LONG TERM FINANCING AND COST OF

CAPITAL
 Cost of Capital: Introduction
 Cost of Debt
 Costs of Preferred Stock
 Cost of Common Stock
 Weighted Average Cost of Capital
 Divisional and Project Costs of Capital
 Flotation Costs
 Theory: i) Pure Play Approach, ii) Subjective

Approach

15-2
 There are consists of
- Bond
- Preferred Share
- Common Share

3
 In terms of: convertible, or straight or non
convertible.
 Types:
◦ Term loan
 In a s/t, flexible and low issuance cost.
 Obtained from bank, insurance co. or pension fund.
◦ Bond
 what? – traditionally fixed rate debt.
 Mortgage bond – secured by a lien on real estates
 Debenture – an secured long term claim.
 Indenture– contractual agreement
  

4
 Market price
Bo = I/m (PVIFA k/m, nxm) + PV (PVIF k/m, nxm)
Example:
A firm purchase a ten years bond where the interest
or coupon rate payment at 14 percent
semiannually basis. Calculate the value of the bond
if k=10%.
 I=PRT
 =1000X0.14X1=RM140
 Bo=140/2(PVIFA 10%/2,10X2) + 1000 (PVIF

10%/2,10X2)
 Bo=70(PVIFA 5%,20) + 1000 (PVIF 5%,20)
 Bo=70(12.4662) + 1000(0.3769)=RM1,249.53
5
 YTM is the rate of return of a bondholder that will receive if the bond is
held until maturity. (Note: YTM = k, if there is no info on k)
 YTM can be derived as following:
YTM = CP + Par– (MP-Fc) Where;
c = coupon payment
(CRx PV)
n_______
m = how many
Par + (MP-FC) times the
coupon payment
2 is paid in a year

n = years remaining
YTM = CP/m + Par – (MP-FC) to maturity

Par = par value

n
MP = purchasing/
x m_____ selling/market
price
Par + (MP-FC)
 A firm purchase a ten years bond where the interest or
coupon rate payment at 14 percent semiannually basis.
The market price is RM1200. Calculate YTM if tax rate
is 25%.

◦ YTM = CP/m + Par – (MP-FC)

◦ n x m_____
 Par + (MP-FC)
 2

◦ YTM = 140/2 + 1000 – (1200-0)

◦ 10 x2_____
 1000 + (1200-0)
 2
 YTM=0.0545=5.45%
 After Tax :- Kd = YTM (1-T) = 0.0545(1-0.25)=4.09%

7
After Tax Cost:
K = Kd (1 – T)
d

Example: a firm sell a bond at RM950 with the

coupon rate 14% paid in semiannually basis and
maturity period is 9 years. Calculate cost of debt
after tax? (marginal tax rate is 40%).
YTM = 140/2 + 1000– (950-0)
◦ 9 x 2_____
 1000 + (950-0)
 2
YTM=0.0746
Kd=YTM(1-T)= 0.0746(1-0.40)
=0.0448=4.48%
8
 Issue 6% bond with 10 years to maturity at
selling price of RM950. the floatation cost is
RM20 and tax bracket is 35%.
◦ YTM = 60 + 1000– (950-20)
◦ 10 _____
 1000 + (950-20)
 2
 YTM= 0.0694
 Kd=YTM(1-T)= 0.0694(1-0.35)

=0.0451=4.51%

9
 Fixed dividend payment
 Par value = RM100
 Unpaid dividend → accumulate
 Cannot be jeopardized in favor of common.
 Fixed maturity date & sinking fund provision.
 Redeemable or callable b4 maturity date.
 Claims on earnings & assets prior to CS, after bond.

 MODEL 1
 ZERO GROWTH (Constant Dividend) Model
 P0 = D/k
 Therefore Kps = D/P0
 Alternatively Kps = D/P0 – F

10
 Cost of Preferred share (Kps)

KPS = dividend payment / (Price – Floatation cost) x 100

Dividend payment = Dividend rate x par value

Example: a firm is planning to issue RM 100 par

value preferred share at RM95. The dividend is
8% and floatation cost equal to 5% of par. Find
cost of PS?

Kps=D/(P-FC)X100=???
11
KPS = dividend payment / (Price – Floatation cost)
x 100

Div=8% X RM100=RM8 FC=5% X RM100=RM5

 KPS=8/(95-5)=0.0889=8.89%

12
 Issue 11% (annual dividend) of preferred
stock with a selling price of RM 96 per share

 Kps=D/(P-FC)X100=???

 Kps=11/(96-0)X100=0.1146=11.46%

13
 Represents ownership.
 Highest risk.
 Legal right: i) Control of firm, ii) Proxy iii)

Preemptive right.
 Bought by individual, institutional investors,

foreign investor or corporate investors.

 Issuance: i) OTC/secondary market ii) IPO iii)

right offering

14
 The cost of equity is the return required by
equity investors, the shareholders on their
investment in the firm
 Since this cost is not directly observable, it

must be estimated
 There are two main methods for determining

the cost of equity:

◦ Dividend Growth Model
◦ CAPM

15-15
 Start with the dividend growth model formula where
g is constant:
D0 (1 g) D1
P0  
RE  g RE  g
 Where: RE is the required return for shareholders, P0
is the current price, D0 is the current/last dividend,
D1 is the next dividend
 and rearrange to solve for RE: D1
RE  g
P0
 Kcs=(D1/P0) + g
 Where D1/P0 is the dividend yield, and g is the
growth rate of dividends 15-
16
 Bentex Ltd. recently paid a dividend of 40
cents per share. This dividend is expected
to grow at 6% per year indefinitely. If the
current market price of Bentex shares is $6
per share, estimate its cost of equity.
 D0 = $0.40, g = 6%, P0 = $6, RE = ?
D1 = D0(1 + g) =0.40(1+0.06) =RM0.424
KE = (D1 / P0) + g=(RM0.424/RM6)+0.06
=0.1307=13.07%
15-17
 Suppose ABC company is expected to pay a
dividend of $1.50 per share next year.
There has been a steady growth in
dividends of 5.1% per year. The current
price is $25. What is the cost of equity?
 D = $1.50, g = 5.1%, P = $25, R = ?
1 0 E

KE = (D1 / P0) + g=(RM1.50/RM25)+0.051

=0.1110=11.10%
KE = (D1/ P0-FC) + g
15-18
 Advantage:
◦ easy to understand and use
 Disadvantages
◦ Only applicable to companies currently paying
dividends
◦ Assumes dividend growth is constant
◦ Cost of equity is sensitive to growth estimate
◦ Does not explicitly consider risk

15-19
 ◦ YTM = 100+ 1000– (950-40)

◦ 10 _____

 1000 + (950-40)

 2
 YTM=109/955=0.1141

◦ kd= YTM(1-T)=0.1141(1-0.24)=0.0867=8.67%

◦ KE = (D1/ P0-FC) + g
 =(0.70/ 8-0.40) +0.04=0.1321=13.21%

KPS = D/ (P – FC) =12/(135-5)=0.0923=9.23%

20
Capital Amount Weight Cost of Capital Average Cost of
(RM’Mil) Capital( %)
BOND 10,500 0.35 (35%) 0.0867 (8.67%) 0.0303 (3.03%)
PS 4,500 0.15 (15%) 0.0923 (9.32%) 0.0138 (1.38%)
CS 15,000 0.50 (50%) 0.1321 (13.21%) 0.0661 (6.61%)
TOTAL 30,000 1 WACC 0.1102≂11.02%

21
 Recall CAPM for any asset i is:
E(Ri )  R f  βi (RM  R f )
 The CAPM cost of equity is:
RE  R f  βE (RM  R f )
 Use the following information to compute our cost
of equity
◦ RE = Required return for shareholders
◦ Rf = Risk-free rate
◦ RM – Rf = Market risk premium
◦ E = Systematic risk of firm’s equity relative to the
market
15-
22
 Suppose our ABC company has an equity
beta of 0.58 and the current risk-free rate is
6.1%. If the expected market risk premium is
8.6%, what is the cost of equity capital?
◦ βE = 0.58, Rf = 6.1%, RM – Rf = 0.086
RE  R f  βE (E(RM )  R f )
RE = 0.061 + 0.58(0.086) = 11.1%
 What if the expected market return is 8.6%?
◦ RE = 0.061 + 0.58(0.086 – 0.061) = 7.55%

15-
23
 Advantages
◦ Explicitly adjusts for risk
◦ Applicable to all companies
 Disadvantages
◦ Have to estimate the expected market risk
premium, which does vary over time
◦ Have to estimate beta, which also varies over time
◦ We are using the past to predict the future, which is
not always reliable

15-24
 Suppose our company has a beta of 1.5. The
market risk premium is expected to be 9%
and the current risk-free rate is 6%. The
market believes our dividends will grow at 6%
per year and our last dividend was $2. The
stock is currently selling for $15.65. What is
the cost of equity?
◦ Using CAPM: RE = 6% + 1.5(9%) = 19.5%
◦ Using DGM: RE = [2(1.06) / 15.65] + .06
= 19.55%

15-25
 Exercise 1; a firm is planning to issue CS at
RM5 per share. Current dividend is RM 0.50
and expected to grow at 6 percent. The
issuing cost is 5%. Calculate the cost of CS.

26
BOND PREFERRED SHARE COMMON SHARE
Par value RM1000 Par value RM100 Value of share carried on
the firm’s balance sheet.
No voting right No voting right Have voting right
Priority of residual Received the residual No priority of residual
claim claim after bondholder claim
Have a maturity period Have a maturity period No maturity period
Received fix interest as Received fix dividend Received dividend
a return to bondholder declared by BOD

27
For bond and PS
Sell at premium – market price above than par
value (RM1500>RM1000)
Sell at discount – market price below than par
value (RM950<RM1000)
Sell at par – market price equal to par value
(RM1000=RM1000)

28
 Choose the lowest rate
 Choose Preferred share because lowest rate,

it means that lowest cost.

29
 COST OF CAPITAL

30
 The return to an investor is the same as the
cost to the company
 Our cost of capital provides us with an

indication of how the market views the risk of

our assets
 Knowing our cost of capital can also help us

determine our required return for capital

budgeting projects

15-31
 The Required Rate of Return = Discount Rate
= Hurdle Rate = Cost of Capital
 Need to know the required return for an

investment so we can compute the NPV and

decide whether or not to take the investment
 Need to earn at least the required return to

compensate investors for their financing

 Required return – from the investor’s point of

view
 Cost of capital – from the firm’s point of view

15-32
 The firm is financed by a mixture of equity
and debt
 Cost of Capital is a mix of Cost of Equity

and Cost of Debt

 These costs are determined by the market
 The firm determines the mix, Debt/Equity

(D/E) reflecting it’s target capital structure.

 To calculate cost of capital:

◦ Calculate cost of equity

◦ Calculate cost of debt
◦ Combine them
15-33
 Capital is necessary
 Co.need for proper financing sources → debt or equity
 Why?
a. To support operation
b. Operate at acceptable level of risk & desired level of return
c. Ensure firm’s ability to acquire additional funds
d. Maintain its stability & growth in the future
 Use of DEBT → fixed obligation (payment of principal + interest), FAIL →
bankruptcy
 PRO
→ cheaper cost as interest payment is tax deductible
→ act as leverage to improve the firm’s profitability
 Consideration of risk and return tradeoff

34
• Company issue 12% bond for 10 years and sold
at 30% premium. the marginal tax rate is 30%.
Floatation cost is 5% from market price.
Calculate the cost of debt after tax.
• Issue 8% preferred share at discount 20%. The
issuing fees is 6% from market price. Find cost
of PS.
• Issue Common shares RM5.50. the growth rate
of dividend is 4%. The dividend yield is 5%. The
placement fees is 3%. Compute the cost for CS.

35
Homemade Craft Berhad is financed by three sources of funds: bonds, preferred stock
and common stock. The 20 years bond, sold at 5% premium is with 10.5% coupon and
5% underwriting fee. The preferred stock, sold at RM100 with a 10% coupon and a call
price of RM110 (no floatation cost). The common stock presently pays a dividend of
RM 2 per share with share price of RM40. The dividend is expected to grow at 5% in
the future and there is no floatation cost. The company has a marginal tax rate of 40%.

a) Compute the cost of the following:

i) Bond (6 marks)

ii) Preferred stock (4 marks)

iii) Common stock (3 marks)