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Chapter 12 - Cost of Capital
2005, Pearson Prentice Hall
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
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Capital Structure
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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.
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
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
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 P 50,000 in
dividends to the stockholders.
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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 P 1,000.00 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 P 50.00 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 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
= =
D
Po
Dividend
Price
Dividend
Net Price
D
NPo
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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 P 8.00 per year and
should be valued at P 75.00 per share. If
flotation costs amount to P 1.00 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.
Why?
If managers are investing stockholders funds,
stockholders will expect to earn an acceptable
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

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Dividend Growth Model
k
nc
= + g
Cost of External Equity
D1
NPo
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
Capital
Source Cost Structure
debt 6% 20%
preferred 10% 10%
common 16% 70%
Weighted cost of capital =
.20 (6%) + .10 (10%) + .70 (16%)
= 13.4%
Weighted Cost of Capital
(20% debt, 10% preferred, 70% common)
Group Work Mechanics
Each group will be assigned a sector/subsector:
Financials Banks; Other Financial Institutions
Industrial 1 Electricity, Energy, Power & Water; Food,
Beverage & Tobacco
Industrial 2 Construction, Infrastructure & Allied
Services; Chemicals; Diversified Industrials
Holding Firms
Property
Services 1 Media; Telecommunications; Information
Technology
Services 2 Hotel & Leisure; Education; Diversified
Services
Mining & Oil
Group Work Mechanics
Each person in the group will compute for one
firms cost of capital using OSIRIS and other
available information
The group will then itemize each of the cost of
capital and get the average of the sector/sub-
sector
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Group Work Mechanics
The group will then prepare a report. The first page
will be a summary of the sector/sub-sectors cost of
capital including the breakdown per company.
The rest of the pages will be the computation on a per
company basis.
Thus, the report will have a maximum of 6 pages if
the group has five members, 7 pages, if there are six
members, etc.
Deadline will be one week.