VALMET530

Cost
of
Capital
A PRESENTATION BY: GROUP 3
Topics:
• Terms
• Overview of WACC
• Cost of Debt
• Cost of Preferred Stocks
• Cost of Retained Earnings
• Computation of WACC
• CAPM
• Bond yield plus Risk premium
approach
• Dividend Yield plus growth rate or
DCF Approach
• Cost of New Common Stocks
• Increase of Cost of Capital
PART 1
• Terms
• Overview of WACC
• Cost of Debt
• Cost of Preferred Stocks
• Cost of Retained Earnings
• Computation of WACC
 Basic Terms
one of the types of capital used
Capital Components
by firms to raise funds.

rd = before-tax cost of debt

interest rate on the firm's new
debt

rd(1-T) = after tax cost of debt debt cost used to calculate WACC;
T = Firms's marginal tax rate
 Basic Terms
rp = cost of Preferred Stock rate of return investors require
on the firm's preferred stock

rs = cost of Retained rate of return required by

Earnings (internal equity) stockholders on a firm's common
stock.

re = cost of New Common based on the cost of retained

Stock (external equity) earnings, but increased for
flotation costs.
 Basic Terms

Wd, Wp, We = target weights

percentages of the different types
of debt, preferred stock,
of capital the firm plans to use
common equity, and new
when it raises capital in the
common stock
future.

WACC = Weighted Average firm's weighted average, or

Cost of Capital overall, cost of capital.
What is Cost of Capital?
•Cost of capital refers to the return a company expects
on a specific investment to make it worth the
expenditure of resources. In other words, the cost of
capital determines the rate of return required to
persuade investors to finance a capital budgeting
project.

•Cost of capital represents the return a company needs

to achieve in order to justify the cost of a capital
project, such as purchasing new equipment or
constructing a new building.

•Cost of capital encompasses the cost of both equity and

debt, weighted according to the company's preferred or
existing capital structure. This is known as the
weighted average cost of capital (WACC).
Overview of WACC
When calculating the WACC, the concern is with capital that
must be provided by investors -- interest-bearing debt, preferred
stock, and common equity.

While these market-based numbers are useful starting point,

what ultimately matters is the target capital structure.

Target Capital Structure - a mix of debt, preferred stock and

common equity the firm plans to raise to funds its future
projects.
Overview of WACC
The target proportions of debt, preferred stock, and
common equity, along with the costs of those
components, are used to calculate the firm's weighted
average cost of capital.

WACC = (% of debt)(After-tax cost of debt) + (% of

preferred stock)(cost of preferred stock) + (% of
common equity)(cost of common equity)
or
= wdrd(1 - T) + wprp + wcrs
What is Cost of
Debt?
- the required return on firm’s debt

- Debt includes corporate bonds and also long-term

loans
Estimating the Cost of
Debt: YTM
There are two common ways of estimating the cost of
debt.

The first approach is to look at the current yield to

maturity or YTM of a company’s debt.

This approach is widely used when the company being

analyzed has a simple capital structure, where it does
not have multiple tranches of debt, including
subordinated debt or senior debt.
An example would be a straight bond:
Bond: 10 000 Term: 10yrs.
Coupon rate: 10% Tax: 30%
Market Value: 98 1/2

YTM = (10 000 * 10 000 - 9

10%) + 850
10
10 000 + 9
850
2
= 1 000 +
15 COST OF = 10.23% *
9 925 DEBT 70%
=
10.23% = 7.16%
Matrix Pricing – Debt Ratings
The other approach is to look at the credit rating of the firm found
from credit rating agencies such as S&P, Moody’s, and Fitch.

This approach is particularly useful for private companies that don’t

have a directly observable cost of debt in the market.

When neither the YTM nor the debt-rating approach works, the
analyst can estimate a rating for the company. This happens in
situations where the company doesn’t have a bond or credit rating or
where it has multiple ratings. We would look at the leverage ratios of
the company, in particular, its interest coverage ratio. A higher number
for this ratio means a safer borrower. The yield spread can then be
estimated from that rating.
 Debt as a Relatively
Cheaper Form of Finance
• When obtaining external financing, the issuance of debt is
usually considered to be a cheaper source of financing
than the issuance of equity.
• In equity financing, however, there are claims on
earnings. The larger the ownership stake of a shareholder
in the business, the greater he or she participates in the
potential upside of those earnings.
• Another reason is the tax benefit of interest expense.
• The marginal tax rate is used when calculating the after-
tax rate.
The true cost of debt is expressed by the formula:
After-Tax Cost of Debt = Cost of Debt x (1 – Tax Rate)
Example:
The cost of debt is assumed as the yield to maturity on a long-term bond of Pfizer
maturing in the year 2038. The yield to maturity is estimated as 5.19%.

Corporate tax rate = 35%

After-tax cost of debt = 5.19 * (1 − 0.35)
After-tax cost of debt = 3.37%

The weights used for estimation of cost of capital are the market value weights of
equity and book value weight of debt.

Market value of equity in 2014 = 200,107.6 million

Book value of debt in 2014 = 36,682 million
Total value = 236,789.6 million
 Cost of Preferred Stock
The rate of return investors requires on the firm’s preferred stock. Rate
that the company must pay investors in order to persuade them into
investing in preferred shares of the company.
Example:
Tunney Industries can issue perpetual preferred
stock at a price of $47.50 a share. The stock would pay
an annual dividend of $3.80 a share. What is the
company’s cost of preferred stock, rp ?
Example: With flotation
Trivoli Industries plans to issue perpetual preferred stock
with an $11.00 dividend. The stock is currently selling for $
97.00, but floatation costs will be 5% of the market price. What
is the cost of preferred stock including floatation?
 Cost of
Retained Earnings
Companies have four possible direct sources of capital for a business firm. They
consist of retained earnings, debt capital, preferred stock, and new common
stock.

Retained Earnings
• The net profit after tax that is not distributed by the company to the
shareholders.
• Such earnings are used for future expansion
• Payment of personal income tax, flotation cost, brokerage fee, and etc.
makes the cost of retained earnings slightly lower than cost of equity.
Why there is a cost for retained earnings?
• Earnings can be reinvested or paid out as dividends
• Investors could buy other securities and earn a return
• If earnings are retained, there is an opportunity cost.
Oppurtunity cost - The return stockholders could earn on alternative investments of
equal risk.

They could buy similar stocks and earn rs, or company could repurchase its own
stock and earn rs. So, rs, is the cost of retained or reinvested eaarnings and it is the
cost of equity.

Formula to calculate the cost of retained earnings:

Rs= cost of retained earnings

Rs = D1 + g D1= expected dividend yield
Po Po = cost of stock
g = growth
For example, if your projected annual dividend is $1.08, the growth rate is 8
percent, and the cost of the stock is $30, your formula would be as follows:

Cost of Retained Earnings = + 0.08 = .116, or 11.6 %

$1.08
$30
Sometimes tax is deducted from it as the shareholders needs to
pay taxes and purchasing new securities

Rs= (Cost of capital) (1-t) (1-b)

t= taxes that investors need to pay on dividends
b= cost of purchasing new securities (brokerage cost)

Example;
Rm, ltd has an annual profit of 50,000 and the required rate of
return of the shareholders is 10%. It is further expected that the
shareholders will have to inuvur 3% brokerage cost of the
dividends received and invested by them for making new
investments. Find out the cost of retained earnings to the firm
given that the tax rate applicable to shareholders is 30%.
Solution:

Cost of equity= 10%

T=30%
B-3%

Rs= 10% (1 - 30%) (1 - 3%)

= 10% (70%) (97%)
= 6.79%
Computation
of
WACC
Patton Paints Corporation has a target capital structure of 40%
debt and 60% common equity, with no preferred stock. Its
before tax-cost of debt is 12% and its marginal tax rate is 40%.
The current stock price is Po= $22.50. The last dividend was
Do= $2.00, and it is expected to grow at a 7% constant rate.
What is its cost of common equity and its WACC?
Debt = 40%; Common Equity = 60%

Given:
Po= $22.50
Do= $2.00
D1= $2.00(1.07)
D1= $2.14
g= 7%

rs =

D $2.14
+ g - T) + wprp
WACC = wdrd(1 + 7% = 16.51%
+ wcrs
1= (0.4)(0.12)(1-0.4)
$ + (0.6) (0.1651)
=
Po= 0.0288 22.50
+ 0.0991
WACC = 12.79%
 Lets
have a
simple
review
 Which of the following best describes a
firm's cost of capital?

a. The average yield to maturity on debt

b. The average cost of the firm's assets
c. The rate of return that must be earned on
its investments in order to satisfy the firm's
investors
d. The coupon rate on preferred stock
Which of the following best describes a
firm's cost of capital?

a. The average yield to maturity on debt

b. The average cost of the firm's assets
c. The rate of return that must be earned on
its investments in order to satisfy the firm's
investors
d. The coupon rate on preferred stock
 Which of the following is a correct formula for
calculating the cost of capital?

a. WACC = weighted after-tax cost of debt + weighted cost of

preferred stock + weighted cost of common stock
b. WACC = weighted after-tax cost of debt + weighted after-tax
cost of preferred stock + weighted after-tax cost of common
stock
c. WACC = (after-tax cost of debt + cost of preferred stock +
cost of common stock)/3
d. WACC = weighted cost of debt + weighted cost of preferred
stock + weighted cost of common stock
 Which of the following is a correct formula for
calculating the cost of capital?

a. WACC = weighted after-tax cost of debt + weighted cost of

preferred stock + weighted cost of common stock
b. WACC = weighted after-tax cost of debt + weighted after-tax
cost of preferred stock + weighted after-tax cost of common
stock
c. WACC = (after-tax cost of debt + cost of preferred stock +
cost of common stock)/3
d. WACC = weighted cost of debt + weighted cost of preferred
stock + weighted cost of common stock
In calculating the costs of the individual
components of a firm's financing, the
corporate tax rate is important to which of
the following component cost formulas?

a. common stock.
b. debt.
c. preferred stock.
d. none of the above.
In calculating the costs of the individual
components of a firm's financing, the
corporate tax rate is important to which of
the following component cost formulas?

a. common stock.
b. debt.
c. preferred stock.
d. none of the above.
End of
Part I