Financial Magament

Chapter 9: Cost of Capital

Cost of Capital - represents the firm’s cost of financing and is the minimum rate of return that a project
must earn to increase firm value. A firm’s cost of capital is estimated at a given point in time and reflects
the expected average future cost of funds over the long run

Capital budgeting - is the process of evaluating and selecting long-term investments. This process is
intended to achieve the firm’s goal of maximizing shareholders’ wealth.
Capital budgeting activities are chief among the responsibilities of financial managers and that
they cannot be carried out without knowing the appropriate cost of capital with which to judge the
firm’s investment opportunities.

Four Souces of Long Term Capital

1. Cost of Long Term Debt

- The cost of long-term debt is the financing cost associated with new funds raised through long-
term borrowing. Typically, the funds are raised through the sale of corporate bonds.

flotation costs – the total costs of issuing and selling a security.

Example:
underwriting costs — compensation earned by investment bankers for selling the security
administrative costs—issuer expenses such as legal, accounting, and printing.

before-tax cost of debt for bonds - the rate of return the firm must pay on new borrowing

three ways to find the ‘’before-tax cost of debt for bonds’’

 Using Market Quotations - observe the yield to maturity (YTM) on the firm’s existing bonds or
bonds of similar risk issued by other companies.
 Calculating the Cost - calculating the YTM generated by the bond cash flows. From the issuer’s
point of view, this value is the cost to maturity of the cash flows associated with the debt.
 Approximating the Cost –

After-tax cost of debt for bonds - the interest payments paid to bondholders are tax deductable for
the firm, so the interest expense on debt reduces the firm’s taxable income and, therefore, the
firm’s tax liability. To find the firm’s net cost of debt, we must account for the tax savings created by
debt and solve for the cost of long-term debt on an after-tax basis.

The after-tax cost of debt: ri = rd * (1 - T)

2. Cost of Preferred Stock - It gives preferred stockholders the right to receive their stated
dividends before the firm can distribute any earnings to common stockholders

Cost of preferred stock - is the ratio of the preferred stock dividend to the firm’s net proceeds from
the sale of the preferred stock

Cost of preferred stock (rp) = preferred dividend (Dp) / net proceeds (Np)
 3. Cost of Common Stock - is the return required on the stock by investors in the marketplace.

Two forms of common stock financing:

 retained earnings
 new issues of common stock.

Cost of common stock equity - , is the rate at which investors discount the expected common stock
dividends of the firm to determine its share value

Finding the “cost of common stock equity”

 Using the Constant-Growth Valuation (Gordon Growth) Model

 Using the Capital Asset Pricing Model (CAPM) - describes the relationship between the required
return, rs, and the nondiversifiable risk of the firm as measured by the beta coefficient

Cost of retained earnings (rr) - the same as the cost of an equivalent fully subscribed issue of additional
common stock. The retention of earnings increases common stock equity in the same way that the sale
of additional shares of common stock does.

Required return on RE = Required return on common stock

Cost of new issues of common stock (rn) - is determined by calculating the cost of common stock, net of
underpricing and associated flotation costs. The cost of new common stock is normally greater than any
other long-term financing cost.
Weighted Average Cost of Capital (WACC) - reflects the expected average future cost of capital over the
long run.

Multiply the individual cost of each form of financing by its proportion in the firm’s capital
structure and sum the weighted values.

WACC = (Long term debt * r ) + (Preferred stock * r) + (Common stock equity * rr or rn)

Weighting Schemes - Firms can calculate weights on the basis of either book value or market value using
either historical or target proportions.

Book value weights - use accounting values to measure the proportion of each type of capital in the
firm’s financial structure.

Market value weights - measure the proportion of each type of capital at its market value.

Historical proportion weights - can be either book or market value weights based on actual capital
structure proportions. Such a weighting scheme would therefore be based on real—rather than
desired—proportions.

Target proportion weights - which can also be based on either book or market values, reflect the firm’s
desired capital structure proportions.

“the preferred weighting scheme is target market value proportions”