corporate finance 6

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6. THE COST OF CAPITALpart I

Chapter 5


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There are costs connected with obtaining financing andcompensating providers of various sources of funds, both

short-term and long-term, which must be considered bymanagement in making any financing decision.

One of managements obligations is to develop a pattern of

funding that both matches the risk/reward profile of thebusiness and is sufficiently adapted to meeting theevolving needs of the company.

The cost of capital


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This section describes the procedures for measuring the cost ofspecific sources of capital.

Our concern is only with the long-term sources of funds availableto a firm, since these sources supply the permanent financing.

There are four basic sources of long-term funds for the business:

1. long-term debt;2. preferred stock;

3. common stock;

4. retained earnings.

The cost of capital


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The right side of a balance sheet can be used to illustrate thesesources.

The cost of capital


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1. Cost of Bonds

Together with the equity and the financing by means of bankloans, important sources of financing from outside the company

are attracted appealing to the public savings that is the bondfinancing.

For any company, in some situations, the equity is insufficient tocover the financing needs, and its growth (by new cash

subscription or by the incorporation of the reserves) mayencounter difficulties, not only from the juridical point of view butmostly from the inherent risks related to the potential investorstrust in the issuer of shares and those related to the possibility ofloosing control for the old shareholders.


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In addition to that, contracting bank loans implies for the company,sometimes, more restrictive conditions to be fulfilled. These are the

reasons that determine the companies, especially the big ones thatare marketable, to apply to bonds financing.

A bond is a security sold by governments and corporations to raisemoney from investors today in exchange for the promised future

payment. Corporate bonds are certificates evidencing that the company has

borrowed a specified sum of money, which it has promised to repay inthe future under clearly defined terms.

Bonds are long-term debt instruments used to raise large sums of

money from a diverse group of lenders.

1. Cost of bonds


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We can define the bond as a security that proves a medium or longterm loan that the issuer obliges to repay in a determined period of

time, that gives the right to its owner (the creditor of the firm) to acertain annual interest, during the whole period, no matter theeconomic or financial situation of the issuer.

There also exist convertible bonds that can be turned/changed in

shares of the firm that issued them, in the conditions established inthe public offer prospect.

At first sight, one might appreciate that a total capital growth bymeans of the issue of bonds has a bad influence on the firmsfinancial structure toward the growth of the balance of debts in the

total capital.

1. Cost of Bonds


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1. Cost of bonds

There are several conditions to be fulfilled by a firm in order to haveaccess to bonds financing market:

- it has to be a joint-stock company;

- the firm has to have at least two or three years of activityreflected in the balance sheet approved by the shareholders;

- the issue of bonds by public offer is made on the basis of aprospect of issue;

- the value of the subscribed bond financing has to be completelysubscribed.


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1. Cost of Bonds (parameters of the issue)

The issuing company of the bonds establishes, through consulting withthe mediation company and based on its own needs of financing the

characteristics (parameters) of the issue:

1. the face value (or par value) of the bond equals the part of theborrowed amount, represented by each bond. The bonds from the sameissue must be of an equal value, to give the owners equal rights.

2. the emission price (issue price) represents the amount paid by thebuyer to become the owner of the bond. In some cases, the issue priceequals the face value, and in other situations (for example, the need tospeed up the bond sale), there is a difference between the face valueand the issue price (the face value may be bigger than the issue price).

The difference is called issue premium.


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1. Cost of bonds (parameters of the issue)

Sometimes, to make the bonds more attractive, or when theperiod is big, they are returned when due time at a bigger price

than the par, the difference being called returning/repaymentpremium. The issuing and returning premiums decide a cost ofthe credit higher than the nominal interest. When the issue ofbond financing is under-par, and its return is at a higher value thanthe par, both an issue premium and a returning premium will

appear.3. the numbers of bonds.

4. the total amount of the bonds financing, is obtained bymultiplying the issue price with the numbers of bonds. This is the

amount which is used to finance the firm.


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5. the date of use is the date when the interest begins toflow.

6. the date of regulation is the date when the investorsdeposit the amounts for the bonds financing.

7. the amount of the interest. The issuer remunerates theborrowed amounts, with a periodic interest. The promised

interest payments of a bond are called coupons. The bondcertificate typically specifies that the coupons will be paidperiodically (for example, semiannually) until the maturitydate of the bond. The amount of each coupon payment is

determined by the coupon rate (interest rate)of the bond.


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This coupon rate is set by the issuer and stated on

the bond certificate. The amount of each couponpayment, CP, is:

For example, a $1000 bond with a 10% coupon rate and semiannual paymentswill pay coupon payments of $100010% / 2 = $50 every six months.


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1. Cost of bonds(parameters of the issue)

8. the life period, the frequency of payments and the

returning modalities. In the financial practice, there are used

many returning ways. A bond may have one or morespecifications for amortization. Generally there are:

a) the normal amortization of the loan;

b) the amortization with specifications for the return withanticipation.


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The cost of the bond credit

The real cost of the bond loans is given by the discountrate (r) that equals the net present value (NPV) of this

operation with zero, as follows:

I0 - the initial cash flow (cash flow at the beginning of year 1)CFi the annual cash flows that occur during the loan period


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When estimating the annual cash flows we will keep in mind:

the returning modalities (if the reimbursement is made entirely

and the end of those nyears; proportionally in time; or in moredelicate situations, uneven in time).

the incidence of the profit taxes.

In this way, under the incidence of the taxes, the interests aredeductible of the taxable profit and the real load undertaken bythe company is smaller, that is if the debtor company isprofitable, the interest that it will deliver each year to its lender

will allow realizing tax shield.


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This calculated diminish allows if the company isprofitable, to accomplish a tax shield:

Ni * (PR- P

E)* T

So, the cost of bonds credit, r, obtained with emission andrepayment premium, is the solution of the followingequation:


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Where:

Ai Annuity of year i (A

i= interest

i+ amortization

i)

Ii interest paid in year i

- annual tax savings due to interest and emission and repaymentpremium expenses that reduce the total taxable income of the firm.

A special observation must be made, and that is that as long as theinterest rate can be fixed or variable, this has a special influence on theinterest flows. In the first case, the interest flows are known from thebeginning, and in the second case, these can only be estimated with acertain probability.


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exercises

1. U.S. Treasury has just issued a five-years, $1000 bond with a 5%coupon rate (annually). What cash flows you will receive if you hold

the bond until maturity?CF=

2. Consider the five-years, $1000 bond with a 5% coupon rate of annualcoupons. If this bond is currently trading for a price of $957.35, whatis the bonds yield to maturity? The bond is redeemed at the end of

the fifth year. Interest Rate = 5 %PV = - $957.35

NPER = 5

PMT= 50

FV= $1000

r = ?


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Example

Consider again the five-years, $1000 bond with a 5% coupon rate ofannual coupons. Suppose you are told that its yield to maturity has

increased to 6.30%. What price is the bond trading for now? PV =

R= 6.3%

PMT= 50

FV = $1000

NPER= 5

PV= - $

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