7.

THE COST OF CAPITAL

part II

Chapter 5

2. Cost of Bank Loans

When a firm borrows money at a stated rate of interest from
a bank, determining the real cost rate of the debt is
relatively straightforward.
Because the interest paid on bank loans is a tax-deductible
expense, the firms cost rate is less than the required rate
of interest of the suppliers of debt capital.
The explanation is the same as in the case of bond credits.

2. Cost of Bank Loans

Under the incidence of the taxes, the interests are deductible

from the taxable profit and the real load undertaken by the
company is smaller, that is if the debtor company is profitable,
the interest that it will deliver each year to its lender will allow
realizing tax shield.
In this case:
The after-tax % cost of debt (real rate of cost) = nominal
interest rate * (1 T)
T Corporate income tax rate
Observation: If the debtor company is not profitable, the real
cost rate equals the nominal interest rate paid to the bank,
because in this case there are no tax savings.

2. Cost of Bank Loans

2. Cost of Bank Loans

3. Cost of Preferred Stock

Preferred stock represents a special type of ownership interest in the

firm. Preferred shareholders must receive their stated dividends prior
to the distribution of any earnings to common stockholders.
Calculating the cost of preferred stock:
The cost of preferred stock is found by dividing the annual preferred
stock dividend by the net proceeds from the sale of the preferred
stock.
The net proceeds represent the amount of money to be received net of
any flotation costs required to issue and sell the stock. For example,
if a preferred stock is sold for $100 per share but $3 per share
flotation costs are incurred, the net proceeds from the sale are $97.

3. Cost of Preferred Stock

EXAMPLE:
The Zero Company is contemplating issuance of a 9 percent preferred
stock expected to sell for its $85 per share par value. The cost of issuing
and selling the stock is expected to be $3 per share. The firm would like
to determine the cost of the stock.

Application

The first step in finding this cost is to calculate the dollar

amount of preferred dividends, since the dividend is
stated as a percentage of the stocks $85 par value.
The annual dollar dividend is: $85 * 9% = $7,65.
The net proceeds = $85 - $3 = $82 per share.
So, the cost of the preferred stock is: $7,65 / $82 =
9,33%.

Ex. The Beta Company issues 100 preferred shares of stock at

a par value $90. The cost of issuing and selling the stock is
expected to be $4 per share. The annual rate of the preferred
dividend is 10%. The firm would like to determine the cost of
the stock.

3. Cost of Preferred Stock

Preferred stock is more expensive than debt because:

(1) preferred stockholders accept more risk than debt
holders who have a claim senior to that of preferred
stockholders and
(2) the cost of debt (interest) is tax deductible.

4. Cost of Common Stock

The cost of common stock is not as easy to calculate as

the cost of debt or the cost of preferred stock.
The difficulty arises from the definition of the cost, which is
based on the premise that the value of a share of stock in
a firm is determined by the present value of all future
dividends expected to be paid on the stock over an infinite
period of time.
The rate at which these expected dividends are
discounted to determine their present value represents
the cost of common stock.

4. Cost of Common Stock

Not all earnings are paid out as dividends, but it is

expected that earnings that are retained and reinvested will
boost future dividends. At infinity, a liquidating, or final
dividend is expected, which actually represents the
distribution of the firms assets.
Two techniques for measuring the cost of common stock
equity capital are available.
A. One is the constant growth valuation method;
B. The other relies on the capital asset pricing model
(CAPM).

4. Cost of Common Stock

A. The constant growth valuation model
To value any security, we must determine the expected cash
flows an investor will receive from owning it.
One-year investor
There are two potential sources of cash flows from owning a
stock.
First, the firm might pay out cash to its shareholders in the
form of a dividend.
Second, the investor might generate cash by choosing to sell
the shares at some future date.
The total amount received in dividends and from selling the
stock will depend on the investors investment horizon.

4. Cost of Common Stock

A. The constant growth valuation model

When an investor buys a stock, he will pay the current

market price for a share, P0. While he continues to hold
the stock, he will be entitled to any dividends the stock
pays.
Let Div1 be the total dividends paid per share of the
stock during the year. At the end of the year, the investor
will sell his share at the new market price P1. Assuming
for simplicity that all dividends are paid at the end of the
year, we have the following timeline for this investment:

4. Cost of Common Stock

A. The constant growth valuation model

The future dividend payment and the stock price in the

timeline above are not known with certainty; rather, these
values are based on the investors expectations at the time
the stock is purchased.
Given these expectations, the investor will be willing to
pay a price today up to the point that this transaction has a
zero NPV that is, up to the point at which the current
price equals the present value of the expected future
dividend and sale price. Because these cash flows are
risky, we cannot discount them using the risk-free interest
rate.

4. Cost of Common Stock

A. The constant growth valuation model
Instead, we must discount them based on the equity cost of
capital, rE, for the stock, which is the expected rate of return of
other investments available in the market with equivalent risk to
the firms shares. Doing so leads to the following equation for the
stock price:
(1)
If the current market price were less than this amount, it would
be a positive NPV investment. We would therefore expect
investors to rush in and buy it, driving up the stocks price. If the
stock price exceeded this amount, selling it would have a
positive NPV and the stock price would quickly fall.

4. Cost of Common Stock

A. The constant growth valuation model

Dividend Yields, Capital Gains, and Total Returns. We can

reinterpret the equation (1) if we multiply by (1 + rE), divide by
P0, and subtract 1 from both sides:

The first term on the right side of the equation is the stocks dividend yield,
which is the expected annual dividend of the stock divided by its current price.
The dividend yield is the percentage return the investor expects to earn from
the dividend paid by the stock.

4. Cost of Common Stock

A. The constant growth valuation model

The second term on the right side of the equation reflects the
capital gain the investor will earn on the stock, which is the
difference between the expected sale price and purchase price
for the stock, P1 P0. We divide the capital gain by the current
stock price to express the capital gain as a percentage return,
called the capital gain rate.
The sum of the dividend yield and the capital gain rate is called
the total return of the stock.
The total return is the expected return that the investor will earn
for a one-year investment in the stock.

4. Cost of Common Stock

A. The constant growth valuation model
Thus, Eq. 2 states that the stocks total return should equal the
equity cost of capital. In other words, the expected total return of
the stock should equal the expected return of the investments
available in the market with equivalent risk.
This result is what we expected: the firm must pay its
shareholders a return commensurate with the return they can
earn elsewhere while taking the same risk. If the stock offered a
higher return than other securities with the same risk, investors
would sell those other investments and buy the stock instead.

4. Cost of Common Stock

A. The constant growth valuation model
A multiyear investor
Eq. 1 depends upon the expected stock price in one year, P1. But
suppose we planned to hold the stock for two years. Then we
would receive dividends in both year 1 and year 2 before selling
the stock, as shown in the following timeline:

Setting the stock price equal to the present value of the future cash flows in this
case implies:

4. Cost of Common Stock

A. The constant growth valuation model

A multiyear investor

We suppose the investor sells the stock to another one-year

investor with the same beliefs. The new investor will
expect to receive the dividend and the stock price at the
end of year 2, so he will be willing to pay

Substituting this expression for P1 into Eq. 1, we get the same result as
in Eq. 3:

4. Cost of Common Stock

A. The constant growth valuation model

We can continue this process for any number of

years by replacing the final stock price with the value
that the new holder of the stock would be willing to
pay. Doing so leads to the general dividenddiscount model for the stock price, where the
horizon N is arbitrary:

4. Cost of Common Stock

A. The constant growth valuation model

For the special case in which the firm eventually pays dividends
and is never acquired, it is possible to hold the shares forever.
Consequently, we can let N go to infinity in Eq. 4 and write it as
follows:

That is, the price of the stock is equal to the present value of the expected
future dividends it will pay.

Exercise
An investor bought a share of stock for 4.5 lei in January 2008.
The share of stock offered dividends in amount of 0.25 lei in
2008, 0.28lei in 2009, 0.25lei in 2010 and 0.3 lei in 2011. In
November 2011 he sold the share for 4.6 lei.
What was the real profitability from holding the share during this
period?