Socio-Economic Factors

APPLIED ECONOMICS
 Applied Economics

 CONTENT STANDARDS
 various socioeconomic impacts of business on the
following sectors: consumer, supplier and investors,
government, households, and international trade
 PERFORMANCE STANDARDS
 conduct a socioeconomic impact study on consumers
(new product and services); suppliers; investors (capital,
income) government (tax revenues, poverty alleviation,
basic services); households (standard of living,
employment) and international trade (exports and
imports of goods and services) leading to options in
venturing into a business
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 LEARNING COMPETENCIES
 Identify and explain the various
socioeconomic factors affecting business and
industry
 analyze and evaluate the viability of a business and
its impact on the community
 formulate recommendations and strategies on how
to minimize and maximize a business’s negative
impact and positive impact, respectively
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 PEST
 Political
 Economic
 Social
 Technological
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Example: PEST analysis for the

automobile industry
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 PESTEL
 Political
 Economic
 Social
 Technological
 Environmental
 Legal
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What does
PEST means ?
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Where does
the firms get
their capital?
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If you need

additional capital
would you get a
loan or look for
investors ?
 Applied Economics

 LEARNING COMPETENCIES
 Identify and explain the various socioeconomic
factors affecting business and industry
 analyze and evaluate the viability of a
business and its impact on the community
 formulate recommendations and strategies on how
to minimize and maximize a business’s negative
impact and positive impact, respectively
 Applied Economics

 Common problems in establishing/expanding businesses

 A. Lacking/limited access to capitalization.

 B. Lack of Technical Assistance towards the development/improvement
of a product or service.
1. Production
2. Marketing
3. Management
4. Creating Value to the product or service
5. Incentives and subsidies
C. Competition
D. Impact to the Community
E. Sustainability
 Applied Economics

The Cost of Capital

The firm can raise investment funds
A. Internally ( undistributed profits)
B. Externally (by borrowing and from selling stocks)

The cost of internal funds is the opportunity cost or

forgone return on these funds outside of the firm.
The cost of external funds is the lowest rate of return
that lenders and stockholders require to lend to or invest
their funds in the firm.
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The Cost of Debt – the cost of

raising capital by borrowing.

The Cost of Equity Capital – the

cost of raising capital by selling
stocks.
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The Cost of Debt is the return that lenders

require to lend their funds to the firm. Since
the interest payments made by the firm on
borrowed funds are deductible from the firms
taxable income, the after-tax cost of borrowed
funds to the firm (kd) is given by the interest
paid ( r ) multiplied by 1 minus the firm’s
marginal tax rate, t. That is,
kd = r (1- t)
 Applied Economics

kd = r (1- t)
For Example, if the firm borrows at a 12.5 % interest
rate and faces a 40 % marginal tax rate on its taxable
income, what will be the after-tax cost of debt?
kd = r (1- t)
kd = 12.5 % ( 1-.40)
kd = 7.5 %
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To be noted is that if the firm has no taxable income

after all costs are deducted during a particular year,
the firm’s after tax-tax cost of debt is equal to its pretax
interest rate charged on borrowed funds.
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The Cost of Equity Capital externally usually

exceeds the cost of raising equity capital
internally by floatation costs (the cost of
issuing the stock). Since dividends paid on
stock ( as opposed to the interest paid on
bonds) are not deductible as a business
expense, there is no adjustment in
determining the equity cost of capital.
a. The Cost of Equity Capital: The risk-free
rate plus premium
ke = rf + rp
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rf is usually taken as the Treasury bills rate

or T-Bills rate while the risk premium (rp)
has two components
p1 –results from the greater risk that is
involved in investing in a firm’s securities.
p2 – is the additional risk resulting from
purchasing the common stock rather than
the bonds of the firm
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ke = rf + rp

Can be restate as
ke = rf + p1 + p2
p1 is usually measured by the excess
of the rate of interest on the firms
bonds over the rate of return on
government bonds.
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Example if the risk-free rate of

return on government securities is
8% and firms bonds yield is 11 %
and the additional risk involved in
purchasing the firm’s stocks is
about 4 %. What is the cost of
equity capital.
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ke = rf + p1 + p2

ke = 8%+ 3% + 4%

ke = 15 %
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b. The Cost of Equity Capital: The dividend

valuation model- The equity cost of capital to a
firm can also bee estimated by the dividend
valuation model. To derive this model, we begin
by pointing out that, with perfect information, the
value of a share of the common stock of a firm
should b equal to the present value of all future
dividends expected to be paid on a stock,
discounted at the investor’s required rate of
return (ke), if the dividend per share (D) paid to
stockholders is expected to remain constant over
time, the present value of a share of the common
stock of the firm (P) is then
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P=Σ D
t=1
( 1 + ke )t
If dividends are assumed to remain constant
over time and to be paid indefinitely the
above equation is nothing else but an annuity
and can be rewritten as :
P = D
ke
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If dividends are instead expected to

increase over time at the annual rate of
g, the price of a share of the common
stock of the firm will be greater and is
given by.
P = D
ke- g
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Therefore the equity cost of capital of the

firm can be stated as
ke = D + g
P
Example, if the firm pays a dividend of P
7.50 per share on common stock that sells
for P200 per share and the growth rate of
dividend payments is expected to be 5
percent per year, the cost of equity capital
for this firm is
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ke = 7.50 + .05
200

ke = .0375 + .05

ke = .0875 or 8.75 %
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c. The Cost of Equity Capital: The

Capital Asset Pricing Model –This
method takes into consideration not
only the risk differential between
common stocks and government
securities but also the risk
differential between common stocks
of the firm and the average common
stock of all firms or broad-based
market portfolio.
 Applied Economics

The cost of equity capital to the firm

estimated by the capital asset pricing
model (CAPM) is then measured by
ke = r f + β (km - r f)
Where, ke is the cost of equity capital to
the firm, r f is the risk free rate, β is the
beta coefficient, and km is the average
return on the stock of all firms.
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For example, suppose that the risk-free

rate is 8 % ,the average return on
common stocks is 15 %, and the beta-
coefficient for the firm is 1. What will
be the cost of equity capital of the
firm.

ke = 8% + 1 ( 15% - 8%) = 15%

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What if the risk involved in holding

the stock of a firm is 1.5 larger than the
risk on the average stock and using all
previous data. What is the cost of
equity capital to the firm.

ke = 8% + 1.5 ( 15% - 8%) = 18.5%

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On the other hand what if the risk

involved in holding the stock of a firm
is ½ the risk on the average stock and
using all previous data. What is the
cost of equity capital to the firm.

ke = 8% + .5 ( 15% - 8%) = 11.5%

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In general, a firm is likely to raise

capital from undistributed profits,
by borrowing, and by the sale of
stocks, and so the marginal costs of
capital to the firm is a weighted
average of the cost of raising the
various types of capital.
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Firms often try to maintain or achieve a

particular long-term capital structure of
debt to equity. For example, public utility
companies may prefer a capital structure
involving 60 % debt 40 % equity , while
auto manufacturers may prefer 30 % debt
to 70 % equity. When a firm needs to raise
investment capital, it borrows and sell
stocks so as to maintain or achieve a
desired debt/equity ratio.
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The composite cost of capital to the

firm (kc) is then a weighted average of
the cost of debt capital (kd) and equity
capital (ke) as stated by
kc = wd kd + we ke
Where wd and we are the proportion of
debt and equity respectively in the
firms capital structure.
 Applied Economics

The cost of debt is 7.5 %, the cost of

equity capital is 15 %, and the firm
wants to have a debt/capital ratio of
40:60 , the composite or weighted
marginal cost of capital to the firm is
kc = wd kd + we ke
kc = (.40)(.075) + (.60)(.15)
kc = .12 0r 12 %
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Suppose that the Eldridge Manufacturing

Company pays the interest rate of 11 % on its
bonds, the marginal income tax rate that the
firm faces is 40 %, the rate of government bonds
is 7.5 %, the return on the average stock of all
firms in the market is 11.55 %, the estimated
beta coefficient for the common stock of the firm
is 2, and the firm wishes to raise 40 % of its
capital by borrowing. Determine a) the cost of
debt b) the cost of equity capital, and c) the
composite capital of the firm.
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a) kd = r (1 – t) = 11%(1-.4) = 6.6 %
b) ke =r f + β (km - r f)
ke = 7.5% + 2 ( 11.55%- 7.5%) = 15.6 %
c) kc = wd kd + we ke
kc = .4(6.6%) + .6 (15.6) = 12.0 %
 Applied Economics

Basic Decision-Making
Techniques in
Approving a Business
Project
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Payback Period- determines

how much time will lapse
before the total of after-tax
cash flows will equal, or pay
back the initial investment.
The shorter the payback
period the better
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What if the following is the cash flow of the firm in

what year will the company recover its capital if the
cost of investment is Php 1,000,000?
Year 1 290,000
Year 2 320,000
Year 3 353,000
Year 4 389,300
Year 5 779,230

Answer : on the 4th year

 Applied Economics

2. Net Present Value (NPV)

One method of deciding whether or not a firm should accept
an investment project is to determine the net present value
of the project. The NPV of a project is equal to the present
value of the expected stream of net cash flows from the
project, discounted at the firm’s cost of capital, minus the
initial cost of the project. The higher the NPV the better
n Rt
NPV = Σ (1+k)t - Co
t -1
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n Rt
NPV = Σ (1+k)t - Co
t -1

Where Rt refers to the estimated net cash flow from

the project in each n years considered, k is the risk-
adjusted discount rate, Σ “refers to the sum of”, and Co
initial cost of the project.
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n Rt
NPV = Σ (1+k)t - Co
t -1

For Example, if k or the cost of capital of the project to the

firm is 12 %. What will be the net present value of Project A
if the estimated cash flow of the project is as follows with
an initial cost of Php 1,000,000
Year 1 290,000
Year 2 320,000
Year 3 353,000
Year 4 389,300
Year 5 779,230
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290,000 320,000 353,000

NPV = (1+.12)1 + (1+.12)2 + (1+.12)3 +

389,300 779,230
(1+.12)4 + (1+.12)5 - Php 1,000,000

NPV = Php 1,454,852.25 – Php 1,000,000

NPV = Php 454,852.25
 Applied Economics

3. Internal Rate of Return – (IRR)

Another method of determining whether a firm should or
should not accept an investment project is to calculate the
(IRR). The IRR is the discount rate that equates the present
value of the net cash flow from the project to the initial cost
of the project.
The firm should undertake the project if the IRR on
the project exceeds or is equal to the marginal cost of capital
or risk-adjusted discount rate that the firm uses.
The IRR can be computed by trial and error using the
data we used in computing the NPV.
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n Rt
IRR = Σ (1+k)t = Co
t -1

Where Rt refers to the estimated net cash flow from

the project in each n years considered, k is the risk-
adjusted discount rate, Σ “refers to the sum of”, and Co
initial cost of the project.
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Using the same data we use in the

NPV let us try to solve for the IRR.
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1. To Click the “=“ sign, click alpha + calc

2. To click the “x” sign, click alpha + )
3. After typing the equation, click the shift + calc then
equal sign