CHAPTER THREE

VALUATION OF FINANCIAL
INSTRUMENTS &
COST OF CAPITAL
 Part-I
Cost of Capital
 General Features of Equity, Debt and
Preference shares .

The two long term securities available for

raising long term capital in a cmpnay are
usually shares and bonds.
Shares includes ordinary (equity) shares
and preference shares.
Bonds provide loan capital to the company
and investor gets the status of lenders.
 Equity shares
 Also called ordinary shares or common shares.
 The holders of ordinary shares are called shareholders and are
legal owners of the company and represents a residual ownership
position in the corporation.
 Equity capital represents ownership capital as equity shareholders
collectively own the company.
 Ordinary shares are the sources of permanent capital since they
do not have a maturity date.
 Shareholders enjoy the rewards and bear the risks of ownership.
However, their liability unlike the liability of the owners in sole
proprietorship or partnership, is limited to their capital
contribution.
 The majority of shares issued by most companies are equity
shares.
 Basic terminologies in equity capital
Par value:
It is the value stated in the memorandum and
written on the share scrip. The paid up capital
is stated at the par value.
Issue price:
The price at which the equity share is issued.
The existing highly profitable company may
issue ordinary shares at premium and the
excess amount is separately shown as share
premium (paid- in- capital excess of par).
 Cont.…

 Market value:
Is the price at which the share is traded in the market. This
price can be easily established for a company which is listed
on the stock market and actively traded.
 Net worth:
The total shareholders’ equity is the sum of paid- up share
capital, share premium and reserves and surplus.
 Reserves and surplus:
The company’s earnings which have not been distributed to
shareholders and have been retained in the business.
 Book value per share:
It is the ratio of net worth to number of ordinary shares.
Book value is based on the historical figures in the balance
sheet.
Legal rights and privileges of Ordinary
shareholders
 Ordinary shares have a number of special features which
distinguish it from other securities. These are:
1. Control of the firm:
common stockholders have the right to elect a firm’s directors,
who, in turn, elect the officers who manage the business and
hence they are legal owners of the firm who can exercise
control over the firm, though indirectly.
2. Residual claim on income:
Residual income is the earnings available for ordinary share
holders after paying expenses, interest charges and preference
dividend.
The residual income is either directly distributed to shareholders
in the form of dividend or indirectly in the from of capital
gains on the ordinary shares (retained earnings reinvested in
the business)
 Cont.…
3. Residual claims on assets:
Ordinary share holders also have a residual
claim on the company’s assets in the case of
liquidation.
Out of realized values of assets, first the claims
of debt holders and then preference
shareholders are satisfied and the remaining
balance, if any, is paid to ordinary shareholders.
In case of liquidation, the claims of ordinary
shareholders, may generally remain unpaid.
 Cont.…

4. Preemptive Right:
The right to purchase any additional shares sold by
the firm.
A provision in the corporate charter or bylaws that
gives common stockholders the right to purchase
on a pro-rata basis new issues of common stock
(or convertible securities).
The purpose of the preemptive right is twofold.
First, it enables current stockholders to maintain
control. The second, and by far the more important,
reason for the preemptive right is to protect
stockholders against a dilution of value.
 Cont..
 For example, suppose 1,000 shares of common stock
outstanding with a price of Birr 100 each, making the total
market value of the firm Birr100,000. If an additional 1,000
shares were sold at Birr 50 a share, or for Birr 50,000, this
would raise the total market value to Birr 150,000.
 When total market value is divided by new total shares
outstanding, a value of Birr 75 a share is obtained
(150,000/2000).
 The old stockholders thus lose Birr 25 per share, and the new
stockholders have an instant profit of Birr 25 per share.
 Thus, selling common stock at a price below the market value
would dilute its price and transfer wealth from the present
stockholders to those who were allowed to purchase the new
shares. The preemptive right prevents such occurrences.
 Cont..
5. Voting rights:
Ordinary share holders as being the legal owners of the
firm are required to vote on a number of important
matters.
Example:
Election of directors, change in memorandum of
association, need to change authorized share capital,
change in its objectives require approval of ordinary
share holders.

6. Limited liability:
ordinary share holders have limited liability- that is their
liability is limited to the amount of their investment in
shares.
 Pros and cons of equity financing
Equity capital is the most important long-term
source of financing. It offers the following
advantages to the company.
A. Permanent capital:
ordinary share are not redeemable and the capital is
available for use as long as the company exists
B. Borrowing base:
lenders generally lend in proportion to the
company’s equity capital
C. Dividend payment discretion:
A company is not legally obliged to pay dividends.
 Cont.…
Equity capital has some disadvantages as:
A. Cost: shares have a higher cost at least for two
reasons- dividends are not tax deductible as
interest payments and flotation costs are on
ordinary shares are higher than those on debt.
B. Risk: ordinary share are riskier from investors
point of view as there is uncertainty regarding
dividend and capital gains. Therefore they require
a relatively higher rate of return. This makes
equity capital as the costly source of finance(it is
variable income security).
C. Ownership dilution: The issuance of new
ordinary shares may dilute the ownership and
control of the existing shareholders.
BOND
 Bond is a long-term debt instrument or security issued
by businesses and governmental units to raise large
sums of money.
 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.
 Investment in a bond provides two types of cash flows:
 One is the periodic interest payment by the issuing party.

 Another is the price paid to the investor upon maturity

which is the Face Value of the Bond.
07/08/2022 14
 con’t….

 So, It is a long term promissory note for

raising loan capital. The firm promises to pay
interest and principal as stipulated in the
note.
 Most bonds are distinguished from bank loans
by the existence of a secondary market.
 Bonds are bought and sold among individual
investors after they are initially issued by the
firm. Thus if the holder of a corporate bond
no longer wishes to keep the bond (i.e., no
longer wishes to be a creditor of the firm),
then he can simply sell the bond to another
investor in the bond market.
07/08/2022 15
 Basic terminologies
 Par value is the face value of the bond which will be paid to
the investor upon maturity. Par value is also called maturity
value. It is the face value of a bond stated in the corporate
charter.
 Coupon Interest Rate- is the rate of interest paid on
the bond's par value. The interest rate on bonds is
fixed and known. The periodic interest rate is
expressed as a percentage of the face value of the
bond.
 Prior claim on assets: bond holders have the right
to claim on the company’s assets prior to
shareholders.
 Redemption: bonds are mostly redeemable and they
are usually redeemed as maturity.
07/08/2022 16
 Con’t…
 Maturity period- is the number of years after which the
par value is payable to the bondholders.
 maturity date/ period refers to the date on which the bond
issuer must repay the principal or the par value to the
bondholder.

 Market Value: is the bond’s current price or it is the

price at which bonds are trading in the market place.
 Yield to maturity: YTM is the bond’s required rate of
return, which an investor can expect to earn if the bond
is held till maturity.
07/08/2022 17
Who Issues the Bonds?
Investors have many choices when investing in
bonds, but bonds are classified into four main
types based on the type of issuers :

Treasury bond
Municipal bonds
Corporate bonds , and
Foreign bonds
Treasury Bonds
T-bonds are issued to finance the national
debt and other federal government
expenditures
Backed by the full faith and credit of the
government and are default risk free
Pay relatively low rates of interest (yields
to maturity)
Given their longer maturity, not entirely
risk free due to interest rate fluctuations
 Municipal Bonds (Munis)
Securities issued by state and local governments
to fund either temporary imbalances between
operating expenditures and receipts or to finance
long-term capital outlays for activities such as
school construction, public utility construction
or transportation systems
Tax receipts or revenues generated are the
source of repayment
Attractive to household investors because
interest is tax exempted.
 Corporate Bonds
 Corporate bonds as the name implies, are issued by
corporations.
 A corporate bond is a long-term debt instrument indicating that
a corporation has borrowed a certain amount of money and
promises to repay it in the future under clearly defined terms.
 Corporate bonds are characterized by higher yields because
there is a higher risk of a company defaulting than a
government.
 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.
 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.
Foreign bonds
 These are corporate bonds, issued in the country of
denomination, by a firm based outside that country.
 It is a bond that is issued in a domestic market by a
foreign entity, in the domestic market's currency.
e.g. A bond denominated in U.S. dollars that is issued in the
United States by the Canadian organization is a foreign bond
 Foreign corporate bonds are, of course, exposed to default
risk, and 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 the dollar.
 Pros and cons of bonds
 Bonds have the following advantages as long term
sources of finance:
1. Less costly: it involves less cost to the firm than
equity financing because (a)Investors consider
Bonds as a relatively less risky investment
alternative and therefore require a lower rate of
return and (b) Interest payments are tax deductible.
2. No owner ship dilution: Bond holders do not have
voting right and therefore debenture issue does not
cause dilution of ownership
3. Fixed payment of interest : Bond holders do not
participate in extraordinary earnings of the
company. The payment are limited to fixed interest
rates
 Bonds have some limitation like:
1. Obligatory payment: Bonds results in
legal obligation of paying interest and
principal, which if not paid can force the
company into liquidation
2. Cash outflow: it involves substantial cash
out flow at the time of redemption
 Preferences Shares
 Preferred stock is a hybrid source of finance—it is similar to
bonds in some aspects and to common stock in other aspects.
 Similar to common stock in that it represents an ownership
interest but, like bonds, pays a fixed periodic dividend.
 Like common stocks, preferred stocks do not have a fixed
maturity date. Also, like bond, preferred stocks may be
redeemable
 like common stocks, nonpayment of dividends does not lead
to bankruptcy of the firm.(Dividend is not a liability i.e.
although preferred stock has a fixed payment like bonds, a
failure to make this payment will not lead to bankruptcy.
 Preferred stockholders have preference over common
stock in the payment of dividends and in the distribution of
corporation assets in the event of liquidation.
 Features of preference shares
1. Preferential claim on income and assets
 It has a prior claim on the company's income in the
sense that the company must first pay preference
dividend before paying ordinary dividend.
 It has also a prior claim on the company’s assets in
the event of liquidation.

2. It is a fixed income security: The dividend rate is

fixed in the case of preference shares and
preference shares are not tax deductible. The fixed
preference rate is expressed as a percentage of par
value. Thus preference share is called fixed income
security.
3. Cumulative dividend: Most preference share
carry a cumulative dividend feature, requiring
that all past unpaid preference dividend be paid
before any ordinary dividends are paid. This
feature is a protective device for preference
shareholders since preference share does not
have a dividend enforcement power.
Thus, preferred stocks are less risky than common
stocks but more risky than bonds.
 Generally do not have voting rights
 Nonparticipating preferred stock
 Dividend is fixed regardless of any increase or
decrease in the firm’s value
Pros and cons of preference shares
 Preference share have a number of advantages
to the company which ultimately occur to
ordinary shareholders.
1. Riskless leverage advantage:
 Preference share provides financial leverage
advantage since preference dividend is a fixed
obligation.
 The non- payment of preference dividends does not
force the company in to solvency
2. Dividend postponability:
 Preference share provides some financial flexibility
to the company since it can postpone payment of
dividend.
 3. Fixed dividend:
 Dividend payments are restricted to the stated
amount
4. Limited voting rights:
 The control of ordinary shareholders is preserved as
preference shareholders do not have/have limited
voting rights.
Limitations of preference shares:
1. Non-tax deductibility of dividends: The primary
disadvantage of preference share is that preference
dividends is not tax deductible. Thus it is costlier than
bonds.
2. Commitment to pay dividend: Although declaration of
preference dividend may be postponed, it may have to
be paid if the preference share is cumulative in nature.
Cost of capital
The concept of cost of capital has its root
in the items on the right hand side-of
balance sheet, which includes various
types of debt, preferred stock, common
stock and retained earnings. These items
are called the Capital components.

 The concept of cost of capital is based on

the assumption that the core goal of profit-
seeking business firms is to maximize the
wealth of shareholders.
Business firms raise the needed fund from internal
sources and external sources. Undistributed and
retained profit is the main source of internal fund.
External fund is raised either by the issue of shares
or by issue of debenture (debt) or by both means.

The fund collected by any means is not cost free.

Interest is to be paid on the fund obtained as debt
and dividend is to be paid on the fund
collected through the issue of shares. The average
cost rate of different sources of fund is known as
cost of capital.
cost of capital is the is the minimum
rate of return that the firm must earn on its
invested capital.
It is a break-even point at which the current
market value of the firm is maintained. If
this cots of capital is not earned the market
value of the firm will decline.
It is the average cost of various sources of
finance used by a firm.
I.e. The minimum rate of return required
by suppliers of the firm's capital.
A company’s cost of capital is the average rate it pays
for the use of its capital funds. That rate provides a
benchmark against which to measure investment
opportunities in the context of capital budgeting.
 The idea is very straightforward. No one should invest in
any project that will return less than the cost of
invested funds.
 When the corporation’s rate of return exceeds its cost of
capital:-

◦ The bondholders and preferred stockholders will

receive their fixed rate of return.

◦ The remaining (excess) portion of the corporation’s rate

of return that is available to common stockholders may
be treated in several ways:
1.The corporation may distribute these
earnings to common stockholders through
increased dividends
2. The corporation may retain and
reinvest these earnings to further increase
its subsequent rate of return.
3. The corporation may divide these
earnings b/n increased dividends and
retained earnings.
 Cont.…
As the consequence of excess earnings,
the common shares will become more
demanded in the stock market which in
turn will increase the resale prices of
common shares.

In such a way shareholders wealth will be

maximized –thus meeting the basic goal
of the business firm.
 The importance of cost of capital
 Decision on capital budgeting-
It is used to measure the investment proposal to
choose a project which satisfies return on
investment.
Designing Capital structure:
The proportion of debt and equity is called capital
structure. The proportion which can minimize the cost
of capital and maximize the value of the firm is called
optimal capital structure. Cost of capital helps to
design the capital structure considering the cost of each
sources of financing, investor's expectation, effect of tax
and potentiality of growth.
Evaluating The Performance:
Cost of capital is the benchmark of
evaluating the performance of different
projects or departments.

The department is considered the best which

can provide the highest positive net present
value to the firm. The activities of different
departments are expanded or dropped out on
the basis of their performance.
 Basic assumptions under the cost of
capital
 
1. Business risk: The risk to the firm of being unable
to cover operating cost is assumed to be unchanged.
2. Financial risk: The risk to the firm of being unable
to cover required financial obligations (interest,
lease payment, principal) is assumed to be
unchanged.

3. After-tax cost: The cost of capital is measured on

after tax basis and is expressed as annual percentage.
Any increase in total assets must be financed
by an increase in one or more of these capital
components.

The cost of capital is used primarily to make

decisions which involve raising and
investing new capital. So, we should focus on
future cost or marginal costs.

Marginal cost of funds refers is to the

increase in financing costs for adding one
more dollar of the new funding to its portfolio.
 Cont.….
The historical cost that was incurred in the
past in raising capital is a sunk cost that is
not relevant in financial decision-making.
The cost of capital of each source of capital
is known as the specific or component cost
of capital.

The combined cost of all sources of capital

is called weighted average cost of capital
(WACC).
Cost of Specific Sources of Capital
1. The cost of Long-Term Debt
The cost of long-term debt(kd,) is the after-
tax cost today of raising long-term funds
through borrowing. This is the rate of return
required by suppliers of debt.
The cost of debt is merely the interest rate
paid by the company on such debt.
However, since interest expense is tax-
deductible, the after-tax cost of debt should
be calculated.
 In computing the cost of a new bond issue requires three steps

Step 1. Determine the Net proceeds from the

sale of each bond
NPd = Pd – f

Where
NPd = net proceeds from the sales of a bond
Pd = the market price of the bond
 F = flotation costs (any costs that are related
with issuing new bonds like printing costs, legal
fees, commission/ underwriting fees and other
related expenses.
Step 2. Compute the effective before-tax
cost of the bond using formula

Kd = I + (Pn – NPd)/n
Pn + NPd
2

Step 3. Compute the after tax cost of debt

 
Kdt = Kd (1-T)
Example
ABC Company plans to issue 25-year bonds with a face value of
$40,000,000. Each bond has a par value of $1000 and carries an
interest rate of 9.5%. The firm’s marginal tax rate is 34%. Assume
the following independent conditions:

1.The bonds sell at par with no flotation costs

2.The bond is expected to sell for 98% per bond and flotation costs
are estimated to be $26 per bond
3. The bond is expected to be sold for 104% of par value and
flotation costs are anticipated to be $26 per bond

Required: under each of the above assumptions calculate:

a. Net proceeds per bond
b. The before tax cost of the bond
c. The after tax cost of the bond
 
Solution
Case 1
 f =$0, Pd = $1000
 Npd = Pd – f = $1000- $0 =$1000

 Kd = I + (Pn – Npd)/n
Pn + Npd
2
I = 9.5% * $1000 = $95

 Kd = $95 + (1000 – 1000)/25 = 9.5%

$1000 + $1000
2
 Kdt= kd (1 – T) = 9.5 %( 1-.34) = 6.27
Case 2
 
f =$26, Pn = $1000,
Pd = 0.98 *$1000 = $980

NPd = Pd - f = $980 – 26 = $954

Kd = I + (Pn – Npd)/n

Pn + Npd
2
 
Kd = $95 + (1000 – 954)/25
$1000 + $954
2 = 9.91%
After tax cost of the debt( bond)
 Kdt = Kd(1-T) =9.91(1-0.34) = 6.54%
Case 3
 
f =$26, Pn = $1000,
Pd = 1.04 *$1000 = $1040

NPd = Pd - f = $1040 – 26 = $1014

 
Kd = I + (Pn – Npd)/n
Pn + Npd
2

Kd = $95 + (1000 – 1014)/25

$1000 + $1014
2 = 9.38%

After tax cost of the debt (bond)

Kdt = Kd(1-T) =9.38(1-0.34) = 6.19%

Cost of Preferred Stock
Preferred stock represents a special type
of ownership interest in the firm.
Preferred stockholders must receive their
stated dividends before any earnings can
be distributed to common stockholders.

Preferred stock dividends are stated as a

birr amount “x birr per year”. Some times
preferred stock dividends are stated as an
annual percentage rate.
Some concepts in determining Cost of
Preferred Stock
1. Dividend payments on preferred stock are made
a. After interest payment on debt
b. Before dividend payment on common stock
2. Thus, both the riskness of preferred stock to
investors and the resulting cost of issuing preferred
stock fall somewhere b/n debt and common stock
3. Cost of new preferred stock can be approximated
by
Kp = Dp
NPp
Example
Suppose that ABC International Bank is
issuing preferred stock at $100 per share, with
a stated dividend of $12, and a flotation cost
of 3%, then:

Kp = Dp = $12_____
NPp $100 ( 1-0.03)

= 12.4%
The cost of common stock equity

The cost of common stock is the return

required on stock by investors in the market
place.
Conceptually, the cost of common stock may
be defined as the minimum rate of return
that a firm must earn on equity financed
portion of an investment project in order to
leave unchanged the market price of the
shares.
Techniques for measuring the cost of common stock

1. Constant growth valuation model

2. Capital asset Pricing model (CAPM)
Constant growth valuation
model(Gordon Constant )
The a cost of new common stock is found
using the following formula:

Ks = D1 + g
NPs
  D1 = the expected dividend of the current year

NPS = Ps-f
 
Example:

An issue of common stock is sold to

investors for $20 per share. The issuing
corporation incurs a selling expense of $1
per share. The current dividend is $ 1.50
per share and is expected to grow at a 6%
annual rate. Compute the specific cost of
this common stock.
Po= $20 per share, f = $1 per share,
Do = $1.5 per share, g = 6%
 NPS = Po - f
= $20 - $1
= $19
 D1 = Do(1+g)
= $1.5(1+0.06)
= $1.59 ----- expected next year dividend

 Ks = Dl + g
NPs
 Ks = $1.59 + 0.06
$19
 Ks = 0.0837 +0.06
= 14.37 %
CAPM (capital asset pricing model)

The CAPM is one of the most commonly

used ways to determine the cost of
common stock. This “cost” is the
discount rate for valuing common stocks,
and provides an estimate of the cost of
issuing common stocks.

Ks = Krf + (Km - Krf)

ABC Energy Services has a  = 1.6. The
risk free rate on T-bills is currently 4%
and the market return has averaged 15%.

Ks = Krf +  (Km - Krf)

= 4 + 1.6 (15 – 4) = 21.6 %

 The Cost of Retained Earning
 Retained earnings are not securities like stocks and
bonds and therefore they do not have market prices
that can be used to compute cost of capital.
 Retained earnings represent profits available to
common stock holders that the corporation chooses to
reinvest in itself rather than payout as dividends. Thus,
a. The shareholders are reinvesting part of their
earnings in corporation
b. In turn, the shareholders expect the corporation
to earn rate of return on those funds at least equal to
the rate earned on the outstanding common stock.
Therefore, the specific cost of retained
earnings is equated with the specific cost of the
common stock.
Using the Gordon Constant growth cost of
retained earnings is computed by
Kr = Dl + g
Ps
Note: Ps is considered because retained earnings
do not have market prices and also do not
involve flotation costs.
 Example
Consider the example discussed in cost of capital, compute
the cost of retained earnings.

Po = $20 per share, Do = $1.5 per share of the current

dividend, g = 0.06

D1 = Do(1+g) = $1.5(1+0.06) = $1.59

 Kr = Dl + g
Po
 = $1.59+ 0.06
$20

 = 13.95%
 Weighted Average Cost of Capital
(WACC)
The overall or composite cost of capital is
the weighted cost of all long-term capital
sources where by each specific cost of
capital is weighted by its relative importance
in the firm's total capital.

Once the specific cost of capital of each

permanent or long-term financing source is
measured, the firm's weighted average cost
of capital can be determined.
 The formula for the estimation of WACC is:

WACC = wd (cost of debt after tax) + ws

(cost of stock/RE) + wp(cost of PS)
 

WACC = W ki i
The WACC is the rate of return that must be earned
by the corporation in order to satisfy the
requirements of the individual specific cost of
capital.
Steps in computing the overall cost of capital:
1. Multiply the specific cost of each type of capital
source by its proportion or percentage composition
in the firm's capital structure based on either the
book value weights or market value weights
2. Add the products. The resulting sum is called the
corporations weighted average cost of capital.
Value of long source of capital Amount in Cost of capital
Example Birr %(after tax)

Book value
Debt 2,000,000 10
2,000 bonds at par, or $1000
Preferred stock 450,000 12
4,500 shares at $100 par value
Common equity 2,500,000 13.5
500,000 shares outstanding at $5.00 par valu
Total book value of capital 4,950,000
Market value
Debt 1,800,000 10
2,000 bonds at $900 current market price
Preferred stock 405,000 12
4,500 shares at $90 current market price
Common equity 3,750,000 13.5
500,000 shares outstanding at $7.5 current market price

Total market value of capital 5,955,000

Required: Calculate WACC based on
1. Book value weight
2. Market value weight

Solution:
i. Book value weight
WACC = Wd (cost of debt after tax) + Ws (cost of Cs) + Wp (cost of Ps)
= 0.404(0.10 ) + 0.091 (0.12) + 0.505(0.135)
= 0.0404 + 0.01092 +0.06818
= 11.94%

ii. Market value weight

WACC = Wd (cost of debt after tax) + Ws (cost of Cs) + Wp (cost of Ps)
= 0.302(0.1) + 0.068(0.12) + 0.63(0.135)
= 12.34 %
INDIVIDUAL ASSIGNMENT (20
points)
What is valuation of financial assets?
How to calculate:
◦ Bond valuation
◦ Stock valuation
Note: explain the meaning of each term and
their classification and give at least one
example in each term by showing all the
necessary steps.
 Assignment with presentation (15-20%)

Meaning and importance of valuation.

Valuation of bond, common equity and
preferred stock.
(note: show all the necessary steps and
formulas)
THANK
YOU