Cost of Capital

Cost of Capital
5-1
What sources of long-term
capital do firms use?
Long-Term Capital
Long-Term Debt Preferred Stock Common Stock
Retained Earnings New Common Stock
5-2
Overall Cost of
Capital of the Firm
Cost of Capital is the required

rate of return on the various
types of financing. The overall
cost of capital is a weighted
average of the individual
required rates of return (costs).
5-3
Market Value of
Long-Term Financing
Type of Financing Mkt Val Weight

Long-Term Debt $ 35M 35%
Preferred Stock $ 15M 15%
Common Stock Equity $ 50M 50%
$ 100M 100%
5-4
Cost of Debt
Cost of Debt is the required rate
of return on investment of the
lenders of a company.
n
Ij + Pj
P0 =  (1 + kd)j
j =1
ki = kd ( 1 - T )
5-5
Determination of
the Cost of Debt
Assume that Basket Wonders (BW) has
$1,000 par value zero-coupon bonds
outstanding. BW bonds are currently
trading at $385.54 with 10 years to
maturity. BW tax bracket is 40%.
$0 + $1,000
$385.54 =
(1 + kd)10
5-6
Determination of
the Cost of Debt
(1 + kd)10 = $1,000 / $385.54
= 2.5938
(1 + kd) = (2.5938) (1/10)
= 1.1
kd = .1 or 10%
ki = 10% ( 1 - .40 )
ki = 6%
5-7
Cost of Preferred Stock
Cost of Preferred Stock is the

required rate of return on
investment of the preferred
shareholders of the company.
kP = D P / P 0
5-8
Determination of the
Cost of Preferred Stock
Assume that Basket Wonders (BW)
has preferred stock outstanding with
par value of $100, dividend per share
of $6.30, and a current market value of
$70 per share.
kP = $6.30 / $70
kP = 9%
5-9
Cost of Equity
Approaches
 Dividend Discount Model
 Capital-Asset Pricing
Model
 Before-Tax Cost of Debt
plus Risk Premium
5-10
Dividend Discount Model
The cost of equity capital,

capital ke, is
the discount rate that equates the
present value of all expected future
dividends with the current market
price of the stock.
D1 D2 D
P0 = + +...+
(1+ke)1 (1+ke)2 (1+ke) 
5-11
Constant Growth Model
The constant dividend growth

assumption reduces the model to:
ke = ( D1 / P0 ) + g
Assumes that dividends will grow

at the constant rate “g” forever.
5-12
 Po= D1/K-g
 K-g= D1/P0
 K= D1/P0+g
5-13
Cost of Equity Capital
Assume that Basket Wonders (BW) has
common stock outstanding with a current
market value of $64.80 per share, current
dividend of $3 per share, and a dividend
growth rate of 8% forever.
ke = ( D1 / P 0 ) + g
ke = ($3(1.08) / $64.80) + .08
5-14 ke = .05 + .08 = .13 or 13%

Capital Asset
Pricing Model
The cost of equity capital, ke, is
equated to the required rate of
return in market equilibrium. The
risk-return relationship is described
by the Security Market Line (SML).
ke = Rj = Rf + (Rm - Rf)j
5-15
Cost of Equity (CAPM)
Assume that Basket Wonders (BW) has a
company beta of 1.25. Research by Julie
Miller suggests that the risk-free rate is
4% and the expected return on the
market is 11.2%
ke = Rf + (Rm - Rf)j
= 4% + (11.2% - 4%)1.25
5-16 ke = 4% + 9% = 13%
Before-Tax Cost of Debt
Plus Risk Premium
The cost of equity capital, ke, is the
sum of the before-tax cost of debt
and a risk premium in expected
return for common stock over debt.
ke = kd + Risk Premium*
* Risk premium is not the same as CAPM risk

premium
5-17
Cost of Equity (kd + R.P.)
Assume that Basket Wonders (BW)
typically adds a 3% premium to the
before-tax cost of debt.
ke = kd + Risk Premium
= 10% + 3%
ke = 13%
5-18
Comparison of the
Cost of Equity Methods
Constant Growth Model 13%

Capital Asset Pricing Model 13%
Cost of Debt + Risk Premium 13%
Generally, the three methods
will not agree.
5-19
Weighted Average
Cost of Capital (WACC)
n
Cost of Capital = 
kx(Wx)
x=1
WACC = .35(6%) + .15(9%) +

.50(13%)
WACC = .021 + .0135 + .065
= .0995 or 9.95%
5-20
Calculating the weighted
average cost of capital
WACC = wdkd(1-T) + wpkp + wcks
 The w’s refer to the firm’s capital

structure weights.
 The k’s refer to the cost of each
component.
5-21
Flotation Cost
Flotation Costs are the costs

associated with issuing
securities such as underwriting,
legal, listing, and printing fees.
5-22
Book Value Weights
 Book Values are readily available
from the published records of the
firm.
 Firms set their capital structure
targets in terms of book values
rather than market values.
 Finally, the analysis of capital
structure in terms of debt equity ratio
is based on book value.
5-23
Market Value Weights
Use of market value weights for calculating the
cost of capital is more appealing than the use
of book value weights because:
1. Market values of securities closely

approximate the actual amount to be received
from their sale
2. Cost of the specific sources of finance which

constitute the capital structure of the firm are
calculated using market prices.
5-24
 There are practical difficulties in its use as
calculating the market value of securities may
present difficulties:
 particularly the market values of retained
earnings.
 Moreover, weights based on market values are
likely to fluctuate widely.
 While the book value is operationally convenient,
the market value basis is theoretically consistent
and sound, and therefore, a better indicator of a
firm’s true capital structure
5-25
Why is there a cost for
retained earnings?
 Earnings can be reinvested or paid out as
dividends.
 Investors could buy other securities, earn a return.
 If earnings are retained, there is an opportunity cost
(the return that stockholders could earn on
alternative investments of equal risk).
 Investors could buy similar stocks and earn.
 Firm could repurchase its own stock and earn.
5-26

Cost of Capital

Uploaded by

Copyright:

Available Formats

Cost of Capital

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Cost of Capital

Uploaded by

Copyright:

Available Formats

Cost of Capital

Long-Term Debt Preferred Stock Common Stock

Retained Earnings New Common Stock

Cost of Capital is the required

Type of Financing Mkt Val Weight

Cost of Preferred Stock is the

The cost of equity capital,

The constant dividend growth

Assumes that dividends will grow

5-14 ke = .05 + .08 = .13 or 13%

* Risk premium is not the same as CAPM risk

Constant Growth Model 13%

WACC = .35(6%) + .15(9%) +

 The w’s refer to the firm’s capital

Flotation Costs are the costs

1. Market values of securities closely

2. Cost of the specific sources of finance which

You might also like