m
 

    
    
m
 
à DEBT FINANCING

à EQUITY FINANCING

à EQUITY AND DEBT FINANCING

   

m
m
 m

 m 
à mm
d Common Equity
d Retained earnings
d Preferred Stock
d Debt
à The required rate of return on each capital
component is called its 33

à The cost of capital used to analyze capital

budgeting decisions should be a weighted
average of the various components costs
à {ost firms set percentages for the different
financing sources.
à Each componentǯs percentage combined used in
financing a particular firm or project is known as
target capital structure
à Example: ICIǯs target capital structure is 30%
common stock, 30% preferred stock, and 40% debt
financing.
 
    m
m
  mm
à  mm ! "#$ %& ! &
 !

m
'(
à è d = interest rate on the firms new debt

à ! "#) %*+,3*-

à ./01*+,3*-
à The value of the firmǯs stock , which we
want to maximize, depends on after- tax
cash flows.

à Tax savings- lower after tax cost of debt

2 3
 (
à è d = 10%

à T = 40%

à è d (1- T) =
m
  
m!"!
%

à Preferred dividends are not tax deductable that

why no tax adjustment is used when calculating
cost of preferred stock.
Î Component cost of preferred stock= kPS
Î kPS = DPS/ PPS(1-F)
Î DPS is the preferred dividend, PPS is the preferred
stock Price, and F is the flotation cost as a
percentage of the proceeds.
Î The cost of floating the shares or bonds in the
market
Proposal expenditure
Registration fee
Printing fee
Advertisement
Investment bankerǯs fee
Î A company pays Rs.10 dividend per share and sells
for Rs.100 per share, if the expected flotation cost
for a new issue is 2.25% or Rs.2.25 per share what
would be the cost of preferred stock?
à Cost of preferred stock..
kps=D1/P0(1-F)
=10/100(1-0.0225)
= 0.1(0.9775)
= 0.09775
=10.2%
à Two ways of raising funds by equity
d Issuing new common shares (external equity)
d Retained earnings (internal equity).
m  
 "!%(
à ès = Rate of return stockholders require on the firmǯs
common stock.

g (
à Retained earnings are free? As they represent money that
is Dz left overdz after paying dividends, then why is cost
associated to it?

 (
à Retained Earnings are not free

à The cost associated with it is the Dz opportunity costdz

à The firmǯs after tax earnings belong to its shareholders.
 3 m  
 (

1-1 CAP{ approach

1-2 Bond yield & Risk premium
1-3 Discounted Cash Flow Approach
 m
3

 m(
à ès = k RF + (è m Ȃ è rf ) b

à è RF = rate offered by the government on T Ȃ bill

à b = stockǯs beta co Ȃ efficient
à è m = expected rate of return on the market

2 3
 (
à è Rf = 8%
à è m = 13%
à B = 0.7
à ès = ?

m  4#(
à *-#56
à ès=
m  47(
à *-#

à ès=

 ' m!m
3(

à Controversy about T Ȃ bill rates.

à Difficult to estimate beta

à Difficult to estimate market risk premium

#)7'
  
&!
 33

 m(

à è s = Interest Rate + Risk Premium

2 3
 (
à Interest Rate = 8%
à Risk Premium = 4%

à ès = 8% + 4%
à = 12%
à It is logical to think that, firms with risky, low rated and
consequently high interest rate will lead to have a risky,
high cost equity.

à ,(
à Extremely strong firmǯ bonds having interest rate of
8%,so its cost of equity estimated by using this method:

ks=Bond yield +Risk Premium

= 8%+4%=12%

à In the case of bonds of riskier company carries interest

yield of 12%,keeping the same risk premium i.e. 4%
leads to higher cost of common equity.

à ks= 12%+4%=16%
à So as the risk premium is a judgemental value, the
estimated value of ks is also judgmental, so this
method is not likely to produce a precise cost of
equity.
#)8
m
m 

 m(

à Po = D1/ + D2/ + ǥ+ D n/
(1 + k s) (1+ ès) 2 (1+ k s) n

à Po = current price of the stock

à Dt = Dividend expected to be paid at the end of the
year t
à ès = Required rate of return.
m 

à Po = D1/è S - g

à ès = D1 / Po + g

à This approach also known as Discounted cash flow

method.

 3  9:;

à Õistoric trend

à Different financial analyst Company

à Based on retention ratio and ROE

à Õistorical earning and dividends:
If earnings and dividends growth rate have been
stable in the past, then investors expect these trends
to continue and past realized growth rate may be
used to estimate the value of g.
à Retention growth rate model:
g=ROE* (retention ratio)
Where ROE=NI / E and
retention ratio= 1-payout ratio
à /<+3(
Security analysts regularly make earning and
dividends growth forecasts, looking at such factors
such as projected sales, profit margins and
competitive factors. So someone making the cost of
equity estimate can obtain several analystǯs
forecasts, average them and use it as proxy for the
expected growth rate and add them with the current
dividend yield to estimate ks^
à ^ks=D1/Po + projected g by securityǯs analysts
à Suppose a company is expected to have a constant
ROE of 13.4 % . It is expected to pay out 40% of its
earnings. Stock of the company sells for $23. its next
expected dividend is $1.24.
à Calculate the growth rate of the company and hence
the cost of retained earnings.
m m33m!(
à 3 
4#==
>
> mm(

,(

à
+?3m@#AA

à Expected Cash flows after One year = $115

à E.R = 115 / 100 -1

à = 15%
à If firm finance this project by issuing new stock, it has to bear
$ 2 as a flotation cost then

à E.R = [115 / (100 + 2)] -1

à = 12.75%
3 
47=
>mm
 (
à Adjust Cost Of Capital rather then the project cost

à è c = D1/ +g
à Po (1-F)

,(

à Flotation cost = 10%

à
#@#57B
à Po = $23
à g = 8%

à è c = $ 1.24/ + 8%
à $ 23 (1-0.1)
à = 14%

à Cost of issuing new stock is always higher then any other way of financing

à So before selling the new stock firm should finance maximum through retained earnings

à Calculate Retained Earnings breakpoint

  
 ' !
(
à The total amount of financing that can be raised before the firm is
forced to sell new common stock.

,(

à Retained Earnings (2001) = $ 68 m

à Capital Structure = 45% debt

à = 2% preferred stock
à = 53% common equity

à Retained Earnings Break Point = Addition to Retained Earnings/

à Equity Fraction
à
à = 68 / 0.53
à = $128 m
 
    mm
 " mm%(
à Firm should have an optimal capital structure.

à Reason companies try to have optimal capital structure as it affects the

companies share price.
à So firms who want to maximize the value they will determine its
optimal capital structure, use it as a target and then raise new capital
designed in such a manner so that capital structure does not change.

à  mm01 "#$ %&0 1 &03 13

,(

à Capital structure:

à Debt 53%
à Preferred Stock 2%
à Common Equity 45%

è  = 10%
T = 40%
è  (1 ȂT) = 6%
è  = 10.3%
è = 13.4%
WACC = ?
à In order to determine weights of debt and equity book
value of debt and equity should be used

à A high cost of capital is not bad if it is accompanied by the

projects with high rates of return.
3+.*+.33+(
à wevel of interest rates
à {arket risk premium
à Tax rates
3+.*+33+(
à Companyǯs capital structure policy
à Dividend policy
à Investment policy