Ch. 9 Cost of Capital PDF

Chapter 11
The Cost of
Capital
Copyright © 2009 Pearson Prentice Hall. All rights reserved.
Learning Goals
1. Menjelaskan overview of cost of capital

2. Menghitung cost of long-term debt
3. Menghitung cost of preferred stock
4. Menghitung cost of common stock equity
5. Menghitung cost of retained earnings
6. Menghitung cost of new issues of common stock
7. Menghitung Weighted average cost of capital
(WACC)
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-2
2
1. An Overview of the Cost of Capital
• The cost of capital 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.
• Formally, the cost of capital is the rate of return that a
firm must earn on the projects in which it invests to
maintain the market value of its stock.
Some Key Assumptions
• Business Risk—the risk to the firm of being unable to cover

operating costs—is assumed to be unchanged. This means that
the acceptance of a given project does not affect the firm’s
ability to meet operating costs.
• Financial Risk—the risk to the firm of being unable to cover
required financial obligations—is assumed to be unchanged.
This means that the projects are financed in such a way that the
firm’s ability to meet financing costs is unchanged.
• After-tax costs are considered relevant—the cost of capital is
measured on an after-tax basis.
4
1.1 The Basic Concept
• Why do we need to determine a company’s overall

“weighted average cost of capital?”
Assume the ABC company has the following investment
opportunity: (Investment A)
- Initial Investment = $100,000
- Useful Life = 20 years
- Expected return = 7%
- Issued bonds, Debt = 6%
Given the above information, a firm’s financial manager
would be inclined to accept and undertake the investment.
1.1 The Basic Concept (cont.)
• Why do we need to determine a company’s overall

“weighted average cost of capital?”
Imagine now that only one week later, the firm has another
available investment opportunity (Investment B)
- Initial Investment = $100,000
- Useful Life = 20 years
- Expected return = 12%
- Least cost source of financing, Equity = 14%
Given the above information, the firm would reject this
second, yet clearly more desirable investment opportunity.
6
1.1 The Basic Concept (cont.)
• Why do we need to determine a company’s overall “weighted

average cost of capital?”
• As the above simple example clearly illustrates, using this
piecemeal approach to evaluate investment opportunities is
clearly not in the best interest of the firm’s shareholders.
• Over the long haul, the firm must undertake investments that
maximize firm value.
• This can only be achieved if it undertakes projects that provide
returns in excess of the firm’s overall weighted average cost of
financing (or WACC).
1.2 Sources of Long-Term Capital
The Firm’s Capital Structure

Ada 4 sumber
utama modal
jangka Panjang
bagi
perusahaan:
1. Long term
debt
2. Preferred
stock
3. Common
stock
4. Retained
earning
8
2. The Cost of Long-Term Debt
• The financing cost associated with new funds raised through

long-term borrowing (sale of corporate bonds).
• The pretax cost of debt is equal to the the yield-to-maturity on
the firm’s debt adjusted for flotation costs.
• Recall that a bond’s yield-to-maturity depends upon a number
of factors including the bond’s coupon rate, maturity date, par
value, current market conditions, and selling price.
• After obtaining the bond’s yield, a simple adjustment must be
made to account for the fact that interest is a tax-deductible
expense.
• This will have the effect of reducing the cost of debt.
2. The Cost of Long-Term Debt (cont.)
Net Proceeds are the funds actually received by

the firm from the sale of security.
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% or $20. The net proceeds to
the firm for each bond is therefore $960 ($980 - $20).
10
• Before-Tax Cost of Debt, rd, is the rate of

return the firm must pay on new borrowing.
• The before-tax cost of debt can be calculated in
any one of three ways:
– Using market quotations
– Calculating the cost
– Approximating the cost
11
• Before-Tax Cost of Debt – Using Market

Quotations
– When the net proceeds from the sale of a bond equal
its par value, the before-tax cost equals the coupon
interest rate.
– A second quotation that is sometimes used is the
yield-to-maturity (YTM) on a similar risk bond.
12
• Before-Tax Cost of Debt – Calculating the

Cost
– This approach finds the before-tax cost of debt by
calculating the internal rate of return (IRR).
– As discussed in earlier in the text, YTM can be
calculated using: (a) trial and error, (b) a financial
calculator, (c) a spreadsheet or (d) Approximating
the Cost
13
• Before-Tax Cost of Debt – Calculating the Cost

(Approximating the Cost)
In the preceding example, $960 were the net proceeds of a 20-
year bond with a $1,000 par value and 9% coupon interest rate.
The before-tax cost of debt, rd, can be approximated by:
14
• After-tax Cost Of Debt
The interest payment s paid to bond-holders are 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.
Find the after-tax cost of debt for Duchess assuming it has a

40% tax rate:
ri = 9.4% (1-.40) = 5.6%
This suggests that the after-tax cost of raising debt capital for
Duchess is 5.6%.
15
3. The Cost of Preferred Stock
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
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. The dividend is $8.70 (10% x $87). The net
proceeds price (Np) is $82 ($87 - $5).
rP = DP/Np = $8.70/$82 = 10.6%
16
4. The Cost of Common Stock
• There are two forms of common stock financing: retained

earnings and new issues of common stock.
• In addition, there are two different ways to estimate the cost of
common equity: any form of the dividend valuation model, and
the capital asset pricing model (CAPM).
• The dividend valuation models are based on the premise that the
value of a share of stock is based on the present value of all
future dividends.
17
4. The Cost of Common Stock (cont.)
• 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.
• Using the constant growth model, we
rS = (D1/P0) + g
P0 = (D1) / (rS - g)
• We can also estimate the cost of common equity using
the CAPM:
rs = RF + [β × (rm - RF)]
18
• Cost of common stock equity, (rs ) – Constant

Dividend Growth Model
rs = D1/P0 + g
For example, 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 expects to pay a dividend, D1, of $4 at the end
of the coming year, 2016. expects dividends to grow at 5% .
rS = ($4/$50) + 0,05 = 0,130 or 13,0%.
19
• Cost of common stock equity, (rs ) – Capital Asset

Pricing Model (CAPM)
rs = RF + [β × (rm - RF)]
For example, Duchess Corporation wishes to calculate ist cost of

common stock equity, rs, by using the CAPM. The risk-free rate,
Rf, equals 7%; the firm’s beta, β, equal 1,5; and the market return,
rm, equals 11%. The firm’s cost of common stock equity, rs , to be:
rs = 7,0% + [1,5 × (11,0% - 7%)] = 7,0% + 6,0% = 13%
20
• Cost of Retained Earnings (rr)

Cost of Retained Earnings, rr , to the firm is equal to
the cost of common stock equity, rs .
The cost of retained earning 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%
21
• Cost of new issues of common stock (rn)

– Constant Dividend Growth Model
rn = = D1/Nn + g
In the preceding example, we found Duchess Corporation’s

cost of common stock equity, rs to be 13%, using the
following value: an expected dividend, D1, of $4, a current
market price, P0, of $50 ; and an expected growth rate of
dividends, g, of 5% .
22
To determine ist cost of new common stock, rn, Duchess

Corporation’s has estimated that on average, new shares can be sold
for $47. The $3-per-share underpricing is due to the competitive
nature of the market. Flotation costs of $2,50 per share would be
paid to issue and sell the new share. The total underpricing and
floation costs per share are therefore $5,50. Expected net proceed of
$44,50 ($50,00 - $5,50).
D1 = $4
Nn = $44,50
g = 5%
Cost of new common stock, rn :
rn = ($4/($44,50) + 0,05 = 0,09 + 0,05 = 0,140 or 14%.
23
5. The Weighted Average Cost of Capital
• Weighted average cost of capital (WACC), ra , reflects the

expected average future cost of capital over the long run; found
by weighting the cost of each specific type of capital by its
proportion in the firm’s capital structure.
WACC = ra = (wi × ri) + (wp × rp) + (ws × rr or n)
• Where:
wi = proportion of long-term debt in capital structure
wp = proportion of preferred stock in capital structure
ws = proportion of common stock equity in capital structure
wi + wp + ws = 1,0
24
(cont)
• In earlier examples, we found the cost of the various types of

capital for Duchess Corporation to be as follows:
Cost of debt, ri = 5,6%
Cost of preferred stock, rp = 10,6%
Cost of retained earnings, rr = 13,0%
Cost of new common stock, rn = 14,0%
• Company uses the following calculation weights in calculating
its weighted average cost of capital:
Source of capital Weight
Long-term debt 40%
Preferred stock 10%
Common stock equity 50%
Total 100%
25

(cont)
• Calculating of the Weighted Average Cost of Capital for

Duchess Corporation
Source of capital Weight Cost Weighted Cost

(1) (2) [(1) × (2)]
(3)
Long-term debt 0,40 5,6% 2,2%
Preferred stock 0,10 10,6% 1,1%
Common stock equity 0,50 13,0% 6,5%
Total 1,00 WACC = 9,8%
26
(cont)
• Chuck Solis currently has three loans outstanding, all which mature in
exactly 6 years and can be repaid without penalty any time prior to
maturity. The outstanding balances and annual interest rates on these
loans are as follows:
Loan Outstanding balance Annual interest rate
1 $26.000 9,6%
2 $9.000 10,6%
3 $45.000 7,4%
After a thorough search, Chuck found a lender who would loan him $80.000
for 6 years at an annual interest rate of 9,2% on the condition that the loan
proceeds be used to fully repay the three outstanding loans, which combined
have an outstanding balance of $80.000 ($26.000 + $9.000 + $45.000)
Chuck wishes to choose the least costly alternative: (1) to do nothing, or (2) to
borrow the $80.000 and pay off all three loans.
27

(cont)
• Cost of current debt =

= [($26.000 ÷ $80.000) × 9,6%] + [($9.000 ÷ $80.000) × 10,6%] +
[($45.000 ÷ $80.000) × 7,4%]
= (0,3250 × 9,6%) + (0,1125 × 10,6%) + (0,5625 × 7,4%)
= 3,12% + 1,19% + 4,16% = 8,47% = 8,5%
Given that the weighted average cost of the $80.000 of current debt of
8,5% below the 9,2% cot of the new $80.000 loan, Chuck should do
nothing and just continue to pay off the three loans ar originally
scheduled.
28
Soal Latihan
• P9 – 19
29
Selesai
30

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Chapter 11

Copyright © 2009 Pearson Prentice Hall. All rights reserved.

1. Menjelaskan overview of cost of capital

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-2

• The cost of capital acts as a link between the firm’s

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-3

Some Key Assumptions

• Business Risk—the risk to the firm of being unable to cover

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-4

• Why do we need to determine a company’s overall

1.1 The Basic Concept (cont.)

• Why do we need to determine a company’s overall

• Why do we need to determine a company’s overall “weighted

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-7

1.2 Sources of Long-Term Capital

The Firm’s Capital Structure

• The financing cost associated with new funds raised through

2. The Cost of Long-Term Debt (cont.)

Net Proceeds are the funds actually received by

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-10

• Before-Tax Cost of Debt, rd, is the rate of

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-11

2. The Cost of Long-Term Debt (cont.)

• Before-Tax Cost of Debt – Using Market

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-12

• Before-Tax Cost of Debt – Calculating the

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-13

2. The Cost of Long-Term Debt (cont.)

• Before-Tax Cost of Debt – Calculating the Cost

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-14

Find the after-tax cost of debt for Duchess assuming it has a

3. The Cost of Preferred Stock

Cost of Preferred Stock, rp, is the ratio of the

Duchess Corporation is contemplating the issuance of a 10%

rP = DP/Np = $8.70/$82 = 10.6%

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-16

• There are two forms of common stock financing: retained

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-17

4. The Cost of Common Stock (cont.)

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

• Cost of common stock equity, (rs ) – Constant

For example, Duchess Corporation wishes to determine its cost of

rS = ($4/$50) + 0,05 = 0,130 or 13,0%.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-19

4. The Cost of Common Stock (cont.)

• Cost of common stock equity, (rs ) – Capital Asset

For example, Duchess Corporation wishes to calculate ist cost of

rs = 7,0% + [1,5 × (11,0% - 7%)] = 7,0% + 6,0% = 13%

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-20

• Cost of Retained Earnings (rr)

The cost of retained earning for Duchess Corporation

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-21

4. The Cost of Common Stock (cont.)

• Cost of new issues of common stock (rn)

In the preceding example, we found Duchess Corporation’s

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-22

To determine ist cost of new common stock, rn, Duchess

5. The Weighted Average Cost of Capital

• Weighted average cost of capital (WACC), ra , reflects the

WACC = ra = (wi × ri) + (wp × rp) + (ws × rr or n)

• In earlier examples, we found the cost of the various types of

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-25

5. The Weighted Average Cost of Capital