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BOND AND STOCK

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VALUATION AND THE COST
OF CAPITAL

CHAPTER FOUR
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Chapter Objectives:

At the end of this chapter you will be able to:

 Explain the concept of bond and stock valuation,
 Explain the concept of cost of capital and capital structure,
 Describe how the weighted average cost of capital is used in investment
decisions.

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Bond and stock valuation

 Finance is interested more on decision making rather than recording, the value of an asset is determined
before it is purchased. The purpose is to decide whether to acquire or not to acquire the asset.
 The value of any financial asset—a stock, a bond, a lease, or even a physical asset such as an apartment
building or a piece of machinery—is simply the present value of the cash flows the asset is expected to
produce.
Bond Valuation
 The term bond indicates a contract or agreement. It is a long-term source of borrowing. A company
issues bonds when it wants to raise large sum of money from the public at large.
 This type of financing instrument is simply a long term promissory note, issued by: The borrower,
promising to pay its holder (the investor, the creditor) a predetermined and fixed amount of interest plus
the principal at the end of the terms or maturity.
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Bond and stock valuation

As a form of debt, a contract between the borrower and the lender is executed, frequently called an
indenture.
Only three items directly affect the cash flows from owning a bond:
 The bonds par value,
 Maturity date, and
 The coupon rate of interest.
To understand the process of valuing bond it is better to identify the terminologies and institutional
characteristics of bond. Terminologies:
 Par value Yield to maturity
 Coupon interest rate Maturity date
 Market value
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Terminologies
 Par value is the price at which the bond will be redeemed by the issuing company (the borrowing
company) at the end of the life of the bond. For most bonds the par value is set at birr 1000.
Thus, although the price of the bond fluctuates in response to the changing economic and market
conditions, the par value remains constant.
 Coupon interest rate – besides paying the owner of the bond the par value at the maturity date, the
borrower promises to pay a specified amount of interest each year (in fact, it does not necessarily have
to be annual). This rate should not be confused with the required rate of return.
 Maturity date: - as already suggested, a bond normally has maturity date, at which time the borrowing
organization is committed to repay the loan.
 Market value: - is the bonds current price. It is the price at which bonds are traded in the market place.

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Bond Valuation procedure

 The value of a bond is the present value of the periodic interest payments plus the
present value of the par value.
 The valuation process of the bond requires knowledge of three essential elements:
 The amount of each cash flows to be received by the investor
 The maturity date of the loan and
 The investors required rate of return.
 The amount of cash flows is dedicated by the periodic interest to be received and the
par value paid at maturity. Given the elements, we can compute the intrinsic value of
the bond.
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Bond Valuation procedure

 The value of a bond can be computed using the following equitation:
Bo = I (PVIFA kd,n) + M(PVIF kd,n) Where: Bo = the value of the bond
I = interest paid each period = Par Value × Coupon interest rate
Kd = the appropriate (market) interest rate on the bond
n = the number of periods before the bond matures
M = the par value of the bond
 (PVIFA kd,n) = The present value interest factor for an annuity at interest rate of kd per period for n
periods = 1  1
n
(1  k d )
kd
 (PVIFkd,n) = The present value interest factor at interest rate of kd per period for n periods
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Bond Valuation procedure

 Notice that we have used kd instead of i. This is because, generally, in financial management k
designates rate of return and the subscript d denotes debt security.
 So, kd designates the rate of return on a debt security.
Case 1: Consider that Abay Company, on January 1, 1998 issued a 10% coupon interest rate, 10 year bond
with Br. 1000 par value that pays interest annually. Assume that the investor requires a 10% rate of return
on a bond. What is the value of the bond to such investor?
Solution: Interest = Br 1000 x 10% = Br 100
Bo = (Br 100* PVIFA 10%, 10) + (1000*PVIF 10%, 10)
Bo = (Br 100*6.144) + (1000*0.3855)
= Br. 1000 When the required rate of return on a bond is the same as its coupon rate, the
value of the bond is always equal to its par value.
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Required rate of return and bond values

 Whenever the required return on a bond differs from the bond’s coupon interest rate, the bonds value
will differ from its par or face value. The required rate of return on the bond is likely to differ from the
coupon interest rate because of several reasons, for example,
 Economic conditions have changed, causing a shift in the basic cost of long term funds or
 The firms risk has changed
 Regardless of the exact cause, when the required rate of return rises above the coupon interest rate, the
value of the bond will be less than its par value. In this case, the bond is said to be discount Bond. The
discount is equal to the difference between the intrinsic value and the par value of the bond, M-Bo.
What if Kd rise above Abay Co’s coupon interest rate i.e. to 15%
 On the other hand, when the required rate of return falls below the coupon interest rate, the bond’s value
will be greater than its par value. In this situation, the bond is said premium Bond, which equals Bo-M.
What if Kd falls below Abay Co’s coupon interest rate i.e. to 5%
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Required rate of return and bond values

Case 3: Now suppose interest rates in the economy fell after the Abay Co. bonds were issued, and, as a
result, kd fell below the coupon rate, decreasing from 10% to 8%. Find its value
Bo = [(Br 1000*8%)*PVIFA 8%, 10] + [(Br 1000*PVIF 8%, 10)
= (100*6.710) + (1000*0.463)
= Br 1,134
Case 2: Now suppose interest rates in the economy rise after the Abay Co. bonds were issued, and, as a
result, kd raise above the coupon rate, increasing from 10 to 12%. Find its value
Bo = [(Br 1000*12%)* PVIFA 12%, 10] + [(Br 1000* PVIF 12%, 10)
= (100*5.650) + (1000*0.322)
= Br 887
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Required rate of return and bond values

Exercise
 Enchilalen Corporation has a Br. 1,000 par value bond with an 8% coupon interest rate outstanding.
Interest is paid semiannually and the bond has 12 years remaining to its maturity date.
Required: What is the value of the bond if the required return on the bond is 8%?
Solution: Given: M = Br. 1,000; kd = 8% per year or 4% (8%2) per semiannual period; I = Br. 40 (Br.
1,000 x 4%); n = 24 semiannual periods (12 x 2); Bo =?
Bo = I (PVIFA kd,n) + M(PVIF kd,n)
= Br. 40(PVIFA 4%, 24) + Br. 1,000(PVIF 4%, 24)
= Br. 40 (15.2470) + Br. 1,000 (0.3901)
= Br. 1,000
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Required rate of return and bond values

Exercise 2
 Amha Corporation issued a new series of bonds on January 1, 1985. The bonds were
sold at their par of Br. 1,000, have 12% coupon, and mature in 20 years. Coupon
payments are made quarterly.
Required: What was the price of the bond on December 31, 1989, assuming that the level
of interest rate had fallen to 8%?

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Terminologies

YTM is the rate of return investors earn if they buy the bond at a specific price, Bo, and hold it
until maturity. The measures assume that the issuer makes all scheduled interests and principal
payments as promised. YTM is computed using the following approximation formula:
YTM = I + (M - Bo)/n
(M + Bo)/2
 Yield to maturity: - is the bonds required rate of return. The yield to maturity is the discount
rate that equates the bonds market value with the present value of future interest payments and
redemption of par value.
E.g. Suppose you were offered a 14-year, 10% annual coupon, $1,000 par value bond at a price of
$1,494.93. What rate of interest would you earn on your investment if you bought the bond and
held it to maturity? 5%
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Yield to maturity
Example: Strawberry company bond which currently sells for Br 1,080 has a 10% coupon interest rate and
Br 1000 par value, pays interest annually, and has 10 years to maturity.
YTM = 100+ (1000 - 1080)/10
(1000 + 1080)/2
= 8.85%
Exercise
Zebra Company has a Br. 1,000 par value, 10% coupon interest rate, and 15 years to maturity. The bond is
currently selling at Br. 1,090. Compute the YTM.
Solution:
Given: M = Br. 1,000; I = Br. 100 (Br. 1,000 x 10%); n = 15; Bo = Br. 1,090; YTM =?
Approximate YTM = = 8.99% ≈ 9%

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Yield to call (YTC)

 YTC: is the rate of return earned by an investor if he buys a bond at a specified price, Bo, and the bond
is called before its maturity date.
 If current interest rates are well below an outstanding bond’s coupon rate, then a callable bond is likely
to be called, and investors will estimate its expected rate of return as the yield to call (YTC) rather than
as the yield to maturity.
 The YTC can be found by solving the following equation. YTC = I + (M - Bo)/n
(M + Bo)/2
Example: X Company is intending to purchase Y Company’s outstanding bond which was issued on
January 1, 1997. Y’s bond is a Br. 1,000 par value, has a 10% annual coupon, and a 30-year original
maturity. There is a 5-year call protection, after which time the bond can be called at 1080. X Company is
to acquire the bond on January 1, 1999 when it is selling at Br. 1,175.
Required: Determine the yield to call in 1999 for Y company bond.
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Yield to call (YTC)

 The YTC can be found by solving the following equation. YTM = I + (M - Bo)/n
(M + Bo)/2
Solution:
Given: I = Br. 100 (Br. 1,000 x 10%); Bo = Br. 1,175; call price = Br. 1,080 (Br. 1,000 x 108%); n = 3 (call
protection – 2 years elapsed since the bond was issued); YTC =?

Approximate YTC =

If X Company buys Y Company bond and holds the bond until the bonds are called by Y Company, the
approximate annual rate of return would be 6.06%.

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Valuation of stocks

Valuation of preferred stock

 Like a bondholder, the owner of preferred stock should receive a constant income from
the issuer in each period.
 However, the return from preferred stock comes in the form of dividend rather than
interest.
 In addition, while bonds generally have a specific maturity date preferred stocks are
perpetuities. In this instance, finding the value of preferred stock, Vp, is exactly like
finding present value of a perpetual annuity.
Vp = Annual dividend =D
Required rate of return Kp
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Valuation of preferred stock

Example 1: Consider that Star Company preferred stock pays an annual dividend of birr 3.5. The share
does not have maturity date; that is, they go to perpetuity. The investor required rate of return is 7%, find its
value.
Vp = Br 3.5/0.07 = Br 50
Example 2: Abebe wishes to estimate the value of its outstanding preferred stock. The preferred issue has a
Br. 80 par value and pays an annual dividend of Br. 6.40 per share. Similar-risk preferred stocks are
currently earning a 9.3% annual rate of return. What is the value of the outstanding preferred stock?
Solution: Given: Dps = Br. 6.40; Kps = 9.3%; Vps =?
Vps = 6.40/9.3% = Br. 68.82
So, the Br. 6.40 annual dividend an investor receives for an infinite year’s is equal to today’s Br. 68.82 if
the required rate of return is 9.3%.
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Rate of Return on a Preferred Stock

 Kps = Dps/Vps Where: Kps = The expected rate of return on the preferred stock
Dps = Preferred stock dividends
Vps = Value or current price of the preferred stock
Example: A preferred stock pays an annual dividend of Br. 9 and the current market price is Br. 81.
Compute the required rate of return from the preferred stock.
Solution: Given: Dps = Br. 9; Vps = Br. 81; Kps =?
Kps = Br. 9/Br. 81 = 11.11%
For an investor to invest Br. 81 in this preferred stock and to receive an annual dividend of Br. 9, his
minimum required rate of return is 11.11%.

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Valuation of common stock

In contrast to bonds, common stock does not promise its owner interest income or a maturity payment at
some specified time in the future nor does common stock entitle the holder to a predetermined constant
dividend, as does preferred stock.
To understand the value of a common stock we should keep in mind two points.
 First, the dividends are expected for an infinite time period.
 Second, the dividends are not constant.

Therefore, the value of a common stock is found by summing the present values of annual dividends.
Po =

Where: Po = Value of the common stock at time zero (as of today)

D1, D2, …, D∞ = Pre-share dividend expected at the end of each year
Ks = the required rate of return on the common stock.
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Valuation of common stock

The common stock valuation equation can be simplified by redefining each year’s dividend. The dividends are
defined in terms of anticipated dividends growth.
Generally, there are three cases accordingly. These are:
I. Zero growth common stock,
II. Constant growth common stock, and
III. Variable growth common stock.
1. Zero Growth Stock
A zero-growth stock is a common stock whose future dividends are not expected to grow at all. The expected
growth rate (g) is zero. It assumes a constant, non-growing annual dividend. So here the annual dividends are
all equal. That is D1 = D2 = … = D = D.
Po = D/Ks
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Valuation of common stock

Example: The most recent common stock dividend of Shalom Manufacturing Corporation was Br. 3.60 per
share. Due to the firm’s maturity as well as stable sales and earnings, the dividends are expected to remain
at the current level of the foreseeable future.
 Required: Determine the value of Shalom’s common stock for an investor whose required return is 12%.
Solution:
Given: D = Br. 3.60; Ks = 12%; Po =?
Po = 3.60/12% = Br. 30
The maximum price the investor would be willing to pay for a share of Shalom’s common stock is Br. 30
for he to receive a Br. 3.60 annual dividend for some indefinite years.

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Valuation of common stock

2. Constant Growth Stock

Constant growth stock is a common stock whose future dividends are expected to grow at a constant dividend
growth rate (g). It is sometimes called normal growth stock.
The value of a constant growth stock is the present value of the expected future dividends growing at a
constant rate of g. Here the value can be found by using the following formula:

Where: D1 = The expected dividend at the end of year 1.

g = The expected growth rate in dividends.
D1 = Do(1+g), where Do is the most recent dividend. Similarly, D2 = D1 (1+g) and so on. To find the value of
a common stock (constant growth) at one year, first, find the expected dividend at the end of next year.
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Constant Growth Stock

Example: Zeila Motor Corporation’s common stock currently pays an annual dividend of Br. 5.40 per
share. The dividends are expected to grow at a constant annual rate of 5% to infinity. Estimate the value of
Zeila’s common stock if the required return is 12%.
Solution:
Given: Do = Br. 5.40; g = 5%; Ks = 12%; Po =? ; D1 = Do (1+g) = Br. 5.40 (1.05) = Br. 5.67
Po = = = Br. 81
For an investor to receive an annual dividend of Br. 5.40 growing at 5% constantly to infinity, the
maximum price he would pay today is Br. 81.
Find the stock price given that the current dividend is $2 per share, dividends are expected to grow at a rate
of 6% in the forseeable future, and the required return is 12%. Ans: 35.33

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Constant Growth Stock - Expected return

If we are given the value of a constant growth stock, the most recent dividend, the expected dividend
growth rate, we can compute the expected rate of return as follows.
Where: Ks = The expected rate of return on a constant growth stock

Ks = D1/P0 = Expected dividend yield.

g = Expected dividend growth rate = capital gains yield.
Example: Assume the above example except that you are given the value of common stock of Br. 81
instead of the required return. Compute the expected rate of return?
Ks = + 0.05 = 12%

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Variable Growth Stock

3. Variable Growth Stock

Variable growth stock is a stock whose dividends are expected to grow at variable or non-constant rates. It
sometimes is also called supernormal growth model.
The value of a share of variable growth stock is determined by the following 4 procedures.
1. Find the value of the dividends at the end of each year during the initial growth period.
2. Find the present values of the dividends found in step 1.
3. Find the value of the stock at the end of the initial growth period.
4. Add the present value of the dividends found in step 2 and the present value of the value of the stock
found in step 3 to determine the value of the stock at time zero, i.e. Po.

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Variable Growth Stock

Example: Addis Company’s most recent annual dividend, which was paid yesterday, was Br. 1.75 per share.
The dividends are expected to experience a 15% annual growth rate for the next 3 years. By the end of 3 years
growth rate will slow to 5% per year to infinity. Stockholders require a return of 12% on Addis’ stock.
Required: Calculate the value of the stock today.
Solution: Given: Do = Br. 1.75; g1 = 15% for 3 years; g2 = 5% from year 3 to infinity; Ks = 12%; Po =?
D1 = D0 (1 + g1) = Br. 1.75 (1.15) = Br. 2.01 PVIF 12%, 1 PV of D1 = Br. 1.79
D2 = D1 (1 + g1) = Br. 2.01 (1.15) = Br. 2.31 PVIF 12%, 2 PV of D2 = 1.84
D3 = D2 (1 + g1) = Br. 2.31 (1.15) = Br. 2.66 PVIF 12%, 3 PV of D3 = 1.89
PVIF 12%, 3 PV of P3 = 28.40
Po = Br. 33.92
Therefore, the value of Addis Company’s common stock today is Br. 33.92

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Excercise

The current dividend on a stock is $2 per share and investors require a rate of
return of 12%. Dividends are expected to grow at a rate of 20% per year over the
next three years and then at a rate of 5% per year from that point on.
 Find the price of the stock. Answer: 43.8

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PART TWO: The Cost of Capital

The term cost of capital refers to the return a firm intends to pay to its members who contribute the capital
to the firm.
Determination of Cost of Capital
 Cost of capital is determined by taking into account the cost of each component of capital, known as a
specific cost of capital. Specific cost of capital of the given firm is defined as the cost of equity (returns
paid to the equity shareholders) or cost of preference (returns paid to preference shareholders) or cost of
debt (returns paid to the debt holders).
Computation of Specific Costs of Capital
 The cost of capital for any particular capital source or security issue is called specific cost of capital or
component cost of capital. Each type of capital contained the capital structure of a firm include:
1. Debt 3. Common stock
2. Preferred stock 4. Retained earnings
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The Cost of Capital

Two important points you should bear in mind about the specific cost of capital.
 One is that it is computed on an after-tax basis. Meaning, if there would be any tax implication on the
individual source of capital, it should be considered. In almost all circumstances, the tax implication is
only on debt sources of finance.
 The second point is that the specific cost of capital is expressed as an annual percentage or rate like 6%,
9%, or 10%. The cost of capital is not stated in terms of birrs.
1. Cost of Debt cheapest specific cost of capital
 This is the minimum rate of return required by suppliers of debt. The relevant specific cost of debt is the
after-tax cost of new debt. Generally, debt is the cheapest source of finance to a firm and, hence, the cost
of debt is the lowest specific cost of capital.
 First, They receive interest payments before preferred and common dividends are paid.
 Second, raising capital through debt sources entails interest expense.
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1. Cost of Debt

Debt capital can also be issued in two types, and they are
(i) Irredeemable debt, and
(ii) Redeemable debt
Computation of debt capital cost is done as follows:
 Cost of Irredeemable Debt (Kd):  Cost of Redeemable Debt (Kd):

Where Kd = Cost of debt

Where: Int = Interest on the debt capital
Int = Interest paid/payable on the debt
t = corporate tax rate
RV = Redeemable value of the debt
Po = Issue price of the debt capital
SV = Sales proceeds of the debt, which is debt
Kd = cost of the debt
security’s sales price minus Flotation cost.
n = Maturity period in years.
t = corporate tax rate applicable to the firm.
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1. Cost of Debt

Illustrations 3.1:
Find the cost of Debt from the following information given to you: Int = 9%; tax rate = 40 % and Po = Br. 1000;
then Kd =?
Required;
 What will be the cost of debt when it is irredeemable?
 What will be the cost of Debt when it is redeemed after 5 years at (i) 15 % premium and (ii) 10 % discount?
Solution i: What will be the cost of debt when it is irredeemable?

Kd = Br.54/Br.1000

Kd = 0.054 or 5.4%
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1. Cost of Debt

ii. What will be the cost of Debt when it is redeemed after 5 years at (a) 15 % premium and (b) 10 %
discount?
(a). With 15 % premium
Int (1-t) + [(RV-SV)/n]
Kd = ------------------------ = = 0.0781 or 7.81%
[RV + SV]/2
(b). With 10 % discount
Int (1-t) + [(RV-SV)/n] Br. 90 (1 – 0.4) + [(Br. 900-Br. 1,000)/5 years]
Kd = ------------------------ = -------------------------------------------------- = 0.0358 or 3.58%
[RV + SV]/2 [Br. 900 + Br. 1,000]/2
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2. Cost of Preference

2. Cost of Preference
 The cost of preferred stock is the minimum rate of return a firm must earn in order to
satisfy the required rate of return of the firm’s preferred stock investors.
A firm can issue preference shares of two types, and they are:
(i) Permanent preference shares; are shares issued with a condition of non-payment
of the capital to the shareholders, and if at all the payment of the capital arises will be in
the situation of the winding up of the firm.
(ii) Redeemable preference shares. They are being issued with a condition to repay
the capital after certain period, say after 10 years or 15 years.
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2. Cost of Preference

 Cost of Irredeemable preference shares (Kp):

Kp = Pd/Po
Where: Kp = cost of preference share
Pd = Preferential dividend for the year
Po = Issue price of the preference share
 Cost of Redeemable preference shares (Kp):

Where Kp = Cost of preference share

Pd = Preferential dividend for the year
RV = Redeemable value of the preference share
SV = Sales proceeds of the preference share
n = Maturity period in years.
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2. Cost of Preference

Illustration 3.2: Find the cost of the preference from the following information given to you: Pd = Br.7; and
Po = Br. 100; then Kp =?
 What will the cost of preference when the share is redeemed after 5 years at (i) 10 % premium and (ii) 5
% discount?
Solution: When it is irredeemable.
Kp = Pd/Po = Kp = Br. 7/Br. 100 Kp = 0.07 or 7%
 When the preference share is redeemable with 10% premium:
Pd + [(RV-SV)/n] Br. 7+ [(Br. 110-Br. 100)/5 years]
Kp = ------------------ = ---------------------------------- = 0.0857 or 8.57%
[RV + SV]/2 [Br. 110 + Br. 100]/2
 With 5% discount = Br. 7+ [(Br. 95-Br. 100)/5 years]/[Br. 95 + Br. 100]/2 = 0.0615 or 6.15%
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3.1 Cost of Equity

3.1 Cost of Equity- the most expensive cost of capital

 Under this specific cost of capital, we will see cost of new equity/cost of common stock and cost of retained
earnings.
1. The cost of common stock
The cost of common stock can be computed using the constant growth valuation model.

Where: Ks = The cost of new common stock issue

D1 = The expected dividend payment at the end of next year
NPo = Net proceeds from the sale of each common stock
g = The expected annual dividends growth rate
The net proceeds from the sale of each common stock (NPo) is computed as follows:
NPo = Po – f Where: Po = The current market price of the common stock
f = flotation costs

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3.1 Cost of Equity

Illustration 3.3: An issue of common stock is sold to investors for Br. 20 per share. The issuing corporation
incurs a selling expense of Br. 1 per share. The current dividend is Br. 1.50 per share and it is expected to
grow at 6% annual rate. Compute the specific cost of this common stock issue.
Solution: Given: Po = Br. 20; Do = Br. 1.50; g = 6%; f = Br. 1; Ks =?
 Then apply the two steps:
i) NPo = Br. 20 – Br. 1 = Br. 19
ii) Ks = D1/Npo + g = (Br. 1.50(1.06)/Br. 19) + 0.06 = 14.37%
Therefore, the firm should be able to earn a minimum return of 14.37% on investments that are financed by
the new common stock issue.

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3.2 The cost of Retained Earnings

3.2 The cost of Retained Earnings

 Retained earnings represent profits available for common stockholders that the corporation chooses to
reinvest in itself rather than payout as dividends.
 Retained earnings are not securities like stocks and bonds and hence do not have market price that can
be used to compute costs of capital.
 The cost of retained earnings is the rate of return a corporation’s common stockholders expect the
corporation to earn on their reinvested earnings, at least equal to the rate earned on the outstanding
common stock.
 Therefore, the specific cost of capital of retained earnings is equated with the specific cost of common
stock. However, flotation costs are not involved in the case of retained earnings.

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3.2 The cost of Retained Earnings

 Computing the cost of retained earnings involves just a single procedure of applying the following
formula:

Where:
Kr = The cost of retained earnings
D1 = The expected dividends payment at the end of next year
Po = The current market price of the firm’s common stock
g = The expected annual dividend growth rate

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3.2 The cost of Retained Earnings

Illustration 3.4: Zeila Auto Spare Parts Manufacturing company expects to pay a common stock
dividend of Br. 2.50 per share during the next year. The firm’s current common stock price is Br.
50 per share and the expected dividend growth rate is 7%. A flotation cost of Br. 3 is involved to
sale a share of common stock.
Required: Compute the cost of retained earnings
Solution Given: Po = Br. 50; D1 = Br. 2.50; g = 7%; Kr =?
Then apply the formula:
Kr = D1+ g = Br. 2.50 + 7% = 12%
Po Br. 50
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3.3 Simple average cost of capital

Simple average method is the simple arithmetic mean of the specific costs of capital,
Illustration 3.5: From the following information supplied to you calculate the overall cost of
capital of the firm. Cost of equity is given as 15%; cost of preference is 8%; and cost of debt is 7%.
Sol: Calculation of simple average cost of capital:
Ko = (Ke + Kp + Kd)/3 Where: Ke = 15%, Kp = 8%, Kd = 7%
Ko = (15% + 8 % + 7 %)/3
Ko = (30%)/3
Ko = 10%

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3.4. The weighted Average cost of capital

 A value-maximizing firm will determine its optimal capital structure (defined as that mix of
debt, preferred, and common equity that causes its stock price to be maximized), use it as a
target, and then raise new capital to keep the actual capital structure on target over time.
 The target proportions of debt, preferred stock, and common equity, along with the costs of
those components, are used to calculate the firm’s weighted average cost of capital, WACC.
Illustration 3.6: Computation of cost of capital using weighted average cost of capital with the
following weights Ke: Kp: Kd in 2 : 1 : 2 proportions and specific cost of capital for Ke : Kp : Kd
15%, 8% and 7% respectively.
Solution: Weighted average cost of capital (WACC) is calculated as follows:
Ko = (We Ke + Wp Kp + Wd Kd)/(We + Wp + Wd)
Ko = (2 X 15% + 1 X 8% + 2 X 7%)/(2 + 1 + 2) = (30% + 8% + 14%)/ (5) = (52%)/ (5) = 10.4% 12/23/2022
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3.4. The weighted Average cost of capital

To illustrate, suppose a company has a target capital structure calling for 45% debt, 2 percent
preferred stock, and 53% common equity (retained earnings plus common stock). Its after-tax cost
of debt = kd(1 - T) = 10%(0.6) = 6%; its cost of preferred stock, kp, is 10.3%; its cost of common
equity, ks, is 13.4 %; and all of its new equity will come from retained earnings.
Solution: Weighted average cost of capital (WACC) is calculated as follows:
Ko = (We Ke + Wp Kp + Wd Kd)/(We + Wp + Wd)
Ko = WACC = 0.45(6%) + 0.02(10.3%) + 0.53(13.4%)/1 = 10%
Every dollar of new capital that a company obtains consists of 45 cents of debt with an after-tax
cost of 6%, 2 cents of preferred stock with a cost of 10.3%, and 53 cents of common equity (all
from additions to retained earnings) with a cost of 13.4%. The average cost of each whole dollar,
WACC, is 10%. 12/23/2022
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3.4. The weighted Average cost of capital

Illustration 3.7: From the following Statement given to you calculate the cost of capital using (i)
SACC; (ii) WACC using the Book values; and (iii) WACC using market values.

Particulars Book Values in Br. Market values in Br. Specific costs

Common Share Capital Br. 200,000

Br. 500,000 Ke = 13.5%
Retained Earnings 250,000
Preference Share capital 150,000 150,000 Kp = 7.9%
Bonds 150,000 100,000 Kd = 5.8%

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3.4. The weighted Average cost of capital

Solution (i): Calculation of simple average cost of capital:

Ko = (Ke + Kp + Kd)/3 Ko = (13.5% + 7.9% + 5.8%)/3 = Ko = (27.2%)/3 = 9.33 %
(ii) Calculation of WACC using Book weights: WACC Ko = 10.84%
Particulars Book values Specific Book Cost X weights
Cost weights
Common Share capital Br. 200,000 13.5 % 0.267 3.6045 %
Retained earnings 250,000 13.5 % 0.333 4.4955 %
Preferred share capital 150,000 7.9 % 0.200 1.5800 %
Bond capital 150,000 5.8 % 0.200 1.1600 %
Total: Br. 750,000   1.000 10.8400 %
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3.4. The weighted Average cost of capital

(iii) Calculation of Weighted cost of capital using market weights:

Particulars Market values Specific Market Cost X weights

in Br Cost weights
Common Share capital Br. 500,000 13.5 % 0.667 9.00 %
Preferred share capital 150,000 7.9 % 0.200 1.58 %
Bond capital 100,000 5.8 % 0.133 0.77 %
Total: Br. 750,000   1.000 11.35 %

Ko = 11.35%

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3.5. The Retained Earning Breakpoint

 As a firm tries to have more new capital, the cost of each birr will rise at some
point. Thus, the marginal cost of capital (MCC) is the cost of obtaining
additional new capital.
 As a firm raises larger and larger amounts of capital, the weighted average cost of
capital also rises. But the question would be at what point the firm’s costs of debt,
preferred stock, and common equity as well as WACC increase?
 Therefore, the first point in computing the MCC is to determine the breaking
points where the cost of capital will increase.
 The retained earnings breakpoint represents the total amount of financing that
can be raised before the firm is forced to sell new common stock.

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3.5. The Retained Earning Breakpoint

Illustration 3.8: The target capital structure of Sheko Corporation and other pertinent data are given below.
Long-term debt ------------------ 40% Cost of preferred stock (Kps) = 12.06%
Preferred stock -------------------10% Cost of retained earnings (Kr) = 14%
Common equity ----------------- 50% Cost of common stock (Ks) = 15%
 Sheko Corporation has Br. 900,000 available retained earnings.
 But when the firm fully utilizes its retained earnings, it must use the more expensive new common stock
financing to meet its equity needs.
 In addition, the firm expects that it can borrow up to Br. 1,200,000 of debt at 7.3% after-tax cost.
Additional debt will have an after-tax cost of 9.1%.

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3.5. The Retained Earning Breakpoint

Required:
 What is the breaking point associated with the
 Exhausting of retained earnings?
 Increment of debt between Br. 0 to Br. 1,200,000?
 Determine the ranges of total new financing where the WACC will rise
 Calculate the WACC for each range of finance.

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3.5. The Retained Earning Breakpoint

Solutions 1:
a. Breaking point (BP) common equity = Br. 900,000/50% = Br. 1,800,000
b. Breaking point (BP) long-term debt = Br. 1,200,000/40% = Br. 3,000,000
The breaking points computed above can be interpreted as:
 Sheko can meet its equity needs using retained earnings until its total finance need is Br. 1,800,000.
 But when total capital required is more than Br. 1,800,000, its equity needs should be met with common
stock.
 Similarly, until the firm’s total finance need reaches Br. 3,000,000, Sheko can raise any debt at 7.3%
cost.
 Any further finance need beyond Br. 3,000,000 will cause the cost of debt to rise to 9.1%.
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3.5. The Retained Earning Breakpoint

Solutions 2:
There are three ranges of finance that could be identified on the basis of the breaking
points:
1st Range: Br. 0 to Br. 1,800,000,
2nd Range: Br. 1,800,000 to Br. 3,000,000, and
3rd Range: Br. 3,000,000 and above

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3.5. The Retained Earning Breakpoint

Solutions 2:
WACC (1st range) = 0.40 (7.3%) + 0.10 (12.06%) + 0.50 (14%)
= 2.92% + 1.21% + 7.00%
= 11.13%
WACC (2nd range) = 0.40 (7.3%) + 0.10 (12.06%) + 0.50 (15%)
= 2.92% + 1.21% + 7.50%
= 11.63%
WACC (3rd range) = 0.40 (9.1%) + 0.10 (12.06%) + 0.50 (15%)
= 3.64% + 1.21% + 7.50%
= 12.35% 12/23/2022
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THANK YOU!!!
12/23/2022