Chapter four

Bonds and stock valuation and cost of capital

A. Bonds and stock valuation
1. Bond defined
A bond is a long-term contract under which a borrower agrees to make payments of interest and
principal, on specific dates, to the holders of the bond. It is long term debt instrument or security.
1.1. Features of bonds
Par value: The par value is the stated face value of the bond. Generally, bonds are issued at par
value. Interest is paid on par value. The par value generally represents the amount of money the
firm borrows and promises to repay on the maturity date.
Interest rate: it is fixed and known to bond holders (debenture holders). Interest paid on bond is
tax deductible. And it is also called coupon rate which are a detachable certificate of deposits.
Maturity value: a bond is issued for a specified period of time, and is repaid on maturity.
Redemption value: the value that the bond holder will get on maturity, also called maturity
value. A bond may be redeemed at a par or premium (more than par value) or discount (lass than
par value).
Market value: a bond may be traded in a stock exchange. The price at which it is currently sold
or bought is called the market value of the bond. Market value may be different from par value
or redemption value.
Floating rate bond: A bond whose interest rate fluctuates with shifts in the general level of
interest rates.
Zero Coupon Bond: A bond that pays no annual interest but is sold at a discount below par,
thus providing compensation to investors in the form of capital appreciation.
Call Provision: A provision in a bond contract that gives the issuer the right to redeem the bonds
under specified terms prior to the normal maturity date.
Convertible Bond: A bond that is exchangeable, at the option of the holder, for common stock
of the issuing firm.
Sinking Fund Provision: A provision in a bond contract that requires the issuer to retire a
portion of the bond issue each year.
Investors have many choices when investing in bonds, but bonds are classified into four main
types: Treasury, corporate, municipal, and foreign. Each type differs with respect to expected
return and degree of risk.
Treasury bonds, sometimes referred to as government bonds, are issued by the federal
government. It is reasonable to assume that the federal government will make good on its
promised payments, so these bonds have no default risk.
However, Treasury bond prices decline when interest rates rise, so they are not free of all risks.
Corporate bonds, as the name implies, are issued by corporations. Unlike Treasury bonds,
corporate bonds are exposed to default risk, if the issuing company gets into trouble, it may be
unable to make the promised interest and principal payments. Different corporate bonds have

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different levels of default risk, depending on the issuing company’s characteristics and on the
terms of the specific bond. Default risk is often referred to as “credit risk,” and the larger the
default or credit risk, the higher the interest rate the issuer must pay.
Municipal bonds, or “munis,” are issued by state and local governments. Like corporate bonds,
munis have default risk. However, munis offer one major advantage over all other bonds: the
interest earned on most municipal bonds is exempt from federal taxes and also from state taxes if
the holder is a resident of the issuing state. Consequently, municipal bonds carry interest rates
that are considerably lower than those on corporate bonds with the same default risk.
Foreign bonds are issued by foreign governments or foreign corporations. Foreign corporate
bonds are, of course, exposed to default risk, and so are some foreign government bonds. An
additional risk exists if the bonds are denominated in a currency other than that of the investor’s
home currency. For example, if you purchase corporate bonds denominated in Japanese yen, you
will lose money, even if the company does not default on its bonds, if the Japanese yen falls
relative to Birr.
1.2. Bond valuation
The valuation process for a bond requires knowledge of three basic elements.
i. The amount of the cash flows to be received by the investor, which is equal to the
periodic interests to be received and the par value to be paid at maturity.
ii. The maturity date of the loan.
iii. The investor’s required rate of return.
The periodic interest can be received annually or semiannually. The value of a bond is simply the
present value of these cash flows. Two versions of the bond valuation model are presented
below.
® If the interest rate payments are made annually, then;

= I (PVIFAi,n) + M(PVIFi,n)
Where; I= Interest payment each year=coupon rate × par value
M=par value or maturity value
I= investor’s required rate of return
n=number of years to maturity
PVIA=present value interest factor of an annuity of Birr 1
PVIF= present value interest factor of a lump sum of Birr 1
Eg: Consider a bond, maturing in 10 years and having a coupon rate of 8 percent. The par value
is Birr 1,000. Investors consider 10 percent to be an appropriate required rate of return in view of
the risk level associated with this bond. The annual interest payment is Birr 80(8% X Birr l,000).
The present value of this bond is:
Solution: V= I (PVIFAi,n) + M(PVIFi,n)
V= 80×(PVIFA10%,10yrs) + 1000×(PVIF10%10yrs)
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 V= =80(6.1446) + 1,000(0.3855) = 491.57 + 385.50 = Birr 877.07
If the interest is paid semiannually, then;

= I/2 (PVIFAi/2,2n) + M(PVIFi/2,2n)

V= 80/2(PVIFA10%/2, 2×10yrs) + 1000(PVIF10%/2,2×10yrs)
= 40 (12.4622) + 1000 (0.3769) = 498.49 + 376.9 = Birr 875.39
The relationship between coupon rate of a bond and its required rate of return is explained on the
following.
1. Whenever the going rate of interest, coupon rate, is equal to the coupon rate, a fixed-rate
bond will sell at its par value. Normally, the coupon rate is set equal to the going rate
when a bond is issued, causing it to sell at par initially.
2. Whenever the going rate of interest rises above the coupon rate, a fixed-rate bond’s price
will fall below its par value. Such a bond is called a discount bond.
3. Whenever the going rate of interest falls below the coupon rate, a fixed rate bond’s price
will rise above its par value. Such a bond is called a premium bond.
4. Thus, an increase in interest rates will cause the prices of outstanding bonds to fall,
whereas a decrease in rates will cause bond prices to rise.
5. The market value of a bond will always approach its par value as its maturity date
approaches, provided the firm does not go bankrupt.
1.2.1. Yield to Maturity (YTM)
YTM is the rate of return earned on a bond if it is held to maturity. It is the measure of a bond’s
rate of return that considers both the interest income and any capital gain or loss. YTM is the
bond’s internal rate of return (required rate of return).
Eg: the YTM of five years bond, paying 6% interest on the face value of Birr 1,000 and currently
selling for Birr 833.40 is:
Solution:

Here, solve for YTM by try and error. You will get approximately 10%.
1.2.2. Yield To Call
The rate of return earned on a bond if it is called before its maturity date. A number of
companies issue bonds with buy back or call provision. Thus a bond can be redeemed or called
before maturity. The call period is different from maturity and the call value could be different
from the maturity value.
If current interest rates are well below an outstanding bond’s coupon rate, then a callable bond is
likely to be called, and investors will estimate its expected rate of return as the yield to call
(YTC) rather than as the yield to maturity. To calculate the YTC, solve this equation for i:

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 ; Then calculate for i, by try and error, so as to calculate YTM.

1.2.3. Current Yield

Current yield is the annual interest payment on a bond divided by the bond’s current price. If the
bond’s current price is less than its maturity value, its overall rate of return would be less than
the current yield.
Eg: if the annual interest is Birr 80 on the current investment of 887. Therefore the current value
will be:

1.2.4. Pure discount bonds

Pure discount bonds do not carry an explicit rate of interest. It provides for the payment of lump
sum amount at the future date in exchange for the current price of the bond. It is also called Deep
Discount bond, or Zero coupon bond, or Zero interest bonds.

Where, V=is the value of the bond; i=is the investor’s required rate of return;
n=number of periods and M=maturity value
Eg: A zero coupon bond with a face value of Birr10,000 which will mature at 30 years, has a
current yield on the bond 9%, then the value of the pure discount bond will be:

Solution:

1.2.5. Perpetuate bonds (Consols)

Those bonds don’t have maturity value and date. Its life is indefinite. The value of perpetual
bond is the discounted value of the infinite stream of the interest flows.

; Where PV = perpetuity value of a bond

1.3. Risks associated with bond

1. Interest rate risk: the risk of decline in a bond’s price due to an increase in interest
rates. This risk arises from the fluctuating of interest rates. Interest rates will be higher for
long maturity bonds than short maturity bonds and their riskiness increases as the time to
maturity becomes long. The longer the maturity of the bond, the more its price changes in
response to a given change in interest rates.
2. Market risk: risks associated: risks associated with market fluctuation existed in the
stock markets.
3. Default risk: is the risk that a borrower will be unable to make interest payments
(principals) repayment on debt.
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 4. Purchasing power risk: risk associated with changes in the value of a given currency.
1.4. Bond rating criteria
Bond rating is the deciding of the interest rate of a bond. Bond ratings are important both to
firms and to investors. First, because a bond’s rating is an indicator of its default risk, the rating
has a direct, measurable influence on the bond’s interest rate and the firm’s cost of debt. Second,
most bonds are purchased by institutional investors rather than individuals, and many institutions
are restricted to investment-grade securities
Bond ratings are based on both qualitative and quantitative factors, some of which are listed
below:
1. Various ratios, including the debt ratio and the times-interest-earned ratio. The better the
ratios, the higher the rating.
2. Mortgage provisions: Is the bond secured by a mortgage? If it is, and if the property has
a high value in relation to the amount of bonded debt, the bond’s rating is enhanced.
3. Subordination provisions: Is the bond subordinated to other debt? If so, it will be rated
at least one notch below the rating it would have if it were not subordinated. Conversely,
a bond with other debt subordinated to it will have a somewhat higher rating.
4. Guarantee provisions: Some bonds are guaranteed by other firms. If a weak company’s
debt is guaranteed by a strong company (usually the weak company’s parent), the bond
will be given the strong company’s rating.
5. Sinking fund: Does the bond have a sinking fund to ensure systematic repayment? This
feature is a plus factor to the rating agencies.
6. Maturity: Other things the same, a bond with a shorter maturity will be judged less
risky than a longer-term bond, and this will be reflected in the ratings.
7. Stability: Are the issuer’s sales and earnings stable?
8. Regulation: Is the issuer regulated, and could an adverse regulatory climate cause the
company’s economic position to decline? Regulation is especially important for utilities
and telephone companies.
9. Antitrust: Are any antitrust actions pending against the firm that could erode its
position?
10. Overseas operations: What percentage of the firm’s sales, assets, and profits are from
overseas operations, and what is the political climate in the host countries?
11. Environmental factors: Is the firm likely to face heavy expenditures for pollution
control equipment?
12. Product liability: Are the firm’s products safe? The tobacco companies today are under
pressure, and so are their bond ratings.
13. Pension liabilities: Does the firm have unfunded pension liabilities that could pose a
future problem?
14. Labor unrest: Are there potential labor problems on the horizon that could weaken the
firm’s position? As this is written, a number of airlines face this problem, and it has
caused their ratings to be lowered.
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 15. Accounting policies: If a firm uses relatively conservative accounting Policies, its
reported earnings will be of “higher quality” than if it uses less conservative procedures.
Thus, conservative accounting policies are a plus factor in bond ratings.
2. Stock Valuation
Companies issued two types of shares, named as Ordinary shares and Preference shares.
Preference shares have preference over ordinary shares in terms of payments of dividends
and repayment of capital, if the company is liquidated or wound up. Preference share may be
issued with or without maturity period. Redeemable preference shares are shares issued with
maturity, and Irredeemable preference shares are shares that are issued without maturity
period stated. But, ordinary shares are issued mostly without maturity period stated.
Dividends of preference shares can be with or without cumulative features. Commulative
preference shares are shares on which their unpaid dividend are accumulated are payable in
the future. Whereas, Non-commulative preference shares are shares on which dividend in
arrears do not accumulate. There is no such feature in common stock.

Features of stocks
® Claims: preference share holders have a claim on assets and income prior to ordinary
share holders. Ordinary share holders have a residual claim on a company’s income and
assets. They are legal owners of the company.
® Dividend: dividends for preference share holder are fixed. Preference share holders’ can
be cumulate. Ordinary share holders have neither fixed dividend receipts nor accumulate
dividends.
® Redemption: for preference shares, redeemable and irredeemable shares can be issued.
But, for ordinary shares there is no maturity date stated.
® Conversion: a company can issue a convertible preference share, on which such shares
can be converted in to ordinary shares.

Like bonds, the value of stock is the present value of all future cash inflows expected to
receive by the investor. The cash inflows expected to be received are dividends and the future
price at the time of sale of the stock.
2.1. Preference stock valuation
¥ For valuation of preference shares which has maturity date: we can use the following
formula.

OR Po=PD×(PVIFAi,n) + Pn×(PVIFi,n)

Where, Po= value of preference shares, PD= preference dividend per share, Pn= maturity value
of the preference shares, i=the required rate of return of the preference share, and n= maturity
period of the preference share.

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Eg: suppose an investor is considering the purchase of a 12 year, 10% dividend for Rs100 par
value preference share. The redemption value of the preference share on maturity is Rs 120. The
investor’s required rate of return is 10%. What amount should he/she willing to pay for the share
now?
Solution: the dividend is 10% of the par value=100×0.1=10, the present value of the P/share is
=120Rs, the maturity period =12years, required rate of return=11%
Po=10 (PVIFA11%, 12yrs) + 120 (PVIF11%, 12yrs) =10 (6.492) + 120 (0.286) = Rs 99.24
¥ Valuation of preference shares without maturity, we can use the following formula;

Where, PD= dividend payment, i=required rate of return by the investor

Eg: assuming a company issues Rs 100 irredeemable preference shares which it pays a dividend
of 9%. Assume also, this type of preference share is currently yielding a dividend of 11%. What
is the value of the preference share?

Solution:

2.2. Common stock valuation

For an investor holding a common stock for only 1year, the value of the stock would be the
present value of both the expected cash dividend to be received in 1year ( D1 ) and the expected
market price per share of the stock at year-end ( P1). If r represents an investor's required rate of
return, the value of common stock (P0) would be:

OR

Eg: Assume an investor is considering the purchase of stock A at the beginning of the year. The
dividend at year-end is expected to be Birr1.50, and the market price by the end of the year is
expected to be Birr 40. If the investor's required rate of return is 15 percent, the value of the
stock would be:

=1.50(0.870) + 40(0.870) = 1.31 + 34.80 = Birr 36.11

Since common stock has no maturity date and is held for many years, a more general, multi
period model is needed. The general common stock valuation model is defined as follows:

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There are three cases of growth in dividends. They are (1) zero growth; (2) constant growth; and
(3) Non-constant, or supernormal, growth.
In the case of zero growth, if
DO= D1= …= D
Then the valuation model;

Reduces to the formula:

Eg: Assuming D equals Birr 2.50 and i equal 10 percent, then the value of the stock is:

Solution: P0=2.5/0.1= Birr 25

In the case of constant growth, if we assume that dividends grow at a constant rate of g every
year [i.e., D, = Do (l + g)'], then the above model is simplified to:

This formula is known as the Gordon growth model.

Eg: Consider a common stock that paid a Birr 3 dividend per share at the end of the last year and
is expected to pay a cash dividend every year at a growth rate of 10 percent. Assume the
investor's required rate of return is 12 percent. The value of the stock would be:
Solution: D1 = Do (l + g) = 3(1 + 0.10) = Birr 3.30

; = Birr 165

Finally, consider the case of non-constant, or supernormal growth. Firms typically go through
life cycles, during part of which their growth is faster than that of the economy and then falls
sharply. The value of stock during such supernormal growth can be found by taking the
following steps:
1. Compute the dividends during the period of supernormal growth and find their present
value;
2. find the price of the stock at the end of the supernormal growth period and compute its
present value; and
3. Add these two PV figures to find the value (PO ) of the common stock.
Eg: Consider a common stock whose dividends are expected to grow at a 25 percent rate for 2
years, after which the growth rate is expected to fall to 5 percent. The dividend paid last period

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was Birr 2. The investor desires a 12 percent return. To find the value of this stock, take the
following steps:
Solution:
Step-1: Compute the dividends during the supernormal growth period and find their present
value. Assuming Do is Birr 2, g is 25 percent, and i is 12 percent:
D1 = Do (1 + g) = 2(1 + 0.25) = Birr 2.50
D2 = Do (1 +g)2 = 2(1.563) = Birr 3.125 OR
D2 = D1 (1 + g) = 2.50(1.25) = Birr 3.125

= 2.50× (PVIF12%, 1) + 3.125× (PVIF12%,2)

= 2.50× (0.8929) + 3.125× (0.7972) = 2.23 + 2.49 = Birr 4.72

Step-2: Find the price of the stock at the end of the supernormal growth period. The dividend
for the third year is:
D3 = D2 (1+ g’), where g’ = 5%
= 3.125(1 + 0.05) = Birr3.28
The price of the stock is therefore:

PV of stock price = 46.86(PVIF12%, 2) = 46.86(0.7972) = Birr37.36

Step-3: Add the two PV figures obtained in steps-1and 2 to find the value of the stock.
PO = $4.72 + $37.36 = $42.08

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 3. Cost of capital
Cost of capital refers to the rate of return a firm must earn on its investment project to increase
the market value of its common shares. Or it is the rate of return required by market suppliers of
capital to attract funds to the firm.
The opportunity cost of capital for a project is the discount rate for discounting its cash flows.
The project’s cost of capital is the minimum required rate of return on funds committed to the
project which depends on the riskiness of its cash flows.
A firm’s cost of capital will be the overall, or average, required rate of return on the aggregate of
investment projects.
Cost of capital can be useful as a standard of; evaluating investment decisions, designing debt
policy, and appraising the financial performance of top management.
The items on the right side of a firm’s balance sheet, which includes; various types of debts,
preferred stocks and common stock (equity) are called the capital components. Any increase in
total assets must be financed by an increase in one or more of these capital components.
1. Cost of debt
Companies may raise debt through borrowings from financial institutions or public deposits on
bonds for a specified period of the time at a certain rate of return. The before-tax cost of debt
can be found by determining the internal rate of return (or yield to maturity) on the bond cash
flows.

Where; I = annual interest payments in dollars

M = par value, usually $1000 per bond

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 V = value or net proceeds from the sale of a bond
n = term of the bond in years
Since the interest rate payments are tax-deductible, the cost of debt must be stated on after tax
basis. The after-tax cost of debt is:
, where t= tax rate
If the debt is issued at par, the cost of debt will be calculated using:
; Where, I=interest payment, and M=par value or issue price of the bond

Eg: Assume that the Carter Company issues a $l, 000, 8 percent, 20-year bond whose net
proceeds are $940.The tax rate is 40 percent. Then, the before-tax cost of debt, ki, is:
Solution:

Therefore, the after-tax cost of debt is: Kd = Ki(l -t) = 8.56%(1 -0.4) = 5.14%
Interest paid on debt is tax deductible. The higher the interest charged, the lower will be the
amount of tax payable by the firm. The cost of debt will be less, when it is after tax.
2. Cost of preferred shares
The cost of preferred stock, Kp, is found by dividing the annual preferred stock dividend, dp, by
the net proceeds from the sale of the preferred stock, p , as follows:

Since preferred stock dividends are not a tax-deductible expense, these dividends are paid out
after taxes.
Eg1: Suppose that the Carter Company has preferred stock that pays a $13 dividend per share
and sells for $100 per share in the market. The flotation (or underwriting) cost is 3 percent, or $3
per share. What is the cost of preferred stock?
Solution:

Eg2: firm A intends to issue a 10% annual dividend preferred share with an expected value of
$100. Floatation costs amount to 5.6% per share. What is the cost of preferred equity?
Solution:

For preferred stocks which have maturity, cost of preferred stock can be calculated as;

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Where: Kp=the cost of preferred stock, dp=dividends to preferred stockholders, Pn=maturity
value of the preferred share, and P=net proceed from the sale of the stock.
Calculate for Kp by try and error, so as to get the cost of preferred stock with maturity.
3. Cost of equity capital
Cost of equity is the shareholders’ required rate of return, which equates the present value of the
expected dividends with market value of the share.
Measuring cost of equity has two difficulties: one is the difficulty to estimate the expected
dividends and the other one is the future earnings and dividends are expected to grow over time
and estimation of the growth of dividends is very difficult.
Three techniques can be used so as to measure the cost of common stock equity capita1.
(1) The Gordon’s growth model; (2) the capital asset pricing model (CAPM) approach; and
(3) the bond plus approach.
i. Growth model: as we have seen on the valuation of common stock, there are three
growth models.
a. Zero growth model: in case of zero growth model, the valuation equation was:

, here growth of dividends, g, will be zero, if the firm doesn’t retained some of its

earnings.
So as to calculate the cost of equity, calculate for i, in the above equation.

; as there is no retain earnings,

b. Constant growth model: the value of the stock in case of constant growth of dividends
is:

; calculate for i, so as to get cost of common equity on the Gordon Growth

model.

; i is replaced by Ke, so as to indicate it is cost of common equity.

Eg: Assume that the market price of the Carter Company’s stock is $40. The dividend to be paid
at the end of the coming year is $4 per share and is expected to grow at a constant annual rate of
6 percent. Then the cost of this common stock is:
Solution:

The cost of new common stock, or external equity capital, is higher than the cost of existing
common stock because of the flotation costs involved in selling the new common stock.
If f is flotation cost in percent, the formula for the cost of new common stock is:

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Eg: consider the above example, except, the firm is trying to sell new issues of stock A and its
flotation cost is 10%. Then,

c. Supernormal growth model: the present value of the common stock in addition to the
three steps that we have seen , can be calculated by using:

; Where, gs=the supernormal growth of dividends,

gn=the perpetual growth rate (normal growth of dividends after the supernormal).
To get the cost of common stock under supernormal growth of dividends, solve for Ke by try
and error.
ii. The Capital Asset Pricing Model (CAPM) Approach:
An alternative approach to measuring the cost of common stock is to use the CAPM, which
involves the following steps:
1. Estimate the risk-free rate, rf.
2. Estimate the stock’s beta coefficient, β, which is an index of systematic (or non
diversifiable market) risk.
3. Estimate the rate of return on the market portfolio, rm.
4. Estimate the required rate of return on the firm’s stock, using the CAPM (or SML)
equation:
CAPM is a model that is used to determine the required rate of return on asset and indicates the
relationship between return and risk of the asset.
Ke = rf+ β(rm – rf)
Where; rf=risk free rate of return, rm=rate of return on the market, β=the stock’s beta coefficient
Eg: Assuming that rf is 7 percent, β is 1.5, and rm is 13 percent, then:
Ke = rf+ βb(rm – rf) = 7% + 1.5(13% -7%) = 16%
This 16 percent cost of common stock can be viewed as consisting of a 7 percent risk-free rate
plus a 9 percent risk premium, which reflects that the firm’s stock price is 1.5 times more volatile
than the market portfolio to the factors affecting non diversifiable, or systematic, risk.
iii. The Bond-plus Approach: in this approach, the cost of common stock is the firm’s cost
of long term debt plus a risk premium to it.
Ke = long-term bond rate +risk premium
Ke= ki(1-t) +risk premium
A risk premium of about 4 percent is commonly used with this approach.
Eg: consider the example that we have seen in cost of debt, the cost of common stock using the
bond plus approach is:
Ke = long-term bond rate + risk premium
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Ke= ki(1 - t) + risk premium
Ke= 5.14% + 4% = 9.14%
Cost of Retained Earnings
The cost of retained earnings, ks, is closely related to the cost of existing common stock, since
the cost of equity obtained by retained earnings is the same as the rate of return investors require
on the firm’s common stock. Therefore,
ks = ke=D1/P0+g
Measuring the overall cost of capital (weighted average cost of capital (WACC))
The firm’s overall cost of capital is the weighted average of the individual capital costs, with the
weights being the proportions of each type of capital used. Let K0, be the overall cost of capital.

Ke= Wd*kd + wp*kp+ We*Ke + Ws*Ks

Where, Wd = % of total capital supplied by debt,
Wp = % of total capital supplied by preferred stock,
We = % of total capital supplied by external equity,
Ws= % of total capital supplied by retained earnings (or internal equity)
The weights can be historical, target, or marginal.
Historical Weights
Historical weights are based on a firm’s existing capital structure. The use of these weights is
based on the assumption that the firm’s existing capital structure is optimal and therefore should
be maintained in the future. Two types of historical weights can be used-book value weights and
market value weights.
Book Value Weights. The use of book value weights in calculating the firm’s weighted cost of
capital assumes that new financings will be raised using the same method the firm used for its
present capital structure. The weights are determined by dividing the book value of each capital
component by the sum of the book values of all the long-term capital sources.
Eg: Assume the following capital structure for the Carter Company:
Mortgage bonds ($l, 000 par) $20,000,000
Preferred stock ($100 par) 5,000,000
Common stock ($40 par) 20,000,000
Retained earnings 5,000,000
Total $50.000.000
The book value weights and the overall cost of capital are computed as follows:
Source Book Value Weights Cost Weighted
Cost
Debt $20,000,000 40% 5.14% 2.06%
Preferred stock 5,000,000 10 13.40% 1.34
Common stock 20,000,000 40 17.11 6.84
Retained earnings 5,000,000 10 16.00% 1.60
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Totals $50,000,000 100% 11.84%
The overall cost of capital, K0 = 11.84%
Market Value Weights. Market value weights are determined by dividing the market value of
each source by the sum of the market values of all sources. The use of market value weights for
computing a firm’s weighted average cost of capital is theoretically more appealing than the use
of book value weights because the market values of the securities closely approximate the actual
dollars to be received from their sale.
In addition to the data found in the above example , assume that the security market prices are as
follows:
Mortgage bonds = $1,100 per bond
Preferred stock = $90 per share
Common stock = $80 per share
The firm’s number of securities in each category is:
Mortgage bonds = $20,000,000/$1,000=20,000
Preferred stock = $5,000,000/$100=50,000
Common stock = $20,000,000/$40=500,000
Therefore, the market value weights are:
Source Number of Securities Price Market Value
Debt 20,000 $1,100 $22,000,000
Preferred stock 50,000 $90 4,500,000
Common stock 500,000 $80 40,000,000
$66,500,000
The $40 million common stock value must be split in the ratio of 4 to 1 (the $20 million common
stock versus the $5 million retained earnings in the original capital structure), since the market
value of the retained earnings has been impounded into the common stock.
The firm’s cost of capital is as follows:
Source Market Value Weights Cost Weighted Average
Debt $22,000,000 33.08% 5.14% 1.70%
Preferred stock 4,500,000 6.77 13.40 0.91
Common stock 32,000,000 48.12 17.11% 8.23
Retained earnings 8,000,000 12.03 1 16.00% 1.92
Total $66,500,000 100.00% 12.76%
Overall cost of capital, Ke = 12.76%
Target Weights: If the firm has determined the capital structure it believes most consistent with
its goal, the use of that capital structure and associated weights is appropriate.
Marginal Weights: The use of marginal weights involves weighting the specific costs of various
types of financing by the percentage of the total financing expected to be raised using each
method. In using target weights, the firm is concerned with what it believes to be the optimal
capital structure or target percentage. In using marginal weights, the firm is concerned with the
actual dollar amounts of each type of financing to be needed for a given investment project.
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Eg:The Carter Company is considering raising $8 million for plant expansion. Management
estimates using the following mix for financing this project:
Debt $4,000,000 50%
Common stock 2,000,000 25
Retained earnings 2,000,000 25
$8,000,000 100%
The company’s cost of capital is computed as follows:

Source Marginal Weights Cost Weighted Cost

Debt 50% 5.14% 2.57%
Common stock 25 17.11% 4.28
Retained earnings 25 16.00% 4.00
100% 10.85%
Overall cost of capital, K0 = 10.85%

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