Chapter 02-ACF 2020 Cost of Capital

Chapter 2
Cost of Capital
1
Cost of Capital
2
Definitions of Cost of Capital
 The term cost of capital refers to the minimum rate of return a
firm must earn on its investments.
 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
Importance of Cost of Capital
The cost of capital is very important in financial management and plays
a crucial role in the following areas:
i) Capital budgeting decisions: The cost of capital is used for
discounting cash flows under Net Present Value method for
investment proposals.
ii) Capital structure decisions: An optimal capital is that structure
at which the 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 financial Performance: Cost of capital is used to
evaluate the financial performance of top management. The actual
profitably is compared to the expected and actual cost of capital of
funds and if profit is greater than the cast of capital the
performance may 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. 4
 The cost of capital represents the overall cost of
financing to the firm
 The cost of capital is normally the relevant
discount rate to use in analyzing an investment
 The overall cost of capital is a weighted average of
the various sources, including debt, preferred stock,
and common equity:
WACC = Weighted Average Cost of Capital
WACC = After-tax costs x weights
5
What sources of long-term
capital do firms use?
Long-Term Capital
Long-Term Debt Preferred Stock Common Stock
Retained Earnings New Common Stock
6
Required Rates on Projects
 An important part of capital budgeting is
setting the required rate for the individual
projects.
7
 An important part of capital budgeting is
setting the required rate for the individual
projects.
Example: Consider the following project
0 1
-1,000 +1,100
8
 Animportant part of capital budgeting is setting
the required rate for the individual project
0 1
-1,000 +1,100
If Required Rate = 9%: NPV = -1,000 + 1,100 = $9.17

(1+ .09 )
9
0 1
-1,000 +1,100

(1+ .09 )
Accept Project since NPV > 0
10
0 1
-1,000 +1,100

(1+ .09 )
If Required Rate = 11%: NPV = -1,000 + 1,100 = –$9.01

(1+ .11 )
11
0 1
-1,000 +1,100

(1+ .09 )

(1+ .11 )
Reject Project since NPV < 0
12
0 1
-1,000 +1,100

(1+ .09 )

(1+ .11 )
In order to estimate correct required rate, companies
must find their own unique cost of raising capital
13
Factors Affecting Cost of Capital
 General Economic Conditions—inflation, investment
opportunities
◦ Affect interest rates
The Following Factors affect risk premium
 Market Conditions
 Operating and Financing Decisions
◦ Affect business risk
◦ Affect financial risk
 Amount of Financing
◦ Affect flotation costs and market price of security
14
Model Assumptions
Weighted Average Cost of Capital Model
 Here, we determine the average cost of

capital of a firm by assuming that the firm
continues with its business, financing and
dividend policies.
15
Computing Weighted Cost of Capital
Weighted Average Cost of Capital (WACC)
 Average cost of capital of the firm.

To find WACC
1. Compute the cost of each source of capital
2. Determine percentage of each source of
capital
3. Calculate Weighted Average Cost of Capital
16
Computing Cost of Each Source
17
1. 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.
18
 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)
19
 Example
Investors are willing to pay $985 for a bond that
pays $90 a year for 10 years. Fees for issuing the
bonds bring the net price (NP0) down to
$938.55.What is the before tax cost of debt?
The before tax cost of debt is 10%
Interest is tax deductible
20
 Example
Investors are willing to pay $985 for a bond
that pays $90 a year for 10 years. Fees for
issuing the bonds bring the net price (NP0)
down to $938.55.What is the before tax cost
of debt?
Marginal Tax Rate = 40%

After tax cost of bonds = kd(1 - T)
21
 Example
Investors are willing to pay $985 for a bond that
pays $90 a year for 10 years. Fees for issuing the
bonds bring the net price (NP0) down to
$938.55.What is the before tax cost of debt?

Marginal Tax Rate = 40%

After tax cost of bonds = kd(1 - T)
= 10.0%(1– 0.40) = 6 %
22
Exercise
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.
Compute the before tax cost of debt
23
2. Compute Cost Preferred Stock
 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.
24
Cost to raise a dollar of preferred stock.
Dividend (D)
Required rate kps =
Market Price (P0)
25
Computing Cost of Each Source
2. Compute Cost Preferred Stock
Dividend (D)
Required rate kps =
Market Price (P0)
However, there are floatation costs of issuing preferred stock:
26
Dividend (D)
Required rate kps =
Market Price (P0)
However, there are floatation costs of issuing preferred stock:
Cost of Preferred Stock with floatation costs
kps = Dividend (D)

Net Price (NP0)
27
 Example
Your company can issue preferred stock for a
price of $45, but it only receives $42 after
floatation costs. The preferred stock pays a $5
dividend.
Compute Cost of Preferred Stock
kps = $5.00
= 11.90%
$42.00
No adjustment is made for taxes as

dividends are not tax deductible.
28
Exercise
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.
Compute the cost of preferred stock
29
3. Compute Cost of Common Equity
 Cost of Equity is the expected rate of return by

the equity shareholders.
 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.
 Two kinds of Common Equity
◦ Retained Earnings (internal common equity)
◦ Issuing new shares of common stock
30
 Cost of Internal Common Equity
◦ Management should retain earnings only if they
earn as much as stockholder’s next best
investment opportunity.
◦ Cost of Internal Equity = opportunity cost of
common stockholders’ funds.
◦ Cost of internal equity must equal common
stockholders’ required rate of return.
◦ Three methods to determine
 Dividend Growth Model
 Capital Asset Pricing Model
 Risk Premium Model
31
◦ Dividend Growth Model
 Assume constant growth in dividends
32
 Assume constant growth in dividends (Chap. 8)
Cost of internal equity--dividend growth model
D1
kcs = + g
P0
33
Computing Cost of Each
Source
D1
kcs = + g
P0
Example
The market price of a share of common stock is $60. The
dividend just paid is $3, and the expected growth rate is 10%.
34
D1
kcs = + g
P0
Example
dividend just paid is $3, and the expected growth rate is
10%.
kcs = 3(1+0.10) + .10
60
35
 Assume constant growth in dividends
D1
kcs = + g
P0
Example
10%.
kcs = 3(1+0.10) + .10 = .155 = 15.5%
60
36
D1
kcs = + g
P0
Example
10%.
kcs = 3(1+0.10) + .10 = .155 = 15.5%
60
The main limitation in this method is estimating growth accurately.

37
◦ Capital Asset Pricing Model
 Estimate the cost of equity from the CAPM
38
 Estimate the cost of equity from the CAPM
Cost of internal equity--CAPM
kcs = krf + b(km – krf)
39
Source
 Estimate the cost of equity from the CAPM (Chap. 6)

Example
The estimated Beta of a stock is 1.2. The risk-free rate is 5%
and the expected market return is 13%.
40
Source
 Estimate
Cost of internalthe cost of equity
equity--CAPM from the CAPM (Chap. 6)

Example
kcs = 5% + 1.2(13% – 5%)
41
Source
 Estimate the cost of equity from the CAPM (Chap. 6)

Example
kcs = 5% + 1.2(13% – 5%) = 14.6%
42
Source
◦ Risk Premium Approach
 Adds a risk premium to the bondholder’s required rate of
return.
43
Source
return.
Cost of internal equity--Risk Premium
Where:
kcs = kd + RPc RPc = Common stock
risk premium
44
Source
return.
Where:
Example risk premium
If the risk premium is 5% and kd is 10%
45
Source
return.
Where:
kcs = 10% + 5%
46
Source
return.
Where:
kcs = 10% + 5% = 15%
47
Source
 Cost of New Common Stock
◦ If retained earnings cannot provide all the equity capital
that is needed, firms may issue new shares of common
stock.
48
Source
stock.
◦ Dividend Growth Model--Must adjust for floatation
costs of the new common shares.
49
Source
stock.
◦ Dividend Growth Model--must adjust for floatation
Cost of new common stock
costs of the new common shares.
D
kcs = 1 + g
NP0
50
Source
D1
knc = + g
NP0
51
Source
D1
knc = + g
NP0
Example
Using the above example. Common stock price is currently $60.
If additional shares are issued floatation costs will be 12%. D0 =
$3.00 and estimated growth is 10%.
52
Source
D1
knc = + g
NP0
Example
NP0 = $60.00 – (.12x 60) = $52.80
Floatation
Costs
53
Source
D1
knc = + g
NP0
Example
NP0 = $60.00 – (.12x 60) = $52.80
kcs = 3(1+0.10) + .10

52.80
54
Source
D1
knc = + g
NP0
Example
NP0 = $60.00 – (.12x 60) = $52.80
kcs = 3(1+0.10) + .10 = .1625 = 16.25%

52.80
55
Capital Structure Weights
Long Term Liabilities and Equity
Weights of each source should reflect expected
financing mix
Assume a stable financial mix–so use Balance Sheet
percentages to calculate the weighted average cost
of capital.
56
Balance Sheet Green Apple Company
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds 4,000
Total Assets $12,000 Preferred Stock 1,000
Common Stock 5,000
Total Liabilities and
Owners Equity $12,000
Firm Raises $10,000 of capital from long term sources
57
Assets Liabilities
Common Stock 5,000
Compute Firm’s Capital Structure (% of each source)

Amount of Bonds
4,000
Bonds: = 40%
10,000
Total Capital Sources 58
Assets Liabilities
Common Stock 5,000

Amount of Preferred Stock
1,000
Preferred Stock: = 10%
10,000
Assets Liabilities
Common Stock 5,000

Amount of Common Stock
5,000
Common Stock: = 50%
10,000
Assets Liabilities
Plant & Equipment 7,000 Bonds 4,000 40%
Total Assets $12,000 Preferred Stock 1,000 10%
Common Stock 5,000 50%
When money is raised for capital projects, approximately

40% of the money comes from selling bonds, 10%
comes from selling preferred stock and 50% comes from
retaining earnings or selling common stock
61
Computing WACC
Green Apple Company estimates the following costs
for each component in its capital structure:
Source of Capital Cost
Bonds kd = 10%
Preferred Stock kps = 11.9%
Common Stock
Retained Earnings kcs = 15%
New Shares knc = 16.25%
Green Apple’s tax rate is 40%
62
Computing WACC
If using retained earnings to finance the common
stock portion the capital structure
WACC= k0 = %Bonds x Cost of Bonds x (1-T)

+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock
63
Computing WACC - using Retained Earnings
Balance Sheet
Assets Liabilities
Plant & Equipment 7,000 Bonds (9%) 4,000 40%
Total Assets $12,000 Preferred Stock (10%) 1,000 10%
Common Stock(13%) 5,000 50%
Tax Rate = 40% Total Liabilities and

64
Balance Sheet
Assets Liabilities
Total Assets $12,000 Preferred Stock (11.9%) 1,000 10%

WACC = .40 x 10% (1-.4)
65
Balance Sheet
Assets Liabilities

WACC = .40 x 10% (1-.4)

+ .10 x 11.9%
66
Balance Sheet
Assets Liabilities

WACC = .40 x 10% (1-.4)

+ .10 x 11.9%
+ .50 x 15% 67
Balance Sheet
Assets Liabilities

WACC = .40 x 10% (1-.4)

+ .10 x 11.9%
+ .50 x 15% = 11.09% 68
Computing WACC
If use newly issued common stock, use knc rather
than kcs for the cost of the equity portion.

knc
69
Computing WACC - using New Common Shares
Balance Sheet
Assets Liabilities
Plant & Equipment 7,000 Bonds (10%) 4,000
Total Assets $12,000 Preferred Stock (11.9%) 1,000
Common Stock(16.25%)5,000

WACC = .40 x 10% (1-.4)

+ .10 x 11.9%
+ .50 x 16.25% = 11.72% 70
Valuations
71
Contents
2.5. Interest rate and bond valuation
2.6. Stock valuation
72
2.5. Interest Rate and
Bond Valuation
73
Key Concepts and Skills
Know the important bond features and
bond types
Understand:
Bond values and why they fluctuate
Bond ratings and what they mean
The impact of inflation on interest rates
The term structure of interest rates and
the determinants of bond yields
74
1.1 Content Outline
 Bond and Bond Valuation
 More on Bond Features
 Bond Ratings
 Some Different Types of Bonds
 Bond Markets
 Inflation and Interest Rates
 Determinants of Bond Yields
75
1. Bond and Bond Valuation
 Bond Definitions
Corporation or government wishes to borrow money
from the public on a long-term basis, it usually does so by
issuing or selling debt securities that are generically
called bonds.
• Bond
▫ Debt contract
▫ Interest – only loan
For example: Suppose the Beck Corporation wants to borrow
$1,000 for 30 years. The interest rate on similar debt issued by
similar corporations is 12 percent. Beck will thus pay 12 x $1,000
= $120 in interest every year for 30 years. At the end of 30 years,
Beck will repay the $1,000.
76
 Key Features of a Bond
• Par Value:
▫ Face amount
▫ Re-paid at maturity
▫ Assume $1,000 for corporate bonds
• Coupon Interest Rate:

▫ Stated interest rate
▫ Usually – YTM at issue
▫ Multiply by par value to get coupon payment
77
 Key Features of a Bond
• Maturity:
▫ Years until bond must be repaid
• Yield To Maturity (YTM):

▫ The market required rate of return for bonds of similar
risk and maturity
▫ The discount rate used to value a bond
▫ Return if bond held to maturity
▫ Usually – Coupon rate at issue
▫ Quoted as an Annual Percentage of Rate (APR)
78
 Bond Value
Bond Value = PV(coupons) + PV(par)
Bond Value = PV(annuity) + PV(lump sum)
Remember:
As interest rates increase present values decrease
( r → PV  )
As interest rates increase, bond prices decrease
and vice versa
79
 The Bond-Pricing Equation
 1 
 1- (1 YTM) t  F
Bond Value  C 
 (1 YTM)
t
 YTM
 
PV(Annuity) PV(lump sum)
C = Coupon payment; F = Face value
80
 As time passes, interest rates change in the marketplace. The cash
flows from a bond will fluctuate. When interest rates rise, the
present value of the bond’s remaining cash flows declines, and the
bond is worth less. When interest rates fall, the bond is worth
more.
Example-1: Par value = $1,000
Maturity = 10 years
YTM = 8%
Present Value = $1,000/1.0810= $1,000/2.1589 = $463.19
First Year Interest = $1,000 x 8/100 = $80
Annuity present value = $80 x (1-1/1.0810)/.08
= $80 x (1-1/2.1589)/.08
= $80 x 6.7101 = $ 536.81
Total Bond Value = $ 463.19 + 536.81 = $1,000
81
 Valuing a Discount Bond with Annual Coupons
Coupon Rate = 8% Interest only when it sells for $1,000
Maturity = 10 years (In this Illustrate what happens as
interest rates change, suppose a year has
gone by. Now bond has 9 years to maturity)
YTM = 10%
Present Value = $1,000/1.109= $1,000/2.3579 = $424.10
= $80 x (1-1/2.3579)/.10
= $80 x 5.7590 = $ 460.72
Total Bond Value = $ 424.10 + 460.72 = $ 884.82
Note: When YTM > Coupon rate  Price < Par = “Discount Bond”
82
 Valuing a Discount Bond with Annual Coupons
Coupon Rate = 10% Interest only when it sells for $1,000
Maturity = 5 years
YTM = 11%
Note: When YTM > Coupon rate  Price < Par = “Discount Bond”
83
 Valuing a Premium Bond with Annual Coupons
A Bond would sell for more than Par Value / Face Value. Such bond
is said to sell at a Premium and is call a Premium Bond.
Coupon Rate = 8%
Maturity = 9 years
YTM = 6%
Present Value = $1,000/1.069= $1,000/1.6895 = $591.89
= $80 x (1-1/1.6895)/.06
= $80 x 6.8017 = $ 544.14
Total Bond Value = $ 591.89 + 544.14 = $ 1,136.03
Note: When YTM < Coupon rate  Price > Par = “Premium Bond”
84
 Valuing a Premium Bond with Annual Coupons
Coupon Rate = 10%
Maturity = 20 years (Annual Coupons)
YTM = 8%
Note: When YTM < Coupon rate  Price > Par = “Premium Bond”
85
 Graphical Relationship Between Price and Yield-To-
Maturity
1500
1400
Bond Price
1300
1200
1100
1000
900
800
700
600
0% 2% 4% 6% 8% 10% 12% 14%
Yield-to-maturity
86
 Bond Prices: Relationship Between Coupon and Yield
Coupon rate = YTM Price = Par

Coupon rate < YTM Price < Par
―Discount bond‖ … Why?
Coupon rate > YTM Price > Par
―Premium bond‖ … Why?
87
 The Bond-Pricing Equation Adjusted for Semi-annual
Coupons
 1 
 1-
C (1  YTM/2) 2t  F
Bond Value   
 (1 YTM/2)
2t
2 YTM/2
 
C = Annual coupon payment  C/2 = Semi-annual coupon
YTM = Annual YTM (as an APR)  YTM/2 = Semi-annual YTM
t = Years to maturity  2t = Number of 6-month
periods to maturity
88
 Semi-annual Bonds
Usually make coupon payments twice a year is called Semi-annual Bonds.
Example-6:
• Coupon Rate = 14%
• Par Value = $ 1,000
• YTM = 16% (APR)
• Maturity = 7 Years
 Number of Coupon Payments?

 Semiannual Coupon Payment?
 Semiannual Yield?
89
 Semi-annual Bonds  1 
Bond Value  C 
1 -
 
1  YTM
2

2t 
 F

Example-6:   2

YTM
2  1  YTM 2
2t
 
 
• Semiannual Coupon Rate = 1,000 x14% = 140/2 = $70

• Semiannual YTM = 16% /2 = 8%
• Periods to Maturity = 7 Years x 2 = 14 Periods
• Bond Value=
Present Value = $1,000/1.0814 = $1,000/2.9372 = $340.46
= $70 x (1 - .3405) /.08
= $ 70 x 8.2442
= $ 577.10
Bond Value = $340.46 + 577.10 = $ 917.56
To calculate the effective yield on this bond, note that 8 percent every six months is
equivalent to: Effective annual rate = (1 + .08)2 – 1 = 16.64%
90
1 -
 
1  YTM
2

2t 
 F

Example-6:
2

YTM
2 
 1  YTM 2 
2t
 
 
• Semiannual Coupon Rate = 1,000 x14% = 140/2 = $70

• Semiannual YTM = 16% /2 = 8%
• Periods to Maturity = 7 Years x 2 = 14 Periods
• Bond Value=
Present Value = $1,000/1.0814 = $1,000/2.9372 = $340.46
= $70 x (1 –1/ 2.9372) /.08
= $ 70 x (1 – 0.3405) / .08
= $ 70 x 8.2442
= $ 577.10
Bond Value = $340.46 + 577.10 = $ 917.56
To calculate the effective yield on this bond, note that 8 percent every six months is
equivalent to: Effective annual rate = (1 + .08)2 – 1 = 16.64% 91
1 -
 
1  YTM
2

2t 
 F

Example-7:
2

YTM
2 
 1  YTM 2 
2t
 
 
• Coupon Rate = 10%

• Par Value = $ 1,500
• YTM = 12% (APR)
• Maturity = 8 Years
 Number of Coupon Payments?

 Semiannual Coupon Payment?
 Semiannual Yield?
 Bond Valuation?
92
 Interest Rate Risk
Price Risk
Change in price due to changes in interest rates
Long-term bonds have more price risk than
short-term bonds
Low coupon rate bonds have more price risk
than high coupon rate bonds
93
 Interest Rate Risk
Reinvestment Rate Risk

Uncertainty concerning rates at which cash
flows can be reinvested
Short-term bonds have more reinvestment rate
risk than long-term bonds
High coupon rate bonds have more
reinvestment rate risk than low coupon rate
bonds
94
 Computing Yield-to-Maturity (YTM)
Yield-to-maturity (YTM) = the market required
rate of return implied by the current bond price
With a financial calculator,
Enter N, PV, PMT, and FV
Remember the sign convention
 PMT and FV need to have the same sign (+)
 PV the opposite sign (-)
 CPT I/Y for the yield
95
 YTM with Annual Coupons
Example -8:
Consider a bond with a 10% annual coupon rate, 15
years to maturity and a par value of $1000. The current
price is $928.09.
Will the yield be more or less than 10%?
We can use Trial and Error Method to find out YTM
If YTM is 9%:
Bond Value= $100 x (1- 1/(1+0.0915)/0.09 + $1,000 / (1+0.09)15
= $100 x (1 – 1/ 3.642)/0.09 + $ 1,000 / 3.642
= $ 100 x (1 – 0.2745)/0.09 + $ 274.574
= $ 100 x 0.7255/0.09 + $ 274.574
= $ 100 x 8.06 + $ 274.574
= $ 806 + $ 274.574 = $ 1,080.574 96
Example -8:
If YTM is 11%:
Bond Value= $100 x (1- 1/(1+0.1115)/0.11 + $1,000 / (1+0.11)15
= $100 x (1 – 1/ 4.7846)/0.11 + $ 1,000 / 4.7846
= $ 100 x (1 – 0.209)/0.11 + $ 209
= $ 100 x 0.791/0.11 + $ 209
= $ 100 x 7.19 + $ 209
= $ 719 + $ 209
= $ 928
97
Example -9:
Consider a bond with a 8% annual coupon rate, 6 years
to maturity and a par value of $1000. The current price
is $955.14.
Will the yield be more or less than 8%?
98
 YTM with Semi-Annual Coupons
Example -9:
Face Value = $1,000
Coupon Rate = 6%
Maturity = 5 Years
Current Price = $1,080.42
Semiannual Figures:
Semiannual Coupon rate = 1000 x 3% = $30
Semiannual Maturity periods = 10 periods
99
Example -10:
Current Price = $1,080.42
Semiannual Coupon rate = 1000 x 3% = $30
Semiannual Maturity periods = 10 periods
Trail and Error Method:
Present Value = $1,000 / 1.0410 = $1,000/1.480=675.676
Annuity Present Value= 30 x (1-1/1.0410)/0.04
= 30 x (1-1/1.480)/0.04
= 30 x (1-0.6757)/0.04
= 30 x 0.3243/0.04
= 30 x 8.1075
= 243.225
Total Bond Value = $918.901
100
Example -10:
4% YTM is not fit for fulfill Current Price = $1,080.42
Trail and Error Method:
Present Value = $1,000 / 1.02110 = $1,000/1.231=812.34
Annuity Present Value= 30 x (1-1/1.02110)/0.021
= 30 x (1-1/1.231)/0.021
= 30 x (1-0.812)/0.021
= 30 x 0.188/0.021
= 30 x 8.952
= 268.55
Total Bond Value = $812.34+$268.55 = $1,080.89
Therefore Semiannual YTM = 2.1%
Annual YTM = 4.2%
101
Example -11:
Suppose a bond with a 10% coupon rate and semiannual
coupons, has a face value of $1,000, 20 years to maturity
and is selling for $1,197.93.
- Is the YTM more or less than 10%?

- What is the semiannual coupon payment?
- How many periods are there?
102
2. More about Bond Features
 Debt versus Equity
Debt  Equity
 Not an ownership interest ◦ Ownership interest
 No voting rights ◦ Common stockholders vote
 Interest is tax-deductible to elect the board of
directors and on other
 Creditors have legal recourse if
issues
interest or principal payments
are missed ◦ Dividends are not tax
deductible
 Excess debt can lead to financial
distress and bankruptcy ◦ Dividends are not a liability
of the firm until declared.
Stockholders have no legal
recourse if dividends are not
declared
◦ An all-equity firm cannot go
bankrupt
103
 The Bond Indenture ―Deed of Trust‖
The Indenture is the written agreement between the
corporation (the borrower) and its creditors. It is
sometimes referred to as the deed of trust (the words
loan agreement or loan contract are usually used for
privately placed debt and term loans).
Contract between issuing company and bond holders includes:
Basic terms of the bonds
Total amount of bonds issued
Secured versus Unsecured
Sinking fund provisions (Repayment arrangements)
Call provisions
 Deferred call
 Call premium
Details of protective covenants 104
 Bond Classifications
Registered vs. Bearer Bonds
Security
Collateral – secured by financial securities
Mortgage – secured by real property, normally
land or buildings
Debentures – unsecured
Notes – unsecured debt with original maturity
less than 10 years
Seniority
Senior versus Junior, Subordinated
105
3. Bond Ratings
 Bond Ratings – Investment Quality
High Grade
Moody’s Aaa and S&P AAA – capacity to pay is
extremely strong
Moody’s Aa and S&P AA – capacity to pay is very
strong
Medium Grade
Moody’s A and S&P A – capacity to pay is strong,
but
more susceptible to changes in circumstances
Moody’s Baa and S&P BBB – capacity to pay is
adequate, adverse conditions will have more impact
on the firm’s ability to pay 106
3. Bond Ratings
 Bond Ratings – Speculative
Low Grade
Moody’s Ba, B, Caa and Ca
S&P BB, B, CCC, CC
Considered speculative with respect to capacity
to pay. The ―B‖ ratings are the lowest degree
of speculation.
Very Low Grade
Moody’s C and S&P C – income bonds with no
interest being paid
Moody’s D and S&P D – in default with principal
and interest in arrears
107
4. Some Different Types of Bonds
 Government Bonds
Municipal Securities
Debt of state and local governments
Varying degrees of default risk, rated similar to
corporate debt
Interest received is tax-exempt at the federal
level
Interest usually exempt from state tax in issuing
state
108
Treasury Securities = Federal government debt
Treasury Bills (T-bills)
 Pure discount bonds
 Original maturity of one year or less
Treasury notes
 Coupon debt
 Original maturity between one and ten years
Treasury bonds
 Coupon debt
 Original maturity greater than ten years
109
A taxable bond has a yield of 8% and a
municipal bond has a yield of 6%
If you are in a 40% tax bracket, which bond do you
prefer?
8%(1 - .4) = 4.8%
The after-tax return on the corporate bond is
4.8%, compared to a 6% return on the municipal
At what tax rate would you be indifferent between
the two bonds?
8%(1 – T) = 6%
T = 25%
110
 Zero Coupon Bonds
Make no periodic interest payments (coupon
rate = 0%)
Entire yield-to-maturity comes from the
difference between the purchase price and the
par value (capital gains)
Cannot sell for more than par value
Sometimes called zeroes, or deep discount
bonds
Treasury Bills and U.S. Savings bonds are good
examples of zeroes
111
 Floating Rate Bonds
Coupon rate floats depending on some index
value
Examples – adjustable rate mortgages and
inflation-linked Treasuries
Less price risk with floating rate bonds
Coupon floats, so is less likely to differ
substantially from the yield-to-maturity
Coupons may have a ―collar‖ – the rate cannot
go above a specified ―ceiling‖ or below a specified
―floor‖
112
 Other Bond Types
Structured notes
Convertible bonds
Put bonds
Many types of provisions can be added to a bond
Important to recognize how these provisions
affect required returns
Who does the provision benefit?
113
6. Inflation and Interest Rates
 Real Versus Nominal Rates
Real rate of interest
=Change in purchasing power
Nominal rate of interest
= Quoted rate of interest,
= Change in purchasing power and inflation
The ex ante nominal rate of interest includes our
desired real rate of return plus an adjustment for
expected inflation
114
 The Fisher Effect
The Fisher Effect defines the relationship
between real rates, nominal rates and
inflation
(1 + R) = (1 + r)(1 + h)
R = nominal rate (Quoted rate)
r = real rate
h = expected inflation rate
Approximation: R = r + h
115
Example:
The nominal rate was 15.50 percent and the
inflation rate was 5 percent. What was the real
rate?
1 + .1550 = (1+r) x (1+.05)
1 + r = 1.1550/1.05
1 + r = 1.05
r = 1.1-1
r = 0.1 = 10%
116
Example:
If we require a 10% real rate of return and we
expect inflation to be 8%, what is the nominal
rate?
117
2.6 Stock Valuation
118
Key Concepts and Skills
Understand how stock prices depend on
future dividends and dividend growth
Be able to compute stock prices using the
dividend growth model
Understand how corporate directors are
elected
Understand how stock markets work
Understand how stock prices are quoted
119
1.1 Content Outline
 Common Stock Valuation
 Some Features Common and
Preferred Stock
 The Stock Market
120
1. Common Stock Valuation
 Steps in Raising Equity
• Founder’s equity + Friends & Family
• Angel Investors
• Venture Capitalists
• Private Financing
• Initial Public Offering (IPO)
121
 Common Stock
• Stockholders are owners of the firm.
• Stockholders are residual claimants.
• Stockholders have the right to:
 Vote at company meetings
 Dividends and other distributions
 Sell their shares
• Stockholders benefit in two ways:
 Dividends
 Capital gains
• Stock is issued by public corporations to finance
investments.
• Stock is initially issued in the Primary Market (IPOs
and secondary offerings).
• Stock is traded in the Secondary Market on organized
exchanges. 122
 Transactions Involving Stocks
 Buy  Short Sell
 Savings motive  Sell stock without first owning
it.
 Expect stock to
appreciate in value  Borrow stock from your broker
with the promise to repay it at
 Long position
some later date.
 Sell
 Sell the borrowed stock.
 Liquidity needs
 Repurchase it at a later date to
 Expect stock to repay your broker.
decline in value
 Responsible for all dividends
and other distributions while
short the stock.
123
 Cash Flows for Stockholders
If you buy a share of stock, you can receive
cash in two ways
The company pays dividends
You sell your shares, either to another investor
in the market or back to the company
As with bonds, the price of the stock is the
present value of these expected cash flows
124
 One-Period Example
Suppose you are thinking of purchasing the stock
of Moore Oil, Inc.You expect it to pay a $2
dividend in one year, and you believe that you can
sell the stock for $14 at that time. If you require a
return of 20% on investments of this risk, what is
the maximum you would be willing to pay?
Compute the PV of the expected cash flows
P0 = (D1+P1) / (1+R)
P0 – Current Price of the Stock
P1 – Price in One Period
D1 – Cash dividend paid at the end of the period
Price = (14 + 2) / (1.2) = $13.33
125
 Two-Period Example
Now, what if you decide to hold the stock for
two years? In addition to the dividend in one
year, you expect a dividend of $2.10 in two
years and a stock price of $14.70 at the end of
year 2. Now how much would you be willing
to pay?
P0 = D1/ (1+R)1
P1 = (D2+P2) / (1+R)2
PV = 2 / (1.2) + (2.10 + 14.70) / (1.2)2 =
13.33
126
 Three-Period Example
Finally, what if you decide to hold the stock for
three years? In addition to the dividends at the
end of years 1 and 2, you expect to receive a
dividend of $2.205 at the end of year 3 and the
stock price is expected to be $15.435. Now how
much would you be willing to pay?
P0 = D1/ (1+R)1
P1 = D2 / (1+R)2
P2 = (D3+P3) / (1+R)3
PV = 2 / 1.2 + 2.10 / (1.2)2 + (2.205 + 15.435) /
(1.2)3 = 13.33
127
 Developing The Model
You could continue to push back the year in
which you will sell the stock
You would find that the price of the stock is
really just the present value of all expected
future dividends
So, how can we estimate all future dividend
payments?
128
 Estimating Dividends: Special Cases
Constant dividend
The firm will pay a constant dividend forever
This is like preferred stock
The price is computed using the perpetuity formula
Constant dividend growth
The firm will increase the dividend by a constant percent
every period
The price is computed using the growing perpetuity
model
Supernormal growth
Dividend growth is not consistent initially, but settles
down to constant growth eventually
The price is computed using a multi-stage model
129
 Zero Growth
If dividends are expected at regular intervals forever, then this
is a perpetuity and the present value of expected future
dividends can be found using the perpetuity formula
 P0 = D / R
Suppose stock is expected to pay a $0.50 dividend every
quarter and the required return is 10% with quarterly
compounding. What is the price?
 P0 = .50 / (.1 / 4) = $20
Example: Suppose the Paradise Prototyping Company has a
policy of paying a $10 per share dividend every year. If this
policy is to be continued indefinitely, what is the value of share
of stock if the required return is 20$? The stock in this case
amounts to an ordinary perpetuity, so the stock worth?
130
 Constant Growth
Suppose we know that the dividend for some company always
grow at a steady rate. Call this growth rate g. If we let D0 be
the dividend just paid, then the next dividend, D1, is :
D1=D0 x (1+g)
If the dividend t periods into the future, Dt, is given by:
Dt=D0 x (1+g)t
The Hedless Corporation has just paid a dividend of $3 per

share. The dividend of this company grows at a steady rate of
8% per year. Based on this information, what will the dividend
be in five years?
Future amount Dt=$3 x (1+.08)5 =$3 x 1.4693 = $4.41
131
 Dividend Growth Model
Dividends are expected to grow at a constant
percent per period.
P0 = D1 /(1+R) + D2 /(1+R)2 + D3 /(1+R)3 + …
P0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2 +
D0(1+g)3/(1+R)3 + …
With a little algebra and some series work, this
reduces to:
D 0 (1  g) D1
P0  
R -g R -g
132
 DGM – Example 1 D 0 (1  g) D1
P0  
R -g R -g
Suppose Big D, Inc., just paid a dividend of $0.50
per share. It is expected to increase its dividend by
2% per year. If the market requires a return of
15% on assets of this risk, how much should the
stock be selling for?
P0 = .50(1+.02) / (.15 - .02) = $3.92
133
P0  
R -g R -g
Suppose D0 is $2.30, R is 13% and g is 5%. How
much should the stock be selling for?
134
P0  
R -g R -g
Suppose TB Pirates, Inc., is expected to pay a $2
dividend in one year. If the dividend is expected to
grow at 5% per year and the required return is
20%, what is the price? In this example D1 = $2.
So What is P0?
135
 DGM – In case more years
We can actually use the dividend growth model
to get the stock price at any point in time, not
just today. In general, the price of the stock as of
time t is:
D t (1  g) D t 1
Pt  
R -g R -g
136
 DGM – Example 4 D t (1  g) D t 1
Pt  
R -g R -g
Suppose we are interested in the price of the stock
in five years, P5. R is 13%. We first need the dividend
at time 5, D5. Because the dividend just paid is $2.30
and the growth rate is 5% per year, D5is:
D5 = $2.30 x 1.055 = $2,30 x 1.2763 = $ 2.935
From the dividend growth model, we get the price of
the stock in five years.
P5 = D5 x (1+g) / R-g = $2.934 x 1.05 / 0.13-0.05
P5 = $3.0822 / 0.08 = $38.53
137
 DGM – Example 5 D t (1  g) D t 1
Pt  
R -g R -g
Suppose we are interested in the price of the stock
in five years, P5. R is 15%. Basic dividend just paid is
$5 and the growth rate is 5% per year, What is the
value of P5?
138
 Gordon Growth Company – I (Example)
Gordon Growth Company is expected to pay
a dividend of $4 next period, and dividends
are expected to grow at 6% per year. The
required return is 16%.
What is the current price?
P0 = 4 / (.16 - .06) = $40
Remember that we already have the dividend
expected next year, so we don’t multiply the
dividend by 1+g
139
 Gordon Growth Company - II(Example)
 What is the price expected to be in year 4?
P4 = D4(1 + g) / (R – g)
P4 = 4(1+.06)4 / (.16 - .06) = 50.50
 What is the implied return given the change in price during

the four year period?
50.50 = 40(1+return)4; return = 6%
PV = -40; FV = 50.50; N = 4; CPT I/Y = 6%
 The price is assumed to grow at the same rate as the

dividends
140
 Non-constant Growth Problem Statement
The main reason to consider this case is to allow
for ―supernormal‖ growth rates over some finite
length of time. As we discussed earlier, the growth
rate cannot exceed the required return
indefinitely, but it certainly could do so for some
number of years. To avoid the problem of having
to forecast and discount an infinite number of
dividends. We will require that the dividends start
growing at a constant rate sometime in the
future.
141
 Non-constant Growth Problem Statement
 For a simple example of non-constant growth, consider the case
of a company that is currently not paying dividends. You predict
that, it five years, the company will pay a dividend for the first
time. The dividend will be $.50 per share. You expect that this
dividend will then grow at a rate of 10% per year indefinitely. The
required return on companies such as this one is 20%. What is
the price of the stock today?
The first dividend will be paid in five years, and the dividend will
grow steadily from then on. Using the dividend growth model, we
can say that the price in four years will be:
P4 = D4 x (1+g) / (R-g)
= D5 / (R – g) = $0.50 / (0.20 – 0.10) = $5
If the stock will be worth $5 in four years, then we can get the
current value by discounting this price back four years at 20%.
P0 = $5 / 1.204 = $5 / 2.0735 = $2.41
The stock is therefore worth $2.41 today. 142
 Non-constant Growth Example Solution
 Suppose a firm is expected to increase dividends by 20% in one
year and by 15% in two years. After that, dividends will increase at
a rate of 5% per year indefinitely. If the last dividend was $1 and
the required return is 20%, what is the price of the stock?
 Remember that we have to find the PV of all expected future
dividends.
Compute the dividends until growth levels off
 D1 = 1(1.2) = $1.20
 D2 = 1.20(1.15) = $1.38
 D3 = 1.38(1.05) = $1.449
Find the expected future price
 P2 = D3 / (R – g) = 1.449 / (.2 - .05) = 9.66
Find the present value of the expected future cash
flows
 P0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2)2 = 8.67 143
 Using the DGM to Find R
Start with the DGM:
D 0 (1  g) D1
P0  
R -g R -g
D 0 (1  g) D1
R g g
P0 P0
144
 Finding the Required Return - Example
Suppose a firm’s stock is selling for $10.50. It
just paid a $1 dividend, and dividends are
expected to grow at 5% per year. What is the
required return?
R = [1(1.05)/10.50] + .05 = 15%
What is the dividend yield?
1(1.05) / 10.50 = 10%
What is the capital gains yield?
g =5%
145
 Stock Valuation Summary
146
2. Some Features of Common and
Preferred Stocks
 Features of Common Stock
Voting Rights
Proxy voting
Classes of stock
Other Rights
Share proportionally in declared dividends
Share proportionally in remaining assets during
liquidation
Preemptive right – first shot at new stock issue to
maintain proportional ownership if desired
147
Preferred Stocks
 Dividend Characteristics
Dividends are not a liability of the firm until a dividend
has been declared by the Board
Consequently, a firm cannot go bankrupt for not
declaring dividends
Dividends and Taxes
Dividend payments are not considered a business
expense; therefore, they are not tax deductible
The taxation of dividends received by individuals depends
on the holding period
Dividends received by corporations have a minimum 70%
exclusion from taxable income
148
Preferred Stocks
 Features of Preferred Stock
Dividends
Stated dividend that must be paid before dividends
can be paid to common stockholders
Dividends are not a liability of the firm, and
preferred dividends can be deferred indefinitely
Most preferred dividends are cumulative – any
missed preferred dividends have to be paid before
common dividends can be paid
Preferred stock generally does not carry
voting rights
149
3. Stock Market
Dealers vs. Brokers
New York Stock Exchange (NYSE)
Largest stock market in the world
License holders (1,366)
 Commission brokers
 Specialists
 Floor brokers
 Floor traders
Operations
Floor activity
150
3. Stock Market
NASDAQ
Not a physical exchange – computer-based quotation
system
Multiple market makers
Electronic Communications Networks
Three levels of information
 Level 1 – median quotes, registered representatives
 Level 2 – view quotes, brokers & dealers
 Level 3 – view and update quotes, dealers only
Large portion of technology stocks
151
3. Stock Market
Reading Stock Quotes
Sample Quote
What information is provided in the stock quote?

Click on the web surfer to go to Bloomberg for current
stock quotes.
152
3. Stock Market
Ethics Issues
The status of pension funding (i.e., over- vs.
under-funded) depends heavily on the choice of
a discount rate. When actuaries are choosing the
appropriate rate, should they give greater
priority to future pension recipients,
management, or shareholders?
How has the increasing availability and use of
the internet impacted the ability of stock traders
to act unethically?
153
Quick Quiz – Part I
What is the value of a stock that is
expected to pay a constant dividend of $2
per year if the required return is 15%?
What if the company starts increasing
dividends by 3% per year, beginning with
the next dividend? The required return
stays at 15%.
154
Quick Quiz – Part II
You observe a stock price of $18.75.You

expect a dividend growth rate of 5%, and the
most recent dividend was $1.50.What is the
required return?
What are some of the major characteristics
of common stock?
What are some of the major characteristics
of preferred stock?
155
Comprehensive Problem
XYZ stock currently sells for $50 per share.
The next expected annual dividend is $2, and
the growth rate is 6%. What is the expected
rate of return on this stock?
If the required rate of return on this stock
were 12%, what would the stock price be,
and what would the dividend yield be?
156
Review Questions
How do you find the value of a bond and why do
bond prices change?
What is a bond indenture and what are some of the
important features?
What are bond ratings and why are they important?
How does inflation affect interest rates?
What is the term structure of interest rates?
What factors determine the required return on
bonds?
How do you find the Stock Valuation?
What are the features of common and preferred
stocks?
How do assess the Stock Markets and Stock Market
reportings?
157
End of Chapter-2
158

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Chapter 2

Long-Term Debt Preferred Stock Common Stock

Retained Earnings New Common Stock

If Required Rate = 9%: NPV = -1,000 + 1,100 = $9.17

If Required Rate = 9%: NPV = -1,000 + 1,100 = $9.17

If Required Rate = 9%: NPV = -1,000 + 1,100 = $9.17

If Required Rate = 11%: NPV = -1,000 + 1,100 = –$9.01

If Required Rate = 9%: NPV = -1,000 + 1,100 = $9.17

If Required Rate = 11%: NPV = -1,000 + 1,100 = –$9.01

If Required Rate = 9%: NPV = -1,000 + 1,100 = $9.17

If Required Rate = 11%: NPV = -1,000 + 1,100 = –$9.01

 Here, we determine the average cost of

Weighted Average Cost of Capital (WACC)

 Average cost of capital of the firm.

 The cost of debt is the cost associated with

Interest is tax deductible

Marginal Tax Rate = 40%

The before tax cost of debt is 10%

Marginal Tax Rate = 40%

 Preferred stock is a source of long-term

However, there are floatation costs of issuing preferred stock:

However, there are floatation costs of issuing preferred stock:

Cost of Preferred Stock with floatation costs

kps = Dividend (D)

No adjustment is made for taxes as

 Cost of Equity is the expected rate of return by

Cost of internal equity--dividend growth model

The main limitation in this method is estimating growth accurately.

kcs = krf + b(km – krf)

kcs = krf + b(km – krf)

kcs = krf + b(km – krf)

kcs = 5% + 1.2(13% – 5%)

kcs = krf + b(km – krf)

kcs = 5% + 1.2(13% – 5%) = 14.6%

kcs = 10% + 5% = 15%

kcs = 3(1+0.10) + .10

kcs = 3(1+0.10) + .10 = .1625 = 16.25%

Firm Raises $10,000 of capital from long term sources

Compute Firm’s Capital Structure (% of each source)

Compute Firm’s Capital Structure (% of each source)

Compute Firm’s Capital Structure (% of each source)

When money is raised for capital projects, approximately

Source of Capital Cost

Green Apple’s tax rate is 40%

WACC= k0 = %Bonds x Cost of Bonds x (1-T)

WACC= k0 = %Bonds x Cost of Bonds x (1-T)

WACC= k0 = %Bonds x Cost of Bonds x (1-T)

WACC = .40 x 10% (1-.4)

WACC= k0 = %Bonds x Cost of Bonds x (1-T)

WACC = .40 x 10% (1-.4)

WACC= k0 = %Bonds x Cost of Bonds x (1-T)

WACC = .40 x 10% (1-.4)

WACC= k0 = %Bonds x Cost of Bonds x (1-T)

WACC = .40 x 10% (1-.4)

WACC= k0 = %Bonds x Cost of Bonds x (1-T)

WACC= k0 = %Bonds x Cost of Bonds x (1-T)

WACC = .40 x 10% (1-.4)

• Coupon Interest Rate:

• Yield To Maturity (YTM):

C = Coupon payment; F = Face value

Coupon rate = YTM Price = Par

 Number of Coupon Payments?

• Semiannual Coupon Rate = 1,000 x14% = 140/2 = $70

• Semiannual Coupon Rate = 1,000 x14% = 140/2 = $70