Cost of Capital Computations

　　A.Cost of Long-Term Debt(kdx)

　　kdx=kdt x(1-T)

　　B.Cost of Preferred Stock(kps)

　　kps=Dps/Nps

　　C.Cost of Retained Earnings(kre)

　　Is the rate of return required by common stockholders.

　　A firm should earn at least as much on any RE and

　　reinvested in the business as stockholders could have

　　earned elsewhere.

　　After tax consideration is ignored since dividends are

　　not exempt from tax.

　　Three common methods of computing kre：

　　1.Capital asset pricing model(CAPM)

　　2.Discounted cash flow(DCF)

　　3.Bond yield plus risk premium(BYRP)

　　1.The Capital Asset Pricing Model(CAPM)

　　Formula：

　　Kre=risk free rate+risk premium

　　Kre=krf+(bi x PMR)

　　Kre = krf+[bi x(km–krf)]

　　2. Discounted Cash Flow(DCF)

　　Formula

　　Kre=(D1/P0)+g

　　Kre=[D0 x(1+g)]/P0 + g

　　Actually，dividend growth model，or Gordon growth model-refer to B6-59

　　P0=D0x(1+g)/(Kre-g)

　　Key Factors and Formula Notations

　　a.Cost of RE：kre

　　b.Current market value or price of the

　　outstanding common stock：P0

　　c.The dividend per share expected at the end

　　of one year：D1

　　d.The constant rate of growth in dividends：g

　　D.Weighted Average Cost of Capital(WACC)

　　Serves as a major link between the long term investment decisions associated with a corporation‘s capital structure and the wealth of its owners.

　　The theoretical optimal capital structure is the mix of financing instruments(debt & equity)that produces the LOWEST WACC.