FINANCIAL MANAGEMENT

Week 7/ Session 11/Online

COST OF CAPITAL
 Acknowledgement
These slides have been adapted from:
Lawrence J. Gitman, Chad J. Zutter (2012)
Principles of Managerial Finance. Pearson.
Global Edition. 13th Edition. ISBN 978 0 13
611946 3.

COST OF CAPITAL 2
 Learning Goals
LG
1
Students understands basic concept of
cost of capital
LG
2 Students understand various sources of
capital
LG
3
Students understand cost of long term
debt, before tax cost of debt and after tax
cost of debt and how to calculate it

COST OF CAPITAL 3
 Learning Goals
LG
4
Students understand cost of preferred
stock and how to calculate it
LG
5
Students understand cost of common
stock equity, cost of retained earnings
and cost of new issue of common stock
and how to calculate it
LG
6 Students understand how to calculate
WACC
COST OF CAPITAL 4
COST OF CAPITAL BASIC CONCEPT
 Overview

 Cost of Capital is cost of financing. It is a

minimum rate that a project must earn in
order to create value (Gitman, Zutler,
Principal of Managerial Finance)
 Investments that earn return above cost of
capital will increase shareholders wealth
 projects with rate of return below cost of
capital will decrease shareholders wealth
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 Why Calculating Cost of
Capital?
 Cost of Capital play an important role in Capital
Budgeting (a process to select long term investments).
 Good Capital Budgeting decisions will result in
maximizing shareholder’s wealth
 Cost of capital serve as a tool to judge firm’s long term
investment opportunities to ensure it is consistent
with shareholders wealth maximization
 To maximize shareholders wealth an investment must
generate return above cost of capital

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 Sourcess of Long Term
Capital
BASIC SOURCESS OF LONG TERM CAPITAL

Long Term Debt

Preffered Stock

Common Stock

Retained Earnings

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 Overview
 Net Proceeds: funds actually received by firm. It is
net of issuance costs of new security (flotation
costs) and net of any price discounts.
 Flotation Costs: cost of issuing new security such
as bonds, preferred stocks and common stocks.
Example: underwriting cost, administration cost,
printing cost, etc.
 Underprice: When a security is sold at discount
from market price
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COST OF LONG TERM DEBT

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 Overview
 Cost of Long Term Debt: cost of financing resulted
from raising fund through long term debt, commonly
bonds
 Before Tax Cost of Debt: rate of return from new
borrowing
 After Tax Cost of Debt: interest expense on debt paid
by corporations reduces taxable income, thus reduces
firm’s tax liability. Calculation of cost of long term debt
has to be on after tax basis to reflect tax savings
created by debt financing
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 Calculating Before Tax
Cost of Debt rd
 Quotation: Using market  Approximation:  using
quotation on YTM of the firm’s following formula
existing bonds or other bonds
with similar risk

 Calculation: Calculating YTM

generated by bonds cash flow.
YTM can be calculated by trial & I = annual interest in dollars
error method. In practice YTM can Nd = net proceeds from the sale of
be easily calculated with the help debt (bond)
n = number of years to the bond’s
of calculator & spreadsheet maturity
  

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 Calculating After Tax Cost
of Debt ri
 Formula: ri = rd  (1 – T)
 Example:
Duchess Corporation, a major hardware
manufacturer, is contemplating selling $10 million
worth of 20-year, 9% coupon bonds with a par value
of $1,000. Because current market interest rates are
greater than 9%, the firm must sell the bonds at $980.
Flotation costs are 2% or $20. The net proceeds to the
firm for each bond is therefore $960 ($980 – $20).

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 Calculating After Tax Cost
of Debt ri
 Approximating the cost

 Duchess Corporation has a 40% tax rate. Using the

9.452% before-tax debt cost calculated above, we
find an after-tax cost of debt of 5.6% [9.4%  (1 –
0.40)].
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COST OF PREFFERED STOCK

COST OF CAPITAL 15
 Overview
 Preffered Stock is an instrument that represent
ownership in a corporation that provides the
holder with right to receive their stated dividends
before common stockholders
 Cost of Preffered Stock is the ratio of preffered
stock dividends divided by net proceeds from the
of preffered stock
 Preffered Stock dividends are stated either in
dollar amout or as a percentage of the stock’s par
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 Calculating Cost of
Preffered Stock rP
 In calculating Cost of Preffered Stock any
dividend stated in percentage has to be
translated to dollar amount

 Formula:

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 Calculating Cost of
Preffered Stock rP
 Example:
Duchess Corporation is contemplating the issuance of
a 10% preferred stock that is expected to sell for its
$87-per share value. The cost of issuing and selling
the stock is expected to be $5 per share. The dividend
is $8.70 (10%  $87). The net proceeds price (Np) is
$82 ($87 – $5).

rP = DP/Np = $8.70/$82 = 10.6%

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COST OF COMMON STOCK

COST OF CAPITAL 19
 Overview
 Cost of common stock are return required by
investors in the market on the stock
 There are two types of common stock financing:
new issues of common stock and retained
earnings
 To calculate cost of new issues of common stock
or cost of retained earnings we can calculate
using constant growth dividend model or capital
asset pricing model
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 Cost of Common Stock
Equity rs
 Before calculating cost of either new issue of
common stock or cost of retained earning,
one must determine cost of common stock
equity
 Cost of Common Stock Equity reprents the
compensation that the market demands in
exchange for owning asset and bearing the
risk of ownership
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 Calculating Cost of
Common Stock Equity rs
Using Constant Growth Valuation Using Capital Asset Pricing Model
(Gordon Growth) Model (CAPM)
rs = RF + [b  (rm – RF)]

where

P0 = value of common stock

D1 = per-share dividend RF = risk-free rate of return
expected at the end of year
1 rm = market return; return on the
rs = required return on
common stock market portfolio of assets
g = constant rate of growth in
dividends b = nondiversifiable risk of the firm as
measured by the beta coefficient, b.

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 Constant Growth Valuation Model vs
Capital Asset Pricing Model (CAPM)
Capital Asset Pricing Model
Constant Growth Valuation Model

Duchess Corporation wishes to Duchess Corporation now wishes to

determine its cost of common stock
equity, rs. The market price, P0, of its
common stock is $50 per share. The firm
expects to pay a dividend, D1, of $4 at
the end of the coming year, 2013.
Dividends have grown, g, at 5%
calculate its cost of common stock equity,
rs, by using the capital asset pricing
model. The firm’s investment advisors
and its own analysts indicate that the
risk-free rate, RF, equals 7%; the firm’s
beta, b, equals 1.5; and the market
return, rm, equals 11%.

rs = ($4/$50) + 0.05 = 0.08 + 0.05 rs = 7.0% + [1.5  (11.0% – 7.0%)] = 7.0%

= 0.130, or 13.0% + 6.0% = 13.0%

COST OF CAPITAL 23
 Calculating Cost of
Retained Earnings rr
 The cost of retained earnings, rr, is the same
as the cost of an equivalent fully subscribed
issue of additional common stock, which is
equal to the cost of common stock equity, rs.
rr = rs
 Thus cost of retained earnings is 13% as
calculated in the preceding example

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 Calculating Cost of New
Issue of Common Stock rn
 Cost of New Issue of Common Stock Cost is cost of
issuing new common stock in the market. It is cost of
common stock equity, rs , net of underpricing and
flotation costs.
 When new stock are issued they are always at discount
from market price (underpriced). The company must
also pay issuence costs (underwriting costs)
 The cost of new issue of common stock is normally
greater than other long term financing costs

COST OF CAPITAL 25
 Calculating Cost of New
Issue of Common Stock rn
 Formula:

 Example:
To determine its cost of new common stock, rn, Duchess
Corporation has estimated that on average, new shares can be sold
for $47. The $3-per-share underpricing is due to the competitive
nature of the market. A second cost associated with a new issue is
flotation costs of $2.50 per share that would be paid to issue and
sell the new shares. The total underpricing and flotation costs per
share are therefore $5.50.

rn = ($4.00/$44.50) + 0.05 = 0.09 + 0.05 = 0.140, or 14.0%

COST OF CAPITAL 26
WEIGHTED AVERAGE COST OF
CAPITAL
 Overview
 Weighted Average Cost of Capital reflect
expected average cost of capital over the
long run. It is found by weighting the cost of
each type of capital by its proportion in the
firm’s capital structure. (Gitman, Zutler,
Prnciples of Managerial Finance)

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 Calculating Weighted
Average Cost of Capital
 Formula:
ra = (wi  ri) + (wp  rp) + (ws  rr or n)
wi = proportion of long-term debt in capital structure
wp = proportion of preferred stock in capital structure
ws = proportion of common stock equity in capital structure

 Remember that wi + wp + ws must equal 1

COST OF CAPITAL 29
 Calculating Weighted
Average Cost of Capital
 Example :
• Cost of debt ri = 5.6%
• Cost of preferred stock rp = 10.6%
• Cost of retained earnings rr =
13.0%,
• Cost of new common stock rn =
14.0%.
Weights :
Long-term debt = 40%
Preferred stock = 10%,
Common stock equity = 50%
Gitman, Zutter, Principles of Managerial Finance, 13 th Edition

COST OF CAPITAL 30
 Weighting Schemes
 Book Value Weights: measure the
proportion using accounting values
 Market Value Weights: measure the
proportion at its market value
 Historical Weights: measure the proportions
based on actual proportions
 Target Weights: measure the proportions
based on desired proportions
COST OF CAPITAL 31
 Summary
 Cost of Capital is an important tool for capital budgeting. It
represents expected average future cost of funds to the
firm.
 Because firm raises funds using mix type of long term
capital, cost of capital must reflect entirity of firms
financing activity. In this case firms calculation of cost of
capital must be Weighted Average Cost of Capital (WACC).
 Weighted Average Cost of Capital (WACC) is a calculation of
firm’s cost of capital in which each category of capital is
proportionally weighted.

COST OF CAPITAL 32
 Summary
 WACC is the overall required return on the firm as a
whole, it is often used internally by company decision
makers to determine economic feasibility of
expansionary opportunities and mergers.
 WACC in other words represent investor’s opportunity
cost on putting money in the company.
 By understanding cost of capital it is most likely that the
decisions that managers make relating to long term
investment will be consistent with the firm’s goal of
shareholders wealth maximization.
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Thank You
COST OF CAPITAL 34