The document discusses the cost of capital for a firm. It defines cost of capital as the rate of return required by investors in a security, which is also a cost to the firm for raising funds. It then examines how to calculate the cost of various sources of financing, including debt, preferred stock, and common equity. For each type, it considers factors like tax benefits, flotation costs, and required rates of return. It concludes by defining weighted cost of capital as the weighted average of the costs of all a firm's financing sources.

1. Chapter 12 -Chapter 12 - Cost of CapitalCost of Capital
© 2005, Pearson Prentice Hall

2.  Basic Skills:Basic Skills: (Time value of money,(Time value of money,
Financial Statements)Financial Statements)
 Investments:Investments: (Stocks, Bonds, Risk and(Stocks, Bonds, Risk and
Return)Return)
 Corporate Finance:Corporate Finance: (The Investment(The Investment
Decision - Capital Budgeting)Decision - Capital Budgeting)
Where we’ve been...Where we’ve been...

3. Assets Liabilities & EquityAssets Liabilities & Equity
Current Assets Current LiabilitiesCurrent Assets Current Liabilities
Fixed Assets Long-term DebtFixed Assets Long-term Debt
Preferred StockPreferred Stock
Common EquityCommon Equity

4. Assets Liabilities & EquityAssets Liabilities & Equity
Current Assets Current LiabilitiesCurrent Assets Current Liabilities
Fixed Assets Long-term DebtFixed Assets Long-term Debt
Preferred StockPreferred Stock
Common EquityCommon Equity
The investment decision

5. Corporate Finance:Corporate Finance: (The(The FinancingFinancing
Decision)Decision)
 Cost of capitalCost of capital
 LeverageLeverage
 Capital StructureCapital Structure
 DividendsDividends
Where we’re going...Where we’re going...

6. Assets Liabilities & EquityAssets Liabilities & Equity
Current Assets Current LiabilitiesCurrent Assets Current Liabilities
Fixed Assets Long-term DebtFixed Assets Long-term Debt
Preferred StockPreferred Stock
Common EquityCommon Equity

7. Assets Liabilities & EquityAssets Liabilities & Equity
Current Assets Current LiabilitiesCurrent Assets Current Liabilities
Fixed Assets Long-term DebtFixed Assets Long-term Debt
Preferred StockPreferred Stock
Common EquityCommon Equity
The financing decision

8. Assets Liabilities & EquityAssets Liabilities & Equity
Current Assets Current LiabilitiesCurrent Assets Current Liabilities
Long-term DebtLong-term Debt
Preferred StockPreferred Stock
Common EquityCommon Equity

9. Assets Liabilities & EquityAssets Liabilities & Equity
Current assets Current LiabilitiesCurrent assets Current Liabilities
Long-term DebtLong-term Debt
Preferred StockPreferred Stock
Common EquityCommon Equity
}Capital Structure

10. Ch. 12 - Cost of CapitalCh. 12 - Cost of Capital
 For InvestorsFor Investors, the rate of return on a, the rate of return on a
security is asecurity is a benefitbenefit of investing.of investing.
 For Financial ManagersFor Financial Managers, that same, that same
rate of return is arate of return is a costcost of raising fundsof raising funds
that are needed to operate the firm.that are needed to operate the firm.
 In other words, the cost of raisingIn other words, the cost of raising
funds is the firm’sfunds is the firm’s cost of capitalcost of capital..

11. How can the firm raise capital?How can the firm raise capital?
 BondsBonds
 Preferred StockPreferred Stock
 Common StockCommon Stock
 Each of these offers aEach of these offers a rate of returnrate of return toto
investors.investors.
 This return is aThis return is a costcost to the firm.to the firm.
 ““Cost of capitalCost of capital”” actually refers to theactually refers to the
weighted cost of capitalweighted cost of capital - a weighted- a weighted
average cost of financing sources.average cost of financing sources.

12. Cost ofCost of
DebtDebt

13. Cost of DebtCost of Debt
For the issuing firm, theFor the issuing firm, the costcost
of debtof debt is:is:
 thethe rate of returnrate of return requiredrequired
by investors,by investors,
 adjusted foradjusted for flotation costsflotation costs
(any costs associated with(any costs associated with
issuing new bonds), andissuing new bonds), and
 adjusted foradjusted for taxes.taxes.

14. Example: Tax effectsExample: Tax effects
of financing with debtof financing with debt
with stockwith stock with debtwith debt
EBITEBIT 400,000400,000 400,000400,000
- interest expense- interest expense 00 (50,000)(50,000)
EBTEBT 400,000400,000 350,000350,000
- taxes (34%)- taxes (34%) (136,000)(136,000) (119,000)(119,000)
EATEAT 264,000264,000 231,000231,000

15. Example: Tax effectsExample: Tax effects
of financing with debtof financing with debt
with stockwith stock with debtwith debt
EBITEBIT 400,000400,000 400,000400,000
- interest expense- interest expense 00 (50,000)(50,000)
EBTEBT 400,000400,000 350,000350,000
- taxes (34%)- taxes (34%) (136,000)(136,000) (119,000)(119,000)
EATEAT 264,000264,000 231,000231,000
 Now, suppose the firm pays $50,000 inNow, suppose the firm pays $50,000 in
dividends to the stockholders.dividends to the stockholders.

16. Example: Tax effectsExample: Tax effects
of financing with debtof financing with debt
with stockwith stock with debtwith debt
EBITEBIT 400,000400,000 400,000400,000
- interest expense- interest expense 00 (50,000)(50,000)
EBTEBT 400,000400,000 350,000350,000
- taxes (34%)- taxes (34%) (136,000)(136,000) (119,000)(119,000)
EATEAT 264,000264,000 231,000231,000
- dividends- dividends (50,000)(50,000) 00
Retained earningsRetained earnings 214,000214,000 231,000231,000

17. After-tax Before-tax MarginalAfter-tax Before-tax Marginal
% cost of % cost of x tax% cost of % cost of x tax
Debt Debt rateDebt Debt rate
-= 11

18. After-tax Before-tax MarginalAfter-tax Before-tax Marginal
% cost of % cost of x tax% cost of % cost of x tax
Debt Debt rateDebt Debt rate
KKdd = k= kdd (1 - T)(1 - T)
-= 11

19. After-tax Before-tax MarginalAfter-tax Before-tax Marginal
% cost of % cost of x tax% cost of % cost of x tax
Debt Debt rateDebt Debt rate
KKdd = k= kdd (1 - T)(1 - T)
.066 = .10 (1 - .34).066 = .10 (1 - .34)
-= 11

20. Example: Cost of DebtExample: Cost of Debt
 Prescott Corporation issues aPrescott Corporation issues a $1,000$1,000
par,par, 20 year20 year bond paying the marketbond paying the market
rate ofrate of 10%.10%. Coupons areCoupons are
semiannual. The bond will sell for parsemiannual. The bond will sell for par
since it pays the market rate, butsince it pays the market rate, but
flotation costs amount toflotation costs amount to $50$50 perper
bond.bond.
 What is the pre-tax and after-taxWhat is the pre-tax and after-tax costcost
of debtof debt for Prescott Corporation?for Prescott Corporation?

21.  Pre-tax cost of debtPre-tax cost of debt: (using TVM): (using TVM)
P/Y = 2P/Y = 2 N = 40N = 40
PMT = -50PMT = -50
FV = -1000FV = -1000
PV = 950PV = 950
solve: I =solve: I = 10.61%10.61% = kd= kd
 After-tax cost of debtAfter-tax cost of debt::
Kd = kd (1 - T)Kd = kd (1 - T)
Kd = .1061 (1 - .34)Kd = .1061 (1 - .34)
Kd = .07 =Kd = .07 = 7%7%

22.  Pre-tax cost of debtPre-tax cost of debt: (using TVM): (using TVM)
P/Y = 2P/Y = 2 N = 40N = 40
PMT = -50PMT = -50
FV = -1000FV = -1000 So, a 10% bondSo, a 10% bond
PV = 950PV = 950 costs the firmcosts the firm
solve: I =solve: I = 10.61%10.61% = kd= kd onlyonly 7%7% (with(with
 After-tax cost of debtAfter-tax cost of debt:: flotation costs)flotation costs)
Kd = kd (1 - T)Kd = kd (1 - T) since the interestsince the interest
Kd = .1061 (1 - .34)Kd = .1061 (1 - .34) is tax deductible.is tax deductible.
Kd = .07 =Kd = .07 = 7%7%

23. Cost of Preferred StockCost of Preferred Stock
 Finding theFinding the costcost of preferred stockof preferred stock
is similar to finding theis similar to finding the rate ofrate of
returnreturn (from Chapter 8), except(from Chapter 8), except
that we have to consider thethat we have to consider the
flotation costsflotation costs associated withassociated with
issuing preferred stock.issuing preferred stock.

24. Cost of Preferred StockCost of Preferred Stock
 Recall:Recall:

25. Cost of Preferred StockCost of Preferred Stock
 Recall:Recall:
kkpp = == =D
Po
Dividend
Price

26. Cost of Preferred StockCost of Preferred Stock
 Recall:Recall:
kkpp = == =
 From theFrom the firm’sfirm’s point of view:point of view:
D
Po
Dividend
Price

27. Cost of Preferred StockCost of Preferred Stock
 Recall:Recall:
kkpp = == =
 From theFrom the firm’sfirm’s point of view:point of view:
kkpp = == =
D
Po
Dividend
Price
Dividend
Net Price
D
NPo

28. Cost of Preferred StockCost of Preferred Stock
 Recall:Recall:
kkpp = == =
 From theFrom the firm’sfirm’s point of view:point of view:
kkpp = == =
NPo = price - flotation costs!NPo = price - flotation costs!
D
Po
Dividend
Price
Dividend
Net Price
D
NPo

29. Example: Cost of PreferredExample: Cost of Preferred
 If Prescott Corporation issuesIf Prescott Corporation issues
preferred stock, it will pay apreferred stock, it will pay a
dividend ofdividend of $8$8 per year andper year and
should be valued atshould be valued at $75$75 per share.per share.
If flotation costs amount toIf flotation costs amount to $1$1
per share, what is the cost ofper share, what is the cost of
preferred stock for Prescott?preferred stock for Prescott?

30. Cost of Preferred StockCost of Preferred Stock

31. Cost of Preferred StockCost of Preferred Stock
kpkp == Dividend
Net Price
D
NPo =

32. Cost of Preferred StockCost of Preferred Stock
kpkp = == =
= == =
Dividend
Net Price
D
NPo
8.00
74.00

33. Cost of Preferred StockCost of Preferred Stock
kpkp = == =
= = 10.81%= = 10.81%
Dividend
Net Price
D
NPo
8.00
74.00

34. Cost of Common StockCost of Common Stock
There are two sources of Common Equity:There are two sources of Common Equity:
1)1) Internal common equityInternal common equity (retained(retained
earnings).earnings).
2)2) External common equityExternal common equity (new common(new common
stock issue).stock issue).
Do these two sources have the same cost?Do these two sources have the same cost?

35. Cost of Internal EquityCost of Internal Equity
 Since the stockholders own the firm’sSince the stockholders own the firm’s
retained earnings, the cost is simplyretained earnings, the cost is simply
the stockholders’ required rate ofthe stockholders’ required rate of
return.return.
 Why?Why?
 If managers are investingIf managers are investing
stockholders’ funds, stockholders willstockholders’ funds, stockholders will
expect to earn an acceptable rate ofexpect to earn an acceptable rate of
return.return.

36. Cost of Internal EquityCost of Internal Equity

37. Cost of Internal EquityCost of Internal Equity
1)1) Dividend Growth ModelDividend Growth Model

38. Cost of Internal EquityCost of Internal Equity
1)1) Dividend Growth ModelDividend Growth Model
kkcc = + g= + g
D1
Po

39. Cost of Internal EquityCost of Internal Equity
1)1) Dividend Growth ModelDividend Growth Model
kkcc = + g= + g
2)2) Capital Asset Pricing Model (CAPM)Capital Asset Pricing Model (CAPM)
D1
Po

40. Cost of Internal EquityCost of Internal Equity
1)1) Dividend Growth ModelDividend Growth Model
kkcc = + g= + g
2)2) Capital Asset Pricing Model (CAPM)Capital Asset Pricing Model (CAPM)
kkjj = k= krfrf ++ jj (k(kmm - k- krfrf ))
D1
Po
β

41. Cost of External EquityCost of External Equity

42. Dividend Growth ModelDividend Growth Model
Cost of External EquityCost of External Equity

43. Dividend Growth ModelDividend Growth Model
kkncnc = + g= + g
Cost of External EquityCost of External Equity
D1
NPo

44. Dividend Growth ModelDividend Growth Model
kkncnc = + g= + g
Cost of External EquityCost of External Equity
D1
NPo
Net proceeds to the firm
after flotation costs!

45. Weighted Cost of CapitalWeighted Cost of Capital
 The weighted cost of capital is just theThe weighted cost of capital is just the
weighted average cost of all of theweighted average cost of all of the
financing sources.financing sources.

46. Weighted Cost of CapitalWeighted Cost of Capital
CapitalCapital
Source Cost StructureSource Cost Structure
debt 6% 20%debt 6% 20%
preferred 10% 10%preferred 10% 10%
common 16% 70%common 16% 70%

47. Weighted cost of capital =Weighted cost of capital =
.20 (6%) + .10 (10%) + .70 (16%).20 (6%) + .10 (10%) + .70 (16%)
== 13.4%13.4%
Weighted Cost of CapitalWeighted Cost of Capital
(20% debt, 10% preferred, 70% common)(20% debt, 10% preferred, 70% common)