CHAPTER SIX

SHORT-TERM AND LONG TERM SOURCES OF FINANCING

6.1 Short Term sources of Finance -sources of finance that should be settled within a year or
less. The main source of short-term working capital is as follows:

1. Indigenous Bankers. 6. Accrued Expenses

2. Trade Credit 7. Deferred Income
3. Installment Credit 8. Commercial Paper
4. Advances 9. Commercial Banks
5. Accounts Receivable Credit or
Factoring
1. Indigenous Bankers. Private money-lenders and other country bankers used to be the only
source of finance prior to the establishment of commercial banks.
2. Trade Credit .Trade credit refers to the credit extended by the suppliers of goods in the
normal course of business.
The main advantages of trade credit as a source of short-term finance include:

a) It is an easy and convenient method of finance

b) It is flexible as the credit increases with the growth of the firm
c) It is informal and spontaneous source of finance
However, the biggest disadvantage of this method of finance is charging of higher prices by the
suppliers and loss of cash discount.

3. Installment Credit .This is another method by which the assets are purchased and the
possession of goods is taken immediately but the payment is made in installments over a
pre-determined period of time. Generally, interest is charged on the unpaid price or it
may be adjusted in the price.
4. Advances. Some business get advances from their customers and agents against orders
and this source is a short-term source of finance for them. It is a cheap source of finance
and in order to minimize their investment in working capital, some firms having long
production cycle, especially the firms manufacturing industrial products prefer to take
advances from their customers.
5. Factoring or Accounts Receivable Credit -Another method of raising short-term
finance is through account receivable credit offered by commercial banks and factors. A
commercial bank may provide finance by discounting the bills or invoices of its
customers. Thus, a firm gets immediate payment for sales made on credit.
6. Accrued Expenses .Accrued expenses are the expenses which have been incurred but not
yet due and hence not yet paid also. These simply represent a liability that a firm has to
pay for the services already received by it. The most important items of accruals are
wages and salaries, interest, and taxes. Wages and salaries are usually paid on monthly

1
 or weekly basis for the services already rendered by employees. The longer the payment-
period, the greater is the amount of liability towards employees or the funds provided by
them. In the same manner, accrued interest and taxes also constitute a short-term source
of finance. Taxes are paid after collection and in the intervening period serve as a good
source of finance. Even income-tax is paid periodically much after the profits have been
earned. Like taxes, interest is also paid periodically while the funds are used
continuously by a firm. Thus, all accrued expenses can be used as a source of finance.

7. Deferred Incomes. Deferred incomes are incomes received in advance before supplying
goods or services. They represent funds received by a firm for which it has to supply
goods or services in future. These funds increase the liquidity of a firm and constitute an
important source of short-tem finance. However, firms having great demand for its
products and services, and those having good reputation in the market can demand
deferred incomes.
8. Commercial Paper. Commercial paper represents unsecured promissory notes issued by
firms to raise short-term funds. It is an important money market instrument in advanced
countries like U.S.A. Commercial paper is usually bought by investors including banks,
insurance companies, unit trusts and firms to invest surplus funds for a short-period.
9. Commercial banks .Commercial banks are the most important source of short-term
capital. The major portion of working capital loans are provided by commercial banks.
They provide a wide variety of loans tailored to meet the specific requirements of a
concern. The different forms in which the banks normally provide loans and advances
are as follows:
a. Loans c. Overdrafts
b. Cash Credits d. Purchasing and Discounting of bills
a) Loans. When a bank makes an advance in lump-sum against some security it is called a loan.
In case of a loan, a specified amount is sanctioned by the bank to the customer. The entire loan
amount is paid to the borrower either in cash or by credit to his account. The borrower is
required to pay interest on the entire amount of the loan from the date of the sanction. A loan
may be repayable in lump sum or installments. Commercial banks generally provide short-term
loans up to one year for meeting working capital requirements. But now-a-days term loans
exceeding one year are also provided by banks. The term loans may be either medium-term or
long-term loans.

b) Cash Credits. A cash credit is an arrangement by which a bank allows his/her customer to
borrow money up to a certain limit against some tangible securities or guarantees. The customer
can withdraw from his /her cash credit limit according to his needs and he/she can also deposit
any surplus amount with him/her. The interest in case of cash credit is charged on the daily
balance and not on the entire amount of the account. For this reasons, it is the most favorite
mode of borrowing by industrial and commercial concerns.

2
C) Overdrafts. Overdraft means an agreement with a bank by which a current account-holder is
allowed to withdraw more than the balance to this credit up to a certain limits. There are no
restrictions for operation of overdraft limits. The interest is charged on daily overdrawn
balances. The main difference between cash credit and overdraft is that overdraft is allowed for
a short period and is a temporary accommodation where as the cash credit is allowed for a longer
period. Overdraft accounts can either be clean overdrafts, partly secured or fully secured.

d) Purchasing and Discounting of Bills. Purchasing and discounting of bills is the most
important form in which a bank lends without any collateral security. Present day commence is
built upon credit. The seller draws a bill of exchange on the buyer of goods on credit. Such a
bill may be either a clean bill or a documentary bill which is accompanied by documents of title
to goods such as a rail way receipt. The bank purchases the bills payable on demand and credits
the customer’s account with the amount of bill less discount. At the maturity of the bills, banks
present the bill to its acceptor for payment. In case the bill discounted is dishonored by non-
payment, the bank recovers the full amount of the bill from the customer along with expenses in
that connection.

In addition to the above mentioned forms of direct finance, commercial banks help their
customers in obtaining credit from their suppliers through the letter of credit arrangement.

Letter of Credit
A letter of credit popularly known as LC is an undertaking by a bank to honors the obligations of
its customer up to a specified amount, should the customer fail to do so. It helps its customers to
obtain credit form suppliers because it ensures that there is no risk of non-payment. LC is simply
a guarantee by the bank to the suppliers that their bills up to a specified amount would be
honored. In case the customer fails to pay the amount, on the due date, to its suppliers the bank
assumes the liability of its customer for the purchases made under the letter of credit
arrangement.
A letter of credit may be of many types, such as:
i) Clean Letter of Credit. It is a guarantee for the acceptance and payment of bills without
any conditions.
ii) Documentary letter of credit- It requires that the exporter’s bill of exchange be certain
documents evidencing title to the goods.
iii) Revocable letter of credit- It cannot be withdrawn by the issuing bank without the prior
consent of the exporter.
iv) Irrevocable letter of credit-It cannot be withdrawn without the consent of the
beneficiary.
v) Revolving letter of credit- In such type of letter of credit the amount of credit it
automatically reversed to the original amount after such an amount has once been paid as
per defined conditions of the business transaction. There is no deed for further
application for another letter of credit to be issued provided the conditions specified in
the first credit are fulfilled.

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 vi) Fixed letter of credit-It fixes the amount of financial obligation of the issuing bank
either in one bill or in several bills put together.

Security Required in Bank Finance

Banks usually do not provide working capital fiancé without obtaining adequate security. The
following are the most important modes of security required by a bank:
1. Hypothecation-Under this arrangement, bank provides working capital finance against the
security of movable property, usually inventories. The borrower does not give possession of the
property to the bank. It remains with the borrower and hypothecation is merely a charge against
property for the amount of debt. If the borrower fails to pay his dues to the bank, the banker may
file a case to realize his dues by sale of the goods/property hypothecated.

2) Pledge-Under this arrangement, the borrower is required to transfer the physical possession of
the property or goods to the bank as security. The bank will have the right of lien and can retain
the possession of goods unless the claim of the bank is met. In case of default, the bank can even
sell the goods after giving due notice.

3) Mortgage-In addition to the hypothecation or pledge, banks usually ask for mortgages as
collateral or additional security. Mortgage is the transfer of a legal or equitable interest in a
specific immovable property for the payment of a debt. Although, the possession of the property
remains with the borrower, the full legal title is transferred to the lender. In case of default, the
bank can obtain decree from the court to sell the immovable property mortgaged so as to realize
its dues.

6.2 Long -Term Finance

The long-term finance sources available to a company for raising capital are:
1. Equity capital (Ordinary share equity and retained earnings)
2. Preference share capital 3. Long-term debt.
1. ORDINARY SHARES- Ordinary shares represent the ownership position in a company.
Features of ordinary shares
A. Claim on Income
Ordinary shareholders have a residual ownership claim. They have a claim to the residual
income, which is earnings for ordinary share holders, after paying expenses, interest charges,
taxes and preference dividends is paid. An income a company may be split into two parts:
Dividend and Retained earnings. Dividends are immediate cash flows to shareholders. Retained
earnings are reinvested in the business and shareholders stand to benefit in future in the form of
the firm’s enhanced value and earning power and ultimately enhanced dividend and capital gain.
Dividends payable depend on the discretion of the company’s broad of directors. A company is
not under a legal obligation to distribute dividend out of the available earnings. Capital gains
depend on the future market value of ordinary shares. Thus, an ordinary share is a risky security

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from the investor’s point of view. Dividends paid on ordinary shares are not tax deductible in
the hands of company.
B. Claim on assets- Ordinary shareholders also have a residual claim on the company’s assets in
the case of liquidation.
C. Right to control- Control in the context of a company means the power to determine its
policies, to appoint directors (Management). The company’s major policies and decision are
approved by the board of directors while day-to-day operations are carried out by managers
appointed by the board. Ordinary shareholders are able to control management of the company
through their voting right and right to maintain proportionate ownership.
D. Voting Rights- Ordinary shareholders are required to vote on a number of important matters
such as on the election of directors and change in the memorandum of association.
E. Pre-emptive right-the pre-emptive right entitles shareholders to maintain his proportionate
share of ownership in the company. The law grants shareholders the right to purchase new
shares in the same proportion as their current ownership which is known as pre-emptive.
F. Limited Liability-Ordinary shareholders are the true owners of the company, but their
liability is limited to the amount of their investment in shares. If a shareholder has already fully
paid the issue price of shares purchased, he/she has nothing more to contribute in the event of
financial distress or liquidation.
Advantages and disadvantages of equity financing
A. Advantages
Permanent capital Since ordinary shares are not redeemable, the company has no liability for
cash outflow associated with its redemption. It is a permanent capital, and is available for use as
long as the company goes.
i. Borrowing Base: The equity capital increases the company’s financial base, and thus its
borrowing limit. Lenders generally lend in proportion to the company’s equity capital.
By issuing ordinary shares, the company increases its financial capability. It can borrow
when it needs additional funds.
ii. Dividend payment discretion: A company is not legally obligated to pay dividend. In
times of financial difficulties, it can reduce or suspend payment of dividend. Thus, it can
avoid cash outflow associated with ordinary shares.
B. Disadvantages
i) Cost: Shares have a higher cost at least for two reasons. Dividends are not tax deductible
as are interest payments, and flotation costs on ordinary shares arehigher.
ii) Risk: Ordinary shares are riskier from investors’ point of view as there is uncertainty
regarding dividend and capital gains. Therefore, they require a relatively higher rate of
return. This makes equity capital as a highest cost source of finance.

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 iii) Earnings Dilution: the issue of new ordinary shares dilutes the existing shareholders’
earnings per share if the profits do not increase immediately in proportion to the increase
in the number of ordinary shares.
iv) Ownership dilution: The issuance of new ordinary shares may dilute the ownership and
control of the existing shareholders.
2. PREFERENCE SHARES
A preference share is often considered to be a hybrid since it has many features of both ordinary
shares and debentures (bonds).
It is similar to ordinary shares in that:
o The non-payment of dividend does not force the company to insolvency.
o Dividends are not deductible for tax purpose, and
o It has no fixed maturity date
On the other hand, it is similar to debentures (bonds) in that:
o Dividend rate is fixed
o Preference shareholders do not share in the residual earnings,
o Preference shareholders have claims in income and assets prior to ordinary
shareholders, and
o They usually do not have voting right.
Features of Preference shares
a) Claim on Income and assets: preference shares are a senior security as compared to
ordinary share. It has prior claim on the company’s income in the sense that the company
must first pay preference dividends before paying ordinary dividend. It has prior claim
on asset in the event of liquidation. The preference share claim is honored after that of a
debenture and before that of ordinary shares. Thus, in terms of risk, preference share is
less risky than ordinary shares, but more risky than debentures.
b) Fixed dividend: The dividend rate is fixed in case of preference shares and preference
dividends are not tax deductible. Preference share is called fixed income security
because it provides a constant income to investors. The payment of preference dividend
is not a legal obligation.
c) Cumulative Dividends: Preference shares may carry a cumulative dividend feature,
requiring that all past unpaid preference dividends be paid before any ordinary dividends
are paid. This feature is a protective device for preference shareholders. Preference
shareholders do not have power to force the company to pay dividends; non-payment of
preference dividend also does not result into insolvency. Since preference share does not
have the dividend enforcement power, the cumulative feature is necessary to protect the
right of preference shareholders.

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 d) Non-Cumulative dividend preference shares: are preference shares without the above
privilege.
e) Redemption /Maturity: Preference shares are usually perpetual or irredeemable, have no
a maturity date.
f) Call feature: The call feature permits the company to buy back preference shares at a
stipulated buy-back or (call price)
g) Participation feature: Preference shares may in some case have participation feature
which entitles preference shareholders to participate in extraordinary profits earned by
the company. This means that a preference shareholder may get dividend amount in
excess of the fixed dividend. Preference shareholders may also be entitled to participate
in the residual assets in the event of liquidation.
h) Voting Rights: Preference share ordinarily do not have any voting right.
i) Convertibility: preference shares may be convertible or non-convertible. A convertible
preference share allows preference shareholders to convert their preference shares, fully
or partly, into ordinary share at a stipulated price during a given period of time.
Advantages and disadvantages of preference shares
Preference shares have a number of advantages to a company, which ultimately occur to ordinary
shareholders.
a) Risk less Leverage Advantage: Preference share provides financial leverage advantage
since preference dividend is fixed obligation. This advantage occurs without a serious
risk of default. The non-payment of preference dividend does not force the company into
insolvency.
b) Dividend Postponability: Preference share provides some financial flexibility to the
company since it can postpone payment of dividend.
c) Fixed dividend: The preference dividend payment is restricted to the stated amount.
Thus, preference shareholders do not participate in excess profit as do the ordinary
shareholders.
d) Limited Voting Right: Preference shareholders do not have voting right except in case
dividends in arrears exist. Thus, control of ordinary shareholders is preserved.
Limitations (disadvantages) of preference shares:
a) Non-deductibility of dividends: The primary disadvantage of preference shares is that
preference dividend is not tax deductible. Thus, it is costlier than bonds.
b) Commitment to pay dividend: Although preference dividend can be omitted, they may
have to be paid because of their cumulative nature. Non-payment of dividends can
adversely affect the image of a company, since equity holders cannot be paid any
dividends unless preference shareholders are paid dividends.

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 Preference share provide more flexibility and less burden to a company. The dividend rate is
less than on equity and it is fixed. Also, the company can redeem it when it does not require the
capital. In practice, when a company recognizes its capital, it may convert preference capital
into equity.
3. BONDS
A bond is a long-term promissory note for raising loan capital. The firm promise to pay interest
and principle:
Features of bond capital
a) Interest rate-The interest rate on bonds is fixed and known. It is called the contractual rate of
interest. It indicates the percentage of par value of the debenture that will be paid out annually
(or semi-annually) in the form of interest, regardless of the market value.
b) Maturity-Debentures are issued for a specific period of time. The maturity of bonds indicates
the length of time until the company redeems (returns) the part value to debenture holders
and terminates the debentures.
c) Redemption Bonds are mostly redeemable; they are redeemed on maturity. Redemption of
debentures can be accomplished either through a sinking fund or buy back (call) provision.
i. Sinking fund: A sinking fund is cash set aside periodically for retiring debenture.
ii. Buy-back (call) provision: buy back provisions enables the company to redeem debentures at
a specified price before the maturity date. The buy-back (call) price may be more than the
par value of the debentures. This difference is called call or buy-back premium.
d) Indentures: An indenture or debenture trust deed is a legal agreement between the company
issuing the debentures and the debenture trustee who represents the debenture holders.
e) Security: Debentures are either secured or unsecured. A secured bond is secured by a lien on
a company’s specific assets. When bonds are not protected by any security, they are known
as unsecured or naked debentures.
e) Prior Claim on assets and IncomeDebenture (bond) holders have a claim on the company’s
earnings prior to that of shareholders. Bond interest has to be paid before paying any dividend to
preference and ordinary shareholders. In liquidation, the bond holders have a claim on assets
prior to that of shareholders. However, secured debenture holders will have priority over the
unsecured bond holders.
Advantages and disadvantages of bond capital
Bonds have a number of advantages as long-term source of finance.
A) Less Costly: It involves less cost to the firm than the equity financing because:
a) Inventors consider bonds as relatively less risky investment alternative and therefore,
require a lower rate and
b) Interest payments are tax deductible
B) No ownership dilution: Bond holders do not have voting right, therefore, bonds issue does
not cause dilution of ownership.

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C) Fixed Payments of Interest: Debenture holders do not participate in extra ordinary earnings
of the company. Thus the payments are limited to interest.
D) Reduced Real Obligation: During periods of high inflation, bond issue benefits the
company. Its obligation of paying interest and principal which are fixed decline in real
terms.
Debentures have some limitation also:
A) Obligatory payments: debenture result in legal obligation of paying interest and
principal, which if not paid, can force the company into liquidation.
B) Financial Risk: It increases the firm’s financial leverage, which may be particularly
disadvantageous to those firms which have fluctuating sales and earnings.
C) Cash Outflow: Debentures must be paid on maturity, and therefore, at some points, it
involves substantial cash outflow.
D) Restricted Covenant: Debenture indenture may contain restrictive covenant which may
limit the company’s operating flexibility in the futures.

6.3. COST OF CAPITAL

Cost of capital of a firm is the rate of return the firm requires from investment in order to
increase or maintain or leave unchanged the value of the firm in the market.

It is the minimum rate of return expected by its investors. It is average cost of various source of
finance (debt, preference capital, retained earnings and equity shares) used by a firm.

A decision to invest in particular project depends up on the cost of capital of the firm or the cut
off rate which is the minimum rate of return expected by investors. Hence, to achieve the
objective of wealth maximization, a firm must earn a rate of return more than its cost of capital.
If a firm’s actual rate of return exceeds its cost of capital and if this rate of return is earned
without increasing the firm’s risk characteristics, then the shareholders wealth will increase.

The cost of capital is critically important topic for three main reasons.

 To maximize a firm’s value, its management must minimize the cost of all inputs,
including capital, and to minimize the cost of capital they must be able to measure it.
 Financial managers require an estimate of the cost of capital to make correct capital
budgeting decisions.
 Many other types of decisions made by financial managers, including those related to
leasing, to bond refunding, and to working capital policy require estimates of the cost of
capital.
It is useful as a standard for:

a) Evaluating investment
b) Designing a firm’s debt policy, and

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 c) Appraising financial performance.

MEASURING THE SPECIFIC COSTS OF CAPITAL

The cost of capital for any particular source of security issue is called the specific/component/
individual cost of capital.

The higher the risk of a particular component, the higher the return required by investors & the
higher the cost to the firm.

Note that,

 Creditors have priority claim up on liquidation and first get interest before any dividend
in paid to owners.
 Specific cost of capital is computed on an after-tax basis and is expensed as an annual
percentage.
Cost of debt must be adjusted for taxes since interest charges are tax deductible but the costs of
the other sources are paid from after-tax cash flows (they need no adjustment for income taxes).
There are four basic sources of long-term funds for the business firm: Long-term debt,
preferred stock, common stock, and retained earnings.

A. The cost debt: - 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. Computing the new bond issue
(debt) requires the following steps.
i. Determine the net proceeds from the sale of each bond.
NP d=¿ [ P −F ] ¿ , Where NP d=¿ ¿ = Net proceeds from the sale of a Bond (debt)
d

Pd = the market price of the bond (debt)

F = Floatation costs

Flotation costs are any cost associated with selling new securities, which reduce the Net
proceeds of each bond sold & Increase the bond’s cost to the firm such as:

 Sales commission paid to those selling the securities, such as brokerage.

 Cost of printing.
 Advertising.
 Registration with government agencies.
 Under pricing or discounts offered to attached investors to buy.

ii. Compute the effective before-tax cost of the bond using the formula

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 Pn−NP d
I+
n
Kd= Where, K d = effective before tax cost of a new bond
P n+ NP d
2
issue
I = Annual interest payment per share
Pn = Par or principal repayment required in n periods.
NPd = Net proceeds from the sale of the bond
n = length of the holding period of the bond in years.
P n+ NP d
= Average amount borrowed
2
Pn – Np d = floatation cost & any premium/ discount
amortization

iii. Compute the after-tax cost of debt

K dt =K d
( 1−T )

Where, K dt =¿the firm’s after tax cost of debt

K d = effective before-tax cost of a new bond Issue
T = the firm’s marginal tax rate.

Example: ABC Company plans to issue 25 year bonds with a face value of $4,000,000. Each
bond has a par value of $ 1000 and carries a coupon rate (the interest rate paid on the bond’s par
value) or 9.5% the firm’s marginal tax rate is 34%. Assume the following conditions.
The bond is sold at par with no flotation costs.

a) The bond is expected to be sold for 98% or par value and flotation costs are estimated
to be approximately $26 per bond.
b) The bond is expected to be sold for $ 104% of par value and flotation costs are
anticipated to be approximately $26 per bond.
Required: Under each of the above three assumptions calculate,

1) Net proceeds per bond.

2) The before tax cost of bond issued.
3) The after-tax cost of this bond issued.
Solution:
Given : Pn = Par value = $ 1,000
I = Coupon rate = 9.5%
T = the firm's marginal tax = 34%
n = 25 years
Condition (a)
1) Net proceeds per bond (NPd) = Pd – F → 1,000-0= 1,000.

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 o bond sold at par = $1000; No flotation costs
2) Before tax cost of the bond ( K d ).
( Pn + NPd )
I+
n
Solution: K d = , I= rate* 1,000→ 9.5%* 1,000= 95
P n+ NP d
2

Kd=
95+ ( 1,000−1,000
25 )
( 1,000+1,000 )
2

95
K d= = .095 →9.5%
1,000

3) After- tax cost of the bond K dt

Solution

K dt = Kd (1-T) → 9.5% (1 – 0.34)

= 9.5% (0.66) → = 6.27%

Interpretation: ABC is expected to earn at least 6.27% return on the proceeds of the bond issue
to provide the cost elements of the burden at the time they are due. In other words ABC is
expected to earn a minimum return of 6.27% on its investment to be financed by the proceeds
from the bond issue so as to maintain the market value of its shares.

Condition (b)

1. Net Proceeds per bond

 Bond expected to sell at 95% of par value
 Estimated flotation costs per bond is $ 26
Or

Par value of bond $ 1000 Pd = (0.98) ($1000)

Less discount (2%of $1000) 20 = $ 980

Market value, Pd (98% of 1000) $980 NPd = Pd -F

Less flotation costs per bond (F) 26 = 980 -26

Net proceeds (Npd = Pd –F) $954 $ 954

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 2. Before- tax cost of the bond ( K d )
Solution

( Pn + NPd )
I+
n
Kd= , I= rate* 1,000→ 9.5%* 1,000= 95
P n+ NP d
2

Kd=
95+ ( 1,000−954
25 )
( 1,000+954 )
2

95+1.84 96.84
Kd= = =0.09911 → 9.91%
977 977

3. After- tax cost of the bond K dt

Solution

K dt = Kd (1-T) → 9.91% (1 – 0.34)

= 9.91% (0.66) → = 6.54%

Condition (c)

1. Net proceeds per bond.

 Bonds expected to sell at 104% of par value

 Estimated flotation costs per bond is $26
Par value of the bond $ 1000
Add premium (4% of $1000) 40
Market value (104% of $1000)=Pd $ 1040
Less: flotation cost per bond (F) 26
Net proceeds (NPd = Pd -F) $ 1014
2. Before-tax cost of the bond
( Pn + NPd )
I+
n
Kd= , I= rate* 1,000→ 9.5%* 1,000= 95
P n+ NP d
2

Kd=
95+ (
1,000−1,014
25 )
( 1,000+1,014 )
2

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Kd=
95+( )
−14
25 =
95−0.56 94.44
1,007
=
1,007
=0.0938 → 9.38%
1,007
3. After- tax cost of the bond K dt

Solution: K dt = Kd (1-T) → 9.38% (1 – 0.34)

= 9.38% (0.66) → = 6.19%

Why tax adjustment

The interest paid on debt is tax deductible. The higher the interest charges, the lower will be the
amount of tax payable of the firm. This implies that the government indirectly pays a part of the
lender’s required rate of return. As a result of the interest tax shield, the after-tax cost of debt to
the firm will be substantially less than the investor’s required rate of return. The before-tax of
debt, Kd, should, therefore, be adjusted for the tax effect as follows:

After-tax cost of debt = Kd (1-T),Where t is the tax rate of the firm.

It should be noted that the tax benefit of interest deductibility would be available only when the
firm is profitable and is paying taxes. An unprofitable firm is not required to pay any taxes. It
would not gain any tax benefit associated with the payment of interest, and its true cost of debt is
the before tax cost.
It is important to remember that in the calculation of average cost of capital, the after tax cost of
debt must be used, not the before tax cost of debt.

B. The cost of preferred stock: - is the minimum rate return required by preferred stock
investors to purchase a firm's preferred stock.
 When a corporation sells preferred stock, it expects to pay dividends to
investors in return for their money capital
 The dividend payments are the costs to the firm of the preferred stock
 Dividend payments on preferred stock are made:
o After interest payments on debt
o Before dividend payments on common stock.
Thus, both the riskiness of preferred stock to investors and the resulting cost issuing preferred
stock fall somewhere between debt and common stock.

Dp
K P= , where K P= cost of new preferred stock
NPP

D p = Annual Dividend per share on preferred stock

NP p= Net proceeds from the sale of preferred stock

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 P p= the market price of the p/s

F = floatation cost

Example: -
ABC Company plans to sell preferred stock for its par value of $25 per share. The issue is
expected to pay quarterly dividends of $0.60 per share and to have flotation cost of 6% of the par
value.

Required: Calculate the cost of the preferred stock to ABC Company.

If the preferred stock is sold at:
 Par?
 95% of its par?
 102% of its par?
Given

 Stock is expected to sell at per = $25

 Flotation cost (6% x $25) = $ 1.5
 Quarterly dividend = $ 0.6/per share
Solution

NP P = Pp –F
= $25 - $ 1.5
= $ 23.5
Annual dividend = D P = ($0.6) (4) = $ 2.4
D P $ 2.40
K P= = ∗100=10.21 %
NPP $ 23.5

Interpretation: ABC Company should earn at least 10.21% on the preferred stock financed
portion of the investment project in order to leave unchanged the market price of the shares

Note:

Unlike interest payments on bonds, preferred stock dividends are not a tax-deductible expense.
Thus, no tax adjustment is needed to adjust the cost of preferred stock downward because the
before tax cost of p/s are the same.

ii. Sold at 95% of par:

P p= ($25) (95%) = $ 23.75
NP P = Pp – F = $ 23.75 - $ 1.5→ $ 22.25
D p $ 2.4
K p= = ∗100=10.78 %
NP p 22.25
iii. Sold at 102% of par

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 Pp = ($25) (102) = 25.50
NP p = $ 25.50 – 1.50 = $ 24
D p $ 2.4
K p= = ∗100=10 %
NP p $ 24
C. The cost of Common Stock:- is the minimum rate of return that the corporation must
earn for its common shareholders in order to leave unchanged /maintain the market value
of the firm's equity.
A corporation does not make a definite or explicit commitment to pay dividends to common
stockholders but when common stock holders invest their funds 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 the investors and, hence, they carry a cost.

D1
Ks= + g ; Where, K s = the cost of new common stock
NPs

NPs = net proceed of the common stock issue → P0−F

Po = Current market price of the firm's outstanding common stock

F = Flotation cost (resulting from selling new common stock below P0) under pricing & under
writing

D1= dividends to be received during year one.

D1=D0 ( 1+ g )

Where, Do = Current dividend/ share g = Annual Compound constant dividend

growth rate

Example1.

An issue of common stock is sold to investors for $25 per share. The issuing corporation incurs a
selling expense of $ 2 per share. The current dividend is $2 per share and expected to grow at 6%
annual rate. Compute the annual rate. Compute the specific cost of common stock.
Given Solution

Po = $ 25/share Nps = Po – F and D1 = Do (1+g)

F = $ 2/share = $25 - $2 D1 = $2(1+0.06)

Do = $ 2/share = $ 23 D1 = $2 (1.06)

g = 6% D1 = $ 2.12

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 D1 2.12
Ks = + g= + .06→ 15.21%
NPs 23

Example2: Dividend per share on a firm's common stock is expected to be $1 next year and is
expected to grow at 6% per year continuously. Assuming the market price per share is $ 25 and
no floatation costs,

1. Calculate the cost of common stock to the firm

2. Compute the expected market value per share assuming the current dividend / share is
$2. (Do = $1)

 At the end of year 1

 At the end of year 2
 At the end of year 3
 At the end of year 6
Solution i) Given Required

D1
D1= $ 1 K? Ks = +g
NPs
G = 0.06
Nps = Po -F 1+0.06 = 10%
= $25 - 0 = $25
1. Solution
D
K s = 1 + g, but if there are no floatation costs Nps = po
NPs
D
K s = n + g, let D1 = Dn for different years.
P0
D
Ks = n +g
P0
Dn
Ks - g = → Po ( K s−g ) = Dn
P0
Dn
P 0= →
( K s−g )
Po = Dn
Ks - g
- Po at the end of the year 1 Po at the end of year 3
D 1 = D0 (1 + g) D3 = D2 (1 +g)

= $ 1 (1+0.06) = $1.124(1+0.06)

= $ 1.06 = $1.191

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 D1 $ 1.06 D3 $ 1.191
Po = = =$ 26.5 Po= = =$ 29.7
K s−g 0.1−.06 K s−g .1−.06

Po at the end of year 2 Po at the end of year 6

D2 = D1 (1 +g) D6 = Do (1+g)6

= $1.06 (1+0.06) = $1 (1+0.06)6

= $1.124 =

D2 $ 1.124 D2 $ 1.42
Po = = $28.10 Po = = $35.46
K s−g .1−.06 K s−g .1−.06

D. Cost of Retained Earnings: - are internal sources (not external)

 Retain earnings are not securities like stocks and bonds and, therefore, they do not have
market prices that can be used to compute costs of capital.
 Retain earnings represent profits available to common stock holders that the corporation
chooses to reinvest in itself rather than payout as dividends. Thus,
a) The shareholders are made to reinvest part of their earnings in corporation.

b) In turn, the shareholders expect the corporation to earn rate of return on those funds at least
equal to the rate of earned on the outstanding common stock.

Therefore, the specific cost of capital of Retain earnings is equated with the specific cost of the
common stock.

 Retain earnings are not free form of financing

 There is an opportunity cost in retaining profits in the business
 These opportunity costs represent the minimum rate of return that the firm's stockholders
could earn on alternative investments of comparable risk.
There are several ways to measure the cost of retain earnings –one of them is:

 The Gordon constant growth model

D1
K r = + g, Where K r = cost of retain earnings
P0
D1 = dividends to be received during year

g = Annual constant growth rate

Po = Current market price of the firms common stock

D1 = Do (1 +g)

Note; Po is considered b/c

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  Retain earnings do not have market prices
 Retain earnings do not involve flotation costs
Example1: An issue of common stock is sold to investors for $ 40 per share. The issuing
company incurs costs of $ 2 per share. The current dividend is $ 2 per share. The current
dividend is $ 2 share and expected to grow at 6% annual rate.

Compute the specific costs of capital of retained earnings? Ks?

Given :

Po = $ 40 per share
F = $ 2 (is ignored now)
Do= $2/per share of current dividend
G = 0.06
Solution:
D 1 = Do (1+g) Ks?
D1
= $2(1+0.06) Ks= +g
NPs
= $2.12
Nps
NPd = Po -F
Kr = $ 2.12 + 0.06 = 40 - 2
40 = 38
= 11.3% Ks = 2.12 + 0.06
38
Ks = 11.6%

Measuring the weighted average cost of capital (WACC)

- It is the rate of return that must be earned by a corporation in order to satisfy the
requirements of the individual specific cost of capital.

- It is the weighted cost of all long-term capital sources where by each specific cost of capital
is weighted by its relative importance in the firm's total capital.
n
K a =∑ w i k i
i=1

Where K a = weighted average cost of capital

w i = percentage of total permanent capital represented by capital source i.
k i= after tax cost of each new specific cost of capital
n = number of types of new capital.
There are two weighted approaches (plans) in computing the WACC: they are Historical &
target

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1) Historical weights: - are based on a firm's existing capital structure:

They are of two types: Book value&Market Value weights

a) Book Value Weights: - measure the actual proportion of each type of permanent capital
in the firm’s capital structure based on accounting values shown on the firm's balance
sheet.
Example: ABC's existing capital structure and specific cost of new capital are shown below:

Source of capital Book value specific cost

Bonds ($ 1000 par, 9.5% coupon) $15,000,000 6.6%
P/s (200,000 share at $25 par) 5,000,000 10.21%
Common stock (1,000,000 shares at $20 par) 20,000,000 13.33%
Retain earnings 10,000,000 13%
$50,000,000
Required: Compute the WACC for the company if it obtains new capital in book value
proportions.
Solution

Source of capital B.V weights (proportion) Specific cost Weighted cost

Bonds 0.3 0.0660 0.0198
Preferred stock 0.1 0.1021 0.0102
Common stock 0.4 0.1333 0.0533
Retain earnings 0.2 0.1300 0.0260
1 0.1093 WACC
Ka = 10.93%

b) Market value weights: - measure the actual proportion of each type of permanent capital in
the firm's capital structure at current market prices.
 The resulting cost of capital reflects the rates of return currently required by investors
rather than the historical rates embodied in the firm's balance sheet.

Example

Take the above example and the following market prices of the securities.

Bonds = 98% of par (i.e 98% x 1000)

Preferred stock = $ 25 per share (i.e. 100% of par)
Common stock = $ 45 per share (i.e. 125% of par)
Source of capital #of securities Market price Market value
Bonds 15,000 $980 $14,700,000
Preferred stock 200,000 25 5,000,000
Common stock 1,000,000 45 45,000,000

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 Total capital structure $ 64,700,000

Note: - Retain earnings do not have a separate M.V because their value is impounded into the
common stock

- Thus, to compute WACC, the common stock MV of $ 45,000,000 is divided between

common stock & Retain earnings in proportion to the sum of their book values.

B/V Ratio
Common stock …………………………………20,000,000
Retain earnings ………………………… 10,000,000 2:1

Hence: 2/3 x $45,000,000 = $ 30,000,000 for common stock

1/3 x 45,000,000 = 15,000,000 for Retain earnings

Source of capital Market valuesMarket value weightsSpecific costs WAAC

Bonds $14,700,000 0.227 0.0660 0.0150
Retain earnings 5,000,000 0.077 0.1021 0.0079
Common stock 30,000,000 0.464 0.1333 0.0619
Retain earnings 15,000,000 0.232 0.1300 0.0302
Total $64,700,000 1 0.115 Ka= 11.5%

2)Target weight – based on the firm’s desired capital structure

Firms, using this approach, establish these proportions on the basis of optional capital structure
they wish to achieve. Consequently, the firm raises additional funds so as to remain constantly
on target with its optional capital structure.
Example: In addition to the data provided above in the previous example, the company
determined that its optional capital structure is 40% bonds, 10% p/s, and 50% common equity
(i.e. both common stock & R/s)

 The firm wants to maintain this optimal capital structure in raising future long-term
capital. It expects to have sufficient retained earnings so that it can use the cost of retain
earnings as common equity cost component.
 If the company raises new capital in target proportions, what would be its WACC?

WACC = 0.4 (0.0660) + 0.10(0.1021) + 0.50(0.1300)

= 0.0264 + 0.0102 + 0.0650
= 0.1016
Ka = 10.16%

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