Chapter 12 - Cost of Capital
Where we’ve been...
 Basic Skills: (Time value of money,
Financial Statements)
 Investments: (Stocks, Bonds, Risk and
Return)
 Corporate Finance: (The Investment
Decision - Capital Budgeting)
The investment decision
Assets
Current Assets
Fixed Assets
Liabilities & Equity
Current Liabilities
Long-term Debt
Preferred Stock
Common Equity
Where we’re going...
Corporate Finance: (The Financing
Decision)
 Cost of capital
 Leverage
 Capital Structure
 Dividends
The financing decision
Assets
Current Assets
Fixed Assets
Liabilities & Equity
Current Liabilities
Long-term Debt
Preferred Stock
Common Equity
Assets
Current assets
Capital Structure
Liabilities & Equity
Current Liabilities
Long-term Debt
Preferred Stock
Common Equity
Ch. 12 - 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.
How can the firm raise 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.
Basic Definitions
 Flotation costs: underwriter’s spread and
issuing cost associated with issuance and
marketing new securities
 Tax effect: borrow at 9%, tax rate 34%,
what is the after-tax cost of debt?
9% (1 – 34%) = 5.94%
 Cost of capital needs to adjust both flotation
cost and corporate tax
Cost of Debt
For the issuing firm, the cost
of debt is:
 the rate of return required
by investors,
 adjusted for flotation costs
and
 adjusted for taxes.
Example: Tax effects
of financing with debt
EBIT
- interest expense
EBT
- taxes (34%)
EAT
with stock
400,000
0
400,000
(136,000)
264,000
with debt
400,000
(50,000)
350,000
(119,000)
231,000
 Now, suppose the firm pays $50,000 in
dividends to the stockholders.
Example: Tax effects
of financing with debt
with stock
EBIT
400,000
- interest expense
0
EBT
400,000
- taxes (34%)
(136,000)
EAT
264,000
- dividends
(50,000)
Retained earnings
214,000
with debt
400,000
(50,000)
350,000
(119,000)
231,000
0
231,000
After-tax
Before-tax
% cost of = % cost of
Debt
Debt
Kd
.066
=
=
x
1
Marginal
- tax
rate
kd (1 - T)
.10 (1 - .34)
Example: Cost of Debt
 Prescott Corporation issues a $1,000
par, 20 year bond paying the market
rate of 10%. Coupons are annual.
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?
 Pre-tax cost of debt:
N = 20
PMT = 100
FV = 1000
PV = -950
solve: I = 10.61% = kd
 After-tax cost of debt:
Kd = kd (1 - T)
Kd = .1061 (1 - .34)
Kd = .07 = 7%
So, a 10% bond
costs the firm
only 7% (with
flotation costs)
since the interest
is tax deductible.
Cost of Preferred Stock
 Finding the cost of preferred stock
is similar to finding the rate of
return (from Chapter 8), except
that we have to consider the
flotation costs associated with
issuing preferred stock.
Cost of Preferred Stock
 Recall:
kp =
D
Po
=
Dividend
Price
 From the firm’s point of view:
kp =
D
NPo
=
NPo = price - flotation costs!
Dividend
Net Price
Example: Cost of Preferred
 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?
Cost of Preferred Stock
D
kp =
NPo
=
8.00
74.00
=
Dividend
Net Price
=
10.81%
Cost of Common Stock
There are two sources of Common Equity:
1) Internal common equity (retained
earnings).
2) External common equity (new common
stock issue).
Do these two sources have the same cost?
Cost of Internal Equity
 Since the stockholders own the firm’s
retained earnings, the cost is simply
the stockholders’ required rate of
return.
Cost of Internal Equity
1) Dividend Growth Model
D1
kc =
Po
+g
2) Capital Asset Pricing Model (CAPM)
kj = krf + b j (km - krf )
Cost of External Equity
Dividend Growth Model
D1
knc = NPo + g
Net proceeds to the firm
after flotation costs!
Example of Common Stock
 Google stock closes at $368.56 at the end of
2007. The company paid $5 dividend in
2007, and expects that dividend to grow at
13%. If Google issue new common stock,
the flotation cost will be $50 per share.
What is the cost of retained earnings and
cost of new common equity capital?
Example of Common Stock
 For cost of internal equity:
K = D1/ P + g = 5 (1.13) / 368.56 + .13 =
0.145
 For cost of external equity:
K = D1/NP + g = 5 (1.13) /(368.56 – 50) + .13
= .148
Example of Common Stock
 Issues with dividend growth model
-- it is easy
-- constant growth is not applicable
-- have to estimate the growth rate
Example of Common Stock
 If Google’s common stock has a beta of 1.43,
and suppose the risk free rate is 5.69%, and
the expected rate of return on the market
portfolio is 14%. Using the CAPM, what is
the cost of capital for Google?
K = 0.0569 + 1.43 (0.14 -0.0569) = 0.17
 Note that this is the internal equity, since we
do not consider transaction cost
Example of Common Stock
 Issues with CAPM
-- simple
-- does not require dividend growth rate
-- need to pick the risk free rate according to
the life of the project
-- need to estimate beta
-- need to estimate the market risk premium
Weighted Cost of Capital
 The weighted cost of capital is just the
weighted average cost of all of the
financing sources.
Weighted Cost of Capital
Source
Cost
debt
6%
preferred 10%
common 16%
Amount
2M
1M
7M
10 M
Capital
Structure
20%
10%
70%
Weighted Cost of Capital
(20% debt, 10% preferred, 70% common)
Weighted cost of capital =
.20 (6%) + .10 (10%) + .70 (16%)
= 13.4%
Cost of New Project
 Cost of capital for individual projects should
reflect the individual risk of the project
 PepsiCo: restaurants, snack foods, and
beverages
 Use WACC for discount rate for a project
only when the project has similar risk to the
firm
 Cannot use if get into a brand new business