Cost of Capital

Fundamental of FM is time value of money

Financial Management Decisions

Financing Investing Liquidity Dividend

Decision Decision Decision Decision

•Leverage
•Cost of capital
•Capital structure

SWM
 Cost of Capital

• For Investors, the rate of return on a

security is a benefit of investing.
• 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.
 How can the firm raise capital?
• Bonds/debentures
• Preferred Stock
• Common Stock
 Few things to know
• Face value
• Issue price
• Mkt price
• Flotation cost
• Redemption value
• Coupon rate
• INT & Pref. DIV is always on Face value
Cost of
Debt
Debentures can be
1.Perpetual
2.Redeemable
Important points
1.Interest
2.Maturity
3.Taxes
Factors affecting cost of debts
1.Risk free rate
2.Business risk
3.Financial risk
 Cost of Debt
For the issuing firm, the cost of debt is:
• the rate of return required by investors,
• Adjusted for premium and discount ,if any
• adjusted for flotation costs (any costs
associated with issuing new bonds), and
• adjusted for taxes.
 Example: Cost of Debt
• Prescott Corporation issues a 1,000
par, 20 year bond paying the market
rate of 10%. The bond will sell for par
since it pays the market rate, but
flotation costs amount to 50 per bond.
tax rate is 50%
• What is the pre-tax and after-tax cost
of debt for Prescott Corporation?
 Cost of Preferred Stock

• Finding the cost of preferred stock

is similar to finding the rate of
return, except that we have to
consider the flotation costs
associated with issuing preferred
stock.
 Cost of Preferred Stock
• Factors affecting kp-
• Fixed dividend rate
• Issue expenses like underwriting , commission,
etc.
• Discount/premium on issue /redemption of
shares
Type of pref. share
• Perpetual
• Redeemable
 Cost of perpetual Preferred Stock
Rate of return

D Dividend
kp =
Po Price
 Cost of Preferred Stock
• Recall:

D Dividend
kp = =
Po Price

• From the firm’s point of view:

 Cost of Preferred Stock
• Rate of return :

D Dividend
kp = =
Po Price

• From the firm’s point of view:

D Dividend
kp = NPo = Net Price
 Cost of Preferred Stock
• Recall:

D Dividend
kp = =
Po Price

• From the firm’s point of view:

D Dividend
kp = NPo = Net Price
NPo = price - flotation costs!
 Example: Cost of Preferred

• If Prescott Corporation issues

preferred stock, it will pay a
dividend of 8 per year and should
be valued at 75 per share. If
flotation costs amount to 1 per
share, what is the cost of preferred
stock for Prescott?
Cost of Preferred Stock
 Cost of Preferred Stock

D Dividend
kp = =
NPo Net Price
 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 redeemable pref. share
 Cost of Common Stock

There are two sources of Common Equity:

1) Internal common equity (retained

earnings).

2) External common equity (new common

stock issue).

Do these two sources have the same cost?

 Cost of Internal Equity
• Since the stockholders own the firm’s
retained earnings, the cost is simply
the stockholders’ required rate of
return.
• Why?
• If managers are investing stockholders’
funds, stockholders will expect to earn
an acceptable rate of return.
Cost of Internal Equity
 Cost of Internal Equity

1) Dividend Growth Model

 Cost of Internal Equity

1) Dividend Growth Model

D1
kc = +g
Po
 Cost of Internal Equity

1) Dividend Growth Model

D1
kc = +g
Po

2) Capital Asset Pricing Model (CAPM)

 Cost of Internal Equity

1) Dividend Growth Model

D1
kc = +g
Po

2) Capital Asset Pricing Model (CAPM)

kj = krf + j (km - krf )

Cost of External Equity
 Cost of External Equity

Dividend Growth Model

 Cost of External Equity

Dividend Growth Model

D1
knc = NPo+ g
 Cost of External Equity

Dividend Growth Model

D1
knc = NPo+ g

Net proceeds to the firm

after flotation costs!
 Weighted Cost of Capital

• The weighted cost of capital is just the

weighted average cost of all of the
financing sources.
 Weighted Cost of Capital

Capital
Source Cost Structure
debt 6% 20%
preferred 10% 10%
common 16% 70%
 Weighted Cost of Capital
(20% debt, 10% preferred, 70% common)

Weighted cost of capital =

.20 (6%) + .10 (10%) + .70 (16%)
= 13.4%
 WACC
• Book value v/s market
value