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Cost of Capital

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Cost of Capital

Calculating Cost of Capital: * Component Costs * Capital Structure

Component Costs: * Cost of debt – R d * Cost of preferred stock – R p * Cost of equity – R e

Component Cost of Debt (R d) * Loan: R d = Effective Annual Rate of Loan.
EAR=1+APRmm-1

* Bond: R d = YTM.
P0=c×1Rd-1Rd(1+Rd)t+FV(1+Rd)t

Where:
“c” is dollar coupon;
“FV” is Face or par value, which is $1,000;
“t” is remaining years to maturity.
“P 0” is current market price of bond.

Note: If the bond pays semi-annual coupon, divide “C” by 2; multiply “t” by 2; and multiply answer (R d) by 2. * Cost of Preferred Stock (R p):

Rp=DIVPSP0
Where:
DIV is $ preferred stock dividend; or dividend yield x PAR.
P 0 is current market price of preferred stock.

Note: Par value of preferred stock is $100.

* Cost of Equity (Re)

1. Discounted Cash Flow Model (DCF model)
Re=D1P0+g
Where:
D 1 is next period expected dollar dividend of common stock. Or, D1=D0 x (1 + g).
“g” is constant dividend growth rate of common stock.
P0 is current market price of common stock.

2. Capital Asset Pricing Model (CAPM)

Re=Rf+E(Rm)-Rf×β
Market Risk Premium
Market Risk Premium

Where: R f is risk-free rate. E(R m) is expected return on market.  is beta of company.

Estimating beta:
Rstock=c+β×Rmarket+e

Capital Structure: * Debt * Long-term debt * Interest-bearing short-term debt used to finance long-term assets. * Preferred Stock * Equity: * Common stock * Retained Earnings

Step 1: D + PS +E = V or value of firm
Step 2: D/V; PS/V; and E/V as representation of capital structure.

Cost of Capital:

WACC=DV×Rd×1-T+PSV×Rp+EV×Re

Capital Structure: * Book Value Capital Structure * Market Value Capital Structure

Market Value Capital Structure

* Market Value of...

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