Calculating Cost of Capital

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.

[pic 1]

• Bond: R d = YTM.

[pic 2]

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):

[pic 3]

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)

[pic 4]

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.

1. Capital Asset Pricing Model (CAPM)

[pic 5]

[pic 6]

[pic 7]

Where:

        R f is risk-free rate.

        E(R m) is expected return on market.

        β is beta of company.

Estimating beta:

[pic 8]

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:

[pic 9]

Capital Structure: