CHAPTER THREE

BOND AND STOCK VALUATION AND COST OF CAPITAL

Introduction
The valuation of assets is a critical as well as challenging task. In this chapter, we examine the
concepts and procedures for valuing assets, especially financial assets (securities) such as bonds,
preferred stocks, and common stocks.
Book value: is the value of all assets as shown on the firm’s balance sheet. It represents a historical
value rather than a current worth.
Liquidation Value: - is the amount that could be realized if an asset were sold individually and not as
part of a going concern. For example, if a product line is discontinued, the machinery used in its
production might be sold. The sale price would be its liquidation value and would be determined
independently of firm’s value.
Market Value: - is the observed value for the asset in the market place. This value is determined by
the supply and demand forces working together in the market place, where buyers working together in
the market place, where buyers and sellers negotiate a mutually acceptable price for the asset
The Intrinsic Value: the present value of the assets expected future cash flows. This value is also
called the fair value, as perceived by the investor, given the amount, timing, and risky ness of future
cash flows.
4.1. Valuation an Overview:-
For our purposes the value of an asset is its intrinsic value, which is the present value of its expected
future cash flows, where these cash flows are discounted back to the present value using the investor’s
required rate of return. Thus, value is a function of three elements.
1. The amount and timing of the assets expected cash flows.
2. The risky ness of these cash flows.
3. The investor’s required rate of return for undertaking the investment.
4.2. Valuation: - The Basic Process
The valuation process can be described as assigning value to an asset (bond, preferred stock, and
common stock) by calculating the present value of its expected future cash flows.
Using the investor's required rate of return as the discount rate thus value (V) is computed as follows:-
n
V = CF1 + CF2 + CF3 + CF3 + …. …+ CFn or V= CFt

1 2 3 4 n
(1+k) (1+k) (1+k) (1+K) (1+k) t = 1 (1+K) t
Where:
V = the intrinsic value of an asset producing expected future cash flows, CFt, in years 1 through n.
CFt= Cash flows to be received in year t.
K = the investor’s required rate of return.
4.3. Bond Valuation
Bond: is a long term promissory note that promises to pay the bond holder a predetermined, fixed
amount of interest each year until maturity. At maturity, the principal will be paid to the bond holder.
In the case of a firm’s insolvency, a bond holder has a priority of claim to the firm’s assets before the
preferred and common stock holders..
Terminologies
Par Value: - The par value is the stated face value of the bond at the end of the life of the bond
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Coupon Interest Rate: - The rate which is generally fixed determines the periodic coupon or interest
payments. It is expressed as a percentage of bonds face value. It also represents the interest cost of the
bond to the issuer.
Coupon Payments: - The coupon payments represent the periodic interest payments from the bond
issuer to the bond holder. The annual coupon payments are calculated by multiplying the coupon rate
by the bond’s face value.
Maturity Date: - The maturity date represents the date on which the bond matures, i.e. the date on
which the face value is repaid. The last coupon payment is also paid on the maturity date.
Required Return: the rate of return that investors currently require on a bond
Yield-to-Maturity: the rate of return that an investor could earn if he bought the bond at its current
market price and held it until maturity. Alternatively, it represents the discount rate which equates the
discounted value of bonds future cash flows to its current market price.
Valuation Procedure:
The value of the bond is the present value of both interest to be received and the par or maturity value
of the bond. This may be expressed as:
N
It $M
Vb =  + or Vb = (It x Pv 1FA k b,n ) + (Mx PVl Fkb,n)
(1  Kb )t ( kb) N
t 1
Where
It = the dollar interest to be received in each Kb = the required rate of return for the bond
payment holder
M= the par value of the bond N = the number of periods to maturity
The valuation process for a bond requires knowledge of three essential elements.
1. The amount of the cash flows to be received by the investor
2. The maturity date of the loan
3. The investors required rate of return. The amount of cash flow is dictated by the periodic interest to
be received and the par value to be paid at maturity. Given these elements, we can compute the
intrinsic value of the bond.
Example 1. Consider that Habesha cement, on Jan1, 2010 issued a 10% coupon interest rate, 10 year
bond with Br 1000 par value that pays interest annually. If the investor requires a 10% rate of return
on this bond. What is the value of the bond to such an investor?
Solution: I (interest) = M x Kc
= Br 1000* 10%
= Br 100
n
I M
Vb =  + or I (PVIFA kb,n) + M (PVIF kb,n)
(1  Kb )t (1  kb) N
t 1
10
100 1000
=  +
(1.1)10 (1.1)10
t 1
= (Br 100 * 6.1446) + (Br 1000 X0.38 55)
= Br 1000.

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Example 2: Assume that another investor viewed the bond of Habasha cement to be riskier and thus
requires 12% rate of return on this bond. Find the value.
Solution:
n
I M
Vb =  + or I (PVIFA kb,n ) + M (PVIF kb,n)
(1  Kb )t (1  kb) N
t 1
10
100 1000
=  + = (Br 100 X 5.650) + 1000 (0.322) = Br 887
(1.12)10 (1.12)10
t 1

Example 3:- Further assume that an investor requires 8% return on this bond. Find its value
Solution:
n
I M
Vb =  +
(1  Kb )t (1  kb) N
t 1
10
100 1000
=  + = (100 X 6.710) + (1000 0.463) = Br 1,134
(1.12)10 (1.1)10
t 1
Note: - The bond’s coupon rate is fixed by its nature and the coupon rate and required rate of return
moves in the opposite direction.
Semi-Annual Interest Payments
For bonds that pay interest semiannually, we need to adjust the size of interest payments as the coupon
interest amount is to be paid in two semiannual installments rather than one-time annual payments.
The valuation equation becomes,
N I /2
Kb M
Vb =  (1  )2t + or Vb= ( ( I XPVIFA , ) + ( MxPVIF ,2t )
2 kb 2 Kb / 2 2t kb / 2
t 1 (1  ) 2t
2
Example 4: - Suppose a bond has $ 1000 face value, a 10 percent coupon (paid semiannually), five
years remaining to maturity, and is priced to yield 8 percent. What is its value?
I = MC = $1000 x 10% = 100
N I
M
Vb =  2 + or Vb= 100 / 2 + 1000
Kb kb
t 1 (1 
2
) at (1  )t (1  8% / 2)10 (1  8% / 2)10
2

= $ 405 .54 + $ 675. 60 = $1,081.14

Preferred Stock Valuation
Preferred stock is defined as equity with priority over common stock with respect to the payment of
dividends and the distribution of assets in liquidation. Preferred stock is a hybrid security which shares
features with both common stock and debt. Preferred stock is similar to common stock in that it entitle
its owners to receive dividends which the firm must pay out of after – tax in come. However, like the

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coupon payments on debt, the dividends on preferred stock are generally fixed. Also, the claims of the
preferred stock holders against the assets of the firm are fixed as are the claims of the debt holders.
Preferred Dividend/Preferred Dividend Rate: The preferred dividend rate is expressed as a
percentage of the par value of the preferred stock. The annual preferred dividend is determined by
multiplying the preferred dividend rate times the par value of the preferred stock. Since the preferred
dividends are generally fixed, preferred stock can be valued as a constant growth stock with a dividend
growth rate equal to zero. Thus, the price of a share of preferred stock can be determined using the
following equation.
Dp
Vp = Where
Kp
Vp = the preferred stock price Kp = the required return on the stock
Dp = the preferred dividend and
Example: - Find the price of a share of preferred stock given that the par value is $100 per
share, the preferred dividend rate is 8% and the required return is 10%.
Dp $8
Solution: - Vp = but Dp = Mx Dr = 100x0.8=$8, Vp = = $80
Kp 0 .1
Common Stock Valuation
Like 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 stock holder. However, in contrast to bonds, common stock
does not promise its owners 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 on
managements’ decision to pay dividends or to retain the profits for reinvestment purposes.
One Period Valuation Model
For an investor holding a common stock for only one year, the value of the stock would be the present
value of both the expected cash dividend to be received in one year (D1) and the expected market
price per share of the stock at year end (P1) .If ks represents an investors required rate of return, the
value of common stock (po) would be:
D1 p1
Po = +
1  ks 1  ks
Example: - Assume kuku Company is considering the purchase of stock at the beginning of the year.
The divided at year end is expected to be Br 3 and the market price by the end of the year is expected
to be Br 80. If the investor’s required rate of return is 15 percent. What would be the value of the
stock?
Given:- Required solution
D1 P1 Br 3 Br 80
D1= Br 3 Po=? Po= + = +
1  ks 1  ks (1.15)1 1.15
P1= Br 80 Br 3 (0.870) + Br 80 (0.870)
Ks = 15% Br2. 61 + Br 69.6
Br 72.21

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Interpretation; - The implication of Br 72.21 is that if the investor buys this stock for Br 72.21 today,
receives a Br 3 dividend, and sells the stock for Br 80 one year form now, the investor will earn the
15% rate of return that was required to invest.
Two Period Valuation Models
Now, suppose the investor plans to hold a stock for two years before selling. How is the value of the
stock determined when the investment horizon changes? The answer is to in corporate the additional
years in formation be.
D1 D2 P2
Po= + +
(1  ks)1 (1  ks)2 (1  ks)2
Example 1:-Assume the expected dividend for KUKU Company in the second year be Br 4, the
expected price at the end of the second year be Br100, and the required rate of return remains 15%.
Find the value of the common stock.
Value of the Common Stock
Given Required Solution
D1 = Br 3 Po= ? Po = D1 + D2 + D2
(1  ks) (1  ks)2 (1  ks)2
D2 = Br 4
P2= Br 100
3 4

100
Ks = 15% = + (1  15)2 (1.15)2
(1  15)1

3 (0.870) + 4 (0.7561) + 100 (0.7561) = Br 79.38

4.5.3. Multiple Period Valuation Model
Since common stock has no maturity date and is held for many years, a more general, multi period
model is needed. The general formula for common stock valuation model is defined as follows:

Dt Pn
Po =  +
(1  Ks ) n (1  ks)n
t 1
D1 D2 Dn Pn
Po = + + D3 + …………. + +
(1  Ks )1 (1  ks)2 (1  ks)n (1  ks)n
Example: - Assume that an investor expects Br 3 dividend for each of 10 years and a selling price of
Br 50 at the end of 10 years. What would be the value of the common stock to day?

Given Required Solution

10
Br 3 Br 50
D1, D 2....... D10  Br 3 Po=? Po =  + = 3 (6.15) + Br 50 (0.38)
(1.1)10 (1.1)10
t 1
n  10Years
Br 8.4 5 + Br. 19.30 = Br 37.75
P  Br 50
10

Dividend Discount Model

Many investors do not contemplate selling their stock in the near future but are long term holders.
Since a common stock held with such intention has an infinite life, we need to accommodate the

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potentially endless series of dividends that may be received in the future on the stock. The value of
such stock is:
D1 D2 D3 Dn D
Po = + + + ……….. +
(1  ks) (1  ks)2 (1  ks)3 (1  ks)n (1  ks)
This equation is a more general form of the stock valuation model. It is often referred to as the
dividend discount model because it shows the current price of the stock as determined by the
discounted future expected dividends. It is an extremely important.
To implement the dividend valuation model which requires that we discount the entire future stream of
expected dividends, we must model the expected growth rate of dividends. There are three cases of
growth in dividends. They are
1. Zero growth
2. Constant growth and
3. Non constant or super normal growth
Zero Growth (No Growth)
Suppose dividends are not expected to grow at but to remain constant. Here, we have a zero growth
stock for which the dividends expected in future years are equal to some constant amount that is
D1  D2  D3.......... D  D. Notice the two conditions implied here (1) un changing cash flows (2)
this continues forever .when these conditions occur, the dividend discount model mathematically
reduces to a much simpler form called the constant dividend or no-growth model:
Do
Po =
Ks
Po = the current market price Ks = required rate of return
Do= unchanging dividend
Example: - If dividends for MM Company are expected to be constant at Br 2.50 per share forever
and if the required rate of return on equity is 10 percent. Compute the value of the stock.
Given Piqued Solution
Do
Do = Br 2.50 Po =? Po=
Ks
Br 2.50
Ks = 10% = = Br 25
0 .1
Normal or Constant Growth (Gordon Growth Model)
Many companies have expected dividend streams that can be roughly described as growing at constant
rate for along period of time. Thus, if a normal, or constant, growth company’s last dividend, which
has already been paid was Do , its dividend in any future year t may be forecasted as Dt = Do (1+g)t
,where is the constant expected rate of growth. The value of a stock whose dividend is expected to
increase at constant rate is given as:
Po= Do(1  g ) or, equivalently since D1= Do (1+g), Po= D1 in, general, Dt = Do (1+g) t
Ks  g Ks  g

Where
Do = Current dividend (Dividend just paid by Ks = required rate of return
the firm) g= Expected percent growth in dividends
D1= Expected dividend in one year
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Assumptions in Constant (Gordon Growth) Growth Model
 The expected dividend growth rate, g, is constant from year to year.
 The constant growth is forever (g =  )
 Ks > g.
Example: Consider a common stock that paid a $ 5 dividend per share at the end of the last year and is
expected to pay cash divided every year at a growth rate of 10 percent. Assume the investor’s required rate of
return is 12% .what would be the value of the stock?
Given Required Solution
Do(1  g ) $ 5 .5
Do = $5, g = 10% Ks = 12% Po =? Po= = = $ 275
ks  g 0.02
Non Constant or Supernormal Growth Model
Many firms enjoy periods of rapid growth. These periods may result from the introduction of a new product, a
new technology, or an innovative marketing strategy. However, the period of rapid growth cannot continue
indefinitely. Eventually, competitors will enter the market and catch up with the firm.
These firms cannot be valued properly using the constant growth stock valuation approach. This section
presents a more general approach which allows for the dividends/ growth rates during the period of rapid
growth to the dividends/ growth rates during the period of rapid growth to be forecasted. Then it assumes that
dividends will grow form that point on at a constant rate reflects the long-term growth rate in the economy.
Stock which are experiencing the above pattern of growth rate are called non constant, supernormal, or
erratic growth stocks. The value of a non-constant growth stock can be determined using the following
equation.
T
 DT  1 
 1  ks  T
DT
Po =  + 
(1  ks)t  Ks  gc 
t 1
Where
Po = the stock price at time 0
Dt = Expected dividend at time t.
T = the number of years of non-constant growth
Ks = the required return on the stock, and gc < Ks
Example: - The current dividend on stock is Br 2 per share and investors required rate of return of 12%.
Dividends are expected to grow at rate of 20% per year over the next three years and then a rate of 5% per
year from that point on .Find the price of the stock.
Solution
There are 3 years of non-constant growth, thus, T = 3. Before substituting in to the formula given above, it is
necessary to calculate the expected dividends for year 1 though year 4 using the provided growth rates.
D1  Br 2 (1  20)  Br 2.40
D 2  Br 2.40 (1.20)  Br 1.88
D3  Br 2.88 (1.20)  Br 3.456
D 4  Br3.456 (1.05)  Br 3.6288
Using the formula
Br 2.40 Br 2.88 Br 3.456 Br 3.6288
Po = + + + (1.12)  3 = Br 43.80
(1.12)1 (1.12)2 (1.12)3 (0.12  0.05)
An Overview of Cost of Capital
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In pervious section, we have seen the important concept that the expected return on an investment should be a
function of “market risk” embedded in that investment risk – return tradeoff. The firm must earn a minimum
rate of return to cover the cost of generating funds to finance investments; otherwise, no one will be willing to
buy the firms bonds, preferred stock, and common stock. This point of reference, the firms required rate of
return, is called the cost of capital.
The cost of capital is the required rate of return that a firm must achieve in order to cover the cost of
generating funds in the market place. Based on the evaluations of risky ness of each firm, investor will supply
new funds to a firm only if it pays them the required rate of return to compensate them for taking the risk of
investing in the firms bonds and stocks. If indeed, the cost of capital is the required rate of return that the firm
must pay to generate funds, it becomes a guideline for measuring the profitability’s of different investments.
When there are differences in the degree of risk between the firm and its divisions, a risk – adjusted discount
rate approach should be used to determine their profitability.
What Impacts the Cost of Capital?
1. Risky ness of earnings.
2. The debt to equity mix of the firm.
3. Financial soundness of the firm.
4. Interest rate levels in US/ global market place.
Note: - The cost capital becomes a guideline for measuring the profit abilities of different investments.
Another way to think of the cost of capital is as the opportunity cost of funds, since this represents the
opportunity cost for investing in assets with the same risk as the firm. When investors are shopping for places
in which to invest their funds, they have an opportunity cost. The firm, given its risky ness, must strive to earn
the investors opportunity cost. If the firm does not achieve the return investors expect (i.e. the investors
opportunity cost), investors will not invest in the firms debt and equity. As a result, the firms value (both their
debt & equity) will decline.
Significance of Cost of Capital
Cost of capital is useful as a standard for:-
 Evaluating investment decisions
 Designing a firms debt policy, and
 Appraising the financial performance of top management
Capital Structure
 It is the mixture of long term sources of funds used by affirm.
 The primary objective of capital structure decision is to mix the market value of long term sources of
bonds.
 The mix is called optimal capital structure which minimize the firms overall cost of capital.
Major Types of Cost of Capital (Sources of Capital)
The major sources capital is:-
1. Specific cost of capital.
a Cost of Debt (Kd).
b Cost of Preferred Stock (Kp).
c Cost of Common Stock (Ks).
d Cost of Retrained Earnings (Kr).
2. Weighted Average Cost of Capital (WACC)

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The Specific Cost of Capital: A firm’s capital is supplied by its creditors and owners. Firms raise capital by
borrowing it (issuing bonds to investors or promissory notes to banks) or by issuing preferred or common
stock. The overall cost of a firms capital depends on the return demanded by each of these suppliers is called
the specific cost of capital. In the following section, we estimate the cost of debt capital (kd), the cost of
capital raised though a preferred stock issue (kp), and the cost of equity capital supplied by common stock
holders, (ks) for internal equity and kn for external equity.
The Cost Debt (kd)
When a firm borrows money at a stated rate of interest, determining the cost of debt, kd, is relatively straight
forward. The lenders cost of capital is the required rate of return on either a company’s new bonds or
promissory note. The firm’s cost of debt when it borrows money by issuing bonds is the interest rate
demanded by the bond investor. When borrowing money from an individual or financial institution, the
interest rate on the loan is the firm’s cost of debt. The cost of debt to the borrower: the firms cost of debt is the
investors required rate of return on debt adjusted for tax and flotation costs.
This is because interest on debt is a tax –deductible expenses; it reduces the firm's taxable income by the
amount of deductible interest. The interest deduction, therefore, reduces taxes by an amount equal to the
product of the deductible interest and the firm’s tax rate. Flotation costs which are costs incurred in issuing
debt securities – increases the cost of debt. Thus, the after tax cost of debt, kd, is computed as follows:
Where
T = Corporate tax rate
F= Flotation cost as a percentage of value of debt
Ki = investor required rate of return before tax
If there is no flotation costs, the Kd can be computed using the formula
kd  ki(1  T )
Example 1:- Assume that MULU Co. is to issue long term notes, investors will pay Br, 1000 per note when
they are issued if the annual interest payment by the firm is Br 100.The firm’s tax rates is 45%, and flotation
costs are 2%.calculate the cost of this debt.
Given Required Solution
ki(1  T )
I = Br 100 Kd =? kd= = 4.4%
 8%(1  45)
M = Br 1000
T = 45% Note: - The before tax cost of debt can be found by determining
the internal rate of return (or yield to maturity) on bond cash flows as discussed before. However, the
following short cut formula may be used for a approximating the yield to maturity on a bond.

Where
I= Annual interest payment in dollars Vb= Value or net proceeds form the sale of a
M = Par value usually $ 1000 per bond bond
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N = Term of the bond
Example 2: - A Br 1,000 Par value bond with market price of Br 970 and a coupon interest rate of
10% while flotation costs for the issue would be approximately 5%, the bond matures in 10 years and
the corporate tax is 40%. Compute the cost of the bond.
Given Required Solution
M = Br 1000 Kd = ? Ki = I  ( M  Vb )
n
n = 10 ______________
M  Vb
i = 10%
2
( Br1000  Br 921.5)
I = MxKc = 0.1X Br 1000 = Br 100 Br 100+
10
1000  Br 921.5
Vb = Np = Br 970 – (0.05 X Br 970) Br
2
107.85
= Br 921.50 = Br
Br 960.75
11.23%but Kd  Ki (1  T )
11.23 (1-0.40)
= 0.1123X 0.60 = 6.74%
Cost of Preferred Stock (kp)
The cost of preferred stock (kp) is the rate of return investors require on a company’s new preferred
stock plus the cost of issuing the stock. Therefore, to calculate kp; a firm’s managers must estimate the
rate of return that preferred stock holders would demand and add in the cost of the stock issue.
Because preferred stock investors normally buy preferred stock to obtain the stream of constant
preferred stock dividends associated with the preferred stock issue, their return on investment can
normally be measured by dividing the amount of the firm’s expected preferred stock dividend by the
price of the shares. The cost of issuing the new securities known as flotation cost includes investment
bankers’ fees and commissions, and attorneys' fees. These costs must be deducted form the preferred
stock price paid by investors to obtain the net price received by the firm. The following equation
shows how to estimate the cost of preferred stock.

Or
If flotation cost exists

Where:-
Kp = The cost of the preferred stock issue; the Pp = the current price of the
expected return preferred stock
Dp = The amount of the expected preferred F = the flotation costs per share
stock dividend
Example 1: - Suppose that Midrock Company has preferred stock that pays Br 13 dividend per share
and sells for Br 100 per share in the market. Compute the cost of preferred stock.

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 DP Br 13
Kp = = = 13%
Pp Br 100
Example 2; - Suppose Ellis industries has issued preferred stock that has been paying annual
dividends of $ 2.50 and is expected to continue to do so indefinitely. The current price of Ellis
preferred stock is $ 22 a share and the flotation cost is $ 2 per share. Compute the cost of the preferred
stock.
Given Required Solution
( DP ) $2.50
DP = $ 2.50 Kp =? Kp = =
( Pp  F ) $22  2
Pp = $ 22 a share = 0.125 or 12.5%
F = $ 2 a share

Note: - There is not tax adjustments in the cost of preferred stock calculation unlike interest payments
on debt, firms may not deduct preferred stock dividends on their tax returns. The dividends are paid
out of after tax profits. Moreover, the cost of preferred stock higher than the after tax cost of debt, kd
because a company’s bond holders and bankers have a prior claim on the earnings of the firm and its
assets in the event of liquidation. Preferred stock holders, as the result, take a greater risk than bond
holders or bankers and demand a correspondingly greater rate of return.
The Cost of Common Stock (ks) (Cost of Internal Equity)
The cost of common stock equity, ks is the rate at which investors discount the expected dividends of
the firm to determine its share value. Two techniques for measuring the cost of common stock equity
capital are available. One uses the constant growth valuation model (Gordon growth model); the other
uses the capital asset pricing (CAPM).
I. Using the Constant Growth Valuation Model (the Gordon Growth Model)
Using the Gordon growth model, the cost of common stock, Ks is computed as follows:-
D1
Po 
Ks  g
Where
Po= Value of common stock Ks = Investors required rate of return
D1 = Dividend to be received in 1 year g = rate of growth
Solving the model for ks results in the formula for the cost of common stock
D1 Do(1  g )
Ks  + g or Ks 
Po Po
Example: - Suppose that IBM industries common stock is selling for $ 40 a share. A next year's
common stock dividend is expected to be$4.20 and the dividend is expected to grow at a rate of 5%
per year indefinitely. Compute the expected rate of return on IBM’s common stock.
Given Required Solution
D1 $ 420
Po  $40 Ks =? Ks  +g= g
Po 540
D1 = $4.20 0.105 + 0.5 = 0.155 or 15.5%
g = 5%

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ii. The Capital Asset Pricing Model (CAPM) Approach to Estimating (ks): a firm may pay
dividends that grow at changing rate; it may pay dividends that grow at changing rate; it may pay no
dividends at all for the managers of the firm may believe that market risk is the relevant risk. In such
cases, the firm may choose to use the capital asset pricing model (CAPM) to calculate the rate of
return that investors require for holding company’s common stock according to the degree of non
diversifiable risk present in the stock. The CAPM formula for the cost of common stock is:
Ks = rf = b (rm - rf )

Where:-
Ks = the required rate of return from the rf = Risk free rate
company’s common stock equity rm = Return on the market portfoli
B = Beta coefficient which is an index of
systematic risk
Example:- Suppose BATU industries has a beta of 1.39, the risk free rate as measured by the rate on
short term U.S. Treasury bill is 3% and the expected rate of return on the overall stock market is 12%.
Given those market conditions find the required rate of return for BATU’S common Stock.
Given Required Solution
B= 1.39 Ks = Ks = rf + b (rm-rf)
rf = 3% = 3% + 1.39 (12%-3%)
rm= 12% = 3% + 1.39 (9%)
0.1551 or 15.5%
The Cost of Equity from new Common Stock ( kn): The cost incurred by a company when new
common stock s is sold at the cost of equity from new common stock (Kn) .Capital from existing stock
holders is internal equity capital, i.e. the firm already has these funds. In contrast, capital from issuing
new stock is external equity capital. The firm is trying to raise new funds from outside source. New
stocks sometimes finance a capital budgeting project the cost of this capital includes not only
stockholders’ expected returns on their investment but also flotation costs incurred to issue new
securities.To estimate the cost of using fund supplied by new stockholders, we use a variation of the
dividend growth model that includes flotation costs.

Kn = the cost of new common stock equity F = the flotation cost per share
Po = price of one share of the common stock g = the expected constant growth rate of the
D1 = the amount of the common stock company’s common stock dividends
dividend expected to be paid in one year
Example: Assume again that IBM industries anticipated dividend next year is $4.20 a share, its
growth rate is 5% a year and its existing common stock is selling for $40 a share. New shares of stock
can be Sold to the public for the same price but to do so IBM pay its investment bankers 5% of the
stock’s selling price or $2 per share . Given these condition s compute IBM’s new common equity.
Given Required Solution

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 D1
D1 = $ 4.20 Kn =? Kn  g
( Po  F )
$4.20 $4.20
Po = $ 40   5%  5%  16.05%
$40  $2 $38
F= $ 2 , g= 5%
Cost of Retained Earnings (Kr)
The cost of retained earnings, Kr, is closely related to the cost of existing common stock since the cost
of equity obtained by retained earnings is the same as the rate of return investors require on the firm’s
common stock. There fore
Ks = Kr

The Weighted Average Cost of Capital (WACC)

A firm’s weighted average cost of capital (WACC) is a composite of the individual costs of financing,
weighted by the percentage of financing provided by each source. Therefore, a firm’s WACC is a
function of (1) the individual costs of capital and (2) the makeup of the capital structure – the
percentage of funds provided by long term debt, preferred stock and common stock. Thus, the
computation of the cost of capital requires three things.
1) Compute the cost of capital for each and every source of financing used by the firm.
2) Determine the weight percentage of each financing in the capital structure of the firm.
3) Calculate the firm’s weighted average cost of capital (WACC) using the values in (1) & (2)
Example: Assume that IBM industries finance its assets through a mixture of capital sources, as
shown on its balance sheet.
Total Br 1.000,000
Long and short term debt Br 400,000
Preferred stock Br 100,000
Common equity Br 500,000
Total liability and equity Br 1,000,000
And the IBM’s cost of capital were, Kd = 6%, Kp = 12.5% and Ks= 15.5% compute the weighted
average cost of capital;
Solution Ko = ∑% of total capital structure * cost of capital for each
Supplied by each type of capital source of capital
= Wd * kd + Wp* kP + Ws * Ks + Wr * Kr where
Wd =% of total capital supplied by debt
Wp = % of total capital supplied by preferred stock
Ws = % of total capital supplied by common stock
Wr = % of total capital supplied by retained earnings
Source (a) Market value Weight ( c ) Cost (d) Weighted costs e=(
(b) cxd)
Long and short term Br 400,000 40% 6% 2.4%
debt
Preferred stock Br 100,000 10% 12.5% 1.25%
Common equity Br 500,000 50% 15.5% 7.75%
Total Br 1,000,000 100% 11.40%

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