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Ch.

12
Cost of Capital

2002, Prentice Hall, Inc.


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)
Assets Liabilities & Equity
Current assets Current Liabilities

Fixed assets Long-term debt


Preferred Stock
Common Equity
The investment decision

Assets Liabilities & Equity


Current assets Current Liabilities

Fixed assets Long-term debt


Preferred Stock
Common Equity
Where we’re going...

• Corporate Finance: (The Financing


Decision)
Cost of capital
Leverage
Capital Structure
Dividends
Assets Liabilities & Equity
Current assets Current Liabilities

Fixed assets Long-term debt


Preferred Stock
Common Equity
The financing decision

Assets Liabilities & Equity


Current assets Current Liabilities

Fixed assets Long-term debt


Preferred Stock
Common Equity
Assets Liabilities & Equity
Current assets Current Liabilities

Long-term debt
Preferred Stock
Common Equity
Assets Liabilities & Equity
Current assets Current Liabilities

Long-term debt

Capital Structure
}Preferred Stock
Common Equity
Ch. 12 - Cost of Capital
• For Investors, the rate of return on a
security is a benefit of investing.
• Create an opportunity to invest more in
company
• 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.
Cost of Capital vs Required Rate of
Return
• The cost is different because of :
• 1) Flotation Cost
- transaction cost of issuing a new shares.
- firms need to invest in order to produced high
required rate of return compare than investors
needs.
2) Taxes
- interest expense on borrowing is tax deductible.
- cost of debt is less than required rate of return
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.
Cost of
Debt
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.
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
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.
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
After-tax Before-tax Marginal
% cost of % cost of x - tax
Debt
=
Debt
1 rate
After-tax Before-tax Marginal
% cost of % cost of x - tax
Debt
=
Debt
1 rate

Kd = kd (1 - T)
After-tax Before-tax Marginal
% cost of % cost of x - tax
Debt
=
Debt
1 rate

Kd = kd (1 - T)

.066 = .10 (1 - .34)


Example: Cost of Debt
• Prescott Corporation issues a $1,000
par, 20 year bond paying the market
rate of 10%. Coupons are
semiannual. 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?
• 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%
• 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%
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.
Cost of Preferred Stock
• Recall:
Cost of Preferred Stock
• Recall:

D Dividend
kp = =
Po Price
Cost of Preferred Stock
• Recall:

D Dividend
kp = =
Po Price

• From the firm’s point of view:


Cost of Preferred Stock
• Recall:

D Dividend
kp = =
Po Price

• From the firm’s point of view:

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

kp = D = Dividend
Po Price

• From the firm’s point of view:

kp = D = Dividend
NPo Net Price
NPo = price - flotation costs!
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?
Cost of Preferred Stock
Cost of Preferred Stock

D Dividend
kp = =Net Price
NPo
Cost of Preferred Stock

D Dividend
kp = =
NPo Net Price

8.00
= 74.00 =
Cost of Preferred Stock

D Dividend
kp = =
NPo Net Price

8.00
= 74.00 = 10.81%
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?


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.
Cost of Internal Equity
Cost of Internal Equity
1) Dividend Growth Model
Cost of Internal Equity
1) Dividend Growth Model

D1
kc = +g
Po
Cost of Internal Equity
1) Dividend Growth Model

D1
kc = +g
Po

2) Capital Asset Pricing Model (CAPM)


Cost of Internal Equity
1) Dividend Growth Model

D1
kc = +g
Po

2) Capital Asset Pricing Model (CAPM)

kj = krf + β (k - k )
j m rf
Cost of External Equity
Cost of External Equity

Dividend Growth Model


Cost of External Equity

Dividend Growth Model

D1
knc = NPo + g
Cost of External Equity

Dividend Growth Model

D1
knc = NPo + g

Net proceeds to the firm


after flotation costs!
Weighted Cost of Capital

• The weighted cost of capital is just


the weighted average cost of all of
the financing sources.
Weighted Cost of Capital

Capital
Source Cost Structure
debt 6% 20%
preferred 10% 10%
common 16% 70%
Weighted Cost of Capital
(20% debt, 10% preferred, 70% common)

• Weighted cost of capital =


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