The Cost of Capital

Sources of Long-Term Financing

Internal long-Term Sources External Long-Term Sources

Stockholders Equity
Stockholders Equity Long Term Debt
Using Retained Earnings

Issuing Preferred Stock Issuing Bonds

Issuing Common Stock Acquiring Long-Term
Bank Loans

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 The Firms Balance Sheet and Capital Structure
Balance sheet
Capital Structure is :
The firms financing mix of long-term debt and Equity. Current Current
Making Assets Liabilities
Making
Investment Financing
Decisions Decisions
Long-Term
Fixed
Liabilities
Assets
and equity

Sources of
Current Liabilities
Short-term
funds
Debt Capital
Used to finance
current assets

+
= Total Capital
Sources of
long-term
funds include Equity Capital
Used to finance
Fixed assets

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 Basic sources of long-term funds for the firm are :

1. Long-term debt
2. Preferred stock
3. Common stock
4. Retained earnings

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 What about the Cost of Capital?
Definition 1 : The cost of capital :
It 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 and attract funds.

Importance of Cost of capital:

wealth of
firms long-term cost of capital acts the owners as
as a link between determined by
investment
decisions investors in the
marketplace

It is the magic number that is used to decide whether a proposed investment

will increase or decrease the firms stock price.

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 Key Assumptions for Cost of Capital

Business Risk:
The risk to the firm of being unable to cover operating costsis assumed
to be unchanged.
This means that the acceptance of a given project does not affect the firms
ability to meet operating costs.

Financial Risk:
The risk to the firm of being unable to cover required financial obligation
is assumed to be unchanged.
This means that the projects are financed in such a way that the firms
ability to meet financing costs is unchanged.

After-tax costs:
After-tax costs are considered relevant.
This means that the cost of capital is measured on an after-tax basis.

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 After-tax costs and Cost of Capital:
XYZ Company
Income Statement and allocation of net income for the year ended Dec.31, 20xx
Sales $2,000
Cost of Goods Sold (400)
Gross Profit $1,600
Operating expenses (100)
Other Expenses (100)
Earnings before interest and taxes(EBIT) $1,400
Interest Expense (200)
Earnings after interest and before taxes $1,200
Taxes (40%) (480)
Net Income $720
Dividends to Preferred stock (170)
Net Income available to Common stock $550
Dividends declared to Common stock (200)
Remaining Net Income allocated to Retained Earnings $350

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 A firm is currently faced with two investment opportunities:
project 1 available project 2 available
Cost = $100,000 Cost = $100,000
Life = 20 years Life = 20 years
IRR = 7% IRR = 12%
Cost of least-cost financing source Cost of least-cost financing source
available available
Debt = 6% Equity = 14%

Decision: Decision:
The firm undertakes the opportunity The firm rejects the opportunity because
because it can earn 7% on the the 14% financing cost is greater than the
investment of funds costing only 6%. 12% expected return.

Were the firms actions in the best interests of its owners?

The answer is
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NO. The company accepted a project yielding a 7% return and rejected
one with a 12% return which is not in the best interest of the firms
shareholders.

The firm must undertake investments that maximize the firms owners
wealth:
This can only be achieved if it takes projects that provide returns in excess of
the firms overall weighted average cost of financing (or WACC).

Weighted Average Cost of Capital (WACC):
Represents the expected average future cost of funds over the long run.
Tells managers about the return their investments in fixed assets (ex, plant
and equipment) have to earn if the firm is to satisfy its investors.

Essentially, the WACC represents the minimum acceptable rate of return that a
firm should earn on any investment that it makes.

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 A firm is currently faced with two investment opportunities:
project 1 available : project 2 available :
Cost = $100,000 Cost = $100,000
Life = 20 years Life = 20 years
IRR = 7% IRR = 12%
Cost of least-cost financing source Cost of least-cost financing source
available available
Debt = 6% Equity = 14%
Debt weight in capital structure = 50% Equity weight in capital structure = 50%

Solution:
WACC = (weight of Debt cost of Debt) + (weight of Equity cost Equity)
WACC = (.5 6%) + (.5 14%)
WACC = ( 3 %) + ( 7 %)
WACC = 10%
Decision:
The firm rejects project 1 because it has IRR = 7% < WACC = 10%
The firm accepts project 2 because it has IRR = 12% > WACC = 10%

This action is in the best interests of the firms owners

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 Decision role

To select an investment opportunity or project :

If the investment IRR < WACC The firm rejects

If the investment IRR > WACC The firm accepts

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Weighted Average Cost of Capital (WACC) is found by the following equation:

WACC = ra = wi ri + wp rp + ws rr or n

WACC = (weight of source 1 cost of source 1) + (weight of source 2 cost of source 2) +

Weighted Average Cost of Capital = ra

Proportion of long-term debt (bonds) in capital structure = wi Cost of debt ( bonds) = ri
Proportion of preferred stock in capital structure = wp Cost of debt Preferred stock = rp

Proportion of common stock equity in capital structure = w Cost of retained earnings = rr

s

w + w + w = 1.0 Cost of new common stock equity = rn

i p s

We need to learn how to calculate the cost for each source of Long-Term Financing
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 Cost of each long-term Source of Capital:
cost of long-term debt: is the after tax cost today associated with new
funds raised through long-term borrowing.

1 To calculate the cost of long-term debt (Bonds) ri we

need to :

(1) Calculate Net proceeds from selling the bond : N d

(2) Calculate Before-tax (or pre-tax) cost of debt : r d
(3) Calculate After-tax cost of debt : r i

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 (1) How to calculate Net Proceeds?
Net proceeds : are funds actually received from the sale of security
Net proceeds from selling the security = $ security selling price $ Flotation cost

Net proceeds from selling the security = $ security selling price ( percentage of flotation cost security par value)

Floatation costs
1. They are the total costs of issuing and selling a security, they
reduce the net proceeds from the sale.
2. These costs apply to all public offerings of securities debt,
preferred stock, and new common stock.
Components of Flotation costs:

(1) Underwriting costs compensation (2) Administrative costs issuer expenses

earned by investment bankers for selling the such as legal, accounting, printing, and
security other expenses
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Yield-to-Maturity (YTM):
The yield to maturity is the compound annual rate of return earned on a debt security
purchased on a given day and held to maturity.
It is the prevailing market interest rate.

The bond is sold at

discount Bond coupon rate < market interest rate

If
premium Bond coupon rate > market interest rate

If the bond is sold at

discount Then Net Proceeds < Par Value

premium Then Net Proceeds Par Value

premium or Net Proceeds < Par Value

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 (2) Before-tax cost of debt(rd) for a bond can be obtained in 3
ways: 1. Using cost quotation
2. Calculating the cost
3. Approximating the cost

Before-tax cost of debt(rd)

Using Cost Quotations Calculating the Cost Approximating the Cost

When the net proceeds from selling a This approach finds the before-tax cost of debt Can be calculated using the formula
bond equal its par value, the before-tax by calculating the IRR on the bond cash flows. Par value - N
d
cost equals the annual coupon interest IRR is the discount rate that equates present +
rate for the bond value of both the cash inflows and outflows
rd = I n
rd=I% Par value + Nd
and represents the before tax cost of debt rd
A second quotation that is sometimes Where:
2
used is the yield-to-maturity (YTM) Calculated by: 1-Financial calculator, I = annual interest
on a similar risk bond. 2- an excel sheet, 3- or trial-and-error Nd = net proceeds from the sale of debt
technique. (bond)
1- ( 1 + r ) - n + $Par Value ( 1 + r )- n n = no. of years to the bonds maturity
r d = YTM $N =$I
d
r rd
r is the internal rate of return IRR to be calculated
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and r d = IRR
 (3) How to Calculate After-tax cost of debt : r i

Interest expense is a tax deductable expense since it is deducted
before paying taxes in the income statement, and thus it reduces the
firm taxable income.

But all other sources of long-term debt are paid from net income
after tax.

As a result, we will need to adjust before tax cost of debt according
to the companys tax bracket to have the relevant after-tax cost.
T is the tax rate %
After tax cost of = ri = rd ( 1- T )

The costDebt (Bond) debt is less than the cost of any other form of
of long-term
long term financing because of the tax deductibility of interest.

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 Steps to calculate
cost of Bonds r i %
1) If : Nd = par value, then : rd = I %
2) on similar risk bond the (YTM) % = rd
Step 1

Net Proceeds Using cost

Quotation
Nd = $ security selling price $ Flotation cost

Step 2 Par value - Nd

or $I + n
Approximating rd =
Par value + Nd
Pre-tax cost of debt the cost
2
rd or

Step 3 Calculating the

cost
After-tax cost of debt
ri = rd ( 1- T )
-n -n
$N =$I 1- ( 1 + r ) + $Par Value ( 1 + r )
d r
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 Example (1)
The Cost of Long-Term Debt (Bonds) using Quotation method
Net proceeds from selling the bond = $ bond selling price ( percentage of flotation cost bond par value )
Net proceeds from selling the bond = $ 1,020 (.02 $1,000)
= $ 1,020 $ 20 = $1,000
Selling price $1,020
1) using: If : net proceeds Nd = par value, then : rd = I %
Nd = $ 1,000 = par value , then : rd = I % = 9.4 % Flotation coast 2%

Coupon rate = 9.4% this is the before-tax cost of debt r d

Par value $ 1,000
After tax cost of = ri = rd ( 1- T ) Coupon rate
Debt (Bond) 9.4 %
( Annual Interest rate I%)
ri = 9.4% (1 - 0.40) = 5.64% this is the after-tax cost of debt r i

Years to maturity 20
2) using: on similar risk bond the (YTM) % = rd
YTM = 9.4% this is the before-tax cost of debt r d
YTM on similar risk bond 9.4%

After tax cost of = ri = rd ( 1- T ) Tax Rate 40%

Debt (Bond)

ri = 9.4% (1 - 0.40) = 5.64% this is the after-tax cost of debt r i

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 Example (2)
The Cost of Long-Term Debt (Bonds) using calculating method
Net proceeds from selling the bond = $ bond selling price ( percentage of flotation cost bond par value )
Net proceeds from selling the bond = $ 980 (.02 $1,000) Selling price $ 980
= $ 980 $ 20 = 960 Flotation coast 2%
We apply the following equation using: Par value $ 1,000
Coupon rate 9%
1-Financial calculator, 2- or an excel sheet, 3- or trial-and-error
Tax rate 40%
1- ( 1 + r ) - n -n
$N =$I + $Par Value ( 1 + r )
d End of year(s) Cash flow
r
0 $ 960

1- ( 1 + r ) - 20 - 20 1-20 - $ 90
$ 960 = $ 90 + $1,000 (1+r)
r 20 - $ 1,000

IRR = r = 9.452% this is the before-tax cost of debt rd

After tax cost of = ri = rd ( 1- T )

Debt (Bond)

ri = 9.452% (1 - 0.40) = 5.67% this is the after-tax cost of debt ri

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The Cost of Long-Term Debt (Bonds) using approximation method
Net proceeds from selling the bond = $ bond selling price $ Flotation cost
Net proceeds from selling the bond = $ bond selling price ( percentage of flotation cost bond par value )

Bond Par Value Net proceeds from selling the bond

Annual Interest in Dollars
Before tax cost of Number of years to bond maturity
Debt (Bond)
= rd =
Bond Par Value Net proceeds from selling the bond

Par Value Nd
$I
Before tax cost of n
Debt (Bond)
= rd =
Par Value Nd

After tax cost of = ri = rd ( 1- T )

Debt (Bond)

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 Example (3)
The Cost of Long-Term Debt (Bonds) using approximation method

Net proceeds from selling the bond = $ 980 (.02 $1,000)

= $ 980 $ 20 = 960
Selling price $ 980

Flotation coast 2%

Par value $ 1,000

Coupon rate 9%

Years to maturity 20

Tax rate 40%

After tax cost of = ri = rd ( 1- T )

Debt (Bond)

ri = 9.452% (1 - 0.40) = 5.67% this is the after-tax cost of debt ri

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 What about the cost of preferred stock?

It is the ratio of the preferred stock dividend to the firms net proceeds from the
sale of preferred stock.

Most preferred stock dividends are stated as a dollar amount: x dollars per year.
Sometimes preferred stock dividends are stated as an annual percentage rate.

Before the cost of preferred stock is calculated, any dividends stated as

percentages should be converted to annual dollar dividends.

Because preferred stock dividends are paid out of the firms after tax cash flows,
no tax adjustment is required.

Cost of long-term financing with preferred stock is greater than cost of long-term
financing with debt (bonds) because:
1. Preferred stock are riskier than long term debt (bonds).
2. Interest expense for long term debt is tax deductible expense but dividends to
preferred stock are paid from net income after tax.
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 To calculate the cost of Preferred stock rp we need to
2
:
(1) Calculate Net proceeds from selling the preferred stock :
Np
(2) Calculate dividends of preferred stock: D p
(3) Calculate cost of preferred stock : r p

Cost of preferred stock = rP

Annual dividends amount for preferred stock = DP

Net proceeds from selling preferred stock = Np

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 Example (4)
The Cost of Preferred Stock:
Net proceeds from selling the preferred stock = $ stock selling price ( percentage of flotation cost stock par value )
Net proceeds from selling the preferred stock = N p = $ 100 (.05 $100)
= $ 100 $ 5 = $ 95

Dividends of preferred stock = D p = stock par value Annual dividend rate

Dividends of preferred stock = D p = $100 .1 Selling price per share $100

= $10
Flotation coast from par value 5%

Par value per share $100

Cost of preferred stock = dividends as annual percentage

10 %
rate from par value

$ 10
$ 95

r p = 10.53 %

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 What about the cost of Common Stock?

Cost of common stock equity rs: is the rate at which investors discount the
expected dividends of the firm to determine its share value.

There are two forms of common stock financing:

1. Retained earnings

2. New issues of common stock

There are two different ways to estimate the cost of common equity:

1. The constant growth valuation model (Gordon Model)

2. The capital asset pricing model (CAPM).

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3 Cost of common stock equity (r = rr retained earnings):
S

There are two different ways

1. Using constant growth model:

2. Using CAPM:

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1) Cost of retained earnings (rs = rr) using constant growth model

Cost of common = dividend yield + capital gains yield

stock equity

P0 = value of common stock (current market price per share)

D1 = per-share dividend expected at the end of year 1

rs = required return on common stock

g = constant rate of growth in dividends

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Constant-growth valuation (Gordon growth) model:

Assumes that the value of a share of stock equals the present value of
all future dividends (assumed to grow at a constant rate) that it is
expected to provide over an infinite time horizon.

Indicates that the cost of common stock equity can be found by

dividing the dividend expected at the end of year 1 by the current
market price of the stock (the dividend yield) and adding the
expected growth rate (the capital gains yield).

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 Example (5)
Cost of retained earnings using constant growth model :
The market price, P0, of a firms common stock is $50 per share.
The firm expects to pay a dividend, D1, of $4 at the end of the coming year, 2013.
The dividends paid on the outstanding stock over the past 6 years (2007 through 2012) were as
follows:

Calculate the cost of retained earnings using constant growth model

Solution:
P0 = $50 , and D1 = $4 , But g needs to be calculated
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 Calculating g : constant growth rate
2007 2008 2009 2010 2011 2012

$ 2.97 $ 3.12 $ 3.33 $ 3.47 $ 3.62 $ 3.80

n=0 n=1 n=2 n=3 n=4 n=5

To find the historical annual growth rate of dividends, we must solve the following for g:
n
FV = PV (1 + r)
5 5 5
D2012 = D2007 (1 + g) 1.2795 = (1 + g) 5

D2012 Constant growth rate = g

= (1 + g) 5
1.0505 = 1+g ~ g
D2007 %5 =
1.0505 - 1 = g
$ 3.80 5
= (1 + g)
$ 2.97 .0505 = g

5 % 5.05 = g
1.2795 = (1 + g)
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 Now all variables are available:
P0 = $50 , D1 = $4 , g = 5%
Apply the costant growth model formula

$4
= + .05
$ 50
= .080 + .05

= .13

rs = 13% = rr

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 Example (6)
Cost of retained earnings using constant growth model :
Assume that a firm has just paid a dividend of $2.50 per share.

The firm expects dividends to grow at 10% indefinitely.

The firm is currently selling its common stock share for $50 per share.

Calculate the cost of retained earnings using constant growth model

Solution:
P0 = $50 , and D0 = $2.5 per share is actual dividends paid, g = 10% , but D1 is the expected
dividend to be paid at the end of the coming year needs to be calculated:

D1 = D0 (1+ g) = $2.50 (1+.10) = $2.75

$2.75
= + .1 = .055 + .1 = .155
$ 50

rs = 15.5% = rr
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 2) Cost of retained earnings (rs = rr) using CAPM:
cost of retained earnings rr
The same as the cost of an equivalent fully subscribed issue of
additional common stock, which is equal to the cost of common stock
equity, rs

rs= rr

RF = risk-free rate of return

rm = market return; return on the market portfolio of assets

b = coefficient of non diversified risk

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 Capital Asset Pricing Model (CAPM):

Describes the relationship between the required return, rs, and

the non diversified risk of the firm as measured by the beta
coefficient, b.

Using CAPM indicates that the cost of common stock equity is

the return required by investors as compensation for the firms
non diversified risk, measured by beta.

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 Example (7)
Cost of retained earnings using CAPM :
If 3-month T-bill rate is currently 5.0%

The market risk premium is 9%

The firms beta is 1.20

Calculate the cost of retained earnings using CAPM

Solution:
r F = 5% , b = 1.2 , and r m = 9%

rs = rF + b (rM - rF)

rs = 5.0% + 1.2 (9.0%) = 15.8%.

rs = 15.8% = rr

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4 Cost of common stock equity (rN new issues of common stock):
cost of a new issue of common stock, r n
The cost of common stock, net of underpricing and associated flotation costs.

underpriced
Stock sold at a price below its current market price, P0.

Using constant growth model:

rn
Nn

Nn = net proceeds from selling new issues of common stock

D1 = per-share dividend expected at the end of year 1

rn = cost of new issues of common stock

g = constant rate of growth in dividends
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 Example (8)
Cost of new issues of common stock using constant growth model :
Assume that a firm has just paid a dividend of $2.50 per share.
The firm expects dividends to grow at 10% indefinitely.
The selling price of new issue of common stock is $50 per share after underpricing.
flotation costs amount to $4.00 per share.
Calculate the cost of new issues of common stock using constant growth model
Solution:
Selling price = $50 , flotation cost = $4 per share, and D0 = $2.5 per share is actual dividends paid, g
= 10% , but D1 is the expected dividend to be paid at the end of the coming year needs to be
calculated:
D1 = D0 (1+ g) = $2.50 (1+.10) = $2.75

$2.75 ~
rn = + .1 = .0597 + .1 = .1597 = .16
Nn $50 - $4 rn = 16 %
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A comparison of the amount of cost for each source of Long-Term Financing

Highest cost
Cost of New
of Long-Term Issues of
New Common
Financing issues of Stock
common
stock
Cost of
Retained
Earnings
Retained
Decreasing cost
Increasing cost

Earnings
Cost of
preferred
stock
Preferred
stock

Long Cost of Long -

Term Term Debt
Debt
Lowest cost (Bonds)

of Long-Term
Financing
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 An-Najah National University

Prepared by Instructor: E.Shatha Qamhieh

Managerial Finance
 E1
A firm raises capital by selling bonds at par value = $1000, with net proceeds from
selling the bond = $1,000. If the debt matures in 10 years and has a coupon interest rate
of 8%, what is the bonds YTM?

Since:
The bond par value = net proceeds from selling the bond
$1,000 = $1,000

Then:
YTM = rd = coupon interest rate of 8%,

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E2
Your firm, Peoples Consulting Group, has been asked to consult on a potential preferred stock
offering by Brave New World. This 15% preferred stock issue would be sold at its par value of
$35 per share. Flotation costs would total $3 per share. Calculate the cost of this preferred stock.

Cost of preferred stock =

(.15 $35)
($35- $3)
r p = 16.41 %

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 E3
Duke Energy has been paying dividends steadily for 20 years. During that time, dividends have
grown at a compound annual rate of 7%. If Duke Energys current stock price is $78 and the
firm plans to pay a dividend of $6.50 next year, what is Dukes cost of common stock equity?

$6.5
= + .07 = .083 + .07 = .153
$ 78

rs = 15.3% = rr

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 E4
Weekend Warriors, Inc., has 35% debt and 65% equity in its capital structure. The firms
estimated after-tax cost of debt is 8% and its estimated cost of equity is 13%. Determine the
firms weighted average cost of capital (WACC).

Solution:

WACC = (weight of Debt cost of Debt) + (weight of Equity cost Equity)

WACC = (.35 8%) + (.65 13%)
WACC = ( 2.8%) + ( 8.45 %)
WACC = 11.25%

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E5
Oxy Corporation uses debt, preferred stock, and common stock to raise capital. The firms capital
structure targets the following proportions: debt, 55%; preferred stock, 10%; and common stock,
35%. If the cost of debt is 6.7%, preferred stock costs 9.2%, and common stock costs 10.6%, what
is Oxys weighted average cost of capital (WACC)?

WACC = ra = wi ri + wp rp + ws rr or n

Solution:

WACC = (.55 6.7%) + (.10 9.2%) + (.35 10.6%)

WACC = ( 3.685%) + ( .92 %) + ( 3.71 %)
WACC = 8.315%

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P1
Currently, Warren Industries can sell 15-year, $1,000-par-value bonds paying annual interest at a
12% coupon rate. As a result of current interest rates, the bonds can be sold for $1,010 each;
flotation costs of $30 per bond will be incurred in this process. The firm is in the 40% tax
bracket.
a. Find the net proceeds from sale of the bond, Nd.
d. Use the approximation formula to estimate the before-tax cost of debt.
c. Find the after-tax costs of debt.

a. Net Proceeds: Nd = $1,010 - $30

Nd= $980
d. Approximate before-tax cost of debt:

($ 1,000 $ 980 )
$ 120 + kd
kd = 15 =12.26%
($ 980 + $ 1,000 )
2
c. Approximate after-tax cost of debt = 12.26% x (1 - .4) = 7.36%

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 P-2
A bond has been issued by a firm with the following information on the security:
bond
Par value $1,000 Coupon interest rate 6% Tax bracket 20%
Net Selling price $930 Years to maturity 10
Answer the following questions.
a. Calculate the before-tax cost of the Sony bond.
b. Calculate the after-tax cost of the Sony bond given Davids tax bracket.
Annual interest amount on the bond = .06 $1,000
= $60
Par Value Nd $1,000 $930
$I $ 60
Before tax cost of = r = n = 10
Debt (Bond) d Par Value Nd $1,000 $930

r 2 2
d = 6.9 %

After tax cost of = r = 6.9 % ( 1- .2 )

Debt (Bond) i
r = 5.52 %
i
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 P3
For each of the following $1,000 par value bonds, assuming annual interest payment
and a 40% tax rate, calculate the after-tax cost to maturity using the approximation
formula.

Bond Life (years) Underwriting fee Discount or premium Coupon interest rate
A 20 $25 -$20 9%
B 16 40 +10 10
C 15 30 -15 12
D 25 15 par 9
E 22 20 -60 11

$ 1,000 N d
I+
kd = n ki = kd x (1 - T)
N d + $ 1,000
2

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 Bond A

$1,000 $955
$90 +
20 $92.25
kd = = = 9.44%
$955 + $1,000 $977.50
2
ki = 9.44% x (1 - .40) = 5.66%

Bond B

$ 1,000 $ 970
$ 100 +
16 $ 101 .88
kd = = = 10 .34 %
$ 970 + $ 1,000 $ 985
2

ki = 10.34% x (1 - .40) = 6.20%

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 Bond C

$ 1,000 $ 955
$ 120 +
15 $ 123
kd = = = 12 .58 %
$ 955 + $ 1,000 $ 977 .50
2
ki = 12.58% x (1 - .40) = 7.55%

Bond D

$ 1,000 $ 985
$ 90 +
25 $ 90 .60
kd = = = 9 .13 %
$ 985 + $ 1,000 $ 992 .50
2

ki = 9.13% x (1 - .40) = 5.48%

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 Bond E

$ 1,000 $ 920
$ 110 + $ 113 .64
kd = 22 = = 11 .84 %
$ 920 + $ 1,000 $ 960
2
ki = 11.84% x (1 - .40) = 7.10%

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 P4
Gronseth Drywall Systems, Inc., is in discussions with its investment bankers regarding the
issuance of new bonds. The investment banker has informed the firm that different maturities
will carry different coupon rates and sell at different prices.
The firm must choose among several alternatives. In each case, the bonds will have a $1,000
par value and flotation costs will be $30 per bond. The company is taxed at a rate of 40%.
Calculate the after-tax cost of financing with each of the following alternatives.

Alternative Coupon Rate Time to maturity Premium or discount

A 9% 16 $250
B 7 5 50
C 6 7 Par
D 5 10 -75

Alternative A
$ 1,000 $ 1, 220
$ 90 +
16 $ 76 .25
kd = = = 6 .87 %
$ 1, 220 + $ 1,000 $ 1,110
2
ki = 6.87% x (1 - .40) = 4.12%
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 Alternative B

$ 1,000 $ 1,020
$ 70 +
5 $ 66 .00
kd = = = 6 .54 %
$ 1,020 + $ 1,000 $ 1,010
2

ki = 6.54% x (1 - .40) = 3.92%

Alternative C

$ 1,000 $ 970
$ 60 +
7 $ 64 .29
kd = = = 6 .53 %
$ 970 + $ 1,000 $ 985
2
ki = 6.53% x (1 - .40) = 3.92%

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 Alternative D

$ 1,000 $ 895
$ 50 +
10 $ 60 .50
kd = = = 6 .39 %
$ 895 + $ 1,000 $ 947 .50
2

ki = 6.39% x (1 - .40) = 3.83%

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P5
Taylor Systems has just issued preferred stock. The stock has a 12% annual dividend and a
$100 par value and was sold at $97.50 per share. In addition, flotation costs of $2.50 per share
must be paid.
a. Calculate the cost of the preferred stock.
b. If the firm sells the preferred stock with a 10% annual dividend and nets $90.00
after flotation costs, what is its cost?
a. Cost of preferred stock =

(.12 $100)
($97.5- $2.5)
r p = 12.63 %

b. Cost of preferred stock =

(.10 $100)
($90)

r p = 11.11 %
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 P-6
Determine the cost for each of the following preferred stocks.
Preferred stock Par value Sales price Flotation cost Annual dividends

A $100 $101 $9 11%

B 40 38 $3.5 8%

C 35 37 $4 $5

D 30 26 5% of par $3

E 20 20 $2.5 9%

Cost of Preferred Stock: kp = Dp Np

Preferred Stock Calculation

A kp =$11.00 $92.00 =11.96%
B kp = 3.20 34.50 = 9.28%
C kp = 5.00 33.00 =15.15%
D kp = 3.00 24.50 =12.24%
E kp = 1.80 17.50 =10.29%

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 P-7
J&M Corporation common stock has a beta, b, of 1.2. The risk-free rate is 6%, and the
market return is 11%.
a. Determine the risk premium on J&M common stock (not the market risk premium).
b. Determine the required return that J&M common stock should provide.
c. Determine J&Ms cost of common stock equity using the CAPM.

ks = RF + [risk premium on the common stock]

ks = RF + [b x (market risk premium)]
ks = RF + [b x (km - RF)]
ks = 6%+1.2 x (11% - 6%)
ks = 6%+6%
ks = 12%

a. Risk premium on J&M common stock = 6%

b. Rate of return that the company should provide (investor point of view) =12%

c. After-tax cost of common equity (company point of view)using the CAPM = 12%

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P8
Ross Textiles wishes to measure its cost of common stock equity. The firms stock is currently
selling for $57.50. The firm expects to pay a $3.40 dividend at the end of the year (2013). The
dividends for the past 5 years are shown in the following table.
Year Dividends
2012 $3.1
2011 2.92
2010 2.6
2009 2.3
2008 2.12
After underpricing and flotation costs, the firm expects to net $52 per share on a new issue.
a. Determine the growth rate of dividends from 2008 to 2012.
b. Determine the net proceeds, Nn, that the firm will actually receive.
c. Using the constant-growth valuation model, determine the cost of retained earnings, rr.
d. Using the constant-growth valuation model, determine the cost of new common stock rn
D2012 $ 3 .10
a. FV = PV FVIF,i%,4 g= = FVIF, i%,4 g = = 1 .462
D2008 $ 2 .12
From FVIF table, the factor closest to 1.462 occurs at 10% (i.e., 1.464 for 4 years).

b. Nn = $52 (given in the problem)

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 D 2013
c. kr = +g
P0
$ 3 .40
kr = + .10 = 15 .91 %
$ 57 .50

D 2013
d. kr = +g
Nn
$ 3 .40
kr = + .10 = 16 .54 %
$$52
55 .00

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 P-9
Retained earnings versus new common stock Using the data for each firm shown in the
following table, calculate the cost of retained earnings and the cost of new common stock using
the constant-growth valuation model.
Firm Current market Dividend growth Projected dividend per Underpricing Flotation cost
price rate share next year per share per share
A $50 %8 $2.25 $2 $1

B 20 4 1 .5 1.5

C 42 6 2 1 2

D 19 2 2.1 1.3 1.7

Firm Calculation .
A kr = ($2.25 $50.00) + .08 =12.50%
kn=($2.25 $47.00) + .08 =12.79%
B kr =($1.00 $20.00) +.04 = 9.00%
kn =($1.00 $18.00) + .04 = 9.56%
C kr =($2.00 $42.50) + .06 =10.71%
kn =($2.00 $39.50) + .06 =11.06%
D kr =($2.10 $19.00) + .02 =13.05%
kn =($2.10 $16.00) + .02 =15.13%
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P10
Lighting Corp. wishes to explore the effect on its cost of capital of the rate at which the company
pays taxes. The firm wishes to maintain a capital structure of 30% debt, 10% preferred stock, and
60% common stock. The cost of financing with retained earnings is 14%, the cost of preferred
stock financing is 9%, and the before-tax cost of debt financing is 11%. Calculate the weighted
average cost of capital (WACC) given the tax rate assumptions in parts a to c.
a. Tax rate 40%
b. Tax rate 35%
c. Tax rate 25%
d. Describe the relationship between changes in the rate of taxation and the weighted average cost
of capital.

a. WACC = (.30)(11%)(1 .40) + (.10)(9%) + (.60)(14%)

WACC = 1.98% + .9% + 8.4%
WACC = 11.28%
b. WACC = (.30)(11%)(1 .35) + (.10)(9%) + (.60)(14%)
WACC = 2.15% + .9% + 8.4%
WACC = 11.45%
c. WACC = (.30)(11%)(1 .25) + (.10)(9%) + (.60)(14%)
WACC = 2.48% + .9% + 8.4%
WACC = 11.78%
d. As the tax rate decreases, the WACC increases due to the reduced tax shield from the
tax-deductible interest on debt.
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 P11
Ridge Tool has on its books the amounts and specific (after-tax) costs shown in the following
table for each source of capital.

Source of capital Book value Individual cost

Long term debt $700,000 5.3%
Preferred stock 50,000 12
Common stock equity 650,000 16

a. Calculate the firms weighted average cost of capital using book value weights.

Type of Capital Book Value Weight Cost Weighted Cost

L-T Debt $ 700,000 .500 5.3% 2.650%
Preferred stock 50,000 .036 12.0% .432%
Common stock 650,000 .464 16.0% 7.424%
$1,400,000 1.000 10.506%

The WACC is the rate of return that the firm must receive on long-term
projects to maintain the value of the firm. The cost of capital can be compared to
the return for a project to determine whether the project is acceptable.

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P12
Webster Company has compiled the information shown in the following table.
Source of capital Book value Market value After-tax cost
Long term debt $4,000,000 $3,840,000 6%
Preferred stock 40,000 60,000 13
Common stock equity 1,060,000 3,000,000 17
Totals $5,100,000 $6,900,000
a. Calculate the weighted average cost of capital using book value weights.
b. Calculate the weighted average cost of capital using market value weights.
c. Compare the answers obtained in parts a and b.
a. Book value weights:
Type of Capital Book Value Weight Cost Weighted Cost
L-T Debt $4,000,000 0.784 6.00% 4.704%
Preferred stock 40,000 0.008 13.00% .104%
Common stock 1,060,000 0.208 17.00% 3.536%
$5,100,000 8.344%
b. Market value weights:
Type of Capital Market Value Weight Cost Weighted Cost
L-T Debt $3,840,000 0.557 6.00% 3.342%
Preferred stock 60,000 0.009 13.00 .117%
Common stock 3,000,000 0.435 17.00 7.395%
$6,900,000 10.854%
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