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Cost of Capital

Cost of Capital. FACULTY OF BUSINESS AND ACCOUNTANCY. Week 12. Introduction. The cost of capital is the rate of return that a firm must earn on its project investments (required rate of return);. To maintain its market value To attract funds from the market suppliers of capital.

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Cost of Capital

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  1. Cost of Capital FACULTY OF BUSINESS AND ACCOUNTANCY Week 12

  2. Introduction • The cost of capital is the rate of return that a firm must earn on its project investments (required rate of return); • To maintain its market value • To attract funds from the market suppliers of capital • If risk is held constant, projects with; Rate of return > Cost of capital • will increase the value of the firm

  3. It is estimated at a given point in time • It should reflect the expected average future cost of funds over the long run • Since firms normally have a mixture of financing (debt or equity or both), cost of capital should reflect the interrelatedness of financing activities. • Thus, the relevant cost of capital is the overall cost of capital or the weighted average cost of capital (WACC or r) rather than the cost of specific source of funds used to finance a given expenditure. • The cost of capital is measured on an after-tax basis

  4. Rationale of using WACC Example: a firm is currently faced with two investment opportunities. If select each investment based on separate r, then will only accept A.

  5. But do these actions are in the best interests of its owners? ~ recall that it accepted a project yielding a smaller return (7%) & rejected the one with 14% return. • Better alternative is using a combined cost, WACC which ; • Reflects the interrelatedness of financing decisions • Provides better decisions over the long run • WACC is the weighted average, or composite cost of the various types of funds a firm generally uses, regardless of the specific financing used to fund a particular project.

  6. WACCis found by weighting the cost of each source of financing by its target proportion in the firm’s capital structure Assume that a 50-50 mix of debt & equity is targeted, WACC would be; .50 x 6% debt + .50 x 14% equity = 10%

  7. Sources of Capital Four basic sources of long-term funds for business firms; Balance Sheet Current liabilities  Long-term debt (bonds) Assets Stockholders’ equity  Preferred stocks Common Stock Equity  Common Stock  Retained Earnings The relevant cost is the after-tax cost of obtaining the financing today, not the historically based cost reflected by the existing financing on the firm’s book.

  8. Calculating the weighted average cost of capital rp= cost of preferred stock WACC, ra= wdrd(1-T) + wprp+ wsrr, or n rd= cost of debt rror n= cost of common equity • The w’s refer to the firm’s capital structure weights. • The r’srefer to the cost of each component.

  9. Should our analysis focus on before-tax or after-tax capital costs? • Stockholders focus on A-T CFs. Therefore, we should focus on A-T capital costs, i.e. use A-T costs of capital in WACC. Only rdneeds adjustment, because interest is tax deductible. Should our analysis focus on historical (embedded) 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).

  10. How are the weights determined? WACC = wdrd(1-T) + wprp+ wsrr or n • The weights must be in decimal form & the sum of all weights must equal 1.0 • Common stock equity weight, ws, is multiplied by either the cost of retained earnings, rr, or the cost of new common stock, rn.

  11. COMPONENTS OF COST 1. The Cost of Long-Term Debt • Most corporate l-t debt are incurred through the sale of bonds. • Net proceeds are the funds actually received from the sale of a security. • Flotation costs are the total costs of issuing & selling a security. Eg: A bond with a par value of RM1,000 sells at RM980. The flotation costs are 2% of the par value; Flotation costs = 2% x 1,000 = RM20 Net proceeds = RM980 - RM20 = RM960

  12. Before Tax Cost of Debt, rd Can be obtained by; 1. Using cost quotations • When net proceeds equal its par value, rdwould equal the coupon interest rate. E.g.: A 10% coupon ir bond that net proceeds equal to bond’s RM1,000 par value would have a rdof 10% b. Using yield to maturity (YTM) on a similar risk bond E.g.: If a similar-risk bond has a YTM of 9.7%, then, can use this rate as rd

  13. 2. Calculating the cost rdis the IRR on the bond cash flows; Bond’s price = interest pmt x PVIFAi,n + (par value x PVIFi%,n) annually rd IRR or rd, can be calculated through either; a) F/C or b) Approximation Eg: A bond of 20-years, 9% coupon annually & a par value of RM1,000. Sells at RM980 & the flotation costs are RM20

  14. 3. Approximating the cost rd= I + principal pmt - net proceeds n principal pmt + net proceeds 2 I = annual interest or coupon payments in RM n = no. of years to bond’s maturity rd= 90 + 1,000 - 960 20 1,000 + 960 2 = 90 + 2 = 9.3877% 980

  15. After-Tax Cost of Debt, ri • This is the relevant cost because interest on debt is tax deductible & this will reduce the firm’s taxable income. • The interest deduction therefore reduces taxes by an amount equal to the product of the deductible interest & the firm’s tax rate (tax savings) After-tax = interest rate - tax savings on debt cost of debt ri= rd- rdT = rd(1-T) rifor the previous bond given a 40% tax rate; ri= 9.4% (1 – 0.40) = 5.6%

  16. E.g.: A semiannual coupon bond at 12% coupon rate and 15 years to maturity. Current bond price = RM1,153.72. Tax rate = 40% F/C; Component Cost of Debt; ri= 10% (1 – 0.40) = 6%

  17. 2. The Cost of Preferred Stock, rp • Preferred stock represents a special type of ownership interest in the firm. • It gives the owners the rights to receive their stated dividends before any earnings can be distributed to common s/holders • Preferred dividends are not tax-deductible, so no tax adjustments necessary. Just use rp. • Nominal rpis used.

  18. What is the cost of preferred stock? • Cost of p.s. is the rate of return investors required on the firm’s preferred stock. • Cost of preferred stock, rpis calculated as the preferred dividend, Dp divided by the current price: Tells the relationship between the cost of p.s. in the form of its annual dividends, and the amount of funds provided by the p.s. issue.

  19. Sometimes, net proceeds from the sale of the stock, Npis used instead of current price Net proceeds represent the amount of money to be received minus any flotation costs • Because p.s. dividends are paid out of the firm’s after-tax cash flows, a tax adjustment is not required.

  20. Preferred Stock Dividends, Dp • The dividends are stated in 2 ways; • As an RM amount ; RMx per year or RMx preferred stock • e.g. RM4 p.s. is expected to pay preferred s/h RM4 in dividend per year on each share of p.s. owned. 2. As an annual percentage rate - represents the percentage of the stock’s par or face value that equals the annual dividend. e.g. An 8% p.s. with a RM50 par value would be expected to pay an annual dividend of RM4 per share (.08 x RM50 par value = RM4) Note: any dividend stated as percentages, should be converted to annual RM first to calculate rp

  21. Is preferred stock more or less risky to investors than debt? • More risky; company is not required to pay preferred dividend. • However, firms try to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, (3) preferred stockholders may gain control of firm.

  22. 3. The Cost of Common Equity, rs WACC = wdrd(1-T) + wprp+ wsrs New common equity can be raised in 2 ways; Retaining some of the current year’s earnings Issuing new common stocks rris the marginal cost of common equity using retained earnings. The rate of return investors require on the firm’s common equity using new equity is rn.

  23. In equilibrium, expected & required rates of return on stocks should be equal; rs= rs To solve rsthen, we can either find the expected rates of return or rs itself. Finding the required rates of return, rs • CAPM Approach • Bond-Yield-Plus-Risk-Premium Approach • Discounted Cash Flow (DCF) Approach

  24. 1. The CAPM Approach Capital asset Pricing Model (CAPM) is used to estimate the cost of common equity. The steps; • Estimate the risk-free rate, rRF • - taken from government bills or bonds • 2. Estimate the stock’s beta coefficient, bi • - the extent of which the returns on a given stock move with the stock market • 3. Estimate the required rate of return on the market, rm CAPM: rs= rRF+ (rM– rRF) bi

  25. E.g.: If the rRF= 7%, RPM = 6%, and the firm’s beta is 1.2, what’s the cost of common equity based upon the CAPM? rs= rRF+ (rM– rRF) β = 7.0% + (6.0%) 1.2 = 14.2%

  26. 2. Bond-yield-plus-risk-premium Approach Add a judgmental risk premium of 3 to 5 percentage points to the interest rate on the firm’s own long-term debt. For example, if Firm J has bonds that yielded 8% annually, its cost of equity might be estimated as follows; Own-Bond-Yield-Plus-Risk Premium: rs= rd+ RP

  27. If rd= 10% and RP = 4%, what is ks using the own-bond-yield-plus-risk-premium method? • This RP is not the same as the CAPM RPM. • This method produces a ballpark estimate of rs, and can serve as a useful check. • rs= rd+ RP • rs= 10.0% + 4.0% = 14.0%

  28. 3. Discounted Cash Flow (DCF) Approach Po = current price of the stock D1 = dividend expected to be paid at the end of next year, or Year 1 g = constant rate of growth in dividends Implies that investors expect to receive dividend yield, D1/ P0 , plus a capital gain, g.

  29. E.g. If D0 = RM4.19, P0 = RM50, and g = 5%, what’s the cost of common equity based upon the DCF approach? D1 = D0 (1 + g) D1 = RM4.19 (1 + .05) D1 = RM4.3995

  30. What is the expected future growth rate? • The firm has been earning 15% on equity (ROE = 15%) and retaining 35% of its earnings (dividend payout = 65%). This situation is expected to continue. g = ( 1 – Payout ) (ROE) = (0.35) (15%) = 5.25% • Very close to the g that was given before.

  31. Can DCF methodology be applied if growth is not constant? • Yes, non-constant growth stocks are expected to attain constant growth at some point, generally in 5 to 10 years. • Will be complicated to compute.

  32. What is a reasonable final estimate of ks? MethodEstimate CAPM 14.2% DCF 13.8% rd+ RP 14.0% Average 14.0%

  33. Cost of Retained Earnings, rr 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 rs. • Firm could repurchase its own stock and earn rs. • Therefore, rsis the cost of retained earnings.

  34. Why is the cost of retained earnings cheaper than the cost of issuing new common stock? • When a company issues new common stock they also have to pay flotation costs to the underwriter. • Issuing new common stock may send a negative signal to the capital markets, which may depress the stock price.

  35. Cost of New Common Stock, rn In issuing new common stock, firms incur flotation costs (underwriting & selling costs). Therefore, cost of new common stock should reflect both; the required return paid to investors & the flotation fees paid to issue it. DFC approach can be adapted to account for flotation costs when calculating rn rn= D1 + g P0 (1 - F)

  36. E.g. If issuing new common stock incurs a flotation cost of 15% of the proceeds, what is rn? rn

  37. Retained Earnings Breakpoint • The amount of capital raised beyond which new common stock must be issued • The total amount of financing that can be raised before the firm is forced to sell new common stock Retained earnings = addition to retained earnings break point equity fraction from capital struc.

  38. E.g: Firm A’s addition to retained earnings in 2006 is expected to be RM68 mil. Its capital structure consists of 45% debt, 2% p.s. & 53% equity. Retained earnings = addition to retained earnings break point equity fraction from capital struc. = RM68 / 0.53 = RM128.3 Means that the firm’s financing comes from; Debt : 0.45 (128.3) = RM57.74 P.s. : 0.02 (128.3) = RM2.57 Ret. E : 0.53 (128.3) = RM67.9 • If A’s capital budget exceed RM128.3m, the amount of equity required will exceed the available r.e.. So must obtain it from issuance of new stock.

  39. Calculating the weighted average cost of capital WACC = wdrd(1-T) + wprp+ wsrs Eg; Facts: 30% l-t debt 10% P.S. 60% Common Equity Target capital structure rd= 10% ; rp= 9%; rs= 14% ; T = 60% WACC = wdrd(1-T) + wprp+ wsrs = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1%

  40. The Weighted Marginal Cost of Capital (WMCC) • Firm should only invest in projects where the expected return is more than WACC. • WACC varies depending on the volume of financing the firms want to raise. Why? • As the volume of financing increases, the costs of the various types of financing will increase, raising WACC • WMCC is the firm’s WACC associated with its next RM of total new investment.

  41. Breaking Points for Each Components Before calculating WMCC, must calculate BP which reflect the level of total new financing at which the cost of one of the financing components rises. BPj = AFj / wj Capital structure weights Breaking points for financing source j Amount of funds available from financing source j at a given cost

  42. Eg; Firm B exhausts its RM300k of available retained earnings (rr= 13%). It must use the more expensive issuance of new common stock (rn= 14%). Furthermore, the firm expects that it can borrow only RM400k of debt at 5.6% cost, any additional debt will have an after-tax cost of 8.4%. Find the WMCC at each level of financing and construct its schedule. • Steps to calculate & construct WMCC schedule; • Determine the BP points • Calculate the WACC over the range of total new financing btw BPs • a. Find WACC between zero & the first BP • b. Find BP btw first BP and the second one & so on.

  43. The breaking points; (the total financing) • When the RM300k of r.e. costing 13% will be exhausted • BPs = RM300k / 0.50 = RM600,000 • When the RM400k of l-term debt costing 5.6% will be exhausted • BPd = RM400k / 0.40 = RM1,000,000

  44. WACC for Ranges of Total Financing for Firm B

  45. WACC (%) 11.5% 11.5 11.0 10.5 10.0 9.5 WMCC Schedule A B Rates of return C D 10.3% 9.8% 500k 1 m 1.5 m Total new financing (‘000)

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