Example: Ink Inc. is
planning to issue new debt at an interest rate of 8%. Ink is in the 40% marginal federal-plus-
state tax rate. What is Ink’s cost of debt capital?
k
d
(1- t) = 8% (1- .4) = 4.8%
Note: the cost of debt is the interest rate on new (marginal) debt, not the interest rate paid on
existing or old debt. Also note that if it weren’t for the increasing risk of bankruptcy with ever
increasing leverage, the tax deductibility of interest would lead to 100% debt in the capital
structure.
Preferred stock is a perpetuity that pays a fixed dividend (D
ps
) forever. The cost of preferred
stock (k
ps
) is:
Cost of preferred stock = k
ps
= D
ps
/ P
net
Where:
D
ps
= preferred dividends.
P
net
= net issuing price after deducting flotation costs.
Example: Suppose Ink has preferred stock that pays an $8 dividend per share and sells for
$100/share. If Ink were to issue new shares of preferred, it would incur a flotation (or
underwriting) cost of 5%. What is Ink’s cost of preferred stock?
k
ps
= D
ps
/ P
net
P
net
= 100 (1- .05) = $95
k
ps
= $8 / $95 = .084 = 8.4%
The cost of retained earnings (k
s
) is the rate of return stockholders require on the equity
capital the firm retains from earnings. k
s
is the opportunity cost of retaining earnings. You
should know that if a stock is in equilibrium, the rate of return investors require is to equal the
rate of return they expect to get. In equilibrium: required rate of return (k
s
) = expected rate of
return (
k
s
)
The CAPM approach:
Step 1. Estimate the risk-free rate, k
RF.
The short-term T-Bill rate is usually used but some
analysts feel the long-term treasury rate should be used.
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