• It is the required rate of return that a firm must at least earn to cover the cost of raising funds from its investors namely the debt and equity holders
• It therefore represents the overall cost of financing to the firm
• It is always associated with risk in the sense that it is the rate that must be earned by the firm at a given level of risk hence it is normally used as the discount rate in analyzing investments or capital budgeting proposal. In the event the rate of return to be earned from the investment is higher than the firm’s cost of capital, the wealth of the shareholders will then be maximized.

The REASON to know a firm’s cost of capital:-

Is because a firm’s cost of capital is the rate of return which links the firm’s investment and its financing decision. Put it simply, if a firm has an overall cost of capital/financing rate of 10% but invested in projects that earned less than 10%, then shareholders’ wealth will be eroded.

Next we move on to Understand the Company’s Weighted Average Cost Of Capital :-

The company’s cost of capital is actually its “weighted average cost of capital (WACC) which is simply

• The average of the firm’s cost of funds from ALL investors including all types of lenders/debts borrowing and stockholders.

• This weighted average cost of capital weighs each category of source of financing PROPORTIONATELY

• A firm’s weighted average cost of capital is a composite of the individual costs of financing weighted by the percentage of financing provided by each source.

• First calculate the individual cost of financing like cost of debt, preferred stock and common stock

• Secondly determine the percentage(weight) of debt, preferred stock and common stock to be used in the financing

• Lastly, to calculate the firm’s WACC by multiplying the individual cost of financing with the percentage of financing.

Append below is a simple illustration on the computation of a company’s weighted average cost of capital (WACC):

Illustration:

Company ABC Ltd has the following sources of capital and has also determine its individual cost of capital:

The Management intends to invest in a $500,000 investment project with an expected rate of return of 12.5%.

Should the firm make the investment?

 Suggested Solution:

Step 1: Determine the individual cost of financing.

In this case, it has been given. 

Step 2: Determine the weightage(%):- 

 Step 3: Compute the company’s WACC by multiplying the individual cst of financing with the weightage/% of financing: 

Final Step: 

Compare the firm’s weighted average cost of capital (WACC) with the proposed rate of return from the capital investment:

Firm’s WACC = 14.6% Versus Rate of Return from Investment=12.5%

Reject the investment proposal as the firm’s WACC is higher than the project’s rate of return otherwise shareholders wealth will be eroded.

 The cost of issuing new common stock(Kne) is similar to the cost of internal equity except that a company has to incur flotation costs.

• The value of common stock is equal to the PRESENT VALUE OF EXPECTED FUTURE DIVIDENDS, discounted at the stockholders’ required rate of return

Formula is Ke(Required rate of return)= D1/NPo + g

Where NPo is the net proceeds per share received by the company

And D1=Do(1+g)

Illustration Using the DIVIDEND GROWTH MODEL BASIS ON EXTERNAL COMMON EQUITY ( WITH FLOTATION COSTS)

Company ABC Ltd’s recently received $0.15 dividend per share and expect dividends to growth at an annual rate of 10%. The market price of the security is $3. The flotation costs equal 15% of market price. Compute the investors’ required rate of return using the Dividend Growth Model:

Suggested Solution:

Ke( Required rate of return)

= D1/Po + g

= $0.15(1+0.1) / $3-(0.15x$3) + 0.1

= $0.165/2.55+0.1

=0.165

=16.5%

Methods To Compute Of Cost Of INTERNAL Common Equity

• Dividend Growth Model
• Capital Asset Pricing Model (CAPM)

• The value of common stock is equal to the PRESENT VALUE OF EXPECTED FUTURE DIVIDENDS, discounted at the stockholders’ required rate of return
• Formula is Po = D1/(Ke-g)

Where Po = price of the stock today

D1= dividend at the end of the first year

Ke= required rate of return on equity

g = constant growth rate of dividends

If dividends are paid at a constant annual rate of growth(g) which is less than Ke:

Ke= Dividend in year 1/Market price + Annual growth rate in dividends

Therefore Ke(Required rate of return)= D1/Po + g

Illustration Using the DIVIDEND GROWTH MODEL BASIS

Company ABC Ltd’s recently received $0.15 dividend per share and expect dividends to growth at an annual rate of 10%. The market price of the security is $3, compute the investors’ required rate of return using the Dividend Growth Model:

Suggested Solution:

Ke( Required rate of return)

= D1/Po + g

= $0.15(1+0.1) / $3 + 0.1

= $0.165/3+0.1

=0.155

=15.5%