Goals of this session

Sources of capital

Cost of each type of funding

Compute the cost of each source of capital

Determine percentage of each source of capital in the optimal capital

structure

Calculate Weighted Average Cost of Capital (WACC)

Factors Influencing Cost of capital

General Economic Conditions

Market Conditions

Affect business risk

Financial Decisions

Affect risk premiums

Operating Decisions

Affect interest rates

Affect financial risk

Amount of Financing

Affect flotation costs and market price of security

Compute the cost of Debt

Required rate of return for creditors

Same cost found in Chapter 12 as yield to maturity on bonds (k d).

e.g. Suppose that a company issues bonds with a before tax cost of 10%.

Since interest payments are tax deductible, the true cost of the debt is the
after tax cost.

If the companys tax rate (state and federal combined) is 40%, the after
tax cost of debt

AT kd = 10%(1-.4) = 6%.

Compute the cost of preferred stock

Kp = Dp/Mp- Floating Cost

Suppose XYZ company issued a preferred stock with a market price of $42, dividend
worth of $ 5 and without any floating cost. The cost of preferred stock is:
$5/$42= 11.9%

Compute the cost of common stock

Two types of equity Financingo financing from retained earnings and

o Financing by issuing new common stock

Cost of financing from retained earnings (Two methods)

Dividend Growth Model

Example: The market price of a share of common stock is $60. The dividend just
paid is $3, and the expected growth rate is 10%.

o Ke= D0(1+g)/P0+g =3(1.1)/60 +.1=15.5%

Capital Asset Pricing Model

Example: The estimated Beta of a stock is 1.2. The risk-free rate is 5% and the
expected market return is 13%.

Ke= 5%+1.2(.13-o.o5)= 14.6%

Cost of Financing by issuing new common stock

Dividend Growth Model

If additional shares are issued floatation costs will be 12%. D 0 = $3.00 and
estimated growth is 10%, Price is $60 as before.

Ke= D0(1+g)/(P0 F)+g =3(1.1)/(60-7.2) +.1=16.25%

Consolidate the rates

Source of Capital Cost

Bonds

k = 10%
d

Preferred Stock

k = 11.9%
p

Estimate Common
the costStock
of capital for the xyz company under two different equity
financing conditions where the debt, preferred stock and common equity weights
Retained
k = 15%
are 40%, 10% and
50% Earnings
respectively.
s
Financing by retained earnings
New Shares

k = 16.25%
n

WACC = .40 x 10% (1-.4) + .10 x 11.9%

WACC = .40 x 10% (1-.4) + .10 x 11.9%

+ .50 x 15% = 11.09%

Financing by new common stock issue

+ .50 x 16.25% = 11.72

Market Efficiency in a Market-Model and CAPM Context

A perfect market means an economy in continuous equilibrium that is,

a market which instantly and correctly responds to new information,
providing signals for real economic decisions. The following are necessary
conditions for perfect capital markets:
1) Markets are frictionless (a financial market without transaction
costs).
2) Production and securities markets are perfectly competitive.
3) Markets are informationally efficient.
4) All individuals are rational expected-utility maximizers.

In an efficient capital market prices fully and instantaneously reflect all

available information; thus, when assets are traded, prices are accurate
signals for capital allocation. In this case, an efficient capital market only
follows Rule 3 of a perfect capital market.

Fama (1970) defines three types of efficiency, each of which is based on

a different notion of exactly what type of information is understood to be
relevant. They are:

Weak form efficiency: No investor can earn excess returns by

developing trading rules based on historical price or return information.

Semi-strong form efficiency: No investor can earn excess returns from

trading rules based on publicly available information.

Strong form efficiency: No investor can earn excess returns using any
information, whether or not publicly available.