Week 10 – Chapter 14

BY SISI ZHANG, M.SC.

Learning Objectives

1. Cost of Equity
2. Cost of Debt
3. Cost of Preferred Stock
4. WACC (Weighted Average Cost of Capital)
5. Floating Costs
6. The market value of debt, the market value of equity
 Cost of Equity

As firms are mostly price takers, they would need to pay fair
prices for their capitals – required return on equity or cost of
equity is the implied price they pay to their shareholders.

We have learnt two models so far - dividend discount model

and the CAPM
 Cost of Equity

D1
P0 =𝑟𝑟
𝑒𝑒
−𝑔𝑔

Re-arrange this equation:

re = D1/ P0 + g
g : growth rate
P0 = Market Price of your common shares
D1= Dividend in the next Period
 Cost of Equity

Example 1, Kamloops Energy, which just paid an annual dividend of

$4.25 per share, its common shares are currently trading at $74.30 per
share. Assuming the corporation traditionally grows dividends at 5% per
year, and the it is trading at its fair price, what is the cost of common
equity?

re = D1/ P0 + g = $4.25x(1+5%)/$74.30 + 5% = 11%

Cost of Equity

What if you need to estimate the growth rate (g)?

Year Dividend Year-over-year growth (%)

2022 $1.17 N/A

2023 $1.20 2.26% = ($1.20 - $1.17)/$1.17

2024 $1.23 2.5%

2025 $1.27 3.25%
Average Year-over-Year growth 2.77% = (3.25%+2.5%+2.26%)/3
Cost of Equity

Sustainable Growth Rate

ROE = Return on Equity, you can generate growth by re-investing

your cash flows back into the business

Retention Ratio = Earnings per share after subtracting dividends

paid = (1 – Dividend payout ratio)

g = Retention ratio x ROE = ( 1 – Dividend payout Ratio) x ROE

Cost of Equity

Zoey Inc. on average pays out 40% of its earnings as dividends to

its common shareholders every year. Furthermore, Scott Inc’s
Return on Equity has been around 15%. Please estimate its
dividend growth rate.

g = Retention ratio x ROE = ( 1 – Dividend payout Ratio) x ROE =

(1 – 40%) x 15% = 9%
 Cost of Equity

CAPM Method

CEO of Zoey Inc. is interested in estimating its firm’s cost of capital for
its common shares. The company is listed in TSX and has a market
beta of 4.04. He notices that the market return for TSX index has been
8.32% over the past two years while T-bill rate has been 2.45%. Please
estimate the cost of capital based on the CAPM.

Re= Rf + Beta x ( Rm – Rf) = 2.45% + 4.04 x (8.32% - 2.45%) = 26.2%

Cost of Debt

Fairgo is partly financing its business through a 10-year,

$100,000 bond which pays 5% annual coupons. Assuming the
bond initially sold for $99.120, what is Fairgo’s cost of debt?

All we need to do is to calculate the YTM of the bond using

your financial calculator

PV = - $99,120, N = 10, FV = $100,000, PMT = $5,000, CPT YTM

= 5.11%
Cost of Preferred Stock

Again, recall what we learn in the first half.

D
Price of a preferred: P0 = 0
𝑟𝑟𝑝𝑝

D0
Re-arrange the above equation we have rp=
𝑃𝑃0
 Cost of Preferred Stock

Example, Charly has issued preferred shares which will pay a

dividend pf $2.5 per share per year. Assuming the shares sell
for $30 each, which is the cost of preferred stock?

D0
rp= = $2.5/$30 = 8.33%
𝑃𝑃0
 Weighted Average Cost of Capital (WACC)

Putting everything together, WACC without Tax Considerations

 Weighted Average Cost of Capital (WACC)

WACC with Tax Considerations

Putting everything together,

𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸

WACC = 𝑽𝑽
𝑅𝑅𝑑𝑑𝑋𝑋(1 − 𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅) +
𝑽𝑽
𝑅𝑅𝑝𝑝 +
𝑽𝑽
Re

V = Market value of Debt + Market Value of Equity + Market Value of

Common Equity
 Weighted Average Cost of Capital (WACC)

WACC with Tax Considerations

Putting everything together,

𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸

WACC = 𝑽𝑽
𝑅𝑅𝑑𝑑𝑋𝑋(1 − 𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅) +
𝑽𝑽
𝑅𝑅𝑝𝑝 +
𝑽𝑽
Re

V = Market value of Debt + Market Value of Equity + Market Value of

Common Equity
 Weighted Average Cost of Capital (WACC)

Abby Road Restaurant, currently profitable and paying an effective tax rate of
20%, is considering expanding its dining area by raising $200,000 through a
mix of debt, preferred shares, and common shares. Due to leverage
restrictions from its board of directors, Abby Road can only raise 30% of the
$200,000 through debt. It is planning to split the remaining financing equally
between preferred and common shares.
 Weighted Average Cost of Capital (WACC)

Abby Road announces the following plan:

1. Common shares will be sold at $100 per share (market price expected to
remain at that level in the near future). They will pay a dividend of $5.85
after one year and it will grow at a rate of 2% annually.

2. Preferred shares will be sold at $40 per share and will pay a dividend of
$3 per year.

3. Two 6-year, annual coupon rate at 4.50%, $30,000 bonds will be issued.
The bonds are expected to sell at a premium of $1,000.

What is Abby Road’s weighted average cost of capital (WACC)?

 Weighted Average Cost of Capital (WACC)
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
WACC = 𝑅𝑅𝑑𝑑𝑋𝑋(1 − 𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅) + 𝑅𝑅𝑝𝑝 + Re
𝑽𝑽 𝑽𝑽 𝑽𝑽

𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸

=30%, 𝑅𝑅𝑝𝑝= 35%, = 35%
𝑽𝑽 𝑽𝑽 𝑽𝑽

Rd= 3.87% ( PV = -$31,000, PMT = 4.5% X $30,000 = $1,350, FV = $30,000, N = 6, CPT

I/Y )

𝑅𝑅𝑝𝑝= $3/$40 = 7.5%

Re= $5.85/$100 + 2% = 7.85%, Tax Rate = 20%

WACC = 30%𝑋𝑋𝑋.87%𝑋𝑋 1 − 20% + 35% 𝑋𝑋 7.5% +35% X 7.85% = 6.31%

 Floating Costs

Flotation costs are incurred by a publicly-traded company when it issues

new securities and incurs expenses, such as underwriting fees, legal fees,
and registration fees.

Let’s say Scott Inc would like to raise capital for business expansion. It turns
out there are costs associated with issuing new equity and debt. For
preferred shares, there will be an additional 6% and bonds, there is a 4.5%
fee.
Who charged the fees? Investment banks (Morgan Stanley, Goldman
Sachs)
𝐸𝐸 𝐷𝐷
Weighted Floatation Costs are 𝑓𝑓A= [ 𝑋𝑋𝑋𝑋𝑋𝑋] + [ 𝑋𝑋𝑋𝑋𝑋𝑋]
𝑉𝑉 𝑉𝑉
 Floating Costs

Hence, to get $1 new financing ( assuming the 70/30 equity-to-debt mix),

Scott musty actually raise more:

𝐸𝐸 𝐷𝐷
𝑓𝑓A= [𝑉𝑉 𝑋𝑋𝑋𝑋𝑋𝑋] + [𝑉𝑉 𝑋𝑋𝑋𝑋𝑋𝑋] = (70% x 6%) + (30% x 4.5%) = 5.55%

To raise $1, we need to raise $1 = Total Raised - Total Raised x flotation

cost since an investment bank charges on the total amount raised.
$1 = Total Raised - Total Raised x 𝑓𝑓A

Total Raised = $1/(1 - 𝑓𝑓A), if Scott wants to raise $200,000, we have

$200,000/(1-5.55%) = $211,640.21
Thank you!