Corporate Finance

FINC 504

Tutorial 1
Ch. 9: Cost of Capital

Dr. Hadeer Mounir Winter 2022

 Course Information
 Course Assessment:
 Final Exam: 40% (Comprehensive exam)
 Midterm Exam: 30%
 Course Work: 30%
Assessment Grade
Final Exam 40%
Mid-term Exam 30%
Course Work:
• Quizzes 15%
(Best two Quizzes out of three Quizzes)
• Assignments 15%
(Best two assignments out of three assignments)

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 Course Information
Instructor:
• Dr. Hadeer Mounir
• Assistant Professor of Finance, Department of Accounting and Finance
• Instructor Email: hadeer.ali@guc.edu.eg
• Instructor Office Hours: Thursday 4th Slot
• Office number: B3-112

Teaching Assistants:
• Mrs. Radwa Farouk: radwa.farouk@guc.edu.eg
• Ms. Nada Khaled Mostafa: nada.mostafa-ali@guc.edu.eg
• Ms. Rana Samer: rana.massoud@guc.edu.eg

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Course outline
Topic covered Lecture Chapters
No.
Cost of capital (1) 1 Ch. 9
Cost of capital (2) 2 Ch. 9
Capital budgeting techniques (1) 3 Ch. 10
Capital budgeting techniques (2) 4 Ch. 10
Risk and refinements in capital budgeting (1) 5 Ch. 12
Risk and refinements in capital budgeting (2) 6 Ch. 12
Mid-term Exam
Leverage and capital structure (1) 7 Ch. 13
Leverage and capital structure (2) 8 Ch.13
Payout policy (1) 9 Ch.14
Payout policy (2) 10 Ch.14
Working Capital 11 Ch.15

Final Exam Comprehensive

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 Course Information

Textbook:
Gitman and Zutter, Principles of Managerial Finance,
13th or 14th edition, Pearson.

 Lecture Content and Notes-Information from lecture is

important.
 Tutorial Sheets
 Relevant references and articles will be determined per topic
if required.
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Topics Covered

1- Overview of the cost of the capital.

2- Determine cost of long term debt.
3- Determine cost of preferred stock.
4- Determine cost of Common stock (calculate cost of new issue of common stock
& cost of retained earnings).
5- Calculate the weighted average cost of capital (WACC).
 Overview of the Cost of Capital
• The goal of the firm is to maximize shareholders' wealth by investing in projects
that add value to the firm.

• The cost of capital represents the firm’s cost of financing, and is the minimum
rate of return that a project must earn to increase firm value.

• Financial managers are ethically bound to only invest in projects that they
expect to exceed the cost of capital.

• The cost of the capital 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.
Overview of the Cost of Capital
1. Cost of long term Debt
o The pretax cost of debt is the financing cost associated with new funds through long-term borrowing.
Typically, the funds are raised through the sale of corporate bonds.

OR

The pretax cost of debt can also be defined as the rate of return the firm must pay on new borrowing.

o Net proceeds are the funds actually received by the firm from the sale of a security.

Bonds can be sold at: 1) Par value  Par value = bond value at market
2) At discount  Par value > bond value at market
3) At premium  Par value < bond value at market

o 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.
Cost of Long-Term Debt (cont.)
• Calculating the before-tax cost of debt:

• Where:
I=annual interest in dollars
I= Par value * coupon rate
Nd= net proceeds from the sale of debt (bond)
Nd= bond value at the market – flotation costs

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.
Cost of Long-Term Debt: After-Tax Cost of Debt

• The interest payments paid to bondholders are tax deductible 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)
Problem One
Currently, Warren Industries can sell 15-year, $1,000-par-value bonds paying annual interest at a 12% coupon rate. As a result
of current interest rates, the bonds can be sold for $1,010 each; flotation costs of $30 per bond will be incurred in this process.
The firm is in the 40% tax bracket.
Given:
N = 15 years Par value= $1,000
Coupon rate = 12% Bond value at the market = $1,010 (sold at premium)
Flotation Costs = $30 Tax rate = 40%

a. Find the net proceeds from sale of the bond, Nd.

Nd = bond value at the market – flotation costs

Nd = 1,010 - 30 = $980
Problem One cont.
Given:
N= 15 years Par value= $1,000
Coupon rate = 12% Bond value at the market = $1,010 (sold at premium)
Flotation Costs= $30 Tax rate = 40%
b. Use the approximation formula to estimate the before-tax and after-tax costs of debt

I = Par value * coupon rate = 1,000 * 12% = $120

Nd = 980
c. Calculate the tax shield value in dollar.

A Tax Shield is an allowable deduction from taxable income that results

in a reduction of taxes owed.

Tax shield = I * Par value * tax rate

Tax shield = 12% * 1,000 * 40% = $48.
Problem Two
PNC Mining Corporation can sell a 20-year, $1,000 par value, 9 percent bond for $980. A flotation cost of 2
percent of the face value would be required for debt issuance in addition to a discount of $20. Calculate the after
tax cost of debt for PNC Corporation if the marginal tax rate is 40%.
Given:
N= 20 years Par value= $1,000
Coupon rate = 9% Bond value at the market = $980 (sold at discount)
Flotation Costs= 2%*1000= $20 Tax rate = 40%

I = 1,000 * 9% = $90
Nd = 980 – 20 = 960
Pre-tax cost of Debt = (90+(1000-960)/20) / ((1000+960)/2) = 9.4%

After Tax cost of Debt = 9.4% * (1 - 40%) = 5.6%

Problem Three
Gronseth Drywall Systems Inc. is in discussions with its investment bankers regarding the issuance of new bonds. The
investment banker has informed the firm that different maturities will carry different coupon rates and sell at different prices.
The firm must choose among several alternatives to finance a new project that has an expected return 3.85% . In each case, the
bonds will have a $1,000 par value and flotation costs will be $30 per bond. The company is taxed at a rate of 40%.

a. Calculate the after-tax cost of financing of each of the following alternatives.

Alternative Coupon Rate Time to Maturity Premium or

(Years) discount
B 7% 5 50
C 6% 7 Par
D 5% 10 -75
For alternative B:

I = 1,000 * 7% = $0

Nd = (1,000 + 50) – 30 = $1,020

Problem Three Cont.
Alternative Coupon Rate Time to Maturity Premium or
(Years) discount
B 7% 5 50
C 6% 7 Par
D 5% 10 -75

For alternative C:

I = 1,000 * 6% = $60

Nd = 1,000 – 30 = $970

For alternative D:

I = 1,000 * 5% = $50

Nd = (1000 – 75) – 30 = $895

b. As a financial advisor, which alternative will you recommend to finance the new project?
Only alternative D is suitable to finance the new project ( Cost 3.83% < Return 3.85%)
Cost of Capital:
2. Cost of Preferred Stock
• Preferred stock gives preferred stockholders the right to receive their stated dividends before the
firm can distribute any earnings to common stockholders.

• 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)
Dp can be given in the problem in dollar amount. If not given in dollar amount, 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.
 Problem four
MM Systems has just issued preferred stock. The stock has an 8% annual dividend and a $90 par value and was sold at discount
of $5 per share. In addition, flotation costs of $5 per share must be paid.
Given:
Dividends = 8%  Dividends in dollar amount = % of dividends * Par value = 8% * 90 = $7.2
Par value = 90
Discount = 5
Value of the stock at the market = 90 - 5 = 85
Flotation costs = 5

a. Calculate the Np.

Np= Value of the stock in the market – Flotation costs
Np= 85 – 5 = $80

b. Calculate the cost of the preferred stock.

R = Dp / Np
R = 7.2 / 80 = 9%
Cost of Capital:
3. Cost of Common stock
There are two forms of common stock financing:
1. Retained earnings (Existing Common stock)
2. New issues of common stock (New Common Stock)

Two Models are used to calculate the cost of common stock:

1. Gordon Model (Calculates both the cost of existing common stock and the cost of new
common stock)
2. Capital Asset Pricing Model (Calculates only the cost of existing Common Stock)

When to use each model?

Depends on the problem, as the information given for each model will be completely different.
Cost of Common stock using Gordon Model
Used to calculate both the cost of existing common stock and the cost of new common stock.
If existing common stock:

Where:
Rn: Cost of new Common stock
D1= Next Year Dividends (Expected Dividends)  D1= D0 (1+G)
P0 = Current market Price of the stock
G= Growth rate in dividends
G= (𝐧𝐞𝐰𝐞𝐬𝐭 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝𝐬ൗoldest Dividends )𝟏/𝐧 -1
N.B.
N= number of periods
Or G= ROE*(1-PAYOUT RATIO)
 Problem Five
ABC Corp. wishes to measures its cost of common stock equity. The firm’s stock is currently selling for $70.
The firm expects to pay a $5 dividend at the end of the year. The firm has a 3% constant growth of dividends.
Required: Using the Gordon Growth Model, determine the cost of common stock equity.

P0 = 70 D1 = 5 G = 0.03

r = ($5 / $70) + 0.03

= 10.14%
Thank You 