Contact Hour 13

Cost of Capital
MBA ZG521: Financial Management
BITS Pilani Instructor: Prof. Mahalakshmi Mudliar
Cost of Capital - Introduction

Future Enterprises to redeem Bonds to cut finance costs

Decided to redeem ₹600 crs. maturing in 2019. This was issued in 2014
& company was paying interest of 11.5% on them.

Company may issue non-convertible at a lower interest cost of around

9.5% for future requirement.

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 Recap
Risk & Return Valn of bonds & securities

Financing Investment
Cost of capital
Decisions Decisions

Hurdle rate
Firms required rate of return
Reflects investors Firms opportunity cost of funds
required rate of return Discount rate –evaluating new projects
(ROR)
Minimum rate of Is ROR = COC ???
return to attract an 3. Flotation costs on new
Not exactly issues (debt or stock)
investor to buy or hold
If a firm sells new shares of common
1. Taxes on 2. Issue /Market price stock for $25 per share & incurs $5
interest payments different from par value per share as flotation costs. Investors
Consider a firm borrows @ If 10 year debenture with ROR @15%
9% & deducts interest from face value of $1000 is issued
its revenues before paying for $980 with coupon rate
tax at a rate of 34% of 10%
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 rate= 10.33%
Year Amount PVFactor Amount
1 100 0.90637 90.64
2 100 0.82151 82.15
3 100 0.74459 74.46
4 100 0.67488 67.49
5 100 0.61169 61.17
6 100 0.55442 55.44
7 100 0.50251 50.25
8 100 0.45546 45.55
9 100 0.41282 41.28
10 1100 0.37417 411.58
Value of bond= 980.0

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 Logic for tax adjustment

Sales Before 1,000 After 1,000

Interest 100* 0

EBT 900 1,000

Tax 40% 360 400
EAT 540 60 difference 600
If tax rate is 40% then 10% before tax = 6% after tax

BITS Pilani, Deemed to be University

BITSunder
Pilani,Section
Deemed 3 of
to UGC
be University
Act, 1956under Section 3, UGC Act
Sources of Financing - WACC

WACC

Cost of
Cost of Debt
Equity

Cost of Cost of
Preference Common
Stock Stock

Retained
New Issue
Earnings
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Compute the cost for the following
sources of financing:
P.P-1 A $1000 par value bond with a market price of $970 and a coupon interest rate
of 10 percent. Flotation costs for a new issue would be approximately 5
percent. The bonds mature in 10 years and the corporate tax rate is 34 percent.
P.P-2 A preferred stock selling for $100 with an annual dividend payment of $8. If the
company sells a new issue, the flotation cost will be $9 per share. The
company’s marginal tax rate is 30 percent.
P.P-3 Internally generated common stock totalling $4.8 million. The price of the
common stock is $75 per share, and the dividend per share was $9.80 last
year. The dividend is not expected to change in the future.
P.P-4 New common stock where the most recent dividend was $2.8. The company’s
dividends per share should continue to increase at an 8 percent growth rate
into the indefinite future. The market price of the stock is currently $53;
however, flotation costs of $6 per share are expected if the new stock is issued.

BITS Pilani, Deemed to be University under Section 3, UGC Act

Practice Problem -1
A $1000 par value bond with a market price of $970 and a coupon interest rate of 10
percent. Flotation costs for a new issue would be approximately 5 percent. The bonds
mature in 10 years and the corporate tax rate is 34 percent. Compute cost of debt.
Particulars Sym Value
Par value M $1,000.00 N 10
Market price $970.00 PV -921.5
=RATE(nper,pmt,pv,fv,type)
Coupon interest rate INT 10% $100.00 PMT 100
Flotation cost 5% =RATE(10,100,-921.5,1000)
FV 1000
Years to maturity n 10
Before tax cost of debt ? I ?
Tax rate T 34%
Present Value $921.50 PV (rd @11%)=$941.11
PV (rd @12%)=$887.00
PV = $921.50

You can use 4 methods :

1. Financial calculator
2. Excel
3. Interpolation method
4. Approximation method BITS Pilani, Deemed to be University under Section 3, UGC Act
Problem from Pre-recorded session

What is the current cost of debt for a firm that has a 9% coupon bond with 5
years to maturity and a current price of $962?
What is the after tax cost if it is in the 40% tax bracket?

Par value 1000

Market price 962
Coupon rate 9% 90
Years to maturity 5
Tax rate 40%
rd 10.00%
After tax
Cost of capital 6.00%

BITS Pilani, Deemed to be University

BITSunder
Pilani,Section
Deemed 3 of
to UGC
be University
Act, 1956under Section 3, UGC Act
Practice Problem-2
A preferred stock selling for $100 with an annual dividend payment of $8. If the company
sells a new issue, the flotation cost will be $9 per share. The company’s marginal tax rate
is 30 percent. Compute the cost of preferred stock.

BITS Pilani, Deemed to be University under Section 3, UGC Act

Problem from Pre-recorded session

The company has 1 million shares of 8% preferred stock selling for $120 today.
What is rP?

rP = _____ / _____ = ______

Note: 8% preferred means the company pays a preferred dividend of 8% of its

par value which is always $100

BITS Pilani, Deemed to be University

BITSunder
Pilani,Section
Deemed 3 of
to UGC
be University
Act, 1956under Section 3, UGC Act
Practice Problem -3

Internally generated common stock totalling $4.8 million. The price of the common
stock is $75 per share, and the dividend per share was $9.80 last year. The dividend is
not expected to change in the future. Compute the cost of retained earnings.

BITS Pilani, Deemed to be University under Section 3, UGC Act

Practice Problem -4

New common stock where the most recent dividend was $2.8. The company’s dividends
per share should continue to increase at an 8 percent growth rate into the indefinite
future. The market price of the stock is currently $53; however, flotation costs of $6 per
share are expected if the new stock is issued. Compute the cost of new common stock.

BITS Pilani, Deemed to be University under Section 3, UGC Act

Practice Problem – 5 (Calculating WACC)

Samsung Electronics has a capital structure of 40 percent common stock and

60 percent debt. A debt issue of $1000 par value, 6 percent bonds, maturing
in 15 years and paying annual interest, will sell for $975. Flotation costs for
the bonds will be $15 per bond. Common stock of the firm is currently selling
for $30 per share. The firm expects to pay $2.25 dividend next year.
Dividends have grown at the rate of 5 percent per year and are expected to
continue to do so for the foreseeable future. Flotation costs for the stock
issue are 5 percent of the market price. What is Samsung’s cost of capital
where the firm’s tax rate is 30 percent?

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Homework

Independence Mining Corporation (IMC) has 7 million shares of common stock

outstanding, 1 million shares of 6 percent preferred outstanding, and 100,000
$1,000 par, 9 percent semiannual coupon bonds outstanding. The stock sells
for $35 per share and has a beta of 1.2, the preferred stock sells for $60 per
share, and the bonds have 15 years to maturity and sell for 89 percent of par.
The market risk premium is 5.5 percent, T-bills are yielding 6 percent, and the
firm’s tax rate is 34 percent.

Compute IMC’s WACC

BITS Pilani, Deemed to be University

BITSunder
Pilani,Section
Deemed 3 of
to UGC
be University
Act, 1956under Section 3, UGC Act
Practice Problem – 6 (Integrated
problem)
As a member of the Finance department of Hawkins Manufacturing, your supervisor
has asked you to compute the appropriate discount rate of use when evaluating the
purchase of new packaging equipment for the plant. You have determined the
market value of the firm’s capital structure as follows:
SOURCE OF CAPITAL MARKET VALUES
BONDS $4,000,000
PREFERRED STOCK $2,000,000
COMMON STOCK $6,000,000
To finance the purchase, Hawkins manufacturing will sell 10-year bonds paying 7
percent per year at the market price of $1050. Preferred stock paying a $2.00
dividend can be sold for $25. Common stock for Hawkins Manufacturing is currently
selling for $55 per share. The firm paid $3 dividend last year and expects dividends
to continue growing at a rate of 5 percent per year. Firms marginal rate of tax is 30
percent. What discount rate should you use to evaluate the equipment purchase?

BITS Pilani, Deemed to be University under Section 3, UGC Act

 BITS Pilani

Thank you