CHAPTER 4

SECURITY VALUATION AND THE COST OF CAPITAL

Since finance is interested more on decision making rather than recording, the value of an
asset is determined before it is purchased. The purpose is to decide whether to acquire or not to

acquire the asset. Therefore, here the historical cost cannot be used as the value of the asset.
Rather, the value of the asset is determined by valuation.

Valuation is the process of determining the worth of any asset whose value is obtained from
future cash flows. The value of any asset in finance is the present value of all future cash flows.
it is expected to provide over the relevant time period. This value is called intrinsic value.

The intrinsic value of an asset is determined based on three basic inputs: cash flows (returns),
time pattern of the returns, and the discount rate. The value of an asset is, therefore, determined
by discounting the expected cash flows to their present value. To determine the present value, we
use a discount rate appropriate based on the asset’s risk.

4.1 Bond Valuation

Governments and corporations borrow money by selling bonds to investors. The money
they collect when the bond is issued, or sold to the public, is the amount of the loan. In
return, they agree to make specified payments to the bondholders, who are the lenders.
When you own a bond, you generally receive a fixed interest payment each year until the bond
matures. This payment is known as the coupon because most bonds used to
have coupons that the investors clipped off and mailed to the bond issuer to claim the
interest payment. At maturity, the debt is repaid: the borrower pays the bondholder the
bond’s face value (equivalently, its par value).
Bond is a long-term contract under which a borrower agrees to make payments of interest and
principal on specific dates to the holder of the bond. And also, bond is a long-term debt
instrument or security issued by businesses and governmental units to raise large sums of money.
Investment in a bond provides two types of cash flows
1. The periodic interest payment by the issuing party and=COUPON PAYMENT
2. The price paid to the investor upon maturity=MV
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The first, i.e., the interest payment is based on the par value of the bond and the coupon interest
rate. The par value is the face value of the bond which will be paid to the investor upon maturity.
Par value is also called maturity value.
In order to value a bond, you must understand the following.
Features of Bonds
 Par value: It is the amount or value stated on the face of the bond. It represents the amount of
the firm borrows and promises to repay at the time of maturity. It can be any denomination.
 Coupon Rate of Interest: A bond carries a specific interest rate, which is called the coupon
rate. The interest payable to the bondholder is simply par value of bond multiplied by the
coupon rate.
 Maturity period: Every bond will have maturity period. On completion of the maturity
period the principal amount has to be repaid as per the agreed terms while issuing such bonds
call provision. Sometimes bonds may be issued under a provision that the business unit will
have an option to pay back the bond amount before the maturity period. These are known as
callable bonds.
 The intrinsic value of a bond is equal to the present value of its expected case flows. The
coupon interest payments and principal payments are known and the present value is
determined by discounting these future payments from the issuer at an appropriate discount
rate or market yield.
 Zero-Coupon Bonds. Corporations sometimes issue zero-coupon bonds. In this case,
investors receive face value at the maturity date but do not receive a regular
coupon payment. In other words, the bond has a coupon rate of zero. You learned how
to value such bonds earlier. These bonds are issued at prices considerably below face
value, and the investor’s return comes from the difference between the purchase price
and the payment of face value at maturity.
 Floating-Rate Bonds. Sometimes the coupon rate can change over time. For example,
floating-rate bonds make coupon payments that are tied to some measure of current
market rates. The rate might be reset once a year to the current Treasury bill rate plus 2
percent. So, if the Treasury bill rate at the start of the year is 6 percent, the bond’s coupon
rate over the next year would set at 8 percent. This arrangement means that the bond’s
coupon rate always approximates current market interest rates.

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 Convertible Bonds. If you buy a convertible bond, you can choose later to exchange
it for a specified number of shares of common stock. For example, a convertible bond
that is issued at par value of $1,000 may be convertible into 50 shares of the firm’s
stock. Because convertible bonds offer the opportunity to participate in any price
appreciation of the company’s stock, investors will accept lower interest rates on convertible
bonds.
 Put Bond - allows the holder to force the issuer to buy back the bond at a stated price.
 The Call Provision: A call provision allows the company to repurchase or “call” part or all
of the bond issue at stated prices over a specific period. Corporate bonds are usually callable.
The difference between the call price and the stated value is the call premium.
 The Indenture: is the written agreement between the corporation (the borrower) and its
creditors. It is sometimes referred to as the deed of trust. Usually, a trustee (a bank, perhaps)
is appointed by the corporation to represent the bondholders. The trust company must make
sure the terms of the indenture are obeyed, manage the sinking fund, and represent the
bondholders in default—that is, if the company defaults on its payments to them.

Investors have many choices when investing in Bonds, but bonds are classified into four main
types: treasury, corporate, municipal, and foreign.

1. Treasury Bonds: sometimes referred to as government bonds, are issued by the federal
government. It is reasonable to assume that the federal government will make good on its
promised payments, so these bonds have no default risk. However, Treasury bond prices
decline when interest rates rise, so they are not free of risks.
2. Corporate Bonds: as the name implies, are issued by corporations. Unlike Treasury bonds,
corporate bonds are exposed to default risk- if the issuing company gets into trouble, it may
be unable to make the promised interest and principal payments. Different corporate bonds
have different levels of default risk, depending on the issuing company’s characteristics and
on the terms of the specific bond. Default risk is often referred to as “credit risk”. The larger
the default or the credit risk, the higher the interest rate the issuer must pay.
3. Municipal Bonds: or “minis,” are issued by state and local governments. Like corporate
bonds, munis have default risk. However, munis offer one major advantage over all other
bonds. The interest earned on most municipal bonds is exempted for federal taxes, and also

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 from state taxes if the holder is the resident of the issuing state. Consequently, municipal
bonds carry interest rates that are considerably lower than those on corporate bonds with the
same default risk.
4. Foreign Bonds: are issued by foreign governments or foreign corporations. Foreign
corporate bonds are, of course, exposed of default risk, and so are sometimes foreign
government bonds. An additional risk exists if the bonds are denominated in a currency other
than that of the investor’s home currency.
Basic Bond Valuation Model
The value of a bond is the present value of the periodic interest payments plus the present value
of the par value. The value of a bond can be computed using the following equitation:
Bo = I (PVIFA kd,n) + M(PVIF kd,n) Where:
Bo = the value of the bond
I = interest paid each period = Par Value x Coupon interest rate
Kd = the appropriate interest rate on the bond
n = The number of periods before the bond matures
M = the par value of the bond
(PVIFA kd,n) = The present value interest factor for an annuity at interest rate of kd per period
1
1−
(1+k d )n
for n periods = kd

(PVIFkd,n) = The present value interest factor at interest rate of kd per period for n periods =
1
n
periods = ( 1+k d )
Notice that we have used kd instead of i. This is because, generally, in financial management k
labels rate of return and the subscript d denotes debt security. So kd labels the rate of return on a
debt security.
Illustration: Tebaber Corporation has a Br. 1,000 par value bond with an 8% coupon interest
rate outstanding. Interest is paid semiannually and the bond has 12 years remaining to its
maturity date.
Required: What is the value of the bond if the required return on the bond is 8%?
Solution:

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Given: M= Br. 1,000; kd=8% per year or 4% (8%2) per semiannual period; I = Br. 40 (Br.
1,000 x 4%); n = 24 semiannual periods (12 x 2); Bo =?
Bo = I (PVIFA kd,n) + M(PVIF kd,n)
= Br. 40(PVIFA4%, 24) + Br. 1,000(PVIF4%, 24)
= Br. 40 (15.2470) + Br. 1,000 (0.3901)
= Br. 1,000
If the appropriate discount rate (kd) remains constant at 8% (4% per semiannual period), the
value of the bond will not be changed. It will remain Br. 1,000. Suppose the appropriate discount
rate is 8% 2 years from now, what would be the value of the bond?
Solution: now n is reduced to 20[24-(2 x 2)]
Bo = Br.40 (PVIFA4%, 20) + Br. 1,000 (PVIF4%, 20)
= Br. 40 (13.5903) + Br. 1,000 (0.4564)
= Br. 1,000
Suppose the interest rate in the economy when Tebaber’s bonds were issued was 6% rather than
8%, what would be the value of the bond? Since Tebaber’s bond now will be paying more
interest than do other bonds in the market, the company’s bond will be selling at a larger price.
Such bonds which are selling more than their par value are called premium bonds. Here, k d is 6%
(3% per semiannual payment), but other things are not changed. So
Bo = Br. 40 (PVIFA3%, 24) + Br. 1,000 (PVIF 3%, 24)
= Br. 40 (16.9355) + Br. 1,000 (0.4919)
= Br. 1,169.32
So, when the market interest rate (kd) is less than the coupon interest rate, the value of a bond is
always larger than the par value. An investor by deciding to invest his money on Tebaber’s bond,
he will receive a 1% (4% - 3%) more interest payment than he would receive if he invested
somewhere else. This allows the investor to receive Br. 10 [Br. 1,000 x (4% - 3%)] more every
semiannual period. As a result, the investor would be willing to give more price to the bond. The
additional price is the present value of each Br. 10 he is going to receive for the next 24
semiannual periods. Therefore, the value of a premium bond can also be computed as:
Bo = Br. 1,000 + Br. 10 (PVIFA3%, 24)
= Br. 1,000 + Br. 10 (16.9355)
= Br. 1,169.36*

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* The previous value was Br. 1,169.32. The difference is due to rounding problem.
Assuming the interest rate remains constant at 6% for the next 11 years (12 periods), what would
happen to Tebaber’s bond?
Bo = Br. 40 (PVIFA3%, 22) + Br. 1,000 (PVIF3%, 22)
= Br. 1,159.38
Thus, the value of the bond would fall form Br. 1,169.32 to Br. 1,159.38. If you calculate the
value of the bond at other future dates, the price would continue to fall as the maturity date
approaches.
Had the interest rate (kd) was 10% when Tebaber’s bond was selling, the value of the bond
would be:
Bo = Br. 40 (PVIFA5%, 24) + Br. 1,000 (PVIF5%, 24)
= Br. 40 (13.7986) + Br. 1,000 (0.3101)
= Br. 862.04. Since Tebaber’s bond now will be paying less interest than do other
bonds in the market, they are selling at a smaller price (discount bond).
If the interest rate remains constant at 10% for the next 11 years (22 periods), the value of
Tebaber Berta’s bond would be Br. 868.32. Thus, the value of the bond will have risen from Br.
862.04 to Br. 868.32. If you further calculate the value of the bond at other future dates, the price
would continue to rise as the maturity date approaches.
We see a relation developing between the coupon rate, the yield, and the value of a debt security:
If the coupon rate is more than the yield, the security is worth more than its maturity
value—it sells at a premium and it is called premium bond.
If the coupon rate is less than the yield, the security is less than its maturity value—
it sells at a discount and it is called discount bond.
If the coupon rate is equal to the yield, the security is valued at its maturity value
and it is called par value.
Generally, the relationship among a Bond’s price and its coupon rate, current yield and yield to
Maturity
Bond Price<Face Value: Coupon rate<Current yield<YTM
Bond Price=Face Value: Coupon rate=Current yield=YTM
Bond Price>Face Value: Coupon rate>Current yield>YTM
Interest Rate on a Bond

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So far, we have been seeing how to determine the value of a bond if we are given the par value,
the coupon interest rate, the number of periods, and the interest rate on the bond. Next, we shall
discuss on how to find the interest rate on a bond, i.e., k d if we are given the value of the bond.
We will consider yield to maturity and yield to call.
Yield to Maturity (YTM) is the rate of return investors earn if they buy a bond at a specific
price Bo and hold it until maturity. The approximate YTM can be found using the following
approximation formula:
M −Bo
I+
n
M + Bo
Approximate YTM = 2
Example: Zebra Company has a Br. 1,000 par value, 10% coupon interest rate, and 15 years to
maturity. The bond is currently selling at Br. 1,090. Compute the YTM.
Solution:
Given: M = Br. 1,000; I = Br. 100 (Br. 1,000 x 10%); n = 15; Bo = Br. 1,090; YTM =?

Br . 1 ,000−1 , 090
Br .100+
15
=9 %
Br . 1 ,000+Br .1 , 090
Approximate YTM = 2
If an investor buys Zebra’s bond at Br. 1,090 and holds it for 15 years, the approximate yield or
rate of return per year is 9%.
4.2 Stock Valuation
4.2.1 Preferred Stock Valuation
Preferred stock is a type of equity security that provides its owners with limited or fixed claims
on a corporation’s income and assets. Investment in a preferred stock provides a single cash
flow, i.e., constant periodic dividend payments. Preferred stock has similarities to both a bond
and a common stock. As similarities to a bond, preferred dividends are fixed in amount and are
like interest payments. As to a common stock, the preferred dividends are paid for an indefinite
time period.
Preferred Stock Valuation Model

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The value of a preferred stock is the present value of all future preferred dividends it is expected
to provide over an infinite time horizon. Most preferred stocks entitle their owners to regular and
fixed dividend payments. If the payments last forever, the issue is a perpetuity. Since dividends
from preference shares are assumed to be perpetual payments, the intrinsic value of such shares
will be estimated from the following equations.

Vps = C_ + C__ + Cn__

(1 + k) (1 + k) 2 (1 + k) n
Vp = Value of perpetual today
C = Constant dividends received
Kps = Required rate of return appropriate
Therefore, the value of a preferred stock is found by the following formula:
Dps
VPS = Kps
Where:
Vps = Value of the preferred stock
Dps = Preferred stock dividends
Kps = The required rate of return on the preferred stock
Example: Abebe wishes to estimate the value of its outstanding preferred stock. The preferred
issue has a Br. 80 par value and pays an annual dividend of Br. 6.40 per share. Similar-risk
preferred stocks are currently earning a 9.3% annual rate of return. What is the value of the
outstanding preferred stock?
Solution:
Given: Dps = Br. 6.40; Kps = 9.3%; Vps =?
So, the Br. 6.40 annual dividend an investor receives for an infinite year is equal to today’s Br.
68.82 if the required rate of return is 9.3%.
Rate of Return on a Preferred Stock
To evaluate the worthiness of investment in a preferred stock in comparison to other investment
opportunities, we should be able to compute the rate of return on a preferred stock. If we know
the current price of a preferred stock and its dividend, we can compute the expected rate of return
on the preferred stock. This can be done using the following formula:

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 Dps
Kps = Vps
Where
Kps = The expected rate of return on the preferred stock
Dps = Preferred stock dividends
Vps = Value or current price of the preferred stock
Example: A preferred stock pays an annual dividend of Br. 9 and the current market price is Br.
81. Compute the required rate of return from the preferred stock.
Solution:
Given: Dps = Br. 9; Vps = Br. 81; Kps =?
For an investor to invest Br. 81 in this preferred stock and to receive an annual dividend of Br. 9,
his minimum required rate of return is 11.11%.
4.2.2 Common Stock Valuation

The value of a share of common stock is the present value of the common stock’s dividend
expected over an infinite time horizon. The value of a share of common stock is also equal to the
sum of the present value of the expected dividends and the present value of the expected selling
price of the stock. The selling price in turn will depend on the dividends to be received by the
purchasing party.

To understand the value of a common stock we should keep in mind two points. First, the
dividends are expected for an infinite time period. Second, the dividends are not constant.
Therefore, the value of a common stock is found by summing the present values of annual
dividends.
D1 D2 D∞
+ +⋯+
1
Po = ( 1+ks ) ( 1+ks )
2 ( 1+ ks )∞

Where:
Po = Value of the common stock at time zero (as of today)
D1, D2, …, D = Per share dividend expected at the end of each year
Ks = the required rate of return on the common stock.

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The common stock valuation equation can be simplified by redefining each year’s dividend. The
dividends are defined in terms of anticipated dividends growth. Generally, there are three cases
accordingly. These are:
1. Zero growth common stock,
2. Constant growth common stock, and
3. Variable growth common stock.
Hence, common stock valuation approaches are developed under each of the above dividend
growth models. Next sections will discuss each model one by one.
1. Zero Growth Stock
A zero-growth stock is a common stock whose future dividends are not expected to grow at all.
The expected growth rate (g) is zero. This is the simplest model to common stock valuation. It
assumes a constant, non-growing annual dividend. So here the annual dividends are all equal.
That is D1 = D2 = … = D = D.
A common stock with zero growth rate is a security that is expected to provide a fixed dividend
each year. Hence, a zero-growth common stock is a perpetuity. Therefore, the value of a zero-
growth stock is given as:
D
Po = Ks
Example: The most recent common stock dividend of Shalom Manufacturing Corporation was
Br. 3.60 per share. Due to the firm’s maturity as well as stable sales and earnings, the dividends
are expected to remain at the current level of the foreseeable future.
Required: Determine the value of Shalom’s common stock for an investor whose required
return is 12%.
Solution:
Given: D = Br. 3.60; Ks = 12%; Po =?
The maximum price the investor would be willing to pay for a share of Shalom’s common stock
is Br. 30 for he to receive a Br. 3.60 annual dividend for an indefinite year.
2. Constant Growth Stock
Constant growth stock is a common stock whose future dividends are expected to grow at a
constant dividend growth rate (g). It is sometimes called normal growth stock. The constant

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(normal) growth common stock valuation model is the most widely cited approach to common
stock valuation.
The value of a constant growth stock is the present value of the expected future dividends
growing at a constant rate of g. Here the value can be found by using the following formula:
D1
Po = Ks−g ; Ks > g Where:
D1 = The expected dividend at the end of year 1.
g = The expected growth rate in dividends.
D1 = Do(1+g), where Do is the most recent dividend. Similarly, D2 = D1 (1+g) and so on. To
find the value of a common stock (constant growth) at one year, first, find the expected dividend
at the end of next year.
Example: Zeila Motor Corporation’s common stock currently pays an annual dividend of Br.
5.40 per share. The dividends are expected to grow at a constant annual rate of 5% to infinity.
Estimate the value of Zeila’s common stock if the required return is 12%.
Solution:
Given: Do = Br. 5.40; g = 5%; Ks = 12%; Po =?
For an investor to receive an annual dividend of Br. 5.40 growing at 5% constantly to infinity,
the maximum price he would pay today is Br. 81.
If we are given the value of a constant growth stock, the most recent dividend, the expected
dividend growth rate, we can compute the expected rate of return as follows.
D1
+g
Ks = P 0 Where;
Ks = The expected rate of return on a constant growth stock
D1/P0 = Expected dividend yield.
g = Expected dividend growth rate = capital gains yield.
Example: Assume the above example except that you are given the value of common stock of
Br. 81 instead of the required return. Compute the expected rate of return?
3. Variable Growth Stock
Variable growth stock is a stock whose dividends are expected to grow at variable or non-
constant rates. The model of common stock valuation that allows for a change in the dividend

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growth rate is called Variable (Non constant) Growth Model. It sometimes is also called
supernormal growth model.
The value of a share of variable growth stock is determined by following 4 procedures.
1. Find the value of the dividends at the end of each year during the initial growth period.
2. Find the present values of the dividends found in step 1.
3. Find the value of the stock at the end of the initial growth period
4. Add the present value of the dividends found in step 2 and the present value of the value of the
stock found in step 3 to determine the value of the stock at time zero, i.e. po.
Example: Addis Company’s most recent annual dividend, which was paid yesterday, was Br.
1.75 per share. The dividends are expected to experience a 15% annual growth rate for the next 3
years. By the end of 3 years growth rate will slow to 5% per year to infinity.
Stockholders require a return of 12% on Addis’ stock
Required: Calculate the value of the stock today.
Solution:
Given: Do = Br. 1.75; g1 = 15% for 3 years; g2 = 5% from year 3 to infinity; k5 = 12%; p0=?
g1 = 15% g2 = 5%

Year 0 1 2 3 
D0 = Br. 1.75 D1 = Br. 2.01 D2 = Br. 2.31 D3 = Br. 2.66
PV of D1 = Br. 1.79 PVIF 12%, 1
PV of D2 = 1.84 PVIF 12%, 2
PV of D3 = 1.89 PVIF 12%, 3
PV of P3 = 28.40 PVIF 12%, 3 P3 = Br. 39.90
P0 = Br. 33.92
D1 = D0 (1 + g1) = Br. 1.75 (1.15) = Br. 2.01
D2 = D1 (1 + g1) = Br. 2.01 (1.15) = Br. 2.31
D3 = D2 (1 + g1) = Br. 2.31 (1.15) = Br. 2.66
D4 D 3(1+ g )
2 Br .2 .66( 1.05)
P3 = k −g = k −g = 0.12−0.05 =Br .39 .90
s 2 s 2

Therefore, the value of Addis Company’s common stock today is Br. 33.92

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4.3 Capital Structure

Capital structure is defined as the relative amount of permanent short-term debt, long-term debt,
preferred stock, and common equity used to finance a firm. The optimal capital structure occurs
at the point at which the cost of capital is minimized and firm value is maximized.
Capital structure is defined as the amount of permanent short-term debt, long-term debt,
preferred stock, and common equity used to finance a firm. In contrast, financial structure
refers to the amount of total current liabilities, long-term debt, preferred stock, and common
equity used to finance a firm. Thus, capital structure is part of the financial structure,
representing the permanent sources of the firm’s financing. The emphasis of capital structure
analysis is on the firm’s long-range target capital structure, that is, the capital structure at
which the firm ultimately plans to operate. For most companies, the current and target capital
structures are virtually identical, and calculating the target structure is a straightforward process.
Occasionally, however, companies find it necessary to change from their current capital structure
to a different target. The reasons for such a change may involve a change in the company’s asset
mix (and a resulting change in its risk) or an increase in competition that may imply more risk.
Assumptions of Capital Structure Analysis
The analysis that follows is based on some important assumptions. First, it is assumed that
a firm’s investment policy is held constant when we examine the effects of capital structure
changes on firm value and particularly on the value of common stock. This assumption means
that the level and variability of operating income (EBIT) is not expected to change as changes in
capital structure are contemplated. Therefore, capital structure changes affect only the
distribution of the operating income between the claims of debt holders, preferred stockholders,
and common stockholders.
By assuming a constant investment policy, we also assume that the investments undertaken by
the firm do not materially change the debt capacity of the firm. This assumption does not always
hold in practice, but for the overwhelming majority of investment projects, it is a realistic
assumption that also helps us focus on the key determinants of an optimal capital structure.
Business Risk
Two elements of risk are primary considerations in the capital structure decision: the business
risk and the financial risk of a firm. Financial risk is discussed in the following section.

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Business risk refers to the variability or uncertainty of a firm’s operating income (EBIT).
Many factors influence a firm’s business risk (holding constant the effects of all other important
factors), including
1. The variability of sales volumes over the business cycle.
2. The variability of selling prices.
3. The variability of costs
4. Existence of market power
5. The extent of product diversification
6. The level and rate of growth
7. The degree of operating leverage (DOL).
Financial Risk
Financial risk refers to the additional variability of earnings per share and the increased
probability of insolvency that arises when a firm uses fixed-cost sources of funds, such as debt
and preferred stock, in its capital structure.4 (Insolvency occurs when a firm is unable to meet
contractual financial obligations—such as interest and principal payments on debt, payments on
accounts payable, and income taxes—as they come due.) Fixed capital costs represent
contractual obligations a company must meet regardless of the EBIT level.
The use of increasing amounts of debt and preferred stock raises the firm’s fixed financial costs;
this, in turn, increases the level of EBIT that the firm must earn in order to meet its financial
obligations and remain in business. The reason a firm accepts the risk of fixed cost financing is
to increase the possible returns to stockholders.
Capital Structure Theory
Capital Structure Without a Corporate Income Tax
In 1958, two prominent financial researchers, Franco Modigliani and Merton Miller (MM),
showed that, under certain assumptions, a firm’s overall cost of capital, and therefore its value, is
independent of capital structure. In particular, assume that the following perfect capital market
conditions exist
 There are no transaction costs for buying and selling securities.
 A sufficient number of buyers and sellers exists in the market, so no single investor can
have a significant influence on security prices.
 Relevant information is readily available to all investors and is costless to obtain.

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  All investors can borrow or lend at the same rate.
MM also assumed that all investors are rational and have homogeneous expectations of a firm’s
earnings. Additionally, firms operating under similar conditions are assumed to face the same
degree of business risk. This assumption is called the homogeneous risk class assumption.
Finally, MM assumed that there are no income taxes. MM later relaxed this no tax assumption.
The results of the tax case follow after the no-tax case discussion.
In the no-tax MM case, the cost of debt and the overall cost of capital are constant regardless of a
firm’s financial leverage position, measured as the firm’s debt-to-equity ratio, B/E. As a firm
increases its relative debt level, the cost of equity capital, ke, increases, reflecting the higher
return requirement of stockholders due to the increased risk imposed by the additional debt. The
increased cost of equity capital exactly offsets the benefit of the lower cost of debt, kd, so that the
overall cost of capital does not change with changes in capital structure.
MM support their theory by arguing that a process of arbitrage will prevent otherwise equivalent
firms from having different market values simply because of capital structure differences.
Arbitrage is the process of simultaneously buying and selling the same or equivalent securities
in different markets to take advantage of price differences and make a profit. Arbitrage
transactions are risk-free. For example, suppose two firms in the same industry differed only in
that one was levered (that is, it had some debt in its capital structure) and the other was unlevered
(that is, it had no debt in its capital structure). If the MM theory did not hold, the unlevered firm
could increase its market value by simply adding debt to its capital structure. However, in a
perfect capital market without transactions costs, MM argue that investors would not reward the
firm for increasing its debt. Stockholders could change their own financial debt–equity structure
without cost to receive an equal return. Therefore, stockholders would not increase their opinion
of the market value of an unlevered firm just because it took on some debt.
The MM argument is based on the arbitrage process. If one of two unlevered firms with
identical business risk took on some debt and the MM theory did not hold, its value should
increase and, therefore, so would the value of its stock. MM suggest that under these
circumstances, investors will sell the overpriced stock of the levered firm. They then can use an
arbitrage process of borrowing, buying the unlevered firm’s stock, and investing the excess funds
elsewhere. Through these costless transactions, investors can increase their return without
increasing their risk. Hence, they have substituted their own personal financial leverage for

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corporate leverage. MM argue that this arbitrage process will continue until the selling of the
levered firm’s stock drives down its price to the point where it is equal to the unlevered firm’s
stock price, which has been driven up due to increased buying.
The arbitrage process occurs so rapidly that the market values of the levered and unlevered firms
are equal. Therefore, MM conclude that the market value of a firm is independent of its capital
structure in perfect capital markets with no income taxes.
Four primary factors influence the capital structure decision
1. Business risk, or the riskiness inherent in the firm’s operations if it used no debt. The
greater the firm’s business risk, the lower its optimal debt ratio.
2. The firm’s tax position. A major reason for using debt is that interest is deductible,
which lowers the effective cost of debt. However, if much of a firm’s income is already
sheltered from taxes by depreciation tax shields or tax loss carry-forwards, its tax ratio
will be low, so debt will not be as advantageous as it would be to a firm with a higher
effective tax rate.
3. Financial flexibility, or the ability to raise capital on reasonable terms under
adverse conditions. Corporate treasures know that a steady supply of capital is necessary
for stable operations, which is vital for long-run success. They also know that when
money is tight in the economy, or when a firm is experiencing operating difficulties,
suppliers of capital prefer to provide funds to companies with strong balance sheet.
Therefore, both the potential further need for funds and the consequences of a funds
shortage have a major influence on the target capital structure – the greater the probable
future need for capital, and the worse the consequences of a capital budget, the stronger
the balance sheet should be.
4. Managerial conservatism or aggressiveness. Some managers are more aggressive than
others, hence some firms are more inclined to use debt in an effort to boost profits. This
factor does not affect, the optimal, or value- maximizing, capital structure, but it does
influence the target capital structure.
These four points larger determine the target capital structure, but operating conditions can cause
the actual capital structure to vary from the target.

4.4 COST OF CAPITAL

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The cost of capital is the minimum rate of return that a firm must earn in order to satisfy the
overall rate of return required by its investors. It is also the minimum rate of return a firm must
earn on its invested capital to maintain the value of the firm unchanged. The second definition
considers the cost of capital as a break-even rate.
If a firm’s actual rate of return exceeds its cost of capital, the value of the firm would increase. If
on the other hand, the cost of capital is not earned, the firm’s market value will decrease. So the
cost of capital is the rate of return that is just sufficient to leave the price of the firm’s common
stock unchanged. The cost of capital serves as a discount rate when a firm evaluates an
investment proposal.
MEASURING THE SPECIFIC COST OF CAPITAL
The cost of capital for any particular capital source or security issue is called the specific cost of
capital. It is also called individual cost of capital or component cost of capital.

Each type of capital contained the capital structure of a firm include:

1. Debt
2. Preferred stock
3. Common stock
4. Retained earnings

Two important points you should bear in mind about the specific cost of capital. One is that it is
computed on an after-tax basis. Meaning, if there would be any tax implication on the individual
source of capital, it should be considered. In almost all circumstances, the tax implication is only
on debt sources of finance. The second point is that the specific cost of capital is expressed as an
annual percentage or rate like 6%, 9%, or 10%. The cost of capital is not stated in terms of birrs.

1 The cost of debt

This is the minimum rate of return required by suppliers of debt. The relevant specific cost of
debt is the after-tax cost of new debt. Generally, debt is the cheapest source of finance to a firm
and, hence, the cost of debt is the lowest specific cost of capital. There are two basic
explanations for this. First, debt suppliers, generally, assume the lowest risk among all suppliers
of capital. They receive interest payments before preferred and common dividends are paid.
Since they assume the smallest risk, their return is the lowest. Their lowest return would be the

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lowest cost of capital to the firm. Second, raising capital through debt sources entails interest
expense. The inters expense in turn reduces the firm’s income which ultimately would cause tax
payment to be reduced. So, raising money in the form of debt results in the smallest tax burden,
and finally, the firm’s cost of debt would be the lowest.
Debt sources of finance may take several forms like bonds, promissory notes, bank loans. Here,
for our convenience we consider bond issue to illustrate the cost of debt.
Computing the cost of new bond issue involves three steps:
i) Determine the net proceeds from the sale of each bond
NPd = Pd – f
Where:
NPd = The net proceeds from the sale of each bond
Pd = The market price of the bond
f = Flotation costs
ii) Compute the effective before tax cost of the bond using the following approximation formula:
M −Bo
I+
n
M + Bo
Kd = 2
Where:
Kd = The effective before tax cost of debt
I = Annual interest payment
Pn = The par value of the bond
n = Length of the holding period of the bond in years.
iii) Compute the after-tax cost of debt
Kdt = Kd (1 – t)
Where:
Kdt = The after-tax cost of debt
t = The marginal tax rate
Example: Currently, Abyssinia Industrial Group is planning to sell 15-year, Br. 1,000 par-value
bonds that carry a 12% annual coupon interest rate. As a result of lower current interest rates,
Abyssinia bonds can be sold for Br. 1,010 each. Flotation costs of Br. 30 per bond will be
incurred in the process of issuing the bonds. The firm’s marginal tax rate is 40%.

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Required: Calculate the after-tax cost of Abyssinia’s new bond issue:
Solution:
Given:Pn = Br. 1,000; I = Br. 120 (Br. 1,000 x 12%); n = 15; Pd = Br. 1,010; f = Br. 30;
t = 40%; Kdt=?
Then apply the three steps:
i) NPd = Br. 1,010 – Br. 30 = Br. 980
Br .1 ,000−Br . 980
Br .120 +
15
= 12. 26 %
Br .1 , 000+Br .980
ii) Kd = 2
iii) Kdt = 12.26% (1 – 40%) = 7.36%
Therefore, the after – tax cost of Abyssinia’s new bond issue is 7.36%. That is, Abyssinia should
be able to earn a minimum of 7.36% to satisfy bondholders. Otherwise, the firm’s value will
decline.
The cost of preferred stock
The cost of preferred stock is the minimum rate of return a firm must earn in order to satisfy the
required rate of return of the firm’s preferred stock investors. It is also the minimum rate of
return a firm’s preferred stock investors require if they are to purchase the firm’s preferred stock.

When a firm raises capital by issuing new preferred stock, it is expected to pay fixed number of
dividends to the preferred stockholders. So, it is the dividend payment that is the cost of the
preferred stock to the firm stated as an annual rate.
The cost of a new preferred stock issue can be computed by following two steps:
i) Determine the net proceeds from the sale of each preferred stock.
NPpf = Ppf – f
Where:
NPpf = Net proceeds from the sale of each preferred stock
Ppf = Market price of the preferred stock
f = Flotation costs
ii) Compute the cost of preferred stock issue
Kps = Dps__

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 NPpf
Where:
Kps = The cost of preferred stock
DPs = The pre share annual dividend on the preferred stock
Example: Sefa Computer Systems Company has just issued preferred stock. The stock has 12%
annual dividend and Br. 100 par value and was sold at 102% of the par value. In addition,
flotation costs of Br. 2.50 per share must be paid. Calculate the cost of the preferred stock.
Solution:
Given: Pps = Br. 102 (Br. 100 x 102%); Dps = Br. 12 (Br 100 x 12%); f = Br. 2.50;
Kps =?
Then apply the two steps:
i) NPpf = Br. 102 – Br. 2.50 = Br. 99.50
ii) Kps = Br. 12 =12.06%
Br. 99.50
Therefore, Sefa Company should be able to earn a minimum of 12.06% on any investment
financed by the new preferred stock issue. Otherwise, the firm’s value will decrease.
The cost of common stock
The cost of common stock is the minimum rate of return that a firm must earn for its common
stockholders in order to maintain the value of the firm. A firm does not make explicit
commitment to pay dividends to common stockholders. However, when common stockholders
invest their money in a corporation, they expect returns in the form of dividends. Therefore,
common stocks implicitly involve a return in terms of the dividends expected by investors and
hence, they carry cost.
Generally, common stock dividends are paid after interest and preferred dividends are paid. As a
result, common stock investors assume the maximum risk in corporate investment. They
compensate the maximum risk by requiring the highest return. This highest return expected by
common stockholders make common stock the most expensive source of capital.
The cost of common stock can be computed using the constant growth valuation model.
Ks = D1+ g
NPo
Where:

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 Ks = The cost of new common stock issue
D1 = The expected dividend payment at the end of next year
NPo = Net proceeds from the sale of each common stock
g = The expected annual dividends growth rate
The net proceeds from the sale of each common stock (NPo) is computed as follows:
NPo = Po – f
Where:
Po = The current market price of the common stock
f = flotation costs
Example: An issue of common stock is sold to investors for Br. 20 per share. The issuing
corporation incurs a selling expense of Br. 1 per share. The current dividend is Br. 1.50 per share
and it is expected to grow at 6% annual rate. Compute the specific cost of this common stock
issue.

Solution
Given: Po = Br. 20; Do = Br. 1.50; g = 6%; f = Br. 1; Ks = ?
Then apply the two steps:
i) NPo = Br. 20 – Br. 1 = Br. 19
ii) Ks = D1 + g = Br. 1.50 (1.06) = 14.37%
Npo Br. 19
Therefore, the firm should be able to earn a minimum return of 14.37% on investments that are
financed by the new common stock issue.
The cost of Retained Earnings
Retained earnings represent profits available for common stockholders that the corporation
chooses to reinvest in itself rather than payout as dividends. Retained earnings are not securities
like stocks and bonds and hence do not have market price that can be used to compute costs of
capital.
The cost of retained earnings is the rate of return a corporation’s common stockholders expect
the corporation to earn on their reinvested earnings, at least equal to the rate earned on the
outstanding common stock. Therefore, the specific cost of capital of retained earnings is equated

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with the specific cost of common stock. However, flotation costs are not involved in the case of
retained earnings.
Computing the cost of retained earnings involves just a single procedure of applying the
following formula:

Kr = D1 + g
Po
Where:
Kr = The cost of retained earnings
D1 = The expected dividends payment at the end of next year
Po = The current market price of the firm’s common stock
g = The expected annual dividend growth rate.
Example: Zeila Auto Spare Parts Manufacturing company expects to pay a common stock
dividend of Br. 2.50 per share during the next 12 months. The firm’s current common stock price
is Br. 50 per share and the expected dividend growth rate is 7%. A flotation cost of Br. 3 is
involved to sale a share of common stock.
Required: Compute the cost of retained earnings
Solution
Given: Po = Br. 50; D1 = Br. 2.50; g = 7%; Kr =?
Then apply the formula:
Kr = D1+ g = Br. 2.50 + 7% = 12%
Po Br. 50
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
The firm’s capital structure is composed of debt, preferred stock, common stock, and retained
earnings. Each capital source accounts to some portion of the total finance. But the percentage
contribution of one source is usually different from another. So, we must compute the weighted
average cost of capital rather than the simple average.
The weighted average cost of capital (WACC) is the weighted average of the individual costs of
debt, preferred stock and common equity (common stock and retained earnings). It is also called
the composite cost of capital.

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If the weights of the component capital sources are all given, the weighted average cost of capital
can be computed as:
WACC = WdKdt + WpsKps + WceKs
Where:
WACC = The weighted average cost of capital
Wd = The weight of debt
Wps = The weight of preferred stock
Wce = The weight of common equity
Kdt = The after – tax cost of debt
Kps = The cost of preferred stock
Ks = The cost of common equity
The WACC is found by weighting the cost of each specific type of capital by its proportion in
the firm’s capital structure. Weights of the individual capital sources can be calculated based on
their book value or market value.
To illustrate the computation of the WACC, look at the following example.
Muna Tools Manufacturing Company’s financial manager wants to compute the firm’s weighted
average cost of capital. The book and market values of the amounts as well as specific after-tax
costs are shown in the following table for each source of capital.
Source of capital Book value Market value Specific cost
Debt Br. 1,050,000 Br. 1,000,000 5.3%
Preferred stock 84,000 125,000 12.0
Common equity 966,000 1,375,000 16.0
Total Br. 2,100,000 Br. 2,500,000

Required: Calculate the firm’s weighted average cost of capital using:

1) book value weights
2) market value weights
Solution:
1) Total book value = Br. 2,100,000
Wd = Br. 1,050,000 = 0.5; Wps = Br. 84,000__ = 0.04; Wce = Br. 966,000 = 0.46
Br. 2,100,000 Br. 2,100,000 Br. 2,100,000

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 WACC = WdKdt + WpsKps + WceKs
= 0.5 (5.3%) + 0.04 (12.0%) + 0.46 (16.0%)
= 2.65% + 0.48% + 7.36%
= 10.49%
The minimum rate of return on all projects should be 10.49%. Meaning, Muna should accept all
projects so long as they earn a return greater than or equal to 10.49%
2) Total Market value = Br. 2,500,000
Wd = Br. 1,000,000 = 0.4; Wps = Br. 125,000 = 0.05; Wce = Br. 1,375,000 = 0.55
Br. 2,500,000 Br. 2,500,000 Br. 2,500,000
WACC = 0.4 (5.3%) + 0.05 (12.0%) + 0.55 (16.0%)
= 2.12% + 0.60% + 8.80%
= 11.52%
If the market value weights are used, Muna should accept all projects with a minimum rate of
return of 11.52%
MARGINAL COST OF CAPITAL (MCC)
As a firm tries to have more new capital, the cost of each birr will rise at some point. Thus, the
marginal cost of capital (MCC) is the cost of obtaining additional new capital. Technically
speaking, the MCC is the weighted average cost of the last birr of new capital obtained. So, the
concept of marginal cost of capital is discussed in the context of the weighted average cost of
capital.
As a firm raises larger and larger amounts of capital, the weighted average cost of capital also
rises. But the question would be at what point the firm’s costs of debt, preferred stck, and
common equity as well as WACC increase?
The first point, therefore, in computing the MCC is to determine the breaking points where the
cost of capital will increase.
The technical aspects of the MCC can be better understood using an example.
Example: The target capital structure of Shala Corporation and other pertinent data are given
below.
Long-term debt ------------------ 40% cost of preferred stock (Kps) = 12.06%
Preferred stock -------------------10% cost of retained earnings (Kr) = 14%
Common equity ----------------- 50% cost of common stock (Ks) = 15%

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Shala Corporation has Br. 900,000 available retained earnings. But when the firm fully utilizes
its retained earnings, it must use the more expensive new common stock financing to meet its
equity needs. In addition, the firm expects that it can borrow up to Br. 1,200,000 of debt at 7.3%
after-tax cost. Additional debt will have an after-tax cost of 9.1%.
Required
1) What is the breaking point associated with the;
a. exhausting of retained earnings?
b. Increment of debt between Br. 0 to Br. 1,200,000?
2) Determine the ranges of total new financing where the WACC will rise
3) Calculate the WACC for each range of finance.
Solutions
1) a. Breaking point (BP) common equity = Br. 900,000 = Br. 1,800,000
50%
b. Breaking point (BP) long-term debt = Br. 1,200,000 = Br. 3,000,000
40%
The breaking points computed above can be interpreted as:
Shala can meet its equity needs using retained earnings until its total finance need is Br.
1,800,000. But when total capital required is more than Br. 1,800,000, its equity needs should be
met with common stock. Similarly, until the firm’s total finance need reaches Br. 3,000,000,
shala can raise any debt at 7.3% cost. Any further finance need beyond Br. 3,000,000 will cause
the cost of debt to rise to 9.1%.
2) There are three ranges of finance that could be identified on the basis of the breaking points:
1st Range: Br. 0 to Br. 1,800,000,
2nd Range: Br. 1,800,000 to Br. 3,000,000, and
3rd Range: Br. 3,000,000 and above
3) WACC (1st range) = 0.40 (7.3%) + 0.10 (12.06%) + 0.50 (14%)
= 2.92% + 1.21% + 7.00%
= 11.13%
WACC (2nd range) = 0.40 (7.3%) + 0.10 (12.06%) + 0.50 (15%)
= 2.92% + 1.21% + 7.50%
= 11.63%

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WACC (3rd range) = 0.40 (9.1%) + 0.10 (12.06%) + 0.50 (15%)
= 3.64% + 1.21% + 7.50%
= 12.35%

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