FIL 190 Ch.8 CostCapl

FIL 190 Chapter 8 Cost of Capital Remember that corporate finance deals with two major sets of decisions: (1) financing and (2) investing. This chapter is about the cost of firm financing . Sources of Capital (i.e., financing) are _______________________________________ In this chapter, we assume a constant financial policy (debt-equity mix). Ch. 11 deals with optimizing the mix of (the above-mentioned sources of) capital. Cost of capital (k) and required return (r) may differ due to (1) Flotation costs – costs of issuing new debt and equity securities; they __________ the cost of capital; (2) Tax deductibility of debt interest for firms – ____________ the cost of debt. ------------------- Cost of Debt Before-tax cost of debt, k d , is found by finding the yield to maturity (YTM) in the bond pricing equation where the ____________________ of a bond sale (or the net loan proceeds), NP d , are used in place of the bond price: NP d = Cpn k d ( 1 − 1 ( 1 + k d ) n ) + Par ( 1 + k d ) n (use TVM functions on the calculator or in Excel) Example 1a. BN Unicorn Co. sells 7-year, $1,000 par bonds with a 4.5% coupon (paid annually) for $980. In addition, flotation costs are 3% of the selling price. What is the before-tax cost of bonds to the firm? Step 1: Find net proceeds per bond Step 2: Find k d : BAII+: Because interest on debt is tax deductible for firms, the after-tax cost of debt is lower for profitable firms: The after-tax cost of debt is Example 1b. What is the after-tax cost of the bonds from Example 1a if BN Unicorn Co’s tax rate is 26%? 1

-------------------- Cost of equity k s = D 1 /P s + g Cost of internal equity (retained earnings, has no flotation costs). This is the same formula as the one for the expected return, ´ r , in Ch.7. k s = D 1 /NP s + g Cost of external equity (sold to investors, incurs flotation costs). (NP s = net proceeds of equity sale = gross proceeds – flot.costs, $ per share.) Equivalently, the cost of external equity, k s = (r – g*%fl.costs)/(1 - %fl.costs) The above k s formulas apply to both preferred and common stocks (for preferred, g = 0 and D has no time subscript). Example 2 . BN Unicorn Co. sells preferred stock that pays a $2 annual dividend for $30. Flotation costs are 4% of the selling price. What is the cost of the preferred stock? k ps = 6.94% Example 3 . BN Unicorn Co. (BNUC) also sells additional shares of common stock. The stock’s beta is 1.34, the one-month Treasury bill rate is 0.8%, and the expected return on the market is 8%. The most recent annual dividend was $2.16 per share, expected to grow at 4% per annum. Assume the stock’s gross selling price is equal to its intrinsic value. What is the cost of common stock to the firm if the flotation costs are $2 per share? Step 1 : find r (BNUC) = r f +β BNUC *(r m -r f ) = 0.8% + 1.34*(8%-0.8%) = 10.45% Step 2 : Find the stock’s (gross) price (it’s equal to the intrinsic value based on the CAPM, so use the V cs equation): V BNUC = D1/(r-g) = (2.16*1.04)/(0.1045-0.04) = 2.246/0.0645 = 34.83 Step 3 : Find the cost of common stock for BNUC: Net proceeds = 34.83 – 2 = 32.83 k (BNUC) = D 1 /NP s + g = 2.246/32.83 + 0.04 = 10.84% Alternatively, k s = (r – g*%fl.costs)/(1 - %fl.costs) Find %fl.costs = 2/34.83 = 5.74% k (BNUC) = (r – g*%fl.costs)/(1 - %fl.costs) = (0.1045 – 0.04*0.0574)/(1-0.0574) = 10.84% 2