Financial Management Report: COST OF CAPITAL: Cost of preferred stock

and common stock

This topic focuses on how the earning of preferred and common stocks
dividends helps for additional financing and decision making.
Cost of Preferred Stock
The preferred stock represents a special type of ownership interest in the
firm. The rights given to the preferred stockholders were to receive stated dividends
before the firm can distribute any earnings to the common stockholders.
Preferred Stock Dividends
Preferred stock is stated in peso amounts: x pesos per year. When dividend
are stated this way, the stock is often referred to as x-peso preferred stock. Thus
a Php7 preferred stock is expected to pay preferred stockholders of Php7 in
dividends each year on each share of preferred stock owned.
Sometimes, a preferred stock is represented as a annual percentage rate.
This rate represents s the percentage of the sotcks par, or face, value that equals
the annual dividend. For example an 8% preferred stock with a Php50 par value
would be expected to pay an annual dividend of Php4 per share (0.08 x php50 =
php4). Before the cost of preferred stock is calculated, any dividends
stated as percentages should be converted to annual peso dividends.
How to calculate the Cost of Preferred Stock
The cost of preferred stock, rp, is the ratio of the preferred stock
dividend to the firms net proceeds from the sale of the preferred stock.
This preffered stock dividends are paid out of the firms after tax cash flows
therefore a tax adjustment is not requireds
The formula for calculating cost of preferred stock (r p):
rp = Cost of preferred Stock
Np = Net proceeds that represents the amount of
money to be received minus any flotation costs.
Dp= annual peso dividend.
Example: Jellybean Company is contemplating issuance of a 10% preferred
stock that is expected to sell for its Php87 per share par value. The cost of issuing
and selling the stock is expected to be Php5 per share. What is the cost of preferred
stock?
Solution: The first step is to calculate the peso amount of the preferred stock
(Php87 x 10% = Php8.7). Then calculate the net proceeds per share from the

proposed sale of stock equals the sale price minus the flotation costs (php87 php5
= Php82). Substituting the annual dividend, D p, of php8.7 and the net proceeds, N p,
ofphp82 into equation gives the cost of preferred stock of 10.6%.
Computation:

The cost of Jellybean Company preferred stock

(10.6%) is much greater than the cost of its
long-term debt (5.6%). This difference exist both
because the cost of long-term debt (the
interest)is
tax
deductible
and
because
preferred stock is riskier that long-term
debt.

Cost of Common Stock

The cost of common stock is the return required on the stock by
investors in the marketplace.
Two types of common stock financing:
1. Retained earnings
2. New issues of common stock.
How to calculate the Cost of Common Stock Equity
The cost of common stock equity, r s, is the rate at which investors
discount the expected dividends of the firm to determine its share value.
Two techniques to measure the cost of common stock equity:
1. Constant growth valuation (Gordon) model
2. Capital asset pricing model (CAPM).
Technique # 1: Constant Growth Valuation Model (Gordon Model)
The model assumed that the value of a share of stock equals the
present value of all future dividends that is also assumed to grow at
constant annual rate over an infinite time horizon.
The formula to get the value of stock using Gordon model:

P0 = value of common stock

D1= per-share dividend expected at the end of year 1
rs=required return on common stock
g=constant rate of growth in dividends
Common stock dividend are paid from after-tax income, no tax
adjustment is required.
Example: Gingerbread Corporation wishes to determine its cost of common
stock equity. The market price, of its common is php50m per share. The firm
expects to pay a dividend, of php4 at the end of the coming
Divide
year, 2015. The dividends paid on the outstanding stock
Year
nds
2014
Php3.80 over the past 6 years (2009-2014) were as follows:
2013
3.62
2012
3.47
2011
3.33
2010
3.12
2009
2.67

What is the cost common equity?

Solution:
Given: P0 = Php50
D1= Php4
g = 5% (PV of cashflows)
rs=?

Computation:

*The 13% cost of common stock equity

represents the required return by existing
shareholders on their investment.
If the actual return is less that, shareholders are
likely to begin selling their stock.
Technique # 2: Using the Capital Asset Pricing Model (CAPM)
The model describes the relationship between the required return,
rs, and the nondiversifiable risk of the firm as measured by the beta
coefficient b. Using CAPM indicates that the cost of common stock equity is the
return required by the investors as compensation for the firms nondiversifiable risk,
measured by beta.
Formula for required return using CAPM:

RF = Risk-free rate of return

rm =market return; return on the
market portfolio of assets.
Example: (Using the same example in Gordon Model) Gingerbread
Corporation now wishes to calculate its cost of common stock equity by using the
CAPM. The firms investment advisor and its own analyses indicate that the risk-free
rateis 7%; the firms beta is 1.5; and the market return is 11% . What is common
stock equity?
Computation:
equity

same

The 13% cost of common stock

represents the required return of
investors
in
Gingerbread
Corporations common stock which is
as using Gordon Model.

Common Stock Financing #1: Thru Cost of Retained Earnings

When the corporation issues a cash dividend to common stockholders, it
reduces the retained earnings. The cost of retained earnings, r r, to the firm is
the same as the cost of an equivalent fully subscribed issue of additional
common stock. Stockholders find the firms retention of earnings acceptable only
if they expect that it will earn at least their required return on the reinvested funds.
Viewing retained earnings as a fully subscribed issue of additional common stock,
the firms cost of
retained earnings is set, rr, equal to the ost
ofcommon
stock
equity as given in the two previous
techniques.
Therefore:

*The cost of retained earnings is the same as getting the common stock equity by
the two techniques discussed previously. Thus, r r = 13%.
Common Stock Financing #2: Thru Cost of New Issues Of Common Stock
The cost of New issues of common stock, r n, is determined by
calculating the cost of common stock, net of underpricing and associated
flotation costs. Normally, For a new common stock to sell, it has to be underpriced
which means that it is sold at below its current market price, P 0.
Reasons why common stocks are normally underpriced:

1. When the market is in equilibrium, additional demand for shares can be

achieved only at a lower price.
2. When additional share are issued, each shares percentage of ownership
in the firm is diluted, thereby justifying a lower share value.
3. Finally, many investors view the issuance of additional shares as a signal
that management is using common stock equity financing because it
believes that the shares are currently overpriced.
For getting cost of new issues of common
stock, the Constant-growth valuation model
(Gordon Model) expression:

Where:
rn = Cost of new issues of common stock
D1= per-share dividend expected at the end of year 1
Nn= net proceeds less underpricing and floatation costs.
g=constant rate of growth in dividends
Example: In the constant-growth valuation example of Gingerbread
Corporation, we found out that the cost of common equity to be 13%, using
the following values:an expected amount of dividend of Php4; a current
market price of Php50; and an expected growth rate of dividend of 5%. To
determine its cost of new common stock, the firm estimated that on average
new shares can be sold for Php47. The Php3-per-share underpricing is due to
competitive nature of the market. The issuing and selling price woul be
Php2.50 per share. What is the cost of new issue common stock?
Solution:
The net proceeds from
sale of new common stock will
be less that the current market
price. There, the cost of new
issues will always be greater
than the cost of existing issues
which is equal to the cost of
retained earnings.
The cost of new common stock
is normally greater thatn any
other long-term financing cost.
Gingerbread Corporations cost of new common stock is therefore 14%. This
is the value to be used in subsequent calculations of the firms overall cost of
capital.

* Therefore, when choosing a common stock financing, the cost of

retained earnings is always lower than the cost of a new issue of
common stock, because it entails no floatation costs.

Reported by:
Patsy Cline N. Ganiban
BSA4