Chapter Four

Cost of capital, valuation of Bonds and Shares

Contents
oValuation of financial asset
oKey features of bonds
oPricing of bonds
oBond rating
oValuation of share
oCost of capital
oCapital asset pricing model
 Introduction
• The concept of cost of capital has its root in the items on the right hand side-of balance
sheet, which includes various types of debt, preferred stock, common stock and retained
earnings.
• These items are called the Capital components.
• The concept of cost of capital is based on the assumption that the core goal of profit-
seeking business firms is to maximize the wealth of shareholders.
• Business firms raise the needed fund from internal sources and external sources.
• Retained profit is the main source of internal fund.
• External fund is raised either by the issue of shares or by issue of debt or by both means.
• The fund collected by any means is not cost free.
• Interest is to be paid on the fund obtained as debt and dividend is to be paid on
the fund collected through the issue of shares.
• The average cost rate of different sources of fund is known as cost of capital.
• Any increase in total assets must be financed by an increase in one or more of
these capital components.
• The cost of capital of each source of capital is known as the specific or
component cost of capital.
• The combined cost of all sources of capital is called weighted average cost of
capital (WACC).
 Cost of Capital

• cost of capital is the is the minimum rate of return that the firm must earn on its
invested capital.

• It is a break-even point at which the current market value of the firm is maintained.
If this cots of capital is not earned the market value of the firm will decline.

• It is the average cost of various sources of finance used by a firm. I.e. The minimum
rate of return required by suppliers of the firm's capital.
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 Importance of Cost of Capital
• Decision on capital budgeting:

It is used to measure the investment proposal to choose a project which satisfies return
on investment.

• Designing Capital structure:

The proportion of debt and equity is called capital structure. The proportion which can minimize
the cost of capital and maximize the value of the firm is called optimal capital structure. Cost of
capital helps to design the capital structure considering the cost of each sources of financing,
investor's expectation, effect of tax and potentiality of growth.
 Cost of Debt
• This is the rate of return required by suppliers of debt.
INT
kd  i 
• Debt Issued at Par B0

• Tax adjustment After-tax cost of debt  kd (1  T )

Rd= 𝑹𝑹 + 𝑰𝑷 + 𝑫𝑷 + 𝑴𝑷 + 𝑳𝑷 + 𝑬𝑷 𝑤ℎ𝑒𝑟𝑒
• Rd = appropriate discount r
• RR = the real rate of interest , which is the reward for not consuming and for lending to other users.
• IP = inflation premium which is the compensation for the expected decline in purchasing power
• DP = the default risk premium, which is the reward for taking on the risk of default in the case
• MP = the maturity premium, which is the compensation for lending money for long periods of time
• LP = liquidity premium, which is the reward for investing in an asset that may not be readily converted to
cash at a fair market value.
• EP = Exchange rate risk , which is the reward for investing in an asset that may not be readily converted to cash
at a fair market
 Cost of Equity Capital
•.
PDIV
kp 
P0

DIV1 EPS1
ke   (since g  0)
P0 P0

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Weighted Average Cost of Capital Vs. Specific Costs of Capital

• A simple practical approach to incorporate risk differences in projects is to adjust the

firm’s WACC, and use the adjusted WACC to evaluate the investment project.

• The cost of capital of each source of capital is known as component, or specific, cost of
capital.

• The overall cost is also called the weighted average cost of capital (WACC).

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 General Valuation
The following comments are valid for all kind of assets

oBook Value: Stated value from the firm’s Balance Sheet

oMarket Value: The price for the asset at any given time--determined by supply and
demand in the marketplace. Asset can be bought or sold at this price.
oIntrinsic Value: Present value of the asset’s expected cash flow; Investor estimates cash
flows; Investor determines required rate based on risk of asset and market conditions.
oIn a perfect market where all investors have the same expectations & risk aversion:
MarketValue = IntrinsicValue
 Key Features of a Bond
• Par value (“Principal”) is the amount borrowed by the issuer and is paid back at maturity. Sometimes people call this the
“face value”.

• Coupon interest rate is stated interest rate paid by the issuer. Multiply by par value to get dollar payment of interest.
Usually this is a fixed rate that doesn’t change. Exception:Treasury Inflation-Protected bonds.

• Issue date is the date when the bond was issued.

• Maturity date is the date when the par value (“Principal”) of the bond must be repaid.

• “Maturity” is a term sometimes used to describe the amount of time between now and the maturity date

• Yield to maturity - rate of return earned on a bond held until maturity (also called the “promised yield”, “opportunity
cost” and “discount rate”)
 Bond with Maturity
Bond value = Present value of interest + Present value of maturity value:
n
INTt Bn
B0   
t 1 (1  kd ) (1  kd ) n
t

• Suppose that a 10 per cent Rs 1,000 bond will pay Rs 100 annual interest into
perpetuity. What would be its value of the bond if the market yield or interest rate
were 15 per cent?

• The value of the bond is determined as follows: INT 100

B0    Rs 667
kd 0.15
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 Bonds issued with a call provision

• Allows issuer to refund the bond issue. The issuer wants to do this if
interest rates in the economy decline (helps the issuer, but hurts the
investor).
• Borrowers are willing to pay a higher yield, and lenders require a higher
yield, for callable bonds.
• Treasury bonds do not have call provisions.
• Used by some corporations. Most common use is by corporations with
poorer credit ratings (higher default risk).
• Bottom line: all else equal, if bond has call provision, PV is lower and YTM
is higher. And we need to calculate the Yield to Call (YTC).
 Price of bonds issued with a call provision
•.

INT INT Call Price

VB   ...  
(1  rd )1
(1  rd ) N
(1  rd )N
 Yield to maturity
It can be broken down into 2 components: “current yield” and “capital gains yield”

•. Annual coupon payment

Current yi eld (CY) 
Current price

Change in price
Capital gains yield (CGY) 
Beginning price

 Expected  Expected
Expected total return  YTM      
 CY   CGY 
 Evaluating default risk: Bond ratings

Investment Grade Junk Bonds

Moody’s Aaa Aa A Baa Ba B Caa C

S&P AAA AA A BBB BB B CCC C

• Default risk is the risk that a company will default on its promised obligations to
bondholders.
• Bond ratings are designed to reflect the probability of a bond issue going into
default.
Moody’s and Standard & Poor’s regularly monitor issuers’ financial conditions and assign a
rating to the debt. Bond rating shows the relative probability of default. It is similar to a
personal credit report

AAA Top Quality

Investment AA
Grade A
BBB
BB
B
Junk CCC
CC Low Quality
C No interest being paid
D Currently in Default
 Valuation of preferred stock

Vp = Dp/Kp
Where
Vp = the preferred stock price
Dp = the preferred dividend and
Kp = the required return on the stock
 Valuation of common stock

Facts about common stock

• Represents ownership
• Ownership implies control
• Stockholders elect directors
• Directors elect management
• Management’s goal: Maximize the stock price
 Different approaches for valuing common stock

• Dividend growth model

• Corporate value model

• Using the multiples of comparable firms

 Dividend growth model

Value of a stock is the present value of the future dividends expected to be generated by
the stock.

^ D1 D2 D3 D
P0     ... 
1 2
(1  k s ) (1  k s ) (1  k s ) 3
(1  k s ) 
Constant growth stock
• A stock whose dividends are expected to grow forever at
a constant rate, g.

D1 = D0 (1+g)1
D2 = D0 (1+g)2
Dt = D0 (1+g)t

• If g is constant, the dividend growth formula converges

to:
^ D 0 (1  g) D1
P0  
ks - g ks - g
Future dividends and their present values

$ t
D t  D0 ( 1  g )

Dt
0.25
PVD t  t
(1  k )

P0   PVD t
0 Years (t)
What happens if g > ks?
• If g > ks, the constant growth formula leads to a negative stock price, which
does not make sense.
• The constant growth model can only be used if:
• ks > g
• g is expected to be constant forever
Corporate value model
• Also called the free cash flow method. Suggests the value of the entire firm
equals the present value of the firm’s free cash flows.

• Remember, free cash flow is the firm’s after-tax operating income less the net
capital investment
• FCF = NOPAT – Net capital investment
Applying the corporate value model

• Find the market value (MV) of the firm.

• Find PV of firm’s future FCFs
• Subtract MV of firm’s debt and preferred stock to get MV of common stock.
• MV of = MV of – MV of debt and
common stock firm preferred
• Divide MV of common stock by the number of shares outstanding to get
intrinsic stock price (value).
• P0 = MV of common stock / # of shares
Issues regarding the corporate value model

• Often preferred to the dividend growth model, especially when considering number
of firms that don’t pay dividends or when dividends are hard to forecast.

• Similar to dividend growth model, assumes at some point free cash flow will grow at
a constant rate.

• Terminal value (TVn) represents value of firm at the point that growth becomes
constant.
 What is market equilibrium?
• In equilibrium, stock prices are stable and there is no general tendency for
people to buy versus to sell.
• In equilibrium, expected returns must equal required returns.
• Expected returns are obtained by estimating dividends and expected capital
gains.
• Required returns are obtained by estimating risk and applying the CAPM.

^
D1
ks  g  k s  k RF  (k M  k RF )
P0