of the firm will remain unchanged.

d) The overall cost of capital is the weighted average cost of the various
debt and equity components in a firm’s capital structure
THEORIES

Which of the following statements about cost of capital is

6.
false?

a) Cost of capital is based on what the company pays for its capital, not
the return earned on the capital employed.

b) The overall cost of capital is the minimum rate a firm must earn on all
investments to cover capital costs.

c) The overall cost of capital is the cost of the firm’s equity capital at
which the market value of the firm will remain unchanged.

d) The overall cost of capital is the weighted average cost of the various
debt and equity components in a firm’s capital structure
THEORIES
Ideally, a firm’s optimal capital structure is the one that balances the
7. cost of debt and equity capital and their associated risk levels. The
optimal capital structure minimizes the firm’s

a) Weighted average cost of capital (WACC)

b) Cost of debt

c) Cost of equity capital

d) Earnings per share

THEORIES
Ideally, a firm’s optimal capital structure is the one that balances the
7. cost of debt and equity capital and their associated risk levels. The
optimal capital structure minimizes the firm’s

a) Weighted average cost of capital (WACC)

b) Cost of debt

c) Cost of equity capital

d) Earnings per share

THEORIES

8. Which of the following statement is incorrect?

a) Capital structure is the mix of the long-term sources of funds used by

the firms.

b) Capital structure consists of the firms long-term financing, i.e., long-

term debt and stockholders’ equity

c) The optimum capital structure is a combination of long-term debt

and equity that minimizes the cost of capital and value of the firm.

d) Debt is cheaper than equity, but excessive use of debt increases the
firm’s risk and drives up the weighted average cost of capital (WACC).
THEORIES

8. Which of the following statement is incorrect?

a) Capital structure is the mix of the long-term sources of funds used by

the firms.

b) Capital structure consists of the firms long-term financing, i.e., long-

term debt and stockholders’ equity

c) The optimum capital structure is a combination of long-term debt

and equity that minimizes the cost of capital and value of the firm.

d) Debt is cheaper than equity, but excessive use of debt increases the
firm’s risk and drives up the weighted average cost of capital (WACC).
THEORIES

9. Which of the following statement is incorrect?

a) An increase in the corporate income tax rate might encourage a firm

to increase the amount of debt in its capital structure.

b) An increase in economic uncertainty encourages equity financing

c) In general, debt financing is more expensive than equity financing

d) When calculating the cost of capital, the cost assigned to retained

earnings should be lower than the cost of external common equity.
THEORIES

9. Which of the following statement is incorrect?

a) An increase in the corporate income tax rate might encourage a firm

to increase the amount of debt in its capital structure.

b) An increase in economic uncertainty encourages equity financing

c) In general, debt financing is more expensive than equity financing

d) When calculating the cost of capital, the cost assigned to retained

earnings should be lower than the cost of external common equity.
THEORIES
Statement 1: Companies generally do not prefer low-cost
debt financing.
10.
Statement 2: Raising debt requires credit rating payment of
interest even companies suffer losses.

a) Statement 1 is correct, Statement 2 is incorrect.

b) Statement 1 is incorrect, Statement 2 is correct.

c) Both statements are incorrect.

d) Both statements are correct

THEORIES
Statement 1: Companies generally do not prefer low-cost
debt financing.
10.
Statement 2: Raising debt requires credit rating payment of
interest even companies suffer losses.

a) Statement 1 is correct, Statement 2 is incorrect.

b) Statement 1 is incorrect, Statement 2 is correct.

c) Both statements are incorrect.

d) Both statements are correct

THEORIES
Which of the following is not an approach to the Capital
11.
Structure?

a) Gross Profit Approach

b) Net Operating Income Approach

c) Net Income Approach

d) Modigliani and Miller Approach

THEORIES
Which of the following is not an approach to the Capital
11.
Structure?

a) Gross Profit Approach

b) Net Operating Income Approach

c) Net Income Approach

d) Modigliani and Miller Approach

THEORIES
Most common approach for analyzing the capital structure of
12.
a firm is?

a) Ratio Analysis

b) Cashflow Analysis

c) Comparative Analysis

d) Leverage Analysis
THEORIES
Most common approach for analyzing the capital structure of
12.
a firm is?

a) Ratio Analysis

b) Cashflow Analysis

c) Comparative Analysis

d) Leverage Analysis
 PROBLEM
Hector Corporation’s capital structure is as follows:

Bonds Payable, 10 years, 10% P 1,000,000

1. The cost of debt is
10% preferred stocks, P200 par value,
2,000,000
10,000 shares issued and outstanding SOLUTION:

Cost of debt
Common stocks, P50 per share,
1,500,000
30,000 shares issued and outstanding

500,000
Retained earnings

Total P 5,000,000

The company’s earnings per common share (EPS) is P12. The

common shares’ current market price is P60, while that of
preferred shares is P250. The income tax rate is 30%.
 PROBLEM
Hector Corporation’s capital structure is as follows:

Bonds Payable, 10 years, 10% P 1,000,000

2. The cost of preferred stocks is
10% preferred stocks, P200 par value,
2,000,000
10,000 shares issued and outstanding SOLUTION:

Cost of preferred stocks

Common stocks, P50 per share,
1,500,000
30,000 shares issued and outstanding

500,000
Retained earnings

Total P 5,000,000

The company’s earnings per common share (EPS) is P12. The

common shares’ current market price is P60, while that of
preferred shares is P250. The income tax rate is 30%.
 PROBLEM
Hector Corporation’s capital structure is as follows:
3. For the purposes of computing
Bonds Payable, 10 years, 10% P 1,000,000 the company’s overall cost of
capital, the cost of common
10% preferred stocks, P200 par value, stocks and retained earnings is
2,000,000
10,000 shares issued and outstanding

SOLUTION:
Common stocks, P50 per share,
1,500,000
30,000 shares issued and outstanding Cost of Common Stocks and Retained
Earnings
500,000
Retained earnings

Total P 5,000,000

The company’s earnings per common share (EPS) is P12. The

common shares’ current market price is P60, while that of
preferred shares is P250. The income tax rate is 30%.
 PROBLEM
Hector Corporation’s capital structure is as follows:
4. What is the weighted average
Bonds Payable, 10 years, 10% P 1,000,000 cost of capital?

10% preferred stocks, P200 par value,

2,000,000 SOLUTION:
10,000 shares issued and outstanding

Common stocks, P50 per share,

1,500,000
30,000 shares issued and outstanding

500,000
Retained earnings

Total P 5,000,000

The company’s earnings per common share (EPS) is P12. The

common shares’ current market price is P60, while that of
preferred shares is P250. The income tax rate is 30%.
 PROBLEM
The following is the Income Statement of Annabelle 5. What is the total amount of
Corporation for the Year ended December 31,2023 DOL, DFL and DTL?
ANNABELLE CORPORATION
Income Statement
For the year ended December 31,2023 SOLUTION:

Sales (500,000 at P100 each) 50,000,000

Less: Variable Cost (500,000 at P80 each) 40,000,000

Contribution Margin 10,000,000

Less: Fixed Costs 6,000,000

Operating income (or EBIT) 4,000,000

Less: Interest Expense 1,000,000

Income before tax 3,000,000

Less: Income tax (30%) 900,000

Income After Tax 2,100,000

 PROBLEM 6. What is the capital structure
weight?
SOLUTION:

A firm has a market value of equity equal to

Php 300 million and a market value of debt
equal to Php 100 million. Total market value
of the Firm is Php 600 million.
 PROBLEM 7. What is the capital structure
weight?
SOLUTION:

There’s no preferred stock. So, V= E+D

A firm has 100,000 shares of stock
outstanding and 30,000 corporate bonds in
the hands of its investors. Stock is currently
worth Php 150 per share, and bonds are sold
for Php 980 each. What is the capital
structure weight?
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