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Chapter 9 Cost of Capital
Chapter 9 Cost of Capital
Chapter 9
The Cost of Capital
Value of Value of
Outstanding Outstanding Total Capital
Company Debt ($ billions) % Debt Equity ($ billions) % Equity ($ billions)
Alphabet $ 1 0% $ 911 100% $ 912
Johnson & Johnson 29 7 386 93 415
Procter & Gamble 31 10 282 90 313
Facebook 6 1 580 99 586
General Electric 99 66 51 34 150
General Motors 105 77 31 23 136
Cost $100,000
Life 20 years
Expected Return 7%
Cost $100,000
Life 20 years
Expected Return 12%
where:
– Dp = Annual dollar dividend
– Np = Net proceeds from the sale of the stock
Copyright © 2022 Pearson Education, Ltd.
Example 9.6
Duchess Corporation is contemplating issuance of an 8%
preferred stock they expect to sell at par value for $80 per share.
The cost of issuing and selling the stock will be $2.50 per share.
The first step in finding the cost of the stock is to calculate the
dollar amount of the annual preferred dividend, which is $6.40
(0.08 × $80).
The net proceeds per share from the proposed sale of stock
equals the sale price minus the flotation costs ($80 − $2.50 =
$77.50).
Substituting the annual dividend, Dp, of $6.40 and the net
proceeds, Np, of $77.50 into Equation 9.2 gives the cost of
preferred stock, 8.258% ($6.4 ÷ $77.50).
D1
P0 = (9.3)
rs − g
▪ where:
– P0 = Current value of common stock
– D1 = Dividend expected in one year
– rs = Required return on common stock
– g = Constant rate of growth in dividends
$3.99
rs = + 0.05 = 0.0798 + 0.05 = 0.1298 = 12.98%
$50
Because this estimate depends on an imprecise forecast of the
company’s long-run dividend growth rate, a kind of false precision
arises in concluding that the required return on equity is 12.98%,
so we will just round up to 13%.
rj = RF + j ( rm − RF ) (9.5)
▪ where
– rj = Expected return or required return on asset j
– RF = Risk-free rate of return
– βj = Beta coefficient for asset j
– rm = expected market return; expected return on the market
portfolio
• Copyright © 2022 Pearson Education, Ltd.
Example 9.8
Duchess Corporation now wishes to calculate the required return on its common
stock, rs, by using the CAPM. The firm’s investment advisors and its own analysts
indicate that the risk-free rate, RF, equals 3%; the firm’s beta, β, equals 1.5; and
the market return, rm, equals 9%. Substituting these values into Equation 9.5, the
company estimates that the required return on its common stock, rs, is 12%:
Notice that this estimate of the required return on Duchess stock does not line up
exactly with the estimate obtained from the constant-growth model. That is to be
expected because the two models rely on different assumptions. In practice,
analysts at Duchess might average the two figures to arrive at a final estimate for
the required return on common stock.
D1
rn = + g (9.6)
Nn
▪ where
– Nn = net proceeds per share from sale of new common stock
after subtracting underpricing and flotation costs
– D1 = Dividend expected in one year
– g = Constant rate of growth in dividends
To determine its cost of new common stock, rn, Duchess Corporation estimates
that new shares will sell for $48. Thus, Duchess’s shares will be underpriced by
$2 per share. A second cost associated with a new issue is flotation costs of
$1.50 per share that would be paid to issue and sell the new shares. The total
underpricing and flotation costs per share are therefore $3.50.
Subtracting the $3.50-per-share underpricing and flotation cost from the current
$50 share price results in expected net proceeds of $46.50 per share.
Substituting D1 = $3.99, Nn = $46.50, and g = 5% into Equation 9.6 results in a
cost of new common stock, rn:
$3.99
rn = + 0.05 = 0.0858 + 0.05 = 0.1358 = 13.58%
$46.50
Duchess Corporation’s cost of new common stock is therefore between 13%
and 14%.
rr = rs (9.7)
– where
▪ wd = proportion of long-term debt in capital structure
▪ wp = proportion of preferred stock in capital structure
▪ ws = proportion of common stock equity in capital
structure
▪ wd + wp + ws = 1.0
rd (1 – T ) = 4.880% = 4.88%
rp = 8.258% = 8.26%
rs = 13.00%
Preferred stock 10
Total 100%
Blank
Weight Cost Weighted cost
Source of capital w r w×r
Long-term debt 0.40 4.88% 1.95%
Preferred stock 0.10 8.26 0.83
Common stock equity 0.50 13.00 6.50
Totals 1.00 WACC = 9.28%