Chapter 14

The Cost of Capital

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Cost of Capital

In corporate finance, an investment made is for an anticipated return in future

Knowing the appropriate discount rate is vital

Return on investments must be at least equal the costs incurred to acquire it the minimum acceptable return
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Cost of Capital

cost of capital is a combined cost of each type of source by which a firm raises funds.
Cost of capital is the weighted average of the required returns of the securities that are used to finance the firm. We refer to this as the firms Weighted Average Cost of Capital, or WACC.

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Cost of Capital

Lets assume that we are working as a financial analyst at a company named Almarai Corporation It finances its business through three sources: Bond (debt), Preferred Share, and Equity (most firms raise capital with a combination of debt, equity, and hybrid securities). What is the cost of capital of the whole company? We first find cost of all the sources of capital and then compile to find the cost of capital of the whole company
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Cost of Debt
The cost of debt is the rate of return the firms lenders demand when they loan money to the firm. Note, the rate of return is not the same as coupon rate, which is the rate contractually set at the time of issue. We can estimate the markets required rate of return by examining the yield to maturity on the firms debt.

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Adjusting Yield for Tax Considerations

Yield to maturity indicates how much the firm has to pay on a before-tax basis Interest payment on a debt is a taxdeductible expense

Due to this, the true cost is less than the stated cost So cost of debt = Yield (1-tax rate)

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Adjusting Yield for Tax Considerations

Example What will be the yield to maturity on a debt that has par value of $1,000, a coupon interest rate of 5%, time to maturity of 10 years and is currently trading at $900? What will be the cost of debt if the tax rate is 30%? Enter:
N = 10; PV = -900; PMT = 50; FV =1000 I/Y = 6.38% After-tax cost of Debt = Yield (1-tax rate) = 6.38 (1-.3) = 4.47%

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Cost of Preferred Stock

The cost of preferred equity is the rate of return investors require of the firm when they purchase its preferred stock.
Preferred stock dividend is not a tax-deductible expense, with no downward tax adjustment

Computed by dividing dividend payment by net selling price in the market minus flotation cost
flotation cost :The costs incurred by a publicly traded company when it issues new securities. Flotation costs are paid by the company that issues the new securities and includes expenses such as underwriting fees, legal fees and registration fees. Companies must consider the impact these fees will have on how much capital they can raise from 1-8 a new issue.

Cost of Preferred Stock (contd)

The cost of preferred stock is as follows:

Where, = Annual dividend on preferred stock; = Price of preferred stock; F = Floatation, or selling cost Assuming annual dividend as $10.50, preferred stock is $100, and flotation, or selling cost is $4. Effective cost is: = $10.50 = $10.50 = 10.94% $100 - $4 $96
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Cost of Common Equity

The cost of common equity is the rate of return investors expect to receive from investing in firms stock. This return comes in the form of cash distributions of dividends and cash proceeds from the sale of the stock. Dividend valuation model: Where, = Price of the stock today; = Dividend at the end of the year (or period); = Required rate of return; g = Constant growth rate in dividends Assuming 12% 12% = = $2; = $40 and g = 7%, = equals

$2 + 7% = 5% + 7% =
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Alternate Calculation of the Required Return on Common Stock

Capital asset pricing model (CAPM) Where: = Required return on common stock; = Risk-free rate of return, usually the current rate on Treasury bill securities; = Beta coefficient (measures the historical volatility of an individual stocks return relative to a stock market index; = return in the market as measured by an approximate index
Assuming = 5.5%, = 12%, = 1.0, would be:

= 5.5% + 1.0 (12% - 5.5%) = 5.5% + 1.0 (6.5%) = 5.5% + 6.5% = 12%

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Cost of Retained Earnings

Sources of capital for common stock equity:

Purchaser of the new shares external source Retained earnings internal source

The cost of retained earnings is equivalent to the rate of return on the firms common cost representing the opportunity cost
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Cost of Retained Earnings (contd)

represents both the required rate of return on common stock, and the cost of equity in the form of retained earnings

For ease of reference, = Cost of common equity in the form of retained earnings = Dividend at the end of the first year, $2 = Price of stock today, $40 g = Constant growth rate in dividends, 7% = $2 + 7% = 5% + 7% = 12% $40
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Cost of Capital Baker Corporation

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Cost of New Common Stock

A slightly higher return than , representing the required rate of return of present stockholders, is expected
Needed to cover the distribution costs of the new securities

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Cost of New Common Stock (contd)

Assuming = $2, = $40, F (Flotation or selling costs) = $4 and g = 7%; = $2 + 7% $40 - $4 = $2 + 7% $36 = 5.6% + 7% = 12.6%

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Cost of Capital Curve

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Cost of Components in the Capital Structure

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