Cost of Capital Raising funds to pay for capital projects

Cost of Capital k 0, the required rate of return in NPV/IRR the hurdle rate for the acceptance of a project the rate of return that will leave the market price of the stock unchanged

Explicit Costs of Specific Sources Debt Preferred Stock Common Equity –Retained Earnings (Internal) –New Common Stock (External)

Explicit Cost of a Source that discount rate which equates the present value of the funds received by the firm, net of underwriting and other flotation costs, with the present value of the expected outflows very similar to IRR and yield to maturity

Cost of New Debt Solve the equation for k Adjust for the tax-deductibility of interest k i = k (1-t) I 0 = 980, C=40/period, n=40 periods 980 = 40(pvif a -k-40)+1000/(1+k) 40 k=4.1%/period or 8.2%/year k i =.082 (1-.40) = 5.02%/year

Cost of Preferred Stock Perpetual (n   ) Pays a constant dividend (D 1 = D 2 =…= D n ) I 0 = D / k P or k P = D / I 0 I 0 =98.50, P 0 =110, Par=100, D=7.5% k P =.075x100 / = 7.61%

Cost of Common Equity

Normal Growth Model If k e >= g and g  then P 0 = D 1 /(k e - g) k e =D 1 /P 0 + g = dividend yield + growth rate D 1 =2.00, P 0 =$40 and g = 4% k e = 2/ =.09

Cost of Retained Earnings Cost of retained earnings is NOT zero They are not “free” Opportunity cost –what shareholders could make investing their dividends elsewhere in another like company –these other companies earn a return of k e Cost of retained earnings is k e

Cost of New Common Stock To sell new shares to the public –Underpricing of the new shares –Flotation costs paid to investment bankers Net proceeds less than current price I 0 < P 0 but dividend stream paid to shareholders is the same k n > k e

Cost of New Common Stock

Capital Budget of $100 million

Capital Budget of $150 million