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Cost of Capital
Concept of Cost of Capital
2. Component COSTS
1.
Basic Concept
Cost of Debt (=borrowing)
Cost of Preferred Stock
Cost of Equity
1.
2.
3.
4.
1.
2.
I. Cost of Capital
project.
The firm must earn at least this rate, otherwise
Assets
Liability
Owners Equity
2. Cost of Debt ( = bond financing)
P0 = coupon [PVAFr,n] + $1,000 [PVFr,n]
Bond
P/S
Stocks
Kd
After tax cost of debt = kd =
e.g.
$ Div
P0
r
RHS =
$ Div
P0
r
$ Div
Kp
P0
Investor :
Firm :
E (divt )
P0
t
. . . . . t.1. (.1. .r )(1)
(1) is simplified to
Div 0 (1 g )
P0
rg
Div 0 (1 g )
r K cs
g
P0
NP0
t 1
(1 r ) t
(1) is simplified to
Div 0 (1 g )
NP0
rg
r K ncs
Div 0 (1 g )
g
NP0
Example
Compute the cost for the following source of financing
1. A preferred stock sells for $100 with an annual dividend of $8.
The firms Tc = 30%
Answer:
$div
P0
r
Note:
1. r = Kp
2. Tc is an unnecessary information
provided in the question because
stock does not need Tc, but bond does
Example
2.
$div (1 g )
rg
Note:
1. g = 0, because dividends
are not expected to grow
2. r = Kcs
Example
3.
New common stock where the most recent dividend was $2.80.
These dividends are expected to grow at 8% into the infinite
future. The market price of the stock currently is $53. However,
the floatation cost of $6 is expected if new shares are issues.
Answer:
NP0
Div (1 g )
rg
III. WACC
Firms issue many securities and each component has its own cost of capital.
So, we want to know what is the overall cost of capital (or weighted average)
to the firm.
WACC = Wd ( kd) + Wp (Kp) + Wcs (Kcs)
e.g. Market value cost weight
Bond (AT) $1,750,000 7% 35%
Preferred Stock $ 250,000 13% 5%
Common Stock $3,000,000 16% 60%
Total $5,000,000 100%
WACC =
III. WACC
WACC for Selected Companies (Table 13-4 (P. 401))
III. WACC
Table 13-4
III. WACC
Table 12-2
1.
2.
Investment Decision
Financing Decision
Step 3
Highest return
water project
18%
geological
14%
12%
drilling
11%
bond + R/E
10%
$2M
$3M
$3.5M
$6M
$M financing need