•Capital is a necessary element of production, without which the firm cannot

operate.
•All firms need to secure proper financing sources, from debt to equity, to

support its operations especially when involves in large capital expenditures.

•Cost of capital is the minimum rate of return that the firm must earn on its

capital investment project in order to satisfy the required rate of return of the

firm’s investors.

DEBT
•Debt represents a source of permanent financing used

extensively to support capital investment.

•Varieties of long-term instruments:
–Convertible
•Gives the holder the options to exchange the debt issue for

a specified number of firm’s common shares during a

specified period.
–Straight or non-convertible

PREFERENCE OF DEBT

FINANCING OVER

EQUITY FINANCING
•Management control
•Cost of funds

Cost of debt
•The cost of debt is the required

Term Loans return on our company’s debt.

•Can be obtained in a short
•The required return is best

time, flexible and low

estimated by computing the

issuance costs with maturity

yield-to-maturity on the

of more than 5 years. existing debt.

•Sources: banks, insurance
•The cost of debt is NOT the

company, or pension fund. coupon rate.

•May have fixed or variable

interest rates.

Bond
~ Secured Bonds
~ Unsecured Bonds
Present Value of Bond, B0 = CP (PVIFAk,n) + M (PVIFk,n)

Common Equity
Preferred Stock •The cost of equity is the return

•Can be obtained in a short time,

required by equity investors

flexible and low issuance costs

given the risk of the cash flows

with maturity of more than 5

from the firm.
years. •There are two major methods

•Sources: banks, insurance

for determining the cost of

company, or pension fund. equity:

•May have fixed or variable
–Dividend growth model
interest rates. –SML or CAPM

The SML Approach

•Use the following information to compute our cost of equity
–Risk-free rate, Rf
–Market risk premium, E(RM) – Rf
–Systematic risk of asset,