Transcript Foundations of Finance

Chapter 11
Assets
Current assets
Capital Structure
Liabilities & Equity
Current Liabilities
Long-term debt
Preferred Stock
Common Equity
Ch. 11 - Cost of Capital
 For
Investors, the rate of return on a
security is a benefit of investing.
 For Financial Managers, that same
rate of return is a cost of raising funds
that are needed to operate the firm.
 In other words, the cost of raising
funds is the firm’s cost of capital.
How can the firm raise capital?
Bonds
 Preferred Stock
 Common Stock
 Each of these offers a rate of return to
investors.
 This return is a cost to the firm.
 “Cost of capital” actually refers to the
weighted cost of capital - a weighted
average cost of financing sources.

Cost of Debt
For the issuing firm, the cost
of debt is:
 the rate of return required
by investors,
 adjusted for flotation costs
(any costs associated with
issuing new bonds), and
 adjusted for taxes.
After-tax
% cost of
Debt
=
Before-tax
% cost of
Debt
Kd
.066
=
=
x
1
Marginal
- tax
rate
kd (1 - T)
.10 (1 - .34)
Example: Cost of Debt
 Prescott
Corporation issues a $1,000
par, 20 year bond paying the market
rate of 10%. Coupons are semiannual. The bond will sell for par
since it pays the market rate, but
flotation costs amount to $50 per
bond. The tax rate is 34%.
 What
is the pre-tax and after-tax cost
of debt for Prescott Corporation?
 Pre-tax
cost of debt: (using TVM)
N = 40 (remember it’s semi-annual)
PMT = -50
FV = -1000
So, a 10% bond
PV = 950
costs the firm
solve: I = 10.61% = kd only 7% (with
 After-tax cost of debt:
flotation costs)
Kd = kd (1 - T)
since the interest
Kd = .1061 (1 - .34)
is tax deductible.
Kd = .07 = 7%
Cost of Preferred Stock
 Finding
the cost of preferred stock
is similar to finding the rate of
return, (from Chapter 8) except
that we have to consider the
flotation costs associated with
issuing preferred stock.
Cost of Preferred Stock
 Recall:
kp =
 From
D
Po
=
Dividend
Price
the firm’s point of view:
kp =
D
NPo
=
NPo = price - flotation costs!
Dividend
Net Price
Example: Cost of Preferred
 If
Prescott Corporation issues
preferred stock, it will pay a
dividend of $8 per year and
should be valued at $75 per share.
If flotation costs amount to $1 per
share, what is the cost of
preferred stock for Prescott?
Cost of Preferred Stock
D
kp =
NPo
=
8.00
74.00
=
Dividend
Net Price
=
10.81%
Cost of Common Stock
 There
are 2 sources of Common
Equity:
1) Internal common equity (retained
earnings), and
2) External common equity (new
common stock issue)
Do these 2 sources have the same cost?
Cost of Internal Equity
 Since
the stockholders own the firm’s
retained earnings, the cost is simply
the stockholders’ required rate of
return.
 Why?
 If managers are investing
stockholders’ funds, stockholders will
expect to earn an acceptable rate of
return.
Cost of Internal Equity
1) Dividend Growth Model
D1
kc =
Po
+g
2) Capital Asset Pricing Model (CAPM)
kj = krf + b j (km - krf )
Cost of External Equity
Dividend Growth Model
D1
knc = NPo + g
Net proceeds to the firm
after flotation costs!
Weighted Cost of Capital
 The
weighted cost of capital is just
the weighted average cost of all of
the financing sources.
Weighted Cost of Capital
Source
debt
preferred
common
Cost
6%
10%
16%
Capital
Structure
20%
10%
70%
Weighted Cost of Capital
(20% debt, 10% preferred, 70% common)
 Weighted
cost of capital =
.20 (6%) + .10 (10%) + .70 (16%)
= 13.4%