Cost of Capital and Break Point
Abstract
The cost of equity is basically the benefit or the rate of return that the investors are generally
interested in when making equity investment in a particular company. Common stocks do not
attract any taxes as the dividends are usually paid net of taxes.
The cost of common stock is very high just as much as the retained earnings and new common
stock only that there is no adjustment for the flotation costs. The costs are calculated using the
CAPM and the Gordon model of constant dividend average growth model or the DCF model.
Introduction
Break points refer to the total or overall financing that a firm needs or it can afford to raise
before the company is compelled to sell new debts or even part of the equity capital. Once these
point is surpasses any additional capital also raises their WACC. To obtain the Break point of
retained earnings then BPre = Retained earnings/ weight of equity.
Edna Recording Studios, Inc
8400000
Common stock 4,200,000
Dividend payable 1.26
Cost of Capital and Break Point
2
Outstanding shares 1,000,000
Long term debt 3360000
Preferred stock 840000
Debt and Equity
According to the concepts of Modigliani and Miller (1958, p. 260) the actual cost of
equity capital are in most cases determined by the total asset’s cost of capital but not
the other means of raising capital.
a) Cost of retained
earnings
Rr = $1.26 (1 + 0.06)/$40 +
0.06 =
$1.34/$40 = 3.35% + 6% =
9.35%
The cost of retained earnings for Edna is 9.35% which is slightly lower than the cost of new
common stock.
b) Cost of new common
stock
Rs = $1.26 (1+0.06)/$40 -7 +
0.06
= $1.34/$33 = 4.06% + 6% =
10.06%
The cost of new common stock for Edna is 10.06% is still higher than the cost of preferred debt.
c) Cost of preferred stock $2/$25 – $3
Cost of Capital and Break Point
3
$2/422 =
9.9%
Edna’s cost of preferred debt is 9.9%
Debt
Interest payments mostly payable by the lenders are legally deducted from the company’s
taxable income while the other payments to the shareholders as dividends are not. The tax
systems through their incentive initiatives generally encourage more companies to use debt
financing to fund their expansion activities instead of using the equity capital. The higher the
interest rates the higher the incentive for the investors to buy. (Black, Jensen and Scholes,
1972, p.118)
d) Cost of debt financing $100 + ($1000 –
$1175)/5)/($1175
+ $1000/2) = $65/$1087.5 =
5.98%
r1 = 5.98% x (1-0.4) = 3.59%
The cost of debt financing for Edna recording studios is 3.59%.
The Capital Asset Pricing (CAPM) principle suggests that the real cost of capital heavily
depends on the initial status of the asset. The cost of the equity capital, the cost of the
debt capital and the weighted average of the two depend on the type of debt and equity
financing that basically represent the cost of capital.
Cost of Capital and Break Point
4
e) Maximum investment $4,200,000 – ( $1.26 x
1,000,000)/.5 =
$2.940,000/.5 =
$5,880,000
The weighted Average cost of capital is equal to;
WACC = Wd (cost of the debt after tax) + Ws (cost of stock/RE) + Wp (cost of PS)
f) WACC for part e 0.4(3.59%) + (0.1) (9.09%)
+0.5 (9.35%)
WACC = 1.436 + 0.909 +
4.675
WACC = 7.02%
The weighted average cost of capital of maximum investment in Edna studios is 7.02% while the
cost of preferred stock and debt financing are much higher.
g) WACC for part d 0.4(3.59%) + (0.1)
(9.09%) +0.5 (10.06%)
WACC = 1.436 + 0.909 +
5.03
WACC = 7.38%
Cost of Capital and Break Point
5
References
Black, F., Jensen, M.C. and Scholes, M. (1972) “The Capital Asset Pricing Model: Some
Empirical Tests,” in Studies in the Theory of Capital Markets. Michael C. Jensen, ed.
New York, NY: Praeger, 79–121.
Modigliani, F. and Miller, M. (1958) “The Cost of Capital, Corporation Finance, and the Theory
of Investment,” American Economic Review, June, 48:3, 261–97.
