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COST OF

CAPITAL
OBJECTIVES:
Understand the need to know the Cost of
Capital
Explain why WACC is used in capital
budgeting
Estimate costs of different capital
components
Determine the firms WACC
COST OF
CAPITAL
Capital Budgeting Decision
Capital Requirement
Optimum Capital Structure
Resource Mobilization
Determination of duration of Project
Capital

Preferred Common
Debt
Stock Equity

Notes Long-Term Retained New Common


Payable Debt Earnings Stock
Capital

Preferred Common
Debt Stock Equity

New
Retained
Common
Notes Long-Term Earnings
Stock
Payable Debt
Component Cost of Preferred
Stock
rp is the marginal cost of preferred stock, which is the return
investors require on a firms preferred stock.
Preferred dividends are not tax-deductible, so no tax adjustments
necessary. Just use nominal rp.
Our calculation ignores possible flotation costs.
Coleman cost of preferred
stock
The cost of preferred stock can be solved by using this formula:

rp = Dp/Pp
= 0.1 ($100)
$ 111.10
= $10/$111.10
= 0.090
= 9%

COPYRIGHT 2012 PEARSON EDUCATION, INC. PUBLISHING AS PRENTICE HALL 5-26


Is preferred stock more or less risky to
investors than debt?
More risky; because the firm is not required to pay preferred dividend
to the preferred stockholders
However, the firm should pay preferred dividend before compensating
the common dividend.
COST OF Rate of return
investors require on
COMMON the companys common
EQUITY stock
Capital

Preferred Common
Debt
Stock Equity

Notes Long-Term Retained New Common


Payable Debt Earnings Stock
Common Equity

Retained New Common


Earnings Stock
OPPORTUNITY COST
CAP BYPR
DCF
M P
CAPITAL BOND-YIELD- DISCOUNTED
ASSET PLUS-RISK- CASH FLOW
PRICING PREMIUM
MODEL
CAP
M
CAPITAL
ASSET
PRICING
MODEL
CAP
M
CAPITAL
ASSET
PRICING
MODEL
CAP Risk-free rate
M
+
CAPITAL (Risk premium
ASSET
PRICING
beta)
MODEL
5.6% + (5.0%
Risk-free rate + ( Risk premium1.48)
x beta )
DCF

DISCOUNTED
CASH FLOW
DCF

DISCOUNTED
CASH FLOW
(Dividend Current stock
price)
DCF
+ DISCOUNTED
Growth rate CASH FLOW
($1. / $23.06 + 8.3%
25
( Dividend / Current )
stock price) + Growth rate
Risk premium

3-5%
BYPR
P
BOND-YIELD-
PLUS-RISK-
PREMIUM
BYPR Bond yield
P +
BOND-YIELD- Risk premium
PLUS-RISK-
PREMIUM
10% + 4%
Bond yield + Risk premium

JUDGMENTAL
13.0 13.7 14.0
% % %
CAPM DCF BYPRP
13.0 14.0
% %
13.5%
Cost of Common Stock
Cost of New Common Stock

Flotation cost
Includes underwriting fees, legal fees, registration fees, etc.
Cost of New Common Stock

Flotation cost
Add to the Increase the
Project Cost of
Cost Capital
Add Flotation Cost to the Project
Cost

w/o Flotation w/ Flotation


Project Cost $100 million $100 million + $2
million
Inflow $115 million $115 million
($115/$100) - 1 ($115/$102) - 1
Expected Rate
of Return
15% 12.75%
Increase Cost of Capital

10%

90%
100%

100%
DISCOUNTED
DCF CASH FLOW

Dividend
+ Growth
Current stock price
x (1
- F) rate
($1. / $23.06 + 8.3%
25
( Dividend / Current )
stock price) + Growth rate
Dividend
+ Growth
Current stock price x ( 1
F ) rate
$1.25
+ 8.3 %
$23.06 x ( 1 0.10 )
Flotation Cost Adjustment
13.0 14.0
% %
13.5%
Cost of Common Stock
13.5% + 0.6% =
14.1%
Cost of Common Stock
(w/ Flotation cost adjustment)
QUESTIONS?

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