Corporate Finance FINC 504

Lecture 1

Chapter 9 Cost of Capital (1)

Dr. Hadeer Mounir

Hadeer.ali@guc.edu.eg 9-1
Learning Goals

Text Book: Principles of Managerial Finance, Gitman and

Zutter, 13th o r 1 4 t h edition, Pearson.

1. Overview of the Cost of Capital.

2. Understand the basic concept and sources of capital associated

with the cost of capital.

3. Determine the cost of long-term debt, and explain why the after
tax cost of debt is the relevant cost of debt.

4. Determine cost of preferred stock.

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What is corporate finance?

• Every decision that a business makes has financial implications, and any decision
which affects the finances of a business is a corporate finance decision.

• Defined broadly, everything that a business does fits under the rubric of corporate
finance.

• Corporate Finance mainly focuses on investment, financing and dividend

principles/decisions.

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Corporate Finance in one page

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Corporate Finance in one page

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Overview of the Cost of Capital

• The goal of the firm is to maximize shareholders' wealth (Stock Price).

• One way of doing so is by investing in risky projects (High risk, High Return) that add
value to the firm.

• Firms need funds (Capital) to finance their projects. The cost of capital represents the
firm’s cost of financing

• The cost of capital is the minimum rate of return that a project must earn to maintain
(keep) the market value of the stock. It acts as a link between the firm’s long-term
investment decisions and the wealth of the owners as determined by investors in the
marketplace.

• It is the “magic number” that is used to decide whether a proposed investment will
increase or decrease the firm’s stock price. It is the rate of return that financial
managers use to evaluate all possible investment opportunities to determine which
ones to invest in on behalf of the firm’s shareholders.
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Overview of the Cost of Capital

• Financial managers are ethically bound to invest in projects that their returns are
expected to exceed the cost of capital to increase share value.

• Investments with a rate of return above the cost of capital will increase the
value of the firm.
• Projects with a rate of return below the cost of capital will decrease firm
value (Reject these Projects).
– The cost of capital reflects the entirety of the firm’s financing activities.
• Most firms attempt to maintain an optimal mix of debt and equity financing.
– To capture all of the relevant financing costs, assuming some desired mix
of financing, we need to look at the overall cost of capital rather than
just the cost of any single source of financing.

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Overview of the Cost of Capital:
Sources of Long-Term Capital
There are four basic sources of long-term capital for firms: long-term debt,
preferred stock, common stock, and retained earnings. All entries on the right-hand side
of the balance sheet, other than current liabilities, represent these sources:

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 Cost of Long-Term Debt
The cost of long-term debt is the financing cost associated with new funds
raised through long-term borrowing. Typically, the funds are raised through the
sale of corporate bonds.

• A bond is a long-term debt instrument used by firms and governments to

raise large sums of money.

• Corporate Bonds indicate that a corporation has borrowed a certain

amount of money and promises to repay it in the future under clearly
defined terms.

• It pays the bondholder a specified amount of periodic interest rate (called

coupon interest rate) over a specified period of time.
Cost of Long-Term Debt
The cost of long-term debt is the financing cost associated with new funds raised
through long-term borrowing. Typically, the funds are raised through the sale of
corporate bonds.
• By approximating the cost: (Before-Tax Cost of Debt)

• Where I = annual interest in dollars (%*Par value)

$1000 = Par Value
Nd = net proceeds from the sale of debt (bond)
n = number of years to the bond’s maturity
• The first part of the numerator of the equation represents the annual interest, and the second part
represents the amortization of any discount or premium;
• The denominator represents the average amount borrowed. That is, the cost of debt is the
interest payments and discount or premium amount over the average debt.
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Cost of Long-Term Debt
• Net proceeds are the funds actually received by the firm from the sale of a security.
The Total proceeds are reduced by the flotation costs.

Net Proceeds = bond value at the market – flotation costs

If Bond value (B0) = the par value ----- Bond Sold at Par
If Bond value (B0) > the par value ----- Bond Sold at Premium
If Bond value (B0) < the par value ----- Bond Sold at Discount

• Flotation costs are the total costs of issuing and selling a security.
• They include two components:
1. Underwriting costs—compensation earned by investment bankers for
selling the security.
2. Administrative costs—issuer expenses such as legal, accounting, and
printing.
• The before-tax cost of debt, rd, is simply the rate of return the firm must pay on
new borrowing.
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Cost of Long-Term Debt:
After-Tax Cost of Debt
• The interest payments paid to bondholders are tax -deductable for the
firm, so the interest expense on debt reduces the firm’s taxable income and,
therefore, the firm’s tax liability.

• The after-tax cost of debt, ri, can be found by multiplying the before-tax cost, rd,
by 1 minus the tax rate, T, as stated in the following equation:

ri = rd  (1 – T)

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Cost of Long-Term Debt
Duchess Corporation, a major hardware manufacturer, is contemplating
selling $10 million worth of 20-year, 9% coupon bonds with a par value of
$1,000. Because current market interest rates are greater than 9%, the firm
must sell the bonds at $980. Flotation costs are 2%. Duchess Corporation
has a 40% tax rate.

Calculate the After-tax Cost of Debt

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Cost of Long-Term Debt
Approximating the cost
I = 9% * $1000 = $90
Flotation Costs = 2%*$1000 = $20
The net proceeds = Market Value – Flotation Cost =$980–$20 =$960
or N = Par Value – discount – Flotation = 1000 – 20 – 20 = 960

After-Tax Cost of Debt = ri = rd *(1 – T) = [9.4% *(1-0.40)] = 5.6%

Typically, the cost of long-term debt for a given firm is less than the cost of
preferred or common stock, partly because of the tax deductibility (tax advantage)
of interest. 9-14
 Exercise on cost of
debt
Problem. Cost of debt using the approximation formula

For the following $1,000-par value Bond and flotation costs will be $30 per
bond, assuming annual interest payment and a 40% tax rate, calculate the
after-tax cost of financing.

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Exercise on cost of
debt
For the following $1,000-par value Bond and flotation costs will be $30 per bond, assuming
annual interest payment and a 40% tax rate, calculate the after-tax cost of financing.

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Cost of Preferred Stock

• Preferred stock gives preferred stockholders the right to receive

their stated (fixed) dividends before the firm can distribute any
earnings to common stockholders.
– Most preferred stock dividends are stated as a dollar amount.
– Sometimes preferred stock dividends are stated as an annual
percentage rate, which represents the percentage of the
stock’s par, or face, value that equals the annual dividend.

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Cost of Preferred Stock
• The cost of preferred stock, rp, is the ratio of the preferred stock dividend to
the firm’s net proceeds from the sale of preferred stock.

• Where:
Rp = Cost of preferred stock
Dp= Dividends paid to preferred stock holders (must be in dollar amount)
If Dp given as %, then, Dp = Par value of stock * % of dividends
Np= The net proceeds or the funds received from the sale of the stock.
Np= Value of the stock in the market – Flotation costs
**A stock can be sold at par value or at discount or at premium. 9-18
Cost of Preferred Stock
Duchess Corporation is contemplating the issuance of a 10% preferred stock that is
expected to sell for its $87-per share value. The cost of issuing and selling the
stock is expected to be $5 per share.

Calculate the Cost of Preferred Stock.

The dividend is 10% x $87 = $8.70

The net proceeds price (Np) is $87 – $5 = $82
rP = $8.70/$82 = 10.6%

The cost of Duchess’s preferred stock (10.6%) is much greater than the cost of its long-term
debt (5.6%). This difference exists both because the cost of long-term debt (the interest)
is tax deductible and because preferred stock is riskier than long-term debt.
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Exercise on prefered stocks

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Exercise on prefered stocks

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Cost of Common Stock
• The cost of common stock is the return required on the stock
by investors in the marketplace.
• There are two forms of common stock financing:

1. retained earnings (treated as Existing Common Stocks)

2. new issues of common stock

• The cost of common stock equity, rs , is the rate at which

investors discount the expected dividends of the firm to determine
its share value.

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Cost of Common Stock

Two Models are used to measure the cost of common stock equity.

• The Constant-Growth (Gordon) Model

(used for Both the cost of existing and new common stock)

• The Capital Asset Pricing Model (CAPM)

(used for only the cost of existing common Stock).

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Cost of Common Stock

The Constant-Growth (Gordon)Model

Assumes that the value of a share of stock equals the present value of all future dividends
(assumed to grow at a constant rate) that it is expected to provide over an infinite time
horizon.

• Where
P0=value of common stock
D1=per-share dividend expected at the end of coming year 1
rs = required return on common stock
g=constant rate of growth in dividends

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Cost of Common Stock (Existing Shares)

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Cost of Common Stock (Existing Shares)
Duchess Corporation wishes to determine its cost of common stock equity, rs. The
market price, P0, of its common stock is $50 per share. The firm expects to pay a
dividend, D1, of $4 at the end of the coming year, 2013. The dividends paid on the
outstanding stock over the past 6 years (2007–2012) were as follows:

Calculate the Cost of Common Stock

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Cost of Common Stock (Existing Shares)

g = ( (3.8/2.97)^ 1/5 ) – 1 = 5.05%

Growth rate (g) can also be calculated as follows:

g= ROE*Retention ratio
g= ROE*(1-PAYOUT RATIO)

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Cost of Common Stock:
Cost of Retained Earnings
The cost of retained earnings, rr, is the same as the cost of an equivalent fully
subscribed issue of additional common stock, which is equal to the cost of
common stock equity, rs.

rr = rs

The cost of retained earnings for Duchess Corporation was actually calculated
in the preceding examples: It is equal to the cost of common stock equity.
Thus rr equals 13.0%.

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To be continued next
lecture

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