Cost of capital

,
cost of capital
,
bond
,
preferred stock
,
factors influencing cost of capital determination
,
cost of new common stock
,
cost of debt components
,
cost of preferred stock
,
components of cost of capital

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Concept of Cost of Capital
Itistherequiredrateofreturnonthevarioustypes
offinancing.
Costofcapitalmaybedefinedastheminimum
rateofreturnaninvestorwouldbewillingto
acceptforinvestingfundsinaparticular
project.

3. 11-3
An Overview of the Cost of Capital
The cost of capitalacts as a link between the
firm’s long-term investment decisions and the
wealth of the owners as determined by investors
in the marketplace.
It is the “magic number” that is used to decide
whether a proposed investment will increase or
decrease the firm’s stock price.
Formally, the cost of capital is the rate of return
that a firm must earn on the projects in which it
invests to maintain the market value of its stock.
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4. Common Stock
Commonstockisasecuritythatrepresents
ownershipinacorporation.Holdersofcommon
stockexercisecontrolbyelectingaboardof
directorsandvotingoncorporatepolicy.
Commonstockholdersareonthebottomofthe
priorityladderforownershipstructure;inthe
eventofliquidation,commonshareholdershave
rightstoacompany'sassetsonlyafter
bondholders,preferredshareholdersandother
debt holdersare paid infull.
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5. Preferred Stock
Apreferredstockisaclassofownershipinacorporation
thathasahigherclaimonitsassetsandearningsthan
commonstock.Preferredsharesgenerallyhavea
dividendthatmustbepaidoutbeforedividendsto
commonshareholders,andthesharesusuallydonot
carryvotingrights.
Preferredstockcombinesfeaturesofdebt,inthatitpays
fixeddividends,andequity,inthatithasthepotentialto
appreciateinprice.Thedetailsofeachpreferredstock
dependontheissue.
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6. Bond
A bond is a debt investment in which an investor loans
money to an entity (typically corporate or governmental)
which borrows the funds for a defined period of time at a
variable or fixed interest rate. Bonds are used by
companies, municipalities, states and sovereign
governments to raise money and finance a variety of
projects and activities. Owners of bonds are debt holders,
or creditors, of the issuer.
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7. Debenture
A debenture is a type of debt instrument
that is not secured by physical assetsor
collateral.Debentures are backed only by
the general creditworthinessand
reputation of the issuer. Both corporations
and governments frequently issue this
type of bond to secure capital. Like other
types of bonds, debentures are
documented in an indenture.
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8. Retained Earning
Retained earnings refer to the percentage of net
earningsnot paid out as dividends, but retained
by the company to be reinvested in its core
business, or to pay debt. It is recorded under
shareholders' equityon the balance sheet. The
formula calculates retained earningsby adding
net income to, or subtracting any net losses
from, beginning retained earnings, and
subtracting any dividends paid to shareholders.
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9. Factors Influencing Cost of Capital
Determination
The factors influencing the determination of cost
of capital are discussed as follows :
(i) Business Risk
(ii) Financial Risk
(iii) Source of Finance
(iv) Tax
(v) Relative Return
(vi) Capital Structure Composition
(vii) Dividend Policy
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10. Components of Cost of Capital
Cost of Debt
Cost of Preferred Stock
Cost of Retained Earnings
Cost of New Common Stock
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Components of Cost of Capital
CostofDebt:Itistherequiredrateofreturnon
investmentofthelendersofacompanyi.e.
predeterminedinterestrate.
CostofDebtComponents:
Cost of Debt
Net
Proceeds
Before Tax
Cost of Debt
After Tax
Cost of Debt

12. Cost of Debt Components
Net Proceeds:
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Duchess Corporation, a major hardware manufacturer,
is contemplating selling $10 million worth of 20-year,
9% coupon bonds with a par value of $1,000. Because
current market interest rates are greater than 9%, the
firm must sell the bonds at $980. Flotation costs are
2% or $20. The net proceeds to the firm for each bond
is therefore $960 ($980 -$20).

13. Cost of Debt

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14. Example

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15. 11-15
Before-Tax Cost of Debt
Calculating the Cost
Specific Sources of Capital:
The Cost of Long-Term Debt (cont.)
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16. 11-16
Before-Tax Cost of Debt
Calculating the Cost
Specific Sources of Capital:
The Cost of Long-Term Debt (cont.)
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17. 11-17
Before-Tax Cost of Debt
Approximating the Cost
Specific Sources of Capital:
The Cost of Long-Term Debt (cont.)
Where,
I=AnnualInterest in $
Nd=Net Proceeds from the sale of
Debt(Bond)
n= number of years9/28/2019

18. Cost of Debt
Debt capital cost = kd = Before tax cost of
debt = Rate of interest.
 Kdt= After tax cost = kd(1 –T)
 Where T = Tax rate.
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19. Components of Cost of Capital
Cost of Preferred Stock:Itis the required rate of
return on investment of the preferred
shareholders of the company i.e. predetermined
dividend (subject to the sufficient net income) &
transaction cost (if any).
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20. Cost of Preferred Stock

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21. Cost of Preferred Stock
A company want to raise capital through
15% unredeemable preference share with
the current price of per preferred stock Tk.
100 and 5% floatation cost. You are
required to calculate the cost of preferred
stock if,
i) sale with 10% discounted price
ii) sale with 10% decreased price
iii) sale with equal price.
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22. Cost of Preferred Stock

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23. Example
A company’s 14% preferred stock of Tk.
1000 par value, currently sold for Tk. 960
per stock. The stock is redeemable after 10
years. Floatation cost is Tk.10 per stock.
What is the cost of preferred stock?
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24. Cost of New Common Stock
The cost of external equity; based on the cost of
retained earnings but increased for flotation
costs i.e. common shareholders expected
dividend plus transaction cost.
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25. Cost of New Common Stock
Methods for calculating Cost of CS:
1. Capital Asset Pricing Model
2. Dividend Model
3. Dividend Growth Model or Gordon
Model.
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26. Cost of New Common Stock
CAPM: Describes the relationship between the
required return, and the nondiversifiable risk of
the firm as measured by the beta coefficient.
Where,
r
E= Required Rate of Return
r
F=Risk Free Rate of Return
b=Beta Coefficient
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r
E= r
F+ b(r
M-r
F).

27. Cost of New Common Stock

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28. Cost of New Common Stock

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29. Components of Cost of Capital
CostofRetainedEarnings:Therateofreturnrequired
bythestockholdersonfirm’sexistingcommonstock
i.e.opportunitycostofcommonstock.
Kr=Ke(1-Tp)[Tp=PersonalTax]
For example, assume a firm has just paid a dividend of
$2.50 per share, expects dividends to grow at 10%
indefinitely, and is currently selling for $50.00 per share.
First, D
1= $2.50(1+.10) = $2.75, and
r
S= ($2.75/$50.00) + .10 = 15.5%.
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WACC
Aweightedaverageofthecomponentcostsofdebt,
preferredstock,andcommon stock(retained
earnings&newcommonstock).
The weights in the above equation are intended to
represent a specific financing mix (where w
i= % of debt,
w
p= % of preferred, and w
s= % of common).
Specifically, these weights are the target percentagesof
debt and equity that will minimize the firm’s overall cost
of raising funds.
WACC = r
a= w
ir
i+ w
pr
p+ w
sr
r or n

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MCC
Thecostoffinancingforthenextunitof
capitalraised.
The Weighted Marginal Cost of Capital (WMCC)
The WACC typically increases as the volume of new
capital raised within a given period increases.
This is true because companies need to raise the
return to investors in order to entice them to invest to
compensate them for the increased risk introduced by
larger volumes of capital raised.
In addition, the cost will eventually increase when the
firm runs out of cheaper retained equity and is forced
to raise new, more expensive equity capital.

32. Problem
Suppose you are a Financial Analyst of Apex Ltd. and you will have
to evaluate the weighted average cost of capital (WACC) using Book
Valueof your company for the year ended 2015-2016. A company
has the following capital structure:
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Particulars FiguresareinCoreTk
CommonStockCapital 40
11%PreferredStock 10
13%Debentures 20
Total 90

33. Additional information:
The current market price of the share is Tk. 408 per share. Last
year’s dividend is Tk. 10 per share which is expected to growth at
10% per year and flotation cost of common stock is 5% of current
market price.
The face value of preferred stock is Tk. 100 per share of which
current market price is Tk. 120 and flotation cost is Tk. 8 per share.
Maturity period is 5 years.
The par value of the debentures is Tk. 100 which is sold for Tk. 90
and flotation cost is 5% of face value. Maturity period is 10 years.
The corporate tax rate is 40%.
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