CHAPTER FOUR: PART ONE

BOND AND STOCK VALUATION AND THE COST OF CAPITAL

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.
4.1. 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. Therefore, here the historical cost cannot be used as the value of the asset. Rather, the value of
the asset is determined by valuation. 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. It must be noted that all classes of investors
are interested in knowing the values of securities i.e. common stock, preference stock and bonds.
4.1.1. 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.
 As a form of debt, a contract between the borrower and the lender is executed, frequently
called an indenture. Although the terms of the contract generally are extensive, incorporating
detailed protective procedures for the creditor, only three items directly affect the cash flows
from owning a bond:
i. The bonds par value,
ii. Maturity date, and
iii. 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 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. This amount defined as the par value or face value,
cannot be altered after the bond has been issued.
 For most bonds the par value is set at birr 1000. Hence, the issuing company contractually
agrees to pay the investor this amount when the debt matures. The par value is essentially
independent of the intrinsic value of the bond.
Thus, although the price of the bond fluctuates in response to the changing economic and market
conditions, the par values 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).

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  This annual amount is stated either in term of birr, such as Br. 90, or as a percent of par value.
In either instance, the interest to be paid is inflexible. When the contractual agreement specifies
the interest as a percent of par value, this percentage is known as the coupon interest rate or
the contractual interest rate.
The bond’s periodic coupon (interest) equals the coupon interest rate times the par value.
Furthermore, 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. The length of time the bond
will be outstanding is referred to as its maturity period or term of the bond.

Market value: - is the bonds current price. It is the price at which bonds are trading in the market place.
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.
Eg. Suppose you were offered a 14-year, 10 percent 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? Answer = 5%, this rate is called the bond’s yield to maturity (YTM), and it is the interest rate
generally discussed by investors when they talk about rates of return.

4.1.1.1 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.
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 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−
(1+k d )n
= kd
(PVIFkd,n) = The present value interest factor at interest rate of kd per period for n periods
1
n
= (1+k d )
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Notice that we have used k d 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.
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,
1. Economic conditions have changed, causing a shift in the basic cost of long term funds or
2. The firms risk has changed
Increase in the basic cost of long term funds or risk will raise the required return whereas decreases
in the basic cost or risk will lower the required rate of return.
 Regardless of the exact cause, when the required rate of return on a bond is greater than its
coupon interest rate, the value of the bond will be less than its par value. In this case, the bond
is going to be sold at discount. The discount is equal to the difference between the intrinsic
value and the par value of the bond, M-Bo.
 On the other hand, when the required rate of return falls below the coupon interest rate, the
bond value will be greater than its par value. In this situation, the bond is going to be sold at
premium, which equals Bo-M.
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%)*ADF 12%, 10] + [(Br 1000*DF 12%, 10)
= (100*5.650) + (1000*0.322)
= Br 887
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%)*ADF 8%, 10] + [(Br 1000*DF 8 %, 10)
= (100*6.710) + (1000*0.463)
= Br 1,134
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%?

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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(PVIFA4%, 24) + Br. 1,000(PVIF4%, 24)
= Br. 40 (15.2470) + Br. 1,000 (0.3901)
= Br. 1,000
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. What
was the price of the bond on December 31, 1989, assuming that the level of interest rate had fallen to
8%?
4.1.1.2 Yield to maturity
So far, we have been seeing how to determine the value of a bond if we are given the par value, the
coupon interest rate, the number of periods, and the interest rate on the bond. Next, we shall discuss
on how to find the interest rate on a bond, i.e., k d if we are given the value of the bond. We will
consider yield to maturity.
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
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 =?
Br .1 , 000−1 , 090
Br . 100+
15
Br .1 , 000+Br . 1 ,090
Approximate YTM = 2 = 8.99% ≈ 9%
If an investor buys Zebra’s bond at Br. 1,090 and holds it for 15 years, the approximate yield or rate of
return per year is 9%.
Yield to call (YTC)
It 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. YTC, therefore, is computed only for callable bonds. A bond is called
by an issuer when the market interest rate falls below the coupon interest rate. For example, if X Co.

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10 percent coupon bonds are callable, and if interest rates fell from 10 to 5%, then X company could
call in the 10% bonds, replace them with 5% bonds, and save $100 - $50 = $50 interest per bond per
year. This would be beneficial to the company, but not to its bondholders.
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. YTM = 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 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.
YTM = I + (M - Bo)/n
(M + Bo)/2
Required: Determine the yield to call in 1999 for Y company bond.
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 =?
Br .1 , 080−Br .1 , 175
Br . 100+
3
=6 . 06 %
Br . 1, 080+Br . 1 ,175
Approximate YTC = 2
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%.
4.1.2. Valuation of stocks
In this section we will discuss the valuation of preferred stock and common stock as follows:
4.1.2.1 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, with a level of cash flow stream
continuing indefinitely, is exactly like finding present value of a perpetual annuity.
Vp = Annual dividend =D
Required rate of return Kp
Example: 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 = Br 50
0.07
Example 2

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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 =?
Br. 6.40
Vps = 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%.
Rate of Return on a Preferred Stock
To evaluate the worthiness of investment in a preferred stock in comparison to other investment
opportunities, we should be able to compute the rate of return on a preferred stock. If we know the
current price of a preferred stock and its dividend, we can compute the expected rate of return on the
preferred stock. This can be done using the following formula:
Dps
Kps = 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 =?
Br .9
Kps = 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%.
4.1.2.2 Valuation of common stock
The third and last security we will learn to value is common stock. Like both bonds and preferred
stocks, a common stock’s value is equal to the present value of all future cash flows expected to be
received by the stockholder. However, 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.
 For common stock, the dividend is based on the profitability of the firm and management
decision to pay dividends or to retain the profits for reinvestment purpose.
As a consequence, dividend streams tend to increase with the growth in corporate earnings.
 Thus, the growth of future dividends is a prime distinguishing feature of common stock.
 This does not mean that dividends will always increase in the future.
 Weather dividends remains constant or grow depends on the nature and condition of the
firm.

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The value of a share of common stock is the present value of the common stock’s dividend expected
over an infinite time horizon.
 The value of a share of common stock is also equal to the sum of the present value of the
expected dividends and the present value of the expected selling price of the stock.
 The selling price in turn will depend on the dividends to be received by the purchasing party.
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.
D1 D2 D∞
+ +⋯+
1
Po = ( 1+ ks ) ( 1+ ks )
2 ( 1+ks )∞
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.
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.
Hence, common stock valuation approaches are developed under each of the above dividend growth
models. Next sections will discuss each model one by one.
A. 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. This is the simplest model to common stock valuation. It assumes a
constant, non-growing annual dividend. So, here the annual dividends are all equal. That is D 1 = D2 =
… = D = D.
A common stock with zero growth rate is a security that is expected to provide a fixed dividend each
year. Hence, a zero-growth common stock is a perpetuity. Therefore, the value of a zero-growth stock
is given as:
D
Po = Ks
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 =?

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 Br.3.60
Po = 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.

B. 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 constant (normal) growth
common stock valuation model is the most widely cited approach to common stock valuation.
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:
D1
Po = Ks−g ; Ks > g
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.
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
Po = Ks−g ; D1 = Do (1+g0) = Br. 5.40 (1.05) = Br. 5.67
Br . 5.67
= 12 %−5 % = 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.
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.
D1
+g
Ks = P0 Where:
Ks = The expected rate of return on a constant growth stock
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?

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 Br. 5. 40 (1.05 )
Ks = Br .81 + 0.05
= 12%

C. Variable Growth Stock

Variable growth stock is a stock whose dividends are expected to grow at variable or non-constant
rates. The model of common stock valuation that allows for a change in the dividend growth rate is
called Variable (non-constant) Growth Model. It sometimes is also called supernormal growth model.

The value of a share of variable growth stock is determined by 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.

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; k5 = 12%; p0 =?
g1 = 15% g2 = 5%

Year 0 1 2 3 
D0 = Br. 1.75 D1 = Br. 2.01 D2 = Br. 2.31 D3 = Br. 2.66
PV of D1 = Br. 1.79 PVIF 12%, 1
PV of D2 = 1.84 PVIF 12%, 2
PV of D3 = 1.89 PVIF 12%, 3
PV of P3 = 28.40 PVIF 12%, 3 P3 = Br. 39.90
P0 = Br. 33.92
D1 = D0 (1 + g1) = Br. 1.75 (1.15) = Br. 2.01
D2 = D1 (1 + g1) = Br. 2.01 (1.15) = Br. 2.31
D3 = D2 (1 + g1) = Br. 2.31 (1.15) = Br. 2.66
D4 D3 (1+ g2 ) Br .2 . 66 (1 . 05)
= = = Br . 39. 90
P = k 5 − g2
3
k 5 − g2 0 .12 − 0 . 05
Therefore, the value of Addis Company’s common stock today is Br. 33.92

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Page 10 of 23
 CHAPTER FOUR: PART TWO
The Cost of Capital
3.0. Introduction
It is well understood; two parties are involved in a financial asset under normal circumstances. One is
the party issuing the financial asset, another is the one that buys or invests on the financial asset. Between
these two parties there is one thing, which is required rate of return. The rate of return required by
the investor should definitely be provide by some other party. The party which should provide the
investor its required rate of return is the issuing party. For example, if the required rate of return by
an investor on a given bond is 10%, the issuing company should provide this 10% to the investor.
This required rate of return that should be met by the issuing company becomes its cost. This is a cost
on the capital the issuing company wants to raise.

3.1. The Concept of Cost of Capital

Business requires funds for its investment decisions, and every investment requires a return to be
payable. The term cost of capital refers to the return a firm intends to pay to its members who contribute
the capital to the firm. The rate of return a firm pays to the investors so as to retain the market value of
the shareholding capacity of the investors which in-turn protects the liquidity option of the investor.
If a firm pays the expected return to the investors of the firm then the firm, will retain its
marketability of the share value in the secondary markets, and if it is unable to pay, then it loses its
market value.
A firm’s cost of capital is defined, as “the rate of return the firm requires earning for the investment in order
to increase the value of the firm in the market place”. From the above definition, it is to be noted that,
(i) It is simply a real rate of return that is required on the projects investment.
(ii) It is merely the minimum rate of return that will result in minimizing cost of equity and
increasing the value of the equity share.
(iii) Cost of capital comprises three components, and they are
(1)
(1 Return at zero level risk – also referred as risk-free return;
(2) Premium of the business risk – referred as the variability in operating profits with change in
sales; and
(3) Premium in financial risk – referred to the variability caused by patterns of capital structure.
Empirically the above concepts are expressed as follows:
K = Rf + Rb + Rfr
Where: K = Cost of capital
Rf = risk free rate of return
Rb = business risk
Rfr = financial risk

3.1.1. Significance of Cost of Capital

 Cost of capital is useful for the firm in evaluating the capital budgeting decisions and capital
structure decisions.
o A capital budgeting decision is considered with the discounting factor that is used to
evaluate the appraisal of a project.

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 o Cost of capital is the required rate of return usually used in evaluation of the capital project
appraisal as discounting factor.
 Cost of capital plays important role in capital structure decisions.
o It is used in raising capital required, so as to keep the cost of funds at optimum level.
o It is always required for the firm to determine the market value of the firm and keep the
liquidity option of the share or bond value in the market high.
 Hence it is always essential for a firm to ascertain the higher cost of capital to keep the market
value. It is explained through the following diagram:

Increasing cost

Cost of capital

Constant cost

Diminishing cost
Market value of the Common share

3.2. 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).
The overall cost of the capital is determined by taking into account the average value of the specific
cost of capital. The average cost of capital is identified as the simple average and the weighted
average method.
Calculation of simple average cost of capital:
Ke+ Kp+ Kd
 Ko=
3
Weighted average cost of capital (WACC) is calculated as follows:
We Ke+℘ Kp+Wd Kd
 Ko=
We+℘ +Wd
Where; -
Ke = Cost of equity
Kp = Cost of preferred stock/equity
Kd= Cost of debt
We=Weight of equity, Wp= weight of preferred equity, Wd= weight of debt
3.2.1. Computation of Specific Costs of Capital
The cost of capital for any particular capital source or security issue is called the specific cost of
capital. It is also called individual cost of capital or component cost of capital.
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Each type of capital contained the capital structure of a firm include:
1. Debt
2. Preferred stock
3. Common stock
4. Retained earnings
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.
3.2.1.1. Cost of Debt
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. There are two basic explanations for this.
 First, debt suppliers, generally, assume the lowest risk among all suppliers of capital. They
receive interest payments before preferred and common dividends are paid. Since they assume the
smallest risk, their return is the lowest. Their lowest return would be the lowest cost of capital
to the firm.
 Second, raising capital through debt sources entails interest expense. The interest expense in turn
reduces the firm’s income which ultimately would cause tax payment to be reduced. So,
raising money in the form of debt results in the smallest tax burden, and finally, the firm’s cost
of debt would be the lowest.
Debt sources of finance may take several forms like bonds, promissory notes, bank loans. Here, for
our convenience we consider bond issue to illustrate the 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):
{∫ (1−t)}
Kd=
P0
Where Int = Interest on the debt capital
t = corporate tax rate applicable to the firm
Po = Issue price of the debt capital
Kd = cost of the debt
 Cost of Redeemable Debt (Kd):

Kd=
∫ (1−t )+[( RV −SV ) /n]
[RV + SV ]/2
Where: Kd = Cost of debt
Int = Interest paid/payable on the debt
RV = Redeemable value of the debt
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 SV = Sales proceeds of the debt, which is debt security’s sales price minus Flotation cost.
n = Maturity period in years.
t = corporate tax rate applicable to the firm.
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?
Where Kd = cost of debt
Int = 9 % of Br.1000 = Br. 90
Po = Br. 1000
T = 40 %
{Br . 90(1−.4)}
Kd=
Br .1000
Kd = Br.54/Br.1000
Kd = 0.054 or 5.4 %

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 = ------------------------
[RV + SV]/2

Where Kd= Cost of debt

Int= 9 % on Br. 1,000
RV = Br. 1000 + 15 % on Br. 1,000 = Br.1000 + Br. 150 = Br. 1,150
SV = Br. 1000
n = 5 years, T = 40 %
Br. 90 (1 – 0.4) + [(Br. 1,150-Br. 1,000)/5 years]
Kd= ---------------------------------------------------------
[Br. 1,150 + Br. 1,000]/2

Br. 54 + [(Br.150)/5 years]

Kd = ----------------------------
[Br. 2,150]/2
Br. 54+ Br.30
Kd = ----------------
Br.1,075

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 Br. 84
Kd = --------------- = 0.0781 or 7.81 %
Br.1,075

(b). With 10 % discount

Int (1-t) + [(RV-SV)/n]
Kd = -------------------------------
[RV + SV]/2

Where Kd= Cost of debt

Int= 9 % on Br. 1,000
RV = Br. 1000 - 10 % on Br. 1,000 = Br.1000 - Br. 100 = Br. 900
SV = Br. 1000
n = 5 years
T = 40 %
Br. 90 (1 – 0.04) + [(Br. 900-Br. 1,000)/5 years]
Kd = ---------------------------------------------------------
[Br. 900 + Br. 1,000]/2

Br. 54 + [(-Br.100)/5 years]

Kd = -----------------------
[Br. 1,900]/2

Br .54−Br .20 Br .34

Kd=
Br .950
= Kd=
Br .950
= 0.0358 or 3.58%
3.58%
3.2.1.2. 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. It is also the minimum rate of return a
firm’s preferred stock investors require if they are to purchase the firm’s preferred stock.
When a firm raises capital by issuing new preferred stock, it is expected to pay a fixed amount of
dividends to the preferred stockholders. So, it is the dividend payment that is the cost of the
preferred stock to the firm stated as an annual rate.
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.
firm.
(ii) Redeemable preference shares. They are being issued with a condition to repay after certain period,
say after 10 years or 15 years.
Both types differ with each other in only one way, i.e., in repayment of the capital. capital. Preference
shareholders are entitled for the payment of dividends every year, which will be the cost for the
firm, identified as the cost of preference.
(i) Cost of Irredeemable preference shares (Kp):
Kp = Pd/Po
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 Where Kp = cost of preference share
Pd = Preferential dividend for the year
Po = Issue price of the preference share
(ii) Cost of Redeemable preference shares (Kp):
P d +[(RV −SV )/n]
K p=
[(RV + SV )/2]
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.
It is essential to know at this point that, when a firm issues cumulative preference shares, then the
value of the cost of preference share should be changed with the cumulative value of the preferential
dividend i.e., current year dividend with default dividend from the past years.
Illustration 3.2:
Find the cost of the preference from the following information given to you: P d = 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?
Sol:
 When it is irredeemable.
Kp = Pd/Po
Where Kp = cost of preference share
Pd = Br. 7
Po = Br. 100
Kp = Br. 7/Br. 100 Kp = 0.07 or 7%
 When the preference share is redeemable, then Kp will be:
(i) With 10 % premium
Pd + [(RV-SV)/n]
Kp = ------------------------
[RV + SV]/2
Where Kp = Cost of preference share
Pd = Br. 7
RV = Br. 100 + 10 % on Br. 100 = Br.100 + Br. 10 = Br. 110
SV = Br. 100
n = 5 years
Br. 7+ [(Br. 110-Br. 100)/5 years]
Kp = -----------------------------------
[Br. 110 + Br. 100]/2

Br. 7+ [(Br.10)/5 years]

Kp =----------------------------
[Br. 210]/2
Br. 7+ Br.2
Page 16 of 23
Kp = ----------------
Br.105

Br. 9
Kp = --------------- = 0.0857 or 8.57%
Br.105

(ii) With 5 % discount

Pd + [(RV-SV)/n]
Kp = ------------------------
[RV + SV]/2

Where Kp = Cost of preference share

Pd = Br. 7
RV = Br. 100 - 5 % on Br. 100 = Br.100 - Br. 5 = Br. 95
SV = Br. 100
n = 5 years
Br. 7+ [(Br. 95-Br. 100)/5 years]
Kp = -----------------------------------
[Br. 95 + Br. 100]/2

Br. 7+ [(-Br.5)/5 years]

Kp =----------------------------
[Br. 195]/2

Br. 7- Br.1
Kp = ----------------
Br.97.50
Br .6
K p=
Br .97 .5
= 0.0615 or 6.15 %
3.2.1.3. Cost of Equity
Under this specific cost of capital, we will see cost of new equity/cost of common stock and cost of
retained earnings.
3.2.1.3.1. The cost of common stock
The cost of common stock is the minimum rate of return that a firm must earn for its common
stockholders in order to maintain the value of the firm. A firm does not make explicit commitment to
pay dividends to common stockholders. However, when common stockholders invest their money in
a corporation, they expect returns in the form of dividends. Therefore, common stocks implicitly
involve a return in terms of the dividends expected by investors and hence, they carry cost.
Generally, common stock dividends are paid after interest and preferred dividends are paid. As a
result, common stock investors assume the maximum risk in corporate investment. They compensate
the maximum risk by requiring the highest return. This highest return expected by common
stockholders make common stock the most expensive source of capital.

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The cost of common stock can be computed using the constant growth valuation model.
D
K s = 1 +g
NP 0
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
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 + g = Br. 1.50 (1.06) + 0.06 = 14.37%
Npo Br. 19
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.
 Generally, the cost of new common stock equity can be computed in the following ways:
1. Dividend price (D/P) approach.
2. Dividend price plus growth (D/P + g) approach.
3. Earning price (E/P) approach.
4. Realized yield approach.
1. Dividend Price Approach
The value of the common share may be interpreted by the shareholder as the present value of the
expected stream of future dividends. Although in the short-run stockholders may be influenced by a
change in earnings or other variables, the ultimate value of any holdings rests with the distribution of
earnings in the form of dividend payments. Though the stockholders may benefit from the retention
and reinvestment of earnings by the corporation, at some point the earnings must be translated into
cash flows for the stockholders. A stock valuation model based on future expected dividends, which
is termed as dividend valuation model, can be ascertained as follows:
D1 D2 Dœ
Po = + +
(1+ Ke) 1 ( 1+ Ke)2 ( 1+ Ke)œ
Where Po = Price of the Equity/Common share
D = Dividend for each year

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 Ke = Cost of equity or required rate of return or discounting rate
2. Dividend Price Plus Growth Approach
A firm that increases dividends at a constant rate is more likely circumstances. As per this model the
growth is expressed in dividends for valuation is always assumed to be constant. Market price of the
common share is ascertained as follows:
D
Ke= 1 + g
P0
Where P0 = Price of common shares
D1 = Dividend for year
g = growth rate
Ke = required rate of return.
Market value of the common share can be ascertained by transposing the above equation. This can be
done as follows:
D1
P0=
Ke−g
3. Earnings Price Approach
According to this method market price per share is determined by capitalizing the future dividends
per share, derived from the earnings per share. The cost of capital according to this method remains
constant as the earnings percentage keeps to the share price constant. Cost of equity is estimated
using this method as follows:
E
Ke = NP
Where E = Earnings per share
NP= Net proceeds per share.
4. Realized Yield Approach
According to this approach the cost of equity capital is determined on the basis of return actually
realized by the investor in a given firm on their investment. Cost of equity is computed based on the
past records of the given firm according to this approach.
3.2.1.3.2. 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.
Computing the cost of retained earnings involves just a single procedure of applying the following
formula:
D1
Kr= + g
P0
Where:
Kr = The cost of retained earnings

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 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.
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 12 months. 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
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 %
3.2. The weighted Average cost of capital/ The Marginal Cost of capital (MCC)
It is known that each firm has an optimal capital structure, defined as that mix of debt, preferred, and
common equity that causes its stock price to be maximized. Therefore, a value-maximizing firm will
determine its optimal capital structure, use it as a target, and then raise new capital in a manner
designed to keep the actual capital structure on target over time. In this chapter, we assume that the
firm has identified its optimal capital structure, that it uses this optimum as the target, and that it
finances so as to remain on target.
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. 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.
Each dollar the firm raises will consist of some long-term debt, some preferred stock, and some
common equity, and the cost of the whole dollar will be 10 percent. Therefore, the WACC represents
the marginal cost of capital (MCC), because it indicates the cost of raising an additional dollar.

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Weighted average is the weights multiplied by the specific costs and the whole divided by the total
weights of the capital components.

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.
Sol:
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%

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.
WACC = 0.45(6%) + 0.02(10.3%) + 0.53(13.4%) = 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%.
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%
Sol (i):
Calculation of simple average cost of capital:
Ko = (Ke + Kp + Kd)/3
Where Ke = 13.5%
Kp = 7.9%
Kd = 5.8%
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
Cost weights weights
Common Share capital Br. 200,000 13.5 % 0.267 3.6045 %
Retained earnings 250,000 13.5 % 0.333 4.4955 %

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 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 %
(iii) Calculation of Weighted cost of capital using market weights: Ko = 11.35%
Particulars Book Specific Market Cost X
values Cost weights 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 %
3.3. The Retained Earnings Breakpoint
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?
The first point, therefore, 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.
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%.
Required
1) What is the breaking point associated with the
a. Exhausting of retained earnings?
b. Increment of debt between Br. 0 to Br. 1,200,000?
2) Determine the ranges of total new financing where the WACC will rise
3) Calculate the WACC for each range of finance.
Solutions
1) a. Breaking point (BP) common equity = Br. 900,000 = Br. 1,800,000
50%
b. Breaking point (BP) long-term debt = Br. 1,200,000 = Br. 3,000,000
40%
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 or debt…. 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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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
3) WACC (1st range) = 0.40 (7.3%) + 0.10 (12.06%) + 0.50 (14%)
= 2.92% + 1.21% + 7.00%
= 11.13%
nd
WACC (2 range) = 0.40 (7.3%) + 0.10 (12.06%) + 0.50 (15%)
= 2.92% + 1.21% + 7.50%
= 11.63%
rd
WACC (3 range) = 0.40 (9.1%) + 0.10 (12.06%) + 0.50 (15%)
= 3.64% + 1.21% + 7.50%
= 12.35%

The end!!!

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