Cost of Capital

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.
 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.
 The Weighted Cost of Capital
 To calculate the firm’s weighted
cost of capital, we must first
calculate the costs of the individual
financing sources:
 Cost of Debt
 Cost of Preferred Stock
 Cost of Common Stock
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 Rs50,000 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 cost Before-tax cost Tax
= -
of Debt of Debt Savings
After-tax cost Before-tax cost Tax
= -
of Debt of Debt Savings

33,000 = 50,000 - 17,000

After-tax cost Before-tax cost Tax
= -
of Debt of Debt Savings

33,000 = 50,000 - 17,000

OR
After-tax cost Before-tax cost Tax
= -
of Debt of Debt Savings

33,000 = 50,000 - 17,000

OR
33,000 = 50,000 ( 1 - .34)
 After-tax cost Before-tax cost Tax
= -
of Debt of Debt Savings

33,000 = 50,000 - 17,000

OR
33,000 = 50,000 ( 1 - .34)

Or, if we want to look at percentage costs:

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

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

Kd = kd (1 - T)

.066 = .10 (1 - .34)

 Cost of irredeemable debt
kd = I/NP
Pretax Post tax
Kd= I/NP Kdt= I(1-t) /NP (or) kd (1-t)
Eg ;
12% debt of Rs 100/- each .50% tax .what is Kd?
Kd = 12/100 = 0.12 = 12%( interest rate = cost)
Kdt = 12(1-0.50)/100 = 0.06 = 6% ( cost will be less
than interest rate)
 15 % ,Debentures of Rs 100/- each for
Rs 10,00,000/-,t=35%;
i) Issued at Par value
ii) Issued at 10%Premium
iii) Issued at 10%Discount
Find out kd before and after tax?
 Cost of redeemable debt

BE company issues Rs100/- par value of

debentures carrying 15% interest.The
debentures are repayable after a period of 7
years at face value.The cost of issue is 3%
and tax is 35%.What is Kd?
 Example: Cost of Debt
 Prescott Corporation issues a Rs1,000
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 Rs50 per bond.

 What is the pre-tax and after-tax cost of

debt for Prescott Corporation?
 Pre-tax cost of debt:
950 = 100(PVIFA 20, kd) + 1000(PVIF 20, kd)
using the calculator,
kd = 10.61%.

 After-tax cost of debt:

Kd = kd (1 - T)
Kd = .1061 (1 - .34)
Kd = .07 = 7%
 Pre-tax cost of debt:
950 = 100(PVIFA 20, kd) + 1000(PVIF 20, kd)
using the calculator,
kd = 10.61%. So, a 10% bond
costs the firm
 After-tax cost of debt: only 7% (with
Kd = kd (1 - T) flotation costs)
Kd = .1061 (1 - .34) since the interest
Kd = .07 = 7% is tax deductible.
 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:

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

D Dividend
kp = =
Po Price

 From the firm’s point of view:

D Dividend
kp = =
NPo Net Price

NPo = price - flotation costs!

 Example: Cost of Preferred

 If Prescott Corporation issues

preferred stock, it will pay a
dividend of Rs8 per year and should
be valued at Rs75 per share. If
flotation costs amount to Rs1 per
share, what is the cost of preferred
stock for Prescott?
 Cost of Preferred
Stock
D Dividend
kp = =
NPo Net Price
 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)

kc = krf + B ( km - krf )
 Cost of External Equity

Dividend Growth Model

 Cost of External Equity

Dividend Growth Model

D1
knc = +g
NPo
 Cost of External Equity

Dividend Growth Model

D1
knc = +g
NPo

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%