Lecture 3 , 4 & 5
Cost of Capital
Every company collects finance from two sources:
Shares and
Bonds.
Share has two types, common shares and preference shares.
The type of finance collected through shares is called equity finance
while the type collected through bonds is called debt finance.
Since share has two types therefore equity
finance may be Common Equity or Preference Equity.
Against Equity finance, company pays dividend,
While against Debt finance, company pays interest.
Thus, Dividend is the Cost of Equity,
while Interest is the Cost of Debt.
Diagram of Capital Structure:
Capital
Shares Bonds
Common
Shares Preference
Shares
Cost of Debts Cost of Equity
Debt finance is collected through issue of bonds.
The price of the bonds is settled by the management of the company.
The price of the bond is income for company,
while the interest of bond is cost for company.
The price of the bond is settled through following formula:
P
o= MV/ (1+r
d)
n Po means the price of bond, MV means the
current market value, rd is the rate of interest to be given to the bond holders.
Notice that the amount of interest is an
income for bond holder but the same is cost for the company.
In order to know how much cost will be paid against the bonds, rd must be known.
Rd is the amount of interest before tax,
thus tax must be deducted to know the pure cost of debt.
Po = MV/ (1+rd)n (1+rd)n = MV/ Po (1+rd)n*1/n = (MV/Po)1/n
1 + rd = (MV/Po)1/n rd = (MV/Po)1/n – 1
rd is the amount of interest which contains tax , we must deduct the tax to know the real interest cost:
ri = rd(1 - tax)
Formula for Rd
Calculate the after-tax cost of debt under each of the following conditions:
a. Interest rate of 13%, tax rate of 0%
b. Interest rate of 13%, tax rate of 20%
c. Interest rate of 13%, tax rate of 35%
a. rd(1 - T) = 13%(1 - 0) = 13.00%.
b. rd(1 - T) = 13%(0.80) = 10.40%.
c. rd(1 - T) = 13%(0.65) = 8.45%.
LL Incorporated’s currently outstanding 11%
bonds have a yield to maturity of 8%. LL
believes it could issue new bonds at par that would provide a similar yield to maturity. If its marginal tax rate is 35%, what is LL’s after-
tax cost of debt?
Given data:
Rd = 8%, tax=35%
rd(1 - T) = ?
rd(1 - T) = 0.08(0.65)
= 5.2%.
Company sells preferred stock on preferred shareholders.
The price of these shares is comparatively higher than the common stock but these shareholders bear some privileges.
They are preferred in dividend distribution and liquidation.
Similarly, some companies offer a higher rate of dividend to these shareholders.
The price of the share is settled as:
Po = Do / rps
rps is the cost of preference share to the
company. Do is the amount of dividend paid against preference shares while Po is the price of share.
Formula for cost of preferred stock is:
rps = Do / Po
Duggins Veterinary Supplies can issue preferred stock at a price of $50 a
share with an annual dividend of $4.50 a share. what is the company’s cost of
preferred stock, rps?
Given:
p0 = 50, D0 = 4.50,
rps=?
Rps = D0 / p0 Rps = 9%
Common stock refers to the common or equity shares of the company.
Common shares are issued for equity financing.
These shares have fewer prices and less
amount of dividend but they possess a huge portion in capital structure.
Company pays dividend against these shares.
The amount of dividend is cost for company,
while the same is income for the shareholders.
The price of share is settled in the following way:
Po = Do(1+g) / rs – g or
Po = D1 / rs – g
rs is the rate of dividend paid to the shareholders.
Do is the last years dividend, Po is the price of share while g is the growth.
The cost of the common stock can be
calculated through the following formula:
rs – g = Do(1+g) / Po rs =Do(1+g) / Po + g
Summerdahl Resort’s common stock is
currently trading at $36 a share. The stock is expected to pay a dividend of $3.00 a share at the end of the year (D1 = $3.00), and
the dividend is expected to grow at a
constant rate of 5% a year. What is its cost of common equity?
Given data:
Po = 36, D1 = 3,
g = 5%, rs =?
Rs = D1/Po+g Rs = 3/36 + 0.05
Rs = 13.33%
WACC is the overall cost of capital structure.
Every company wants to have an optimum capital structure.
The optimum structure mean a capital
structure having low cost, less risk and more return.
In order to know how much efficient the
capital structure is, it is important to know the cost of that capital structure.
WACC is one of the important techniques to know the cost of capital.
WACC has 6 components:
◦ Weight of common stock
◦ Cost of common stock
◦ Weight of debt
◦ Cost of debt
◦ Weight of preference share
◦ Cost of preference share
Weight of Common Stock (Ws) :
Ws = Common Stock / Total Capital
Weight of Debt (Wd) :
Wd = Total Debt / Total Capital
Weight of Preferred Stock (Wps):
Wps = Preference Stock / Total Capital Now:
WACC = (Ws)(rs) + (Wd)(rd)(1- tax) + (Wps)(rps)
WACC is the amount of cost to pay for availing the debt, equity and preference stock.
If the earning of a company i.e. ROIC is greater than the WACC, than company`s value increases and vice versa.
Shi Importer’s balance sheet shows $300 million in debt, $50 million in preferred stock, and $250 million in total common equity. Shi’s tax rate is 40%, rd = 6%, rps = 5.8%, and rs = 12%. If Shi has a target capital structure of 30% debt, 5% preferred
stock, and 65% common stock, what is its WACC?
Given Data:
Debt= 30% , Preferred Stock= 5%, Equity= 65%, rd
= 6%, T = 40%, rps = 5.8%, rs = 12%.
WACC = (wd)(rd)(1 - T) + (wps)(rps) + (wce)(rs) WACC = 0.30(0.06)(1-0.40) + 0.05(0.058) +
0.65(0.12)
WACC = 9.17%.
