P2B.2 Long Term Financial Management - Cost of Capital

Question 1

Cost of Capital

Answer 1

1. Cost of financing company’s business using debt, equity or both.
2. Affects capital structure
3. Serves as a benchmark for capital investments
4. Internal rate of return (IRR) > Hurdle rate (Cost of capital)
5. Measured on an after-tax basis.

Question 2

Cost of Capital Individual Components

Answer 2

1. Cost of Debt: interest is tax deductible.
   Market interest rate / Yield to maturity / Debt rating
2. Cost of Preferred Stock: Dividend / Market price of preferred stock
3. Cost of Common Stock: CAPM, discounted cash flow, growth-based dividend model

Question 3

Weighted Average Cost of Capital (WACC)

Answer 3

1. Weighted average (historical) cost of outstanding capital in balance sheet based on current market values.
2. Debt > Equity = lower WACC due to tax deductibility of interest

Question 4

Weighted Average Cost of Capital (WACC) Formula

Answer 4

WACC = (CWD × CD(1−t)) + (CWP × CP) + (CWC × CC)

CWD = Current weight of debt
CD(1−t) = After tax cost of debt
CWP = Current weight of preferred stock
CP = Cost of preferred equity
CWC = Current weight of common stock
CC = Cost of common stock

1. Calculate cost of capital
2. Determine weights
3. Compute for WACC

Question 5

Weighted Marginal Cost of Capital (WMCC)

Answer 5

1. Weighted average cost of capital of an additional dollar of capital.
2. Based on future capital (marginal cost)
3. WACC will increase as additional capital is issued when retained earnings have been exhausted.
4. Marginal cost is useful in decision making because it’s futuristic and different among alternatives.

Question 6

Weighted Marginal Cost of Capital (WMCC) Formula

Answer 6

WMCC = (TWD × CD(1−t)) + (TWP × CP) + (TWC × CC)

CD(1−t) = After tax cost of debt

1. Calculate cost of capital
2. Determine target capital mix for future financing
3. Compute for WMCC

Question 7

Cost of Capital - Breakpoint

Answer 7

1. Compute breakpoint if retained earnings will be used.
2. Point where the marginal cost of capital increases.

= Unappropriated Retained Earnings / Target Weight of Common Stock in Capital Structure