Lec 3 By Prof.

Amrit Nakarmi I/II MSREE 02 June 2011

Income Statement Revenue Costs of Goods Sold (COGS) Gross Profit Expenses Net Income

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Cost of Debt
A firm with a 40% tax rate issues $1,000 bonds at a face value with coupon rate of 16%. Ignoring underwriting and issuing expenses,
Market yield (market rate of return) =

rd =160/1000 = 16% Cost of debt (to the company)=Rd=160*(1-0.4)/1000 =9.6%

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Cost of Debt
If people invest in bonds for long-term, then

Pb =Sum(I/(1+rb)t + F/(1+rb)n

Cost of debt (to the Co) NPb =Sum(I*(1-Tax)/(1+kb)t + F/(1+kb)n

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Cost of Preferred Share

A corporation issues new $100 preferred shares that

provide $12 in annual dividends. The firm has identical preferred shares outstanding that also trade at $100/share. Issuing and underwriting expenses are 5% of the issue price and assumed to be tax deductible. The firms tax rate is 40%.

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Cost of Preferred Share

Net Proceeds of preferred share (to the Co.) =NPp=100(1-0.4)*5 =$97 rp=12/100 =12% kp=12/97 =12.37% (cost of preferred share to the Co.)

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Cost of Preferred Share (for longterm investment)

Pp=Dp*Sum(1/(1+ rp)t)

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Cost of Equity
A corporation issues new $100 common shares that

provide $16 in annual dividends. The firm has identical common shares outstanding that also trade at $100/share. Issuing and underwriting expenses are 5% of the issue price and assumed to be tax deductible. The firms tax rate is 40%.

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Cost of Equity
Net Proceeds of common share (to the Co.) =NPe=100-(10.4)*5 =$97 re=16/100 =16% ke=16/97 =16.49% (cost of equity to the Co.)

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Cost of Equity (long-term)

Market capitalization rate

Pe=SUM(Dt/(1+ re)t)

Cost of new shares NPe =SUM(Dt/(1+ ke)t)

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Cost of Equity
Usually cost of equity is not known, then we have to

use Capital Asset Pricing Model (CAPM) to find out cost of equity.

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Cost of Equity (CAPM)

Expected Return

Security market line

Slope:market price of return

Risk free return

Cost of Equity (ke) = Rf + Equity Beta * (E(Rm ) - Rf)

Risk

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Cost of Equity
Cost of Equity (ke) = Rf + Equity Beta * (E(Rm ) Rf) where, Rf = Riskfree rate
E(R m) = Expected Return on the Market Index (Diversified Portfolio) In practice, Short term government security rates are used as risk free rates Historical risk premiums are used for the risk premium Betas are estimated by regressing stock returns against market returns (it shows how much the equity is riskier than the market)
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Weighted Average Cost of Capital (WACC)

If I is the total investment, then I =B+P+E, where B is borrowing (loans and bonds), P is preferred shares, and E is equity. Then, WACC =Rb(1-Tax)*B/I +kp*P/I + ke*E/I

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Example on WACC
A firm plans on financing major new expansion programs by drawing on funds in the following proportions that roughly corresponds to its current capital structure: Long term debt$30 mil Preferred shares $10 mil New common shares $40 mil Issuing and underwriting expenses can be ignored. Debt can be issued at a coupon rate of 12%, and the dividend yield on preferred shares would be 9%. Common Shares currently trade at $45 per share. The current dividend yield on preferred shares would be $2.25 per share. Management feels that, over long run, growth in dividend match inflation rate, which is anticipated to be 10% per year. The corporate tax is 40%. What is the firms weighted average cost of capital (WACC) ?

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Example on WACC
The current interest on government debt is 10%, and

the return on the market is expected to exceed this rate by 7%. What value of beta do we have to assume for the firm if the cost of equity as derived from the CAPM is to match the Ke =15% calculated according to the dividend growth model under above example?

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Example on WACC
kb = (1-T) rb =0.6*12% =7.2% kp = rp =9% Ke =D1 / pe+g =2.25/45+0.1 = 0.15 or 15%
Source Debt Preferred Proportion 30/80 =0.375 10/80 =0.125 Cost in % 7.2% 9% Weighted Cost 2.7% 1.13%

Common

40/80 =0.50

15%

7.5%

WACC = 2.7% +1.13% +7.5% =11.33%

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Example on WACC
A firm plans on financing major new expansion programs by drawing on funds in the following proportions that roughly corresponds to its current capital structure: Long term debt$30 mil Preferred shares $10 mil New common shares $40 mil Issuing and underwriting expenses can be ignored. Debt can be issued at a coupon rate of 12%, and the dividend yield on preferred shares would be 9%. Common Shares currently trade at $45 per share. The current dividend yield on preferred shares would be $2.25 per share. Management feels that, over long run, growth in dividend match inflation rate, which is anticipated to be 10% per year. The corporate tax is 40%. What is the firms weighted average cost of capital (WACC) ?

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Example on WACC
The current interest on government debt is 10%, and

the return on the market is expected to exceed this rate by 7%. What value of beta do we have to assume for the firm if the cost of equity as derived from the CAPM is to match the Ke =15% calculated according to the dividend growth model under above example?

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