2. Cost of Capital - Learning
Goals
1. Understand the key assumptions, the basic
concept, and the specific sources of capital
associated with the cost of capital.
2. Determine the cost of long-term debt and
the cost of preferred stock.
3. Calculate the cost of common stock equity
and convert it into the cost of retained
earnings and the cost of new issues of
commons stock.
11-2
4. An Overview of the Cost of
Capital
The cost of capital acts 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.
11-4
7. The Basic Concept (cont.)
Why do we need to determine a company’s
overall “weighted average cost of capital?”
Over the long haul, the firm must undertake
investments that maximize firm value.
This can only be achieved if it undertakes
projects that provide returns in excess of the
firm’s overall weighted average cost of
financing (or WACC).
11-7
8. Specific Sources of Capital:
The Cost of Long-Term Debt
The pretax cost of debt is equal to the yield-to-maturity
on the firm’s debt adjusted for flotation costs.
Recall that a bond’s yield-to-maturity depends upon a
number of factors including the bond’s coupon rate,
maturity date, par value, current market conditions, and
selling price.
After obtaining the bond’s yield, a simple adjustment
must be made to account for the fact that interest is a
tax-deductible expense.
This will have the effect of reducing the cost of debt.
11-8
9. Specific Sources of Capital:
The Cost of Long-Term Debt (cont.)
11-9
Brian Clara, a major Sport Goods 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 (Discount Bond). Flotation costs are 2% or $20. The
net proceeds to the firm for each bond is therefore $960 ($980
- $20).
Net Proceeds
10. Specific Sources of Capital:
The Cost of Long-Term Debt (cont.)
Before-Tax Cost of Debt
The before-tax cost of debt can be calculated
in any one of following ways:
Calculating the cost
Approximating the cost
https://youtu.be/aP3ZLLxI-vk
11-10
11. Specific Sources of Capital:
The Cost of Long-Term Debt (cont.)
Before-Tax Cost of Debt
Calculating the Cost
This approach finds the before-tax cost of debt
by calculating the internal rate of return (IRR).
As discussed in earlier in the text, YTM can be
calculated using: (a) trial and error, (b) a
financial calculator, or (c) a spreadsheet.
11-11
12. Specific Sources of Capital:
The Cost of Long-Term Debt (cont.)
Before-Tax Cost of Debt
Calculating the Cost
11-12
13. Specific Sources of Capital:
The Cost of Long-Term Debt (cont.)
Before-Tax Cost of Debt
Approximating the Cost
11-13
14. Specific Sources of Capital:
The Cost of Long-Term Debt (cont.)
11-14
Find the after-tax cost of debt for Duchess
assuming it has a 40% tax rate:
ri = 9.4% (1-.40) = 5.6%
This suggests that the after-tax cost of raising
debt capital for Duchess is 5.6%.
15. Specific Sources of Capital:
The Cost of Preferred Stock
11-15
Duchess Corporation is contemplating the issuance of a
10% preferred stock that is expected to sell for its $87-per
share value. The cost of issuing and selling the stock is
expected to be $5 per share. The dividend is $8.70 (10%
x $87). The net proceeds price (Np) is $82 ($87 - $5).
rP = DP/Np = $8.70/$82 = 10.6%
