Professional Documents
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Financial Management 2-Uum
Financial Management 2-Uum
12
Cost of Capital
Long-term debt
Preferred Stock
Common Equity
Assets Liabilities & Equity
Current assets Current Liabilities
Long-term debt
Capital Structure
}Preferred Stock
Common Equity
Ch. 12 - Cost of Capital
• For Investors, the rate of return on a
security is a benefit of investing.
• Create an opportunity to invest more in
company
• For Financial Managers, that same
rate of return is a cost of raising funds
that are needed to operate the firm.
• In other words, the cost of raising
funds is the firm’s cost of capital.
Cost of Capital vs Required Rate of
Return
• The cost is different because of :
• 1) Flotation Cost
- transaction cost of issuing a new shares.
- firms need to invest in order to produced high
required rate of return compare than investors
needs.
2) Taxes
- interest expense on borrowing is tax deductible.
- cost of debt is less than required rate of return
How can the firm raise capital?
• Bonds
• Preferred Stock
• Common Stock
• Each of these offers a rate of return to
investors.
• This return is a cost to the firm.
• “Cost of capital” actually refers to the
weighted cost of capital - a weighted
average cost of financing sources.
Cost of
Debt
Cost of Debt
Kd = kd (1 - T)
After-tax Before-tax Marginal
% cost of % cost of x - tax
Debt
=
Debt
1 rate
Kd = kd (1 - T)
D Dividend
kp = =
Po Price
Cost of Preferred Stock
• Recall:
D Dividend
kp = =
Po Price
D Dividend
kp = =
Po Price
D Dividend
kp = NPo = Net Price
Cost of Preferred Stock
• Recall:
kp = D = Dividend
Po Price
kp = D = Dividend
NPo Net Price
NPo = price - flotation costs!
Example: Cost of Preferred
D Dividend
kp = =Net Price
NPo
Cost of Preferred Stock
D Dividend
kp = =
NPo Net Price
8.00
= 74.00 =
Cost of Preferred Stock
D Dividend
kp = =
NPo Net Price
8.00
= 74.00 = 10.81%
Cost of Common Stock
• There are 2 sources of Common
Equity:
D1
kc = +g
Po
Cost of Internal Equity
1) Dividend Growth Model
D1
kc = +g
Po
D1
kc = +g
Po
kj = krf + β (k - k )
j m rf
Cost of External Equity
Cost of External Equity
D1
knc = NPo + g
Cost of External Equity
D1
knc = NPo + g
Capital
Source Cost Structure
debt 6% 20%
preferred 10% 10%
common 16% 70%
Weighted Cost of Capital
(20% debt, 10% preferred, 70% common)