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FINANCIAL MANAGEMENT
FINALS-HANDOUTS NO.2 (COST OF COMMON STOCK & WEIGHTED AVERAGE COST OF CAPITAL)

3. COST OF COMMON STOCK (Ke)

The cost of common stock is the return required on the stock by investors in the
marketplace. There are two forms of common stock financing: (1) retained earnings and (2)
new issues of common stock.

The cost of common stock equity is the rate at which investors discount the expected
dividends of the firm to determine its share value.

FEATURES OF COMMON STOCK

 Common stock is very easy to buy and sell.
 Unlike preferred stocks, common stock has voting rights.
 The right to vote on certain general governance matters like election of the Board of
Directors, employee stock award plans, mergers, and similar major items.
 An option to buy a proportional part of any additional shares that may be issued by
the company. This "preemptive right" is intended to allow a shareholder to avoid
dilution by being assured a place in line to acquire a fair part of any corporate stock
expansion.
 Right to have capital gain.
 When it is about the liability of the ownership, you have the limited liability. In
simple words, the portion you have purchased from the stock market is actually your
total liability.
 The value of the common stock is not concrete. That means the value fluctuates
time to time. The value of the common stock is backed by the value of the main
company.
 Your original investment is not guaranteed. There is always the risk that the stock
you invest in will decline in value, and you may lose your entire principal.
 There is uncertainty in the return of stock investment as the value is dependent on
many factors such as company earning, taxes, industry factors, or macroeconomic
factors.

Two techniques are used to measure the cost of common stock. One relies on the Dividend
Growth Model (Gordon model), the other on the Capital Asset Pricing Model (CAPM).

GORDON GROWTH MODEL by Myron J. Gordon

The Gordon Growth Model, also known as the dividend discount model (DDM), is a method
for calculating the intrinsic value of a stock, exclusive of current market conditions. The
model equates this value to the present value of a stock's future dividends.

D1
Ke = + g
P0
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Example:

The market price of a share of common stock is $60. The dividend just paid is $3, and the
expected growth rate is 10%. The cost of common stock is 15.50%.

CAPITAL ASSET PRICING MODEL (CAPM) METHOD

The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between
expected return and risk of investing in a security. It shows that the expected return on a
security is equal to the risk-free return plus a risk premium, which is based on the beta of
that security. Below is an illustration of the CAPM concept.

where:

Ke = cost of retained earnings

Rf = risk free rate
β=Beta of the stock Ke = Rf + β (rm-rf)
rm = market return
rm-rf= market risk premium (MRP)

Example:

The estimated Beta of a stock is 1.2. The risk-free rate is 5% and the expected market return
is 13%. By substituting the formula, we get:

Ke = 5% + 1.2(13% – 5%)
Ke = 14.60%

COST OF NEW COMMON STOCK

As an alternative to utilizing the retained earnings, the company may raise funds through the
issuance of new common shares. However, the issuance of new common shares does not
come to pass without a fee or additional expenses. Generally, companies use the services of
investment bankers in selling their shares to the market. The investment banker’s charge
fees which are called floatation costs. Flotation costs are the costs incurred by the company
in issuing the new stock. Flotation costs increase the cost of equity such that cost of new
equity is higher than cost of (existing) equity. But it “reduces” the amount received by the
company from the issuance of such shares.

D1
Kc = + g
P0 - F

Ke = cost of new common stock

Po = stock price today
D1 = dividend at the end of the year
g = growth rate
F = floatation costs (in %)
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Example:

(Same info-Gordon Growth Model example) If additional shares are issued flotation costs
will be 12%. D0 = $3.00 and estimated growth is 10%, Price is $60 as before. By substituting
the formula, we get:

3(1+0.10)
Ke = + 10%
60 x (1-12%)
Ke = 14.60%

SAMPLE PROBLEMS:

1. Assume that you are a consultant to ANTONIO Inc., and you have been provided with the
following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant). What is the cost of
common from retained earnings based on the DCF approach (Gordon Growth Model)?

2. CKM Development Company hired you as a consultant to help them estimate its cost of
capital. You have been provided with the following data: D1 = $1.45; P0 = $22.50; and g =
6.50% (constant). Based on the DCF approach, what is the cost of common from retained
earnings?

3. Assume that KLARETTE Inc. hired you as a consultant to help estimate its cost of common
equity. You have obtained the following data: D0 = $0.90; P0 = $27.50; and g = 7.00%
(constant). Based on the DCF approach, what is the cost of common from retained
earnings?

4. MARYJANE Inc. hired you as a consultant to help estimate its cost of common equity. You
have been provided with the following data: D0 = $0.80; P0 = $22.50; and g = 8.00%
(constant). Based on the DCF approach, what is the cost of common from retained
earnings?

5. CLAIRE and Company hired you as a consultant to help estimate its cost of common equity.
You have obtained the following data: D0 = $0.85; P0 = $22.00; and g = 6.00% (constant).
The CEO thinks, however, that the stock price is temporarily depressed, and that it will soon
rise to $40.00. Based on the DCF approach, by how much would the cost of common from
retained earnings change if the stock price changes as the CEO expects?

6. QUINIE Inc. has the following data: Rf = 5.00%; RPM = 6.00%; and β = 1.05. What is the
firm's cost of common from retained earnings based on the CAPM?
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7. KCY Inc.'s CFO hired you as a consultant to help her estimate the cost of capital. You have
been provided with the following data: Rf = 4.10%; RPM = 5.25%; and β = 1.30. Based on the
CAPM approach, what is the cost of common from retained earnings?

8. JANET Home Cookin' just paid its annual dividend of $0.65 a share. The stock has a market
price of $13 and a beta of 1.12. The return on the U.S. Treasury bill is 2.5% and the market
risk premium is 6.8 percent. What is the cost of equity?

9. JOYCE Home Rentals has a beta of 1.38, a stock price of $19, and recently paid an annual
dividend of $0.94 a share. The dividend growth rate is 4.5%. The market has a 10.6 percent
rate of return and a risk premium of 7.5%. What is the firm's cost of equity?

10. TONI Markets has a growth rate of 4.8% and is equally as risky as the market. Beta is 1. The
stock is currently selling for $17 a share. The overall stock market has a 10.6 percent rate of
return and a risk premium of 8.7 percent. What is the expected rate of return on this stock?

11. RAL Chocolate Co. expects to earn $3.50 per share during the current year, its expected
dividend payout ratio is 65%, its expected constant dividend growth rate is 6.0%, and its
common stock currently sells for $32.50 per share. New stock can be sold to the public at
the current price, but a flotation cost of 5% would be incurred. What would be the cost of
equity from new common stock?

12. MATTHEW Lumber Company hired you to help estimate its cost of common equity. You
obtained the following data: D1 = $1.25; P0 = $27.50; g = 5.00% (constant); and F = 6.00%.
What is the cost of equity raised by selling new common stock?

13. You were recently hired by DENEEN Media Inc. to estimate its cost of common equity. You
obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.00% (constant); and F = 5.00%.
What is the cost of equity raised by selling new common stock?

14. SANCHO Fashions is expected to pay an annual dividend of $0.80 a share next year. The
market price of the stock is $22.40 and the growth rate is 5%. Flotation cost for this issue is
4%. What is the firm's cost of new common stock equity?

15. CLEO Treats common stock is currently priced at $19.06 a share. The company just paid
$1.15 per share as its annual dividend. The dividends have been increasing by 2.5% annually
and are expected to continue doing the same. Flotation cost for this issue is 5%. What is this
firm's cost of new equity?
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