Cost of Capital

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Cost of Capital

Firms need to make capital investment i.e., purchasing fixed assets such as factories, machineries, equipment, etc. After deciding what capital investments to make, they need to decide on the financing – sources of capital. The sources: Long-Term Debt, Common Stock, Preferred Stock and Retained Earnings. Then they need to find the cost of obtaining each source of financing today (not historical). Cost of Capital - The rate of return that a firm must earn on its investment projects to maintain its market value and attract funds. It depends on the risk of that investment (use of funds, not source of funds) 1. Cost of Debt (rd) – we use Bonds to represent the cost of long-term debt. Its required rate of return is the yield-to-maturity (YTM) of the bond. After we calculate the rd, we need to find the after-tax cost of debt : rd (after-tax) = rd(1 –T). In finding the YTM, we need to have the bond’s current price. If there is a flotation costs involved in issuing the bond, we need to deduct these costs first to find the net price of the bonds.

(Example: A company wants to sell $10 million worth of 20-year, 9% coupon bonds with a par value of $1,000 each. The firm must sell the bonds for $980 to reflect the market price of other similar bonds. The flotation costs are 2% of the par value of the bond. The tax-rate is 40%. Find the after-tax cost of debt.)

2. Cost Preferred Stock (rps) – equals to rps = Dps/Pps . Similar to cost of debt, if there is a flotation cost involved, we need to find the net preferred stock price first.

(Example: A company wants to issue A 10% preferred stock that is expected to sell for its $87 per share par value. The cost of issuing & selling the stock is expected to be $5 per share.)

3. Cost of Equity (re). Two approaches – Constant dividend growth model & CAPM.

i) Constant dividend growth model - use P0 = D1/re – g , whereby the cost of equity, re is denoted by: re = D1/Po + g . Several ways to find g, one of them is through average historical return. If there are floatation costs (especially new issue of stocks), the price has be adjusted accordingly to reflect these costs.

(Example: Company D wants to calculate its cost of equity. The market price of its common stock, Po is $50 per share, dividend next year (in 2010) is $4. Dividends for the past 6 years are as follows: 2004: $2.97; 2005: $3.12; 2006: $3.33; 2007: $3.47; 2008: $3.62; 2009: $3.80)

ii) CAPM – use re = rf + B(rm – rf); where rf is the risk-free rate of return, B is the stock’s beta and rm is the average return of the market. (Example: Company D’s beta is 1.5, the risk-free rate is 7%, and the average market return is 11%. Calculate the company’s cost of equity)

4. Cost of retained earnings (rre) – the same as the cost of an equivalent fully subscribed issue of additional common stock, but without the floatation costs (why?). Weighted average cost of capital (WACC) – the overall cost of capital that takes into account the actual weight and cost of each source of capital. It reflects the expected average future cost of funds over the long-run. (Example: Using the above costs of sources of capital and the following weights; debt: 40%, preferred stock: 10%, equity: 50%; calculate the WACC.)

1. A company wants to sell $10 million worth of 20-year, 9% coupon bonds with a par value of $1,000 each. The firm must sell the bonds for $980 to reflect the market price of other similar bonds. The flotation costs are 2% of the par value of the bond. The tax-rate is 40%. Find the after-tax cost of debt.)

2. A company wants to issue A 10% preferred stock that is expected to sell for its $87 per share par value. The cost of issuing & selling the stock is expected to be $5 per share.)

3. Company D wants to calculate its cost of equity. The market price of its common stock, Po is $50 per share, dividend next year (in 2010) is $4. Dividends for the...
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