Ch. 12
Cost of Capital
 2002, Prentice Hall, Inc.
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)
Assets
Current assets
Fixed assets
Liabilities & Equity
Current Liabilities
Long-term debt
Preferred Stock
Common Equity
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
Assets
Current assets
Fixed assets
Liabilities & Equity
Current Liabilities
Long-term debt
Preferred Stock
Common Equity
The financing decision
Assets
Current assets
Fixed assets
Liabilities & Equity
Current Liabilities
Long-term debt
Preferred Stock
Common Equity
Assets
Current 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.
Cost of
Debt
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.
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
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
% cost of
Debt
=
Before-tax
% cost of
Debt
x
1
Marginal
- tax
rate
After-tax
% cost of
Debt
Kd
=
Before-tax
% cost of
Debt
=
x
1
Marginal
- tax
rate
kd (1 - T)
After-tax
% cost of
Debt
=
Before-tax
% cost of
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
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?
• Pre-tax cost of debt: (using TVM)
P/Y = 2
N = 40
PMT = -50
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%
• Pre-tax cost of debt: (using TVM)
P/Y = 2
N = 40
PMT = -50
FV = -1000
So, a 10% bond
PV = 950
costs the firm
solve: I = 10.61% = kd only 7% (with
• After-tax cost of debt:
flotation costs)
Kd = kd (1 - T)
since the interest
Kd = .1061 (1 - .34)
is tax deductible.
Kd = .07 = 7%
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:
Cost of Preferred Stock
• Recall:
kp =
D
Po
=
Dividend
Price
Cost of Preferred Stock
• Recall:
kp =
D
Po
=
Dividend
Price
• From the firm’s point of view:
Cost of Preferred Stock
• Recall:
kp =
D
Po
=
Dividend
Price
• From the firm’s point of view:
kp =
D
NPo
=
Dividend
Net Price
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
Cost of Preferred Stock
D
kp =
NPo
Dividend
=Net Price
Cost of Preferred Stock
D
kp =
NPo
=
8.00
74.00
=
=
Dividend
Net Price
Cost of Preferred Stock
D
kp =
NPo
=
8.00
74.00
=
Dividend
Net Price
=
10.81%
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?
Cost of Internal Equity
• Since the stockholders own the firm’s
retained earnings, the cost is simply
the stockholders’ required rate of
return.
• Why?
• If managers are investing
stockholders’ funds, stockholders will
expect to earn an acceptable rate of
return.
Cost of Internal Equity
Cost of Internal Equity
1) Dividend Growth Model
Cost of Internal Equity
1) Dividend Growth Model
D1
kc =
Po
+g
Cost of Internal Equity
1) Dividend Growth Model
D1
kc =
Po
+g
2) Capital Asset Pricing Model (CAPM)
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
Cost of External Equity
Dividend Growth Model
Cost of External Equity
Dividend Growth Model
D1
knc = NPo + g
Cost of External Equity
Dividend Growth Model
D1
knc = NPo + g
Net proceeds to the firm
after flotation costs!
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
debt
preferred
common
Cost
6%
10%
16%
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%