Slide 1

Cost of Capital Basic Skills: (Time value of money, Financial

Statements) Investments: (Stocks, Bonds, Risk and Return) Corporate Finance: (The Investment Decision – Capital

Budgeting) Corporate Finance: (The Financing Decision)

Cost of capital Leverage Capital Structure Dividends

Slide 2

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

In this later chapters required return and expected return are used interchangeably

Slide 3

Sources of 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

Slide 4

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

)34.01(10.0066.0

)T1(kk taxAfter

Rate) Tax Marginal- (1 x Debt of cost % tax-Before

Debt of cost % tax-After

cdd

Slide 5

Cost of Debt – Example Prescott Corporation issues a $1,000 par, 20 year

bond paying the market rate of 10%. Coupons are semiannual. The bond will sell for par since it pays the market rate, but flotation costs amount to $50 per bond

What is the pre-tax and after-tax cost of debt for Prescott Corporation?

Slide 6

Cost of Debt – Example (Continued) Pre-tax cost of debt: (using TVM)

After-tax cost of debt:

After-tax kd = kd (1 – T)

After-tax kd = 0.1061 (1 – 0.34)

After-tax kd = 0.07 = 7%

N I/Y P/Y PV PMT FV MODE

40 10.61 2 -950 50 1000

Slide 7

Cost of Preferred Stock Finding the cost of preferred stock is similar to

finding the rate of return, except that we have to consider the flotation costs associated with issuing preferred stock

CostsFlotation - Price PriceNet

PriceNet

Dividend

have wecostsflotation toDue

Price

Dividend

0

psps

ps

NP

Dk

P

Dk

Slide 8

Cost of Preferred Stock – Example If Prescott Corporation issues preferred stock, it

will pay a dividend of $8 per year and should be valued at $75 per share. If flotation costs amount to $1 per share, what is the cost of preferred stock for Prescott?

1081.000.74

00.8

psps NP

Dk

Slide 9

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?

Slide 10

Cost of Internal Equity Since the stockholders own the firm’s retained earnings,

the cost is simply the stockholders’ required rate of return If managers are investing stockholders’ funds,

stockholders will expect to earn an acceptable rate of return

)kk(βkk

:(CAPM) ModelPricing Asset Capital 2)

gP

Dk

: ModelGrowth Dividend 1)

rfmjrfj

0

1cs

-+=

+=

Slide 11

Cost of External Equity

costs flotation after firm the to stock

common new of proceeds Net :NP

gNP

Dk

: ModelGrowth Dividend

ncs

ncs

1ncs +=

Slide 12

Weighted Average Cost of Capital The weighted average cost of capital is just the

weighted average cost of all of the financing sources.

)()()()1( ncsncscscspspscddwacc kwkwkwTkwk

Slide 13

Weighted Average Cost of Capital – Example

Capital

Source Cost Structure

debt 6% 20%

preferred 10% 10%

common 16% 70% Weighted cost of capital = 0.20 (6%) + 0.10 (10%) + 0.70 (16%) = 13.4%