Financial Management-I

CHAPTER THREE
VALUATION OF FINACIAL INSTRUMENT AND COST OF CAPITAL
3.1. VALUATION OF BONDS AND STOCKS(SECURITIES)
3.1.1. General Features of Debt and Equity Securities
A. Bond
 Debt security issued by a corporation or government entity.
 Bonds pay a fixed rate of interest and return the face amount on the maturity date.
 Can be bought and sold before maturity.
 Market trading prices are based on current interest rates in relation to the fixed rate a bond
pays
 If the discount rates rise above the interest rate that the bond pays, its price goes down;
 If discount rates drop below the bond's rate, its price rises.
 When Bond Issued at par value(Par Bond), Market Price = face value and Coupon Rate =
market interest rate
 When a bond trades at a premium (premium Bond), Market Price > face value and Coupon
Rate > market interest rate.
 When a bond trades at Discount (Discount Bond), Market Price < face value
and Coupon Rate < market interest rate.
B. Common Stock Shares
 Common stock represents equity ownership in a corporation.
 Allows its holders to make a profit through rising share prices and dividend payments.
 Also get to vote on corporate issues, such as electing new directors to the corporation's board.
 However, should the company end up in bankruptcy; holders of common stock are last on the
list to get their money back (after regular creditors, bondholders, and holders of preferred
stock.
 dividends are not guaranteed and a company can reduce or eliminate dividends at any time
 Aside from dividends, however, the share value of common stocks tends to rise and fall with
market conditions and with the financial results of the underlying company.
 Dividend yields on common stocks are typically lower than the yields available from bonds
or preferred shares
 Common Stock represents the owner’s fund, as equity shareholders jointly own the company.
 The stockholders are entitled to both risk and rewards of ownership, but their liability is
limited to the capital contributed by them. Generally Common stockholders have:-
 Right to Income: Common stockholders have a residual claim on the earnings of the firm.
 Right to Vote: Common stockholders, has the right to elect firm’s board of directors and
vote on various corporate policies, at the general meeting.
 Pre-emptive Right: The pre-emptive rights allow the existing stockholders to buy the
company’s stock before they are publicly available, so as to maintain their proportional
ownership.
 Right in Liquidation: Common Stockholders are entitled to receive the leftover amount and
assets of the firm in the event of liquidation, i.e. once all the creditors, debenture holders,
preferred stock holders are paid off, the amount and assets remained are distributed to
common stockholders in the ratio of their ownership in the company.

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C. Preferred Stock
 Preferred stock also represents owning a share of the company, but it works a bit differently
than common stock.
 Holders do not get a vote on company matters but enjoy preference in certain matters, as to
the payment of fixed amount of dividend and repayment of capital in the event of liquidation
or bankruptcy.
 It is a fixed income bearing investment vehicle, which may or may not have a maturity
period.
 Preferred shares have a fixed dividend rate, which will not change unless the issuing
company does not earn enough money to pay the dividend.
 Nature of dividend is cumulative, in essence, that if the payment of dividend is skipped in a
particular year, then the dividend is carried forward to next year and arrears of dividend have
to be paid by the company.
3.1.2. Valuation Meaning
Valuation is the process of determining the worth of any asset whose value is obtained from
future cash flows. Look, the value here is not historical cost. The value of any asset in finance is
the present value of all future cash flows it is expected to provide over the relevant time period.
This value is called intrinsic value. In the remainder of this unit, we shall emphasize the intrinsic
value of an asset.

The intrinsic value of an asset is determined based on three basic inputs: cash flows (returns),
time pattern of the returns, and the discount rate. The value of an asset is, therefore, determined
by discounting the expected cash flows to their present value. To determine the present value, we
use a discount rate appropriate based on the asset’s risk.
Value can be determined for any kind of asset like buildings, machineries, factories, bonds,
stocks etc. But in this unit, we will discuss the value of three financial assets: bonds, preferred,
and common stocks.
3.1.3. The General Valuations Model
Value of a security is a fundamental variable and depends on its promised return, risk and the
discount rate. You may recall the basic understanding of present value concept, with the mention
of fundamental factors like returns and discount rate. In fact the basic valuation model is none
else than present value procedure. Given a risk adjusted discount rate and the future expected
earnings flow of security in the form of interest, dividend, earnings, or cash flow, you can always
determine the present value of follows.
PV = CF1 + CF2 + CF3 + ……. CFn
1+r (1 + r)2 (1 + r)3 (1 + r)n
PV = Present value
CF = Cash flow interest, dividend, earnings per time period up to ‘n’ number of years
r = Risk adjusted discount rate
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3.1.4. Bond Valuation

Bond is a long-term debt instrument or security issued by businesses and governmental units to
raise large sums of money. Investment in a bond provides two types of cash flows. One is the
periodic interest payment by the issuing party. Another is the price paid to the investor upon
maturity. The first, i.e., the interest payment is based on the par value of the bond and the
coupon interest rate. The par value is the face value of the bond which will be paid to the
investor upon maturity. The coupon interest rate is the rate which the issuer pays to the investor
on the par value of the bond. Interest paid on bonds is usually referred to as coupon.
 Types of bonds
Generally, Bonds may be classified in to four types
a) Treasury (government) bonds:-Bonds issued by the government
b) Corporate bonds:- bonds issued by the corporation
c) Municipal bonds:- bonds issued by state and local government
d) Foreign bonds:- bonds issued by the foreign government and corporations
 Types of Corporate Bonds: - different types of bonds may be issued by different
corporations in different countries; the following are the major ones.
1. Convertible Bonds
A convertible bond may be exchanged for shares of stock of the issuing corporation at the
bondholder’s option.
2. Income bonds: - A long term debt security in which the issuer is required to pay interest
only when interest is earned.
3. Term bond:-bonds whose principal is repaid on specific maturity date in the future.
4. Serial bonds: -bonds whose principal is paid on a periodic basis on certain period.
5. Callable /Redeemable Bonds:- These contain a provision that gives the issuer the right to
call (buy back) the bond before its maturity date, similar to the call provision of some
preferred stocks. A company is likely to exercise this call right when its outstanding bonds
bear interest at a much higher rate than the company would have to pay if it issued new but
similar bonds. The exercise of the call provision normally requires the company to pay the
bondholder a call premium. A call premium is the price paid in excess of face value that the
issuer of bonds must pay to redeem (call) bonds before their maturity date.
6. Puttable /Put Bond
Bonds that are issued with a specific feature where the bondholder has the right to return back
the bonds at a pre-fixed date before maturity are called as puttable bonds. Since these bonds

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allow a benefit to the bondholders to ask for the principal repayment before maturity, these
bonds usually offer a coupon rate lower than a normal straight coupon-bearing bond.
7. Zero Coupon Bonds
A zero coupon bond is a type of bond where there are no coupon payments made. It is not that
there is no yield; the zero coupon bonds are issued at a price lower than the face value (say 950$)
and then pay the face value on maturity ($1000).
8. Secured and Unsecured Bonds
Secured bond is a bond for which a company has pledged specific property to ensure its
payment. Unsecured bond is a bond backed only by the general creditworthiness of the issuer,
not by a lien on any specific property. More easily issued by a company that is financially sound.
A. Basic Bond Valuation Model
The value of a bond is the present value of the periodic interest payments plus the present value
of the par value. The value of a bond can be computed using the following equitation:
Bond value (VB) = PV of the coupon payment + PV the face vale
N
= INT FV
 1  k 
t 1
t

1  K d N
d

 1 
 1 
= INT  (1  kd )N  FV
 kd  (1  k d ) N
 
 

When Interest is paid semiannually:

2N
INT/2 FV
VB   1 
t 1 k d /2 t

1  k d /2 2N
 1 
1 2N 
 (1  k d /2)  FV
 (INT/2)
 k d /2  (1  k d /2) 2N

 
 

PV (VB) = Present value of the bond today (value of the bond)

INT= Coupon interest payment =Par Value x Coupon interest rate (i)
FV = Face Value (the par value of the bond, principal payment at maturity)
Kd = Appropriate discount rate or market yield
N = Number of years to maturity
(PVIF kd,n) = The present value interest factor for an annuity at interest rate of kd per period for
1
1
(1  k d ) n
n periods =
kd
Illustration:
1. Ex. A 10% bond of Birr 1,000 issued with a maturity of five years at par. The discounted rate
of marketing 10%. The interest is paid annually. What would be the bond value.

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PV = 100 __ + 100__ + 100___ + 100___ + 100+ 1000

2 3
(1 + .10) (1 + .10) (1 + .10) (1 + .10)4 (1 + .10)5
= 100 x .9091 + 100x .8264 + 100 x .7513 + 100x .6830 + 1100 x .620
= 90.91 +| 82.64 + 75.13 + 68.30 + 682.99
= 999.97
2. A bond of Birr 1,000 at 6% is issued at par. The bond had a maturity period of five years. As
of today five more years are left for final repayment at par. The current discount rate is 10
percent. What is the present value?

PV = 60__ + 60___ + 60 __ + 60 60 + 1000

2 3 4
(1 + .10) (1 + .10) (1 + .10) (1 + .10) (1 + .10)5
= 60 x .9091 + 60 x .8264 + 60 x .7513 + 60 x .683 + 1060 x .6209
= 54.55 + 45.08 + 40.98 + 658.15
= 847.35
3. Tebaber Berta Corporation has a Br. 1,000 par value bond with an 8% coupon interest rate
outstanding. Interest is paid semiannually and the bond has 12 years remaining to its maturity
date.
Required: What is the value of the bond if the required return on the bond is 8%?
Given: M = Br. 1,000; kd = 8% per year or 4% (8%2) per semiannual period; I = Br. 40 (Br.
1,000 x 4%); n = 24 semiannual periods (12 x 2); Bo =?
Bo = I(PVIFA kd,n) + FV(PVIF kd,n)
= Br. 40(PVIFA4%, 24) + Br. 1,000(PVIF4%, 24)
= Br. 40 (15.2470) + Br. 1,000 (0.3901)
= Br. 1,000
B. Interest Rate on a Bond
So far we have been seeing how to determine the value of a bond if we are given the par value,
the coupon interest rate, the number of periods, and the interest rate on the bond. Next, we shall
discuss on how to find the interest rate on a bond, i.e., kd if we are given the value of the bond.
We will consider yield to maturity and yield to call.
Yield to Maturity (YTM) is the rate of return investors earn if they buy a bond at a specific
price Bo and hold it until maturity. The approximate YTM can be found using the following
approximation formula:
FV  VB
I
Approximate YTM = N
FV  VB
2
Example: Zebra Company has a Br. 1,000 par value, 10% coupon interest rate, and 15 years to
maturity. The bond is currently selling at Br. 1,090. Compute the YTM.
Solution:
Given: FV = Br. 1,000; I = Br. 100 (Br. 1,000 x 10%); n = 15; Bo = Br. 1,090; YTM = ?

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Br.1,000090
Br.100 
Approximate YTM = 15  9%
Br.1,000  Br.1,090
2
If an investor buys Zebra’s bond at Br. 1,090 and holds it for 15 years, the approximate yield or
rate of return per year is 9%.
Yield to call (YTC) is the rate of return earned by an investor if he buys a bond at a specified
price, Bo, and the bond is called before its maturity date. YTC, therefore, is computed only for
callable bonds. A callable bond is a bond which is called and retired prior to its maturity date at
the option of the issuer. A bond is called by an issuer when the market interest rate falls below
the coupon interest rate. The YTC can be found by solving the following equation.
Call Pr ice  VB
I
Approximate YTC = N
Call Pr ice  VB
2
Example: X Company is intending to purchase Y Company’s outstanding bond which was issued
on January 1, 1997. Y bond is a Br. 1,000 par value, has a 10% annual coupon, and a 30 year
original maturity. There is a 5-year call protection, after which time the bond can be called at
108. X Company is to acquire the bond on January 1, 1999 when it is selling at Br. 1,175.
Required: Determine the yield to call in 1999 for Y company bond.
Solution:
Given: I = Br. 100 (Br. 1,000 x 10%); VB = Br. 1,175; call price = Br. 1,080 (Br. 1,000 x
108%);
n = 3 (call protection – 2 years elapsed since the bond was issued); YTC =?
Br.1,080  Br.1,175
Br.100 
Approximate YTC = 3  6.06%
Br.1,080  Br.1,175
2
If X Company buys Y Company bond and holds the bond until the bonds are called by Y
Company, the approximate annual rate of return would be 6.06%.
3.1.5. PREFERRED STOCK VALUATION
Preferred stock is a type of equity security that provides its owners with limited or fixed claims
on a corporation’s income and assets. Preference shares are those, which enjoy the following two
preferential rights:
 Dividend at a fixed rate or a fixed amount on these shares before any dividend on equity
shares.

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 Return of preference share capital before the return of equity share capital at the time of
winding up of the company.
Preference shares also have a right to participate or in part in excess profits left after been paid
to equity shares, or has a right to participate in the premium at the time of redemption. But these
shares do not carry voting rights.
Preferred stock has similarities to both a bond and a common stock. As to similarities to a bond,
preferred dividends are fixed in amount and are like interest payments. As to a common stock,
the preferred dividends are paid for an indefinite time period. Specifically the following are the
major types of preference shares.
1. Redeemable and Irredeemable
Redeemable preference share is very commonly seen preference share which has a maturity date
on which date the company will repay the capital amount to the preference shareholders and
discontinue the dividend payment thereon. Irredeemable preference shares are little different
from other types of preference shares. It does not have any maturity date which makes this
instrument very similar to equity except that the dividend of these shares is fixed and they enjoy
priority in payment of both dividend and capital over the equity shares. Since there is an absence
of maturity, they are also known as perpetual preference share capital.
2. Cumulative and Non cumulative
A preference share is said to be cumulative when the arrears of dividend are cumulative and such
arrears are paid before paying any dividend to equity shareholders.
In the case of non-cumulative preference shares, the dividend is only payable out of the net
profits of each year. If there are no profits in any year, the arrears of dividend cannot be claimed
in the subsequent years. If the dividend on the preference shares is not paid by the company
during a particular year, it lapses. Preference shares are presumed to be cumulative unless
expressly described as non-cumulative.
3. Convertible and Non convertible
The owner of these preference shares has the option, but not the obligation, to convert the shares
to a company's common stock at some conversion ratio. This is a valuable feature when
the market price of the common stock increases substantially, since the owners of preference
shares can realize substantial gains by converting their shares. Non convertible are those shares
which do not carry the right of conversion into equity shares.
4. Participative and Non participative
Participating preference shares are those shares which are entitled in addition to preference
dividend at a fixed rate, to participate in the balance of profits with equity shareholders after they
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get a fixed rate of dividend on their shares. The participating preference shares may also have the
right to share in the surplus assets of the company on its winding up. Such a right may be
expressly provided in the memorandum or articles of association of the company.
Non- participating preference shares are entitled only to a fixed rate of dividend and do not share
in the surplus profits. The preference shares are presumed to be non-participating, unless
expressly provided in the memorandum or the articles or the terms of issue.
A. Preferred Stock Valuation Model
The value of a preferred stock is the present value of all future preferred dividends it is expected
to provide over an infinite time horizon. Most preferred stocks entitle their owners to regular and
fixed dividend payments. If the payments last forever, the issue is perpetuity. Therefore, the
value of a preferred stock is found by the following formula:
Dps
VPS =
Kps
Where:
Vps = Value of the preferred stock
Dps = Preferred stock dividends
Kps = the required rate of return on the preferred stock
Example: Abebe wishes to estimate the value of its outstanding preferred stock. The preferred
issue has a Br. 80 par value and pays an annual dividend of Br. 6.40 per share. Similar-risk
preferred stocks are currently earning a 9.3% annual rate of return. What is the value of the
outstanding preferred stock?
Solution:
Given: Dps = Br. 6.40; Kps = 9.3%; Vps =?
Br.6.40
Vps = = Br. 68.82
9.3%
So the Br. 6.40 annual dividend an investor receives for an infinite years is equal to today’s Br.
68.82 if the required rate of return is 9.3%.
B. Rate of Return on a Preferred Stock
To evaluate the worthiness of investment in a preferred stock in comparison to other investment
opportunities, we should be able to compute the rate of return on a preferred stock. If we know
the current price of a preferred stock and its dividend, we can compute the expected rate of return
on the preferred stock. This can be done using the following formula:
Dps
Kps =
Vps
Where

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Kps = The expected rate of return on the preferred stock

Dps = Preferred stock dividends
Vps = Value or current price of the preferred stock
Example: A preferred stock pays an annual dividend of Br. 9 and the current market price is Br.
81. Compute the required rate of return from the preferred stock.
Solution:
Given: Dps = Br. 9; Vps = Br. 81; Kps =?
Br.9
Kps = = 11.11%
Br.81
For an investor to invest Br. 81 in this preferred stock and to receive an annual dividend of Br. 9,
his minimum required rate of return is 11.11%.
3.1.6. COMMON STOCK VALUATION
The value of a share of common stock is the present value of the common stock’s dividend
expected over an infinite time horizon. The value of a share of common stock is also equal to the
sum of the present value of the expected dividends and the present value of the expected selling
price of the stock. The selling price in turn will depend on the dividends to be received by the
purchasing party.

To understand the value of a common stock we should keep in mind two points. First, the
dividends are expected for an infinite time period. Second, the dividends are not constant.
Therefore, the value of a common stock is found by summing the present values of annual
dividends.
D1 D2 D
Po = 1
 2

(1  ks) (1  ks) (1  ks) 
Where:
Po = Value of the common stock at time zero (as of today)
D1, D2, …, D = Per share dividend expected at the end of each year
Ks = the required rate of return on the common stock.

The common stock valuation equation can be simplified by redefining each year’s dividend. The
dividends are defined in terms of anticipated dividends growth. Generally, there are three cases
accordingly. These are:
1. Zero growth common stock,
2. Constant growth common stock, and
3. Variable growth common stock.
Hence, common stock valuation approaches are developed under each of the above dividend
growth models. Next sections will discuss each model one by one.
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A. Zero Growth Stock

A zero growth stock is a common stock whose future dividends are not expected to grow at all.
The expected growth rate (g) is zero. This is the simplest model to common stock valuation. It
assumes a constant, non-growing annual dividend. So here the annual dividends are all equal.
That is D1 = D2 = … = D = D.

A common stock with zero growth rates is a security that is expected to provide a fixed dividend
each year. Hence, a zero growth common stock is perpetuity. Therefore, the value of a zero
growth stock is given as:
D
Po =
Ks
Example: The most recent common stock dividend of Shalom Manufacturing Corporation was
Br. 3.60 per share. Due to the firm’s maturity as well as stable sales and earnings, the dividends
are expected to remain at the current level of the foreseeable future.
Required: Determine the value of Shalom’s common stock for an investor whose required
return is 12%.
Solution:
Given: D = Br. 3.60; Ks = 12%; Po =?
Br.3.60
Po = = Br. 30
12%
The maximum price the investor would be willing to pay for a share of Shalom’s common stock
is Br. 30 for him to receive a Br. 3.60 annual dividend for indefinite years.
B. Constant Growth Stock
Constant growth stock is a common stock whose future dividends are expected to grow at a
constant dividend growth rate (g). It is sometimes called normal growth stock. The constant
(normal) growth common stock valuation model is the most widely cited approach to common
stock valuation.
The value of a constant growth stock is the present value of the expected future dividends
growing at a constant rate of g. Here the value can be found by using the following formula:
D1
Po = ; Ks > g
Ks  g
Where:
D1 = the expected dividend at the end of year 1.
g = the expected growth rate in dividends.
D1 = Do(1+g), where Do is the most recent dividend. Similarly D2 = D1 (1+g) and so on. To
find the value of a common stock (constant growth) at one year, first, find the expected dividend
at the end of next year.

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Example: Zeila Motor Corporation’s common stock currently pays an annual dividend of Br.
5.40 per share. The dividends are expected to grow at a constant annual rate of 5% to infinity.
Estimate the value of Zeila’s common stock if the required return is 12%.
Solution:
Do = Br. 5.40; g = 5%; Ks = 12%; Po =?
D1
Po = ; D1 = Do (1+g0) = Br. 5.40 (1.05) = Br. 5.67
Ks  g
Br.5.67
= = Br. 81
12%  5%
For an investor to receive an annual dividend of Br. 5.40 growing at 5% constantly to infinity,
the maximum price he would pay today is Br. 81.
If we are given the value of a constant growth stock, the most recent dividend, the expected
dividend growth rate, we can compute the expected rate of return as follows.
D1
Ks = g
P0
Where: Ks = The expected rate of return on a constant growth stock
D1/P0 = Expected dividend yield.
g = Expected dividend growth rate = capital gains yield.
Example: Assume the above example except that you are given the value of common stock of
Br. 81 instead of the required return. Compute the expected rate of return?
Br.5.40 (1.05)
Ks = + 0.05
Br.81
= 12%
C. Variable Growth Stock
Variable growth stock is a stock whose dividends are expected to grow at variable or non-
constant rates. The model of common stock valuation that allows for a change in the dividend
growth rate is called Variable (non constant) Growth Model. It sometimes is also called
supernormal growth model.
The value of a share of variable growth stock is determined by following 4 procedures.
1. Find the value of the dividends at the end of each year during the initial growth period.
2. Find the present values of the dividends found in step 1.
3. Find the value of the stock at the end of the initial growth period
4. Add the present value of the dividends found in step 2 and the present value of the value of the
stock found in step 3 to determine the value of the stock at time zero, i.e. po.

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Example: Addis Company’s most recent annual dividend, which was paid yesterday, was Br.
1.75 per share. The dividends are expected to experience a 15% annual growth rate for the next 3
years. By the end of 3 years growth rate will slow to 5% per year to infinity.
Stockholders require a return of 12% on Addis’ stock
Required: Calculate the value of the stock today.
Solution:
Given: Do = Br. 1.75; g1 = 15% for 3 years; g2 = 5% from year 3 to infinity; k5 = 12%; p0 =?
g1 = 15% g2 = 5%

Year 0 1 2 3 
D0 = Br. 1.75 D1 = Br. 2.01 D2 = Br. 2.31 D3 = Br. 2.66
PV of D1 = Br. 1.79 PVIF 12%, 1
PV of D2 = 1.84 PVIF 12%, 2
PV of D3 = 1.89 PVIF 12%, 3
PV of P3 = 28.40 PVIF 12%, 3 P3 = Br. 39.90
P0 = Br. 33.92
D1 = D0 (1 + g1) = Br. 1.75 (1.15) = Br. 2.01
D2 = D1 (1 + g1) = Br. 2.01 (1.15) = Br. 2.31
D3 = D2 (1 + g1) = Br. 2.31 (1.15) = Br. 2.66
D4 D3 (1  g 2 ) Br.2.66 (1.05)
P3 =    Br.39.90
k5  g 2 k5  g 2 0.12  0.05
3.2. COST OF CAPITAL
3.2.1. Definition of Cost of Capital:
The term cost of capital refers to the minimum rate of return a firm must earn on its investments.
Cost of capital is a complex, controversial but significant concept in financial management.
The following definitions are given by different scholars.
 Hamption J.: The cost of capital may be defined as “the rate of return the firm requires from
investment in order to increase the value of the firm in the market place”.
 James C. Van Horne: The cost of capital is “a cut-off rate for the allocation of capital to
investments of projects. It is the rate of return on a project that will leave unchanged the
market price of the stock”.
 Soloman Ezra:”Cost of Capital is the minimum required rate of earnings or the cut-off rate of
capital expenditure”.
It is clear from the above definitions that the cost of capital is that minimum rate of return which
a firm is expected to earn on its investments so that the market value of its share is maintained.
3.2.2. Importance of Cost of Capital:
The cost of capital is very important in financial management and plays a crucial role in the
Following areas:

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i) Capital budgeting decisions: The cost of capital is used for discounting cash flows under Net
Present Value method for investment proposals. So, it is very useful in capital budgeting
decisions.
ii) Capital structure decisions: An optimal capital is that structure at which the value of the
firm is Value of the firm is maximum and cost of capital is the lowest. So, cost of capital is
crucial in designing optimal capital structure.
iii) Evaluation of final Performance: Cost of capital is used to evaluate the financial
performance of top management. The actual profitability is compared to the expected and actual
cost of capital of funds and if profit is greater than the cast of capital the performance nay be said
to be satisfactory.
iv) Other financial decisions: Cost of capital is also useful in making such other financial
decisions as dividend policy, capitalization of profits, making the rights issue, etc.
3.2.3. Cost of Debt, Kd (1-T)
The cost of debt is the cost associated with raising one more dollar by issuing debt. Suppose you
borrow one dollar and promise to repay it in one year, plus pay 10 cents to compensate the lender
for the use of her money.
Interest payments (or interest expenses) are tax-deductible expenses and are paid before taxes,
partially reducing the firm’s income taxes. The after-tax cost of debt, Kd (1-T), is the net cost of
debt, which is used to calculate the weighted average cost of capital. It is the interest rate on
debt, Kd, minus the tax savings that result because interest is deductible. This is the same as Kd
multiplied by (1-T), where T is firm’s tax rate:
After -tax cost of debt = Interest expense – Tax savings
= Kd – Kd T
= Kd (1-T)
For example, if ABC Corporation can borrow at an interest rate of 10 percent, and if it belongs to
a tax rate of 40 percent, then it’s after-tax cost of debt will be 6 percent:
Kd (1-T) = 10% (1-40%)
= 10% (1-0.4)
= 10% (0.6)
= 6%
The after-tax cost of debt used in calculating the weighted average cost of capital because the
value of the firm’s stock, which we want to maximize, depends on after-tax cash flows. Interest
is a tax-deductible expense. As result, interest expense produces tax savings that reduce the net
cost of debt. Thus, interest expense being a tax-deductible item; the after-tax cost of debt is less
than the before-tax cost of debt.
The after-tax cost of debt is the after-tax rate of return that must be earned on the debt-financed
assets of the firm. It also provides us with a point of reference in comparing the cost of debt to
the costs of other sources of capital. The cost of retained earnings, preferred and common stocks
are normally calculated on after-tax basis.
If a debt (or bond) is issued to the public and flotation costs are incurred, the proceeds of the debt
will be computed by deducting flotation costs from par value of bond. (Flotation costs are
discussed in detail under the cost of preferred and common stocks sections). Thus, issue price of
the bond is the bond’s par value minus the flotation costs. Thus, the before-tax cost of debt in
presence of floatation costs is calculated as follows:
Kd = I + FV – VB (1-F)
N_______
FV + VB (1-F)
Where, 2

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Kd = the firm’s approximate cost of debt before-tax adjusted for flotation cost
I = the annual interest payment
FV = the Face value of the bond
VB = the current price of the bond
N = the remaining years in the life of the bond
F = Flotation cost as a percentages of bond price (Po)
Then, the after-tax cost of debt will be computed as follows:
After – tax cost of debt = Kd (1-T)
For example, assume that XYZ Corporation issued a bond with the following characteristics:
Annual interest payment (I) = Br. 70
Bond life (years to maturity) (n) = 15
Corporate tax rate (T) = 40%
Face value of the bond (FV) = Br. 1000
Current price of the bond (VB) = Br. 771.82
Flotation cost (F) = 3%
Using the above example, the cost of debt before-tax adjusted for flotation cost is calculated as
follows:

Kd = Br. 70 + 1000 - 771.82 (1- 0.03)

15 .
= 1000 + 771.82 (1-0.03)
2
= 70 + 1000 - 748. 6654
. 15 .
= 1000 - 748. 6654
2
= = K7d0(1-T)
Then, after-tax cost debt + 16.75564
874.3327
= 9.9% (1-0.40)
= 099
= = 9.9%
9.9% (0.6)
= 0.594
= 5.9%
Thus, the after-tax cost of debt adjusted for flotation cost is 5.9 percent for the XYZ Corporation.
3.2.4.Cost of Preferred Stock, KP
Preferred stock is a source of long-term capital for a firm. When a corporation sells preferred
stock, it expects to pay dividends to investors in return for their money capital. The dividend
payments are the cost of preferred stock to the firm.
Preferred stock is both similar to and different from debt. Like a debt, preferred stock entitles
investors to a fixed, periodic payment called Preferred stock dividend. Unlike a debt, preferred
stock carries no maturity date. Thus, investors often consider preferred stock to be a perpetual
annuity, whose periodic dividends extend indefinitely into the future. Preferred stock dividends,
although contractually fixed, are not risk-free: in claim priority they are lower than interest
payments but higher than common stock dividends. In general, then, preferred stock is more
risky to investors than are bonds, but less risky than is common stock.
The required rate of return for preferred stock, Kp, is computed as;
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Kp = Preferred dividend
Market value of preferred stock
= Dp
Pp
Since a new share of preferred stock has a selling cost (flotation cost), the proceeds to the firm
are equal to the selling price in the market minus flotation cost
Kpr = Dp
Pp – F
Where, Kpr is the cost of preferred stock, ‘Dp’ the annual dividend on preferred stock, ‘Pp’ the
price of preferred stock, and ‘F’ flotation cost
The firm’s cost of preferred stock, Kp, represents the minimum required rate of return investors
demand on a preferred stock of this risk level.
For example, if the ABC Corporation’s preferred stock is currently selling at a market price of
Br.100 that pays a Br. 9 dividend per share per year, the cost of preferred stock to the ABC
Corporation is 9 percent:
Kp = Dp
Pp
= 9/100
= 0.09
= 9%
Note that this cost of preferred stock is not adjusted for taxes because the preferred dividend used
in the formula is already an after tax figure –preferred stock dividends being paid after taxes.
Thus, the explicit cost of preferred stock is greater than that of debt. When a firm sells a
preferred stock, it may incur a selling cost ( i.e., floatation costs). The floatation costs will reduce
the proceeds it receives from the issuance of the preferred stock. This will increase the cost of
preferred stock since it incurs floatation costs in addition to the dividend payments. The specific
cost of preferred stock, when there are flotation costs, can be computed by adjusting the current
market price of the stock for the flotation costs.
For preferred stock, the flotation- adjusted cost is the preferred dividend, Dp, ivided by the net
issuing price, Pn, which is the price the firm receives on preferred stock after deducting flotation
costs. Therefore, if the cost of flotation cost is significant enough, the cost of issuing new
preferred stock will be computed as follows:

Kp = Dp = Dp
Pp (1-F) Pn
When flotation cost, F, is expressed in terms of Br. per share of the preferred stock, the above
formula can be modified as follows:
Kp = Dp
Pp - F
For example, if the ABC Corporation issues its new preferred stock at Br. 100 per share (Pp),
and that pays a Br. 9 dividend per share (Dp) per year. It incurs a 10 percent or Br. 10 flotation
cost (F) of the selling price of the stock, where the net proceeds will be Br. 90 per share. The
cost of preferred stock will then be 10 percent:

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Kp = Dp
Pn (1-F)
= 9
100 (1-1.10)
= 9
100 (0.9)
= 9
90
= 10%
Or Kp = DP (when F is expressed in birr per share instead of percentage)
Pp - F
= Br. 9/ Br. 100 – Br. 10 per share
= 9/ 90
=10%
Thus, the cost of preferred stock when the flotation cost exists is 10 percent for the ABC
Corporation. From this figure, one can understand that flotation cost increases the cost of
preferred stock (i.e., Kp = 9% increased to Kp = 10%).
3.2.5. Cost of Stockholders' Equity
Cost of Equity is the expected rate of return by the equity shareholders. Some argue that, as there
is no legal for payment, equity capital does not involve any cost. But it is not correct. Equity
shareholders normally expect some dividend from the company while making investment in
shares. Thus, the rate of return expected by them becomes the cost of equity. Conceptually, cost
of equity share capital may be defined as the minimum rate of return that a firm must earn on the
equity part of total investment in a project in order to leave unchanged the market price of such
shares. For the determination of cost equity capital it may be divided into two categories:
 Retained earnings.
 External equity or new issue of equity shares.

A. Cost of Retained earnings (RE): RE belongs to common stockholders who are the owners
of the firm. By permitting a firm to retain earnings, stockholders incur an opportunity cost
because they give up cash dividend. So they expect the firm to earn the same rate of return on
the RE as it provides on common stock. That means the component cost of RE (Kr) is equal
to the rate of return on common stock (Ke)
Kr = Ke
Kr = D1 +g
P0
Where D1 =cash dividend per share at the end of first year
P0 = Price of stock today
g = constant growth rate in dividend
For example, assume that the ABC Corporation’s common stock is currently selling at Br. 22 per
share and this year’s expected common stock dividend which is Br. 1.10 per share, is assumed to
grow at a constant 10 percent rate (g) in all-future years. ABC’s expected and required rate of
return and, hence, its cost of retained earnings, Kre, will then be 15 percent:
Kre = D1 +g
Po
= 1.10 + 10%
22
= 5% + 10%
= 15%
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Thus, the cost of retained earnings is 15 percent. This 15 percent is also the minimum rate of
return that management of ABC Corporation must expect to earn to justify retaining earnings
rather than paying them out to stockholders as dividends.
B. Cost of new common stock: The cost of new common equity, Ke, or external equity, is
[

higher than the cost of retained earnings, Kre, because of flotation costs involved in issuing
new common stock. Flotation costs include
a. commissions paid to those selling the common stocks for the firm
b. printing expenses,
c. advertising costs,
d. registration fees for government agencies and
e. Any reduction (discount) from the current market price of the same type of existing
common stocks introduced.
The cost of new common stock that promises to pay dividends that grow at a constant annual
growth rate is found by applying the following formula:
Ke = D1 +g
Po (1-F)
Here, D1 is the expected common stock dividend for this year. Po is prevailing common stock
price, and F is the percentage flotation cost incurred in selling the new stock issue. So, Po (1-F)
is the net price per share received by the firm, which issues the new common stock. If F is
provided in birr per share, the net proceeds of issuing common stock per share will be current
market price of common stock per share minus floatation cost per share (i.e., net proceed = Po -
F).

For example, assume that the ABC Corporation is currently issuing its new common stock at Br.
22 per share and this year’s expected common stock dividend which is Br. 1.10 per share, is
assumed to grow at a constant 10 percent rate (g) in all-future years. Assume that the ABC
Corporation has flotation costs of 10 percent of the selling price of a share of stock or Br. 2.2 per
share (0.10 x Br.22 = Br. 2.2). The cost of new common stock for the ABC Corporation would
be computed as follows:
Or, Ke = D1 + g (when F is expressed in birr per share)
Po -F
= 1.10 + 10%
22 – Br. 10
= 1.10 + 10%
19.8
= 15.5%
Investors require a return of Ke = 15.5 % on the new common stock. Specifically, if the firm
earns 15.5 percent on funds obtained by issuing new stock, then earnings per share will remain at
the previously expected level. The firm’s expected dividend can be maintained, and, as a result,
the price per share will not decline. If the firm earns less than 15.5 percent, then earnings,
dividends and growth will fall below expectations, causing the stock price to decline. If the firm
earns more than 15.5 percent, the stock price will rise.
3.2.6. Weighted Average Cost of Capital
WACC: is the cost of capital determined by multiplying the cost of each item in the optimum
capital structure by its weighted representation in the overall capital structure and summing up
the results. WACC may be calculated using book value weights, market value weights, and
target value weights. So far, you have learnt how to compute the cost of specific capital. Now,

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you will learn techniques for determining the overall cost of capital. The overall cost of capital
for a firm is the average of the cost of each specific capital, weighted by each specific capital’s
proportion in capital structure.

Capital structure is the mix of long-term debt and equity maintained by the firm. In other
words, it is the proportion of a firm’s long-term debt and equity capital such as common stock,
preferred stock and retained earnings. A firm has an optimal capital structure defined as the mix
of debt, preferred stock, common stock and retained earnings that cause its stock price to be
maximized. It is a capital structure at which the weighted average cost of capital is minimized,
thereby maximizing the firm’s value.

Therefore, a value-maximizing firm will establish a target (optimal) capital structure and then
raise new capital in a manner that will keep the optimal capital structure. Thus, the overall cost
of capital for a firm, which is also called, weighted average cost of capital, WACC, can be
calculated by the following formula.
WACC=Wd Kd (1-T) + WpKp + Wre Kre +WeKe
Where,
Wd = proportion or weight of long term debt in capital structure
Wp = proportion or weight of preferred stock in capital structure
Wre = proportion or weight of retained earnings in capital structure
We = proportion or weight of common stock equity in capital structure
Wd Kd (1-T) + WpKp + Wre Kre +WeKe = 1.0
The optimal capital structure of debt, preferred stock, common stock and retained earnings, along
with the specific costs of capital, are used to calculate the firm’s weighted average cost of
capital, WACC.
Illustration
Let us assume the ABC Corporation has a target capital structure calling for 45 percent debt, 2
percent preferred stock, and 23 percent retained earnings, 30 percent common stock. Its before-
tax cost of debt, Kd, is 10 percent; its cost of preferred stock, kp, is 9 percent; its cost of new
common stock, ke, is 15.5 percent; its cost of retained earnings, Kre, is 15 percent; its tax rate is
40 percent. Now, you can calculate ABC’s weighted average cost of capital, WAAC, as follows:
WACC = Wd Kd (1-T) + WpKp + Wre Kre +WeKe
= 0.45 (10%) (1-0.4) + 0.02 (9%) + 0.23 (15%) +
0.30 (15.5%)
= 0.45(6%) + 0.02(9%) +0.23(15%) +0.30(15.5%)
= 0.027 + 0.0018 + 0.0345 + 0.0465
= 2.7% + 0.18% + 3.45% + 4. 65%
= 10.98%
Here Wd = 45 %, Wp = 2%, Wre = 23and We = 30% are the weights or proportions of debt,
preferred stock, retained earnings and common equity in the target capital structure respectively.
That means every birr of new capital that ABC Corporation obtains consists of 45 cents of debt
with an after-tax cost of 6 percent, 2 cents of preferred stock with a cost of 9 percent, 23 cents of
retained earnings with a cost of 15.5 percent and 30 cents of new common stock with a cost of 15
percent. The average cost of each whole birr, WACC, is 10.98 percent.

That is, a firm will incur, on average, 10.08 percent cost for every birr raised from debt,
preferred stock, retained earnings, and common stock as per its capital structure.
The weights or proportions of debt, preferred stock, retained earnings and common stock could
be based either on the accounting values shown on the firm’s balance sheet (book values) or on
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the market values of debt, preferred stock and common stock. Theoretically, the weights should
be based on market values, but if a firm’s book value proportions are reasonably close to its
market value proportions, book value proportions can be used as an alternative for market value
weights. For example, if a firm has book values of Br. 700,000, Br. 50,000 and Br. 650,000 for
its debt, preferred stock and common stock respectively on the balance sheet, the proportion of
debt, preferred stock, and common stock in the capital structure based on these book values will
be 50%( 700,000/14,00,000 = 0.50), 3.6% (50,000/1,400,000 = 0.036) and 46.4%(
650,000/1,400,000 = 0.464) respectively.

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