Chapter 12 - Cost of Capital

Basic Skills: (Time value of money,

Financial Statements)
Investments: (Stocks, Bonds, Risk and
Return)
Corporate Finance: (The Investment
Decision - Capital Budgeting)
Where weve been...
Assets Liabilities & Equity
Current Assets Current Liabilities

Fixed Assets Long-term Debt
Preferred Stock
Common Equity

The investment decision
Corporate Finance: (The Financing
Decision)
Cost of capital
Leverage
Capital Structure
Dividends

Where were going...
Assets Liabilities & Equity
Current Assets Current Liabilities

Fixed Assets Long-term Debt
Preferred Stock
Common Equity

The financing decision
Assets Liabilities & Equity
Current assets Current Liabilities

Long-term Debt
Preferred Stock
Common Equity

Capital Structure
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 firms 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: underwriters 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
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000

Now, suppose the firm pays $50,000 in
dividends to the stockholders.
Example: Tax effects
of financing with debt
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000
- dividends (50,000) 0
Retained earnings 214,000 231,000

After-tax Before-tax Marginal
% cost of % cost of x tax
Debt Debt rate

Kd = kd (1 - T)

.066 = .10 (1 - .34)

- =
1
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 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:

k
p
= =

From the firms point of view:

k
p
= =

NPo = price - flotation costs!
D
Po
Dividend
Price
Dividend
Net Price
D
NPo
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
kp = =


= = 10.81%
Dividend
Net Price
D
NPo
8.00
74.00
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 firms
retained earnings, the cost is simply
the stockholders required rate of
return.
Cost of Internal Equity
1) Dividend Growth Model

k
c
= + g

2) Capital Asset Pricing Model (CAPM)

k
j
= k
rf
+
j
(k
m
- k
rf
)
D1
Po
Dividend Growth Model

k
nc
= + g


Cost of External Equity
D1
NPo
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 Googles 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
Capital
Source Cost Amount Structure
debt 6% 2M 20%
preferred 10% 1M 10%
common 16% 7M 70%
10 M
Weighted cost of capital =
.20 (6%) + .10 (10%) + .70 (16%)
= 13.4%
Weighted Cost of Capital
(20% debt, 10% preferred, 70% common)
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