Ch.

12
Cost of Capital

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 Where we’ve been...

● Basic Skills: (Time value of money,

Financial Statements)
● Investments: (Stocks, Bonds, Risk and
Return)
● Corporate Finance: (The Investment
Decision - Capital Budgeting)

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Assets Liabilities & Equity
Current assets Current Liabilities

Fixed assets Long-term debt

Preferred Stock
Common Equity

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 The investment decision

Assets Liabilities & Equity

Current assets Current Liabilities

Fixed assets Long-term debt

Preferred Stock
Common Equity

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 Where we’re going...

● Corporate Finance: (The Financing

Decision)
Cost of capital
Leverage
Capital Structure
Dividends

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Assets Liabilities & Equity
Current assets Current Liabilities

Fixed assets Long-term debt

Preferred Stock
Common Equity

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 The financing decision

Assets Liabilities & Equity

Current assets Current Liabilities

Fixed assets Long-term debt

Preferred Stock
Common Equity

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Assets Liabilities & Equity
Current assets Current Liabilities

Long-term debt
Preferred Stock
Common Equity

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Assets Liabilities & Equity
Current assets Current Liabilities

Long-term debt
}
Capital Structure Preferred Stock
Common Equity

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 Ch. 12 - Cost of Capital
● For Investors, the rate of return on a
security is a benefit of investing.
● For Financial Managers, that same
rate of return is a cost of raising funds
that are needed to operate the firm.
● In other words, the cost of raising
funds is the firm’s cost of capital.

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 How can the firm raise capital?
● Bonds
● Preferred Stock
● Common Stock
● Each of these offers a rate of return to
investors.
● This return is a cost to the firm.
● “Cost of capital” actually refers to the
weighted cost of capital - a weighted
average cost of financing sources.
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 Cost of
Debt

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 Cost of Debt

For the issuing firm, the cost

of debt is:
● the rate of return required
by investors,
● adjusted for flotation costs
(any costs associated with
issuing new bonds), and
● adjusted for taxes.
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 Example: Tax effects of
financing with debt
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000

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 Example: Tax effects of
financing with debt
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000

● Now, suppose the firm pays $50,000 in

dividends
* to the stockholders. 15
 Example: Tax effects of
financing with debt
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000
- dividends (50,000) 0
Retained earnings 214,000 231,000
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After-tax Before-tax Marginal
% cost of = % cost of x - tax
Debt Debt
1 rate

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After-tax Before-tax Marginal
% cost of = % cost of x - tax
Debt Debt
1 rate

Kdt = kd (1 - T)

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After-tax Before-tax Marginal
% cost of = % cost of x - tax
Debt Debt
1 rate

Kd = kd (1 - T)

.066 = .10 (1 - .34)

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 Example: Cost of Debt
● Prescott Corporation issues a $1,000
par, 20 year bond paying the market
rate of 10%. Coupons are annual.
The bond will sell for par since it pays
the market rate, but flotation costs
amount to $50 per bond.

● What is the pre-tax and after-tax cost

of debt for Prescott Corporation?
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● Pre-tax cost of debt: (using TVM)
P/Y = 2 N = 40
PMT = -50
FV = -1000
PV = 950
solve: I = 10.61% = kd
● After-tax cost of debt:
Kd = kd (1 - T)
Kd = .1061 (1 - .34)
Kd = .07 = 7%
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● Pre-tax cost of debt: (using TVM)
P/Y = 2 N = 40
PMT = -50
FV = -1000 So, a 10% bond
PV = 950 costs the firm
solve: I = 10.61% = kd only 7% (with
● After-tax cost of debt: flotation costs)
Kd = kd (1 - T) since the interest
Kd = .1061 (1 - .34) is tax deductible.
Kd = .07 = 7%
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 Cost of Preferred Stock

● Finding the cost of preferred stock

is similar to finding the rate of
return, (from Chapter 8) except
that we have to consider the
flotation costs associated with
issuing preferred stock.

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 Cost of Preferred Stock
● Recall:

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 Cost of Preferred Stock
● Recall:

D Dividend
kp = =
Po Price

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 Cost of Preferred Stock
● Recall:

D Dividend
kp = =
Po Price

● From the firm’s point of view:

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 Cost of Preferred Stock
● Recall:

D Dividend
kp = =
Po Price

● From the firm’s point of view:

kp = D = Dividend
NPo Net Price
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 Cost of Preferred Stock
● Recall:

D Dividend
kp = =
Po Price

● From the firm’s point of view:

kp = D = Dividend
NPo Net Price
NPo *= price - flotation costs! 28
 Example: Cost of Preferred

● If Prescott Corporation issues

preferred stock, it will pay a
dividend of $8 per year and
should be valued at $75 per share.
If flotation costs amount to $1 per
share, what is the cost of
preferred stock for Prescott?

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 Cost of Preferred Stock

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 Cost of Preferred Stock

D Dividend
kp ==
NPo Net Price

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 Cost of Preferred Stock

D Dividend
kp = =
NPo Net Price

8.00
= =
74.00

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 Cost of Preferred Stock

D Dividend
kp = =
NPo Net Price

8.00
= = 10.81%
74.00

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 Cost of Common Stock

● There are 2 sources of Common

Equity:
1) Internal common equity (retained
earnings), and
2) External common equity (new
common stock issue)

Do these 2 sources have the same cost?

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 Cost of Internal Equity

● Since the stockholders own the firm’s

retained earnings, the cost is simply
the stockholders’ required rate of
return.
● Why?
● If managers are investing
stockholders’ funds, stockholders will
expect to earn an acceptable rate of
*
return. 35
 Cost of Internal Equity

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 Cost of Internal Equity
1) Dividend Growth Model

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 Cost of Internal Equity
1) Dividend Growth Model

kc = D 1
+g
Po

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 Cost of Internal Equity
1) Dividend Growth Model

kc = D 1
+g
Po

2) Capital Asset Pricing Model (CAPM)

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 Cost of Internal Equity
1) Dividend Growth Model

kc = D 1
+g
Po

2) Capital Asset Pricing Model (CAPM)

kj = krf + (k
jβ m
- krf
)
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 Cost of External Equity

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 Cost of External Equity

Dividend Growth Model

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 Cost of External Equity

Dividend Growth Model

D1
knc = NPo + g

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 Cost of External Equity

Dividend Growth Model

D1
knc = NPo + g

Net proceeds to the firm

after flotation costs!
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 Weighted Cost of Capital

● The weighted cost of capital is just

the weighted average cost of all of
the financing sources.

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 Weighted Cost of Capital

Capital
Source Cost Structure
debt 6% 20%
preferred 10% 10%
common 16% 70%

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 Weighted Cost of Capital
(20% debt, 10% preferred, 70% common)

● Weighted cost of capital =

.20 (6%) + .10 (10%) + .70 (16%)
= 13.4%

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