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Cost of Capital

PROF. PETER CHUNG

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.

Cost of internally generated equity (=Retained Earning)


Cost of external equity

WACC (Weighted Average Cost of Capital)


4. Level of Financing & WACC
3.

I. Cost of Capital

The return which must be earned from the firms

project.
The firm must earn at least this rate, otherwise

II. Component Cost of Capital


1. Concept
Left Hand Side (LHS)

Right Hand Side (RHS)

Assets
Liability
Owners Equity
2. Cost of Debt ( = bond financing)
P0 = coupon [PVAFr,n] + $1,000 [PVFr,n]

Bond
P/S
Stocks

II. Component Cost of Capital (Cont)


P0 = coupon [ PVAFr,n] + $1000 [PVFr,n]
at what i, will the RHS equal to P0 (LHS)?
or what interest rate (required return) do the
bondholders use to discount these promised CFs?

Kd
After tax cost of debt = kd =
e.g.

if Kd = 10 % and Tc (corporate tax rate) = 0.3


then kd =

II. Component Cost of Capital (Cont)


3. Cost of P/S Financing

$ Div
P0
r
RHS =
$ Div
P0
r

$ Div
Kp
P0

Investor :
Firm :

II. Component Cost of Capital (Cont)


4. Cost of Equity Financing
1. Cost of Internal equity (Retained earning)

E (divt )
P0
t
. . . . . t.1. (.1. .r )(1)

if the dividends are expected to grow at a constant rate:

(1) is simplified to

Div 0 (1 g )
P0
rg
Div 0 (1 g )
r K cs
g
P0

II. Component Cost of Capital (Cont)


2. Cost of external equity
.. . E
. .(.div
. . t. ). (1)

NP0
t 1

(1 r ) t

if the dividends are expected to grow at a constant rate:

(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.

The firm has $4.8M of Retained earning. The price of the


firms C/S is $75 per share and the most recent dividend
was $9.80, and these dividends are not expected to grow.
Answer:
P0

$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))

WACC = D/V x Kd(1-T) + S/V Kcs


D is the book value of the firms debt and S is the market
value of the firms equity. (V is the total value of the firm.)
Kd is estimated from YTM on similarly rated bonds.
Kcs is estimated by the expected rate of return with CAPM,
using the historically estimated beta. (Table 12-2 (P. 372)).

III. WACC

Table 13-4

III. WACC

Table 12-2

IV. Level of Financing & Its Impact


on the Firms WACC

1.

2.

Impact of issuing new common stocks on the firms


WACC

Investment Decision

Financing Decision

IV. Level of Financing (Cont)


e.g. The firm is considering three projects
Cost
IRR
geological equipment
$ 1,500,000 14%
water flooding equipment
$ 2,000,000 18%
drilling equipment
$ 2,500,000 11%
Company have bonds and stocks.
Component costs:
bond (after tax)
6%
internal equity $1,500,000 14%
new common stock
18 %
Project will be financed by 50% bonds and 50% equity
Which project should be accepted?

IV. Level of Financing (Cont)


Step 1

if bond + R/E, then WACC

if bond + new C/S, then WACC


Step 2

R/E = $ 1,500,000 (50%)


Bond
= $ 1,500,000 (50%)
Total
$ 3,000,000 (100%)

Step 3

Highest return
water project

18%

2nd high return

geological

14%

bond + New C/S

12%

drilling

11%
bond + R/E

10%

$2M

$3M

$3.5M

$6M

$M financing need