This document discusses the cost of capital, which is the rate of return a firm must earn on investments to maintain its market value and attract funds. It is affected by business risk, financial risk, and after-tax costs. There are four basic sources of long-term capital: long-term debt, preferred stock, common stock, and retained earnings. The cost of each is calculated differently based on factors like interest rates, dividends, and valuation models. The weighted average cost of capital combines the costs of each source based on their relative weights and represents the overall expected cost of funds for a firm.

1. Chapter 3
Cost Of Capital
Lawrence J. Gitman

2. Cost of Capital
• The rate of return that a firm must earn on the project in which it
invests to maintain its market value and attract funds.
• Its also called required rate of return.
• Its in effect, the “magic number” that is used to decide whether a
proposed investment will increase or decrease the firm’s stock price.

3. Some key assumptions of COC
• The cost of capital is a dynamic concept affected by a variety of
economic and firm specific factors. The key assumption of cost of
capital are:
1. Business Risk
2. Financial Risk
3. After tax costs.

4. The basic concept of Cost of Capital
• Target Capital Structure:
The desired optimal mix of debt and equity financing that most firms
attempt to maintain.
Example: Page 505

5. Specific sources of capital
• There are four basic sources of long term funds for the business firm:
1. Long term Debt
2. Preferred Stock
3. Common Stock
4. Retained Earnings

6. Sources of fund
• Balance Sheet
Sources of
Long term Funds
Liabilities & owners equity Assets
Current Liabilities
Long Term Liabilities
Stockholder’s Equity:
Preferred stock
Common Stock
Retained earnings
Current Assets
Fixed Assets

7. Cost of Long term debt
• Cost of long term debt (ri) is the after tax cost today of raising long
term funds through borrowings. Most corporate long term debts are
incurred through the sale of bonds. There are two concepts of this
sale:
1. Net Proceeds
2. Flotation costs
a. Underwriting costs
b. Administrative costs

8. Before tax cost of Debt
• The before tax cost of debt (rd) can be obtained as,
(rd)= [I+(Face value-Nd )/n]/[(Nd + Face value)/2]
where,
I= Annual interest in dollar
Nd =Net proceeds from the sale of debt
n = number of years to the bond’s maturity

9. Example
• The net proceeds of a $1000, 9% coupon interest rate, 20 year bond were
found to be $960. Calculate the approximate before tax cost of debt.
Solution: We know that,
(rd)= [I+(Face value-Nd )/n]/[(Nd + Face value)/2]
Where, I = 1000x9% = $90
Face Value= $1000
Nd = $960 & n=20 years
So that, rd= [ 90+(1000-960)/20]/[(960+1000)/2]
= 9.4%
So that we can say that, if the approximate cost of debt is greater than the
coupon interest rate then the bond will be treated as discounted bond.

10. Situation
• Interest rate > Coupon rate = Discount bond
• Interest rate < Coupon rate = Premium bond
• Interest rate = Coupon rate = At par bond

11. After tax cost of Debt
• The specific cost of financing may be stated on an after tax basis. Because
interest on debt is a tax deductible, it reduces the firms taxable income. So
the after tax cost of debt can be obtained as,
ri= rd x (1-T)
Example: If the tax rate is 40% for the previous example, then the after tax
cost of debt can be obtained as,
ri= 9.4% x (1-0.40)
= 5.6%
Note: Typically the cost of long term debt is less than a given firm’s cost of
any of the alternative forms of long term financing, primarily because of the
tax deductibility of the interest.

12. Cost of Preferred Stock
• The cost of preferred stock, rp, is the ratio of the preferred stock dividend
to the firm’s net proceeds from the sale of the preferred stock.
• Net proceed= Amount of money received - flotation cost
• rp = Dp/Np
Where, Dp= Dividend from preferred stock
Np= Net proceeds from the PS.
Since PS dividend are paid out of the firm’s after tax cash flows, a tax
adjustment is not required.
EX: Page 512

13. Cost of Common Stock
• The cost of common stock is the required rate of return on the stock
by investors in the market place. There are two forms of common
stock financing:
1. Retained Earnings
2. New issues of Common stock

14. Finding the cost of Common Stock Equity
• Two techniques are used to measure the cost of common stock
equity.
1. Constant Growth Valuation (Gordon) Model
2. Capital Asset Pricing Model
• Constant Growth Model:
According to this model the value of a share of stock equals the present
value of all future dividends that it is expected to provide over an
infinite time horizon.

15. Cont.
• The formula of this model:
P0= D1/(rs-g)
Where, Po= Value of common stock
D1= per share dividend at the end of one year
rs= Required return on common stock
g= Constant rate of growth in dividends
So that,
rs= D1/P0 + g
Ex: 513

16. Capital Asset Pricing Model (CAPM)
• CAPM describes the relationship between the required rate of return
and the non-diversifiable risk of the firm as measured by the beta
coefficient (𝛽).The basic CAPM is
rs= Rf+[𝛽 x (rm-Rf)]
Where, rs= Cost of Common stock
Rf = Risk free Rate of return
Rm = Market return
(rm-Rf )= Risk Premium
Ex; 514

17. Cost of Retained Earnings
• The same as the cost of an equivalent fully subscribed issue of
additional common stock, which is equal to the cost of common
stock. i.e., rr=rs
• Weighted Average Cost of Capital:
WACC reflects the expected average future cost of funds over the long run.
WACC= (wdxrd) + (wsxrs) + (wpxrp)
Ex: Page 517