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CHAPTER 13 The Cost of Capital

CHAPTER 13 The Cost of Capital. Sources of capital Component costs WACC. Cost of Capital . The cost of capital represents the overall cost of financing to the firm The cost of capital is normally the relevant discount rate to use in analyzing an investment

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CHAPTER 13 The Cost of Capital

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  1. CHAPTER 13The Cost of Capital Sources of capital Component costs WACC

  2. Cost of Capital • The cost of capital represents the overall cost of financing to the firm • The cost of capital is normally the relevant discount rate to use in analyzing an investment • The overall cost of capital is a weighted average of the various sources, including debt, preferred stock, and common equity: WACC = Weighted Average Cost of Capital WACC = After-tax costs x weights

  3. What sources of long-term capital do firms use?

  4. Calculating the weighted average cost of capital WACC = xd(pretax kd)(1-Tax rate) + xpskps + xcskcs • The x’s refer to the firm’s capital structure weights. • The k’s refer to the cost of each component.

  5. Should our analysis focus on before-tax or after-tax costs? • Stockholders focus on After-Tax CFs. Therefore, we should focus on A-Taxcapital costs. • Only cost of debt needs adjustment, because interest is tax deductible.

  6. Should our analysis focus on historical costs or new (marginal) costs? • The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on today’s marginal costs (for WACC).

  7. How are the weights determined? WACC = xd(pretax kd)(1-Tax rate) + xpkp + xcskcs • As a percentage of total financing

  8. Weighting example Bonds 40 Pref. Stock 100 Common 100 Ret. Earn. 160 Total L & E 400 What is weight of each component?

  9. Weighting example Bonds 40 Pref. Stock 100 Common 100 Ret. Earn. 160 Total L & E 400 Bonds = 40/400 = 10% Pref. Stock = 100/400 = 25%

  10. Component cost of debt WACC = xd(pretax kd)(1-T) + xpkp + xcskcs • kd is the marginal cost of debt capital. • The yield to maturity on outstanding L-T debt is often used as a measure of kd. • Why tax-adjust, i.e. why kd(1-Tax rate)?

  11. If tax rate is 40% then 10% before tax = 6% after tax 60 difference

  12. Component cost of debt • Interest is tax deductible, so aftertax kd = pretax kd (1-T) = 10% (1 - 0.40) = 6% T = tax rate = 40%

  13. Cost of debt • What is the current cost of debt for a firm that has a 9% coupon bond with 5 years to maturity and a current price of $962? • What is the after tax cost if it is in the 40% tax bracket?

  14. Component cost of preferred stock WACC = xdkd(1-T) + xpkp + xcskcs • kp is the marginal cost of preferred stock. • The rate of return investors require on the firm’s preferred stock.

  15. What is the cost of preferred stock? • The cost of preferred stock can be solved by using this formula: kp = Dp / Pp = $8 / $111 = 7.2%

  16. Component cost of preferred stock • Preferred dividends are not tax-deductible, so no tax adjustments necessary.

  17. Component cost of equity WACC = xd(pretax kd)(1-T) + xpkp + xcskcs • kcs is the marginal cost of common equity

  18. Why is there a cost for retained earnings? • Earnings can be reinvested or paid out as dividends. • Investors could buy other securities, earn a return. • If earnings are retained, there is an opportunity cost (the return that stockholders could earn on alternative investments of equal risk). • Investors could buy similar stocks and earn kcs. • Firm could repurchase its own stock and earn kcs. • Therefore, kcs is the cost of retained earnings.

  19. Two ways to determine the cost of common equity, kcs 1. CAPM: kcs = RRF + β x (Mkt. risk premium [E(RM)– RRF]) • RRF = Risk Free Rate (now around 2.7%) • RM = Return on the market • β = Beta - the relation of its returns with that of the stock market e.g. • 0 – not correlated • 1 - moves with the market • 2 – twice as volatile

  20. Two ways to determine the cost of common equity, kcs 2. DCF: P0 = (D1 / r - g) r = kcs kcs = (D1 / P0)+ g

  21. If the market premium is 6%, risk-free rate is 2.7% and the firm’s beta is 1.48, what’s the cost of common equity based upon the CAPM? kcs = RRF + β(mkt premium) = 2.7% + 1.48(6.0%) = 11.58%

  22. If D0 = $1.72, P0 = $43, and g = 5%, what’s the cost of common equity based upon the DCF approach? D1 = D0 (1+g) D1 = $1.72 (1 + .05) D1 = $1.81 kcs = (D1 / P0)+ g = ($1.81 / $43) + 0.05 = 9.2%

  23. What is a reasonable final estimate of kcs? MethodEstimate CAPM 11.58% DCF 9.2% Average 10.4%

  24. Calculate WACC • If 40% of your financing is from debt at an after tax cost of 8% and 60% is from pref. stock at 10%, what is the WACC? • It will be between what two numbers?

  25. 40% (.08) + 60% (.10) • .032 + .06 = .092 • 9.2%

  26. Balance Sheetuse costs that were just calculated Market values

  27. Ignoring issuance costs, what is the firm’s WACC? WACC = xd(pretaxkd)(1-Tax) + xpkp + xcskcs = .3(10%)(0.6) + .1(7.2%) + .6(10.4%) = 1.8% + 0.72% + 6.2% = 8.7%

  28. WACC • You are analyzing the cost of capital for a firm that is financed with 60 percent equity and 40 percent debt. The after-tax cost of debt capital is 10 percent, while the cost of equity capital is 20 percent for the firm. What is the overall cost of capital for the firm? • (.6 x .2) + (.4 x .1) = 16% Equity + Debt

  29. Cardinal Health has bonds outstanding with 15 years to maturity and are currently priced at $800. If the bonds have a coupon rate of 8.5 percent, then what is the after-tax cost of debt for Beckham if its marginal tax rate is 30%? • 7.9%

  30. Should the company use the composite WACC as the hurdle rate for each of its projects? • NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the “hurdle rate” for a typical project with average risk. • Different projects have different risks. The project’s WACC should be adjusted to reflect the project’s risk.

  31. Optimum Capital Structure • The optimal (best) situation is associated with the minimum overall cost of capital: • Optimum capital structure means the lowest WACC • Usually occurs with 30-50% debt in a firm’s capital structure • WACC is also referred to as the required rate of return or the discount rate

  32. Optimal Capital Structure Cost (After-tax) Weights Weighted Cost Financial Plan A: Debt………………………… 6.5% 20% 1.3% Equity………………………. 12.0 80 9.6 10.9% Financial Plan B: Debt………………………… 7.0% 40% 2.8% Equity………………………. 12.5 60 7.5 10.3% Financial Plan C: Debt………………………… 9.0% 60% 5.4% Equity………………………. 15.0 40 6.0 11.4%

  33. Cost of capital curve

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