Chapter 9: The Cost of Capital

1. Chapter 9:The Cost of Capital

2. The Cost of Capital:

3. Chapter Outline: • The Purpose of the Cost of Capital • Capital Components • Calculating Component Costs of Capital • Calculating the WACC • Factors that affect the cost of capital • Problem areas in cost of capital

4. The Purpose of the Cost of Capital: • The cost of capital—the average rate paid for the use of capital. • Primarily used in capital budgeting • Used as the ‘hurdle rate,’ or benchmark for projects • Compare IRR to this rate • Discount cash flows at this rate to find NPV • If a project cannot earn above this return, it is not worthwhile

5. The Purpose of the Cost of Capital: • It is important to estimate the cost of capital as accurately as possible in order to effectively manage the firm • Firm’s cost of capital can be viewed as its required rate of return on projects of average risk

6. Required Rate of Return(Opportunity Cost Rate): • The return that must be raised on invested funds to cover the cost of financing such investments

7. Capital Components: • Components of firm’s capital are: • Debt: • Borrowed money, either loans or bonds • Common equity: • From sale of common shares or from retained earnings • Preferred shares: • Cross between debt and common equity

8. Capital Components: • Capital structure is mix of three capital components • Target Capital Structure • Mix of capital components that management considers optimal and strives to maintain

9. Basic Definitions: • Capital Component: • Types of capital used by firms to raise money • kd = before tax interest cost • kdT = kd(1-T) = after tax cost of debt • kps = cost of preferred stock • ke = cost of retained earnings • ks = cost of issuing new stocks

10. Basic Definitions: • WACC:Weighted Average Cost of Capital • Capital Structure:A combination of different types of capital(debt and equity) used by a firm

11. After-Tax Cost of Debt: • The relevant cost of new debt • Taking into account the tax deductibility of interest • Used to calculate the WACCkdT = bondholders’ required rate of return minus tax savingskdT = kd(1-T).

12. Cost of Debt: • Interest is tax deductible, so kdT = kd (1-T) = 10% (1 - 0.40) = 6% • Use nominal rate. • Flotation costs are small, so ignore them.

13. Cost of Preferred Stock: • Rate of return investors require on the firm’s preferred stock • The preferred dividend divided by the net issuing price

14. Cost of Preferred Stock: • The cost of preferred stock can be solved by using this formula: kp = Dp / Pp = $10 / $111.10 = 9%

15. Cost of Retained Earnings: • Rate of return investors require on the firm’s common stock

16. Why there is 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 ks. • Firm could repurchase its own stock and earn ks. • Therefore, ks is the cost of retained earnings.

17. Three ways to determine the cost of common equity: • The CAPM Approach. • The Discounted Cash Flow Approach. • The Bond-Yield-Plus-Premium Approach.

18. ( ) k k k - k b = + M RF s RF s The CAPM Approach: ks = kRF + (kM – kRF) β = 7.0% + (6.0%)1.2 = 14.2%

19. The Discounted Cash Flow Approach: • Price and expected rate of return on a share of common stock depend on the dividends expected on the stock.

20. The Discounted Cash Flow Approach:

21. The Discounted Cash Flow Approach: ks = D1 / P0 + g = $4.3995 / $50 + 0.05 = 13.8%

22. The Bond-Yield-Plus-Premium Approach: • Estimating a risk premium above the bond interest rate • Judgmental estimate for premium • “Ballpark” figure only

23. The Bond-Yield-Plus-Premium Approach: ks = kd + RP ks = 10.0% + 4.0% = 14.0%

24. Cost of Newly Issued Common Stock: • External equity, ke • Based on the cost of retained earnings • Adjusted for flotation costs (the expenses of selling new issues)

25. Flotation costs: • Flotation costs depend on the risk of the firm and the type of capital being raised. • The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small. • We will frequently ignore flotation costs when calculating the WACC.

26. The Weighted Average Cost of Capital—The WACC: • A firm’s WACC is the average of the costs of the separate sources weighted by the proportion of each source used To compute a WACC, we need two things: the mix of the capital components in use and the cost of each component

27. Weighted Average Cost of Capital, WACC: • A weighted average of the component costs of debt, preferred stock, and common equity

28. Q: Calculate the WACC given the following capital structure. A: First calculate the capital structure weights. For debt this weight is $60,000  $200,000 = 30%. Next, multiply each component’s cost by its weight. Capital Component Value Cost Debt $60,000 6% Preferred shares 50,000 4 Common shares 90,000 10 $200,000 Example Capital Component Value Weight Cost Debt $60,000 30% 6% 1.8% Preferred shares 50,000 25% 4 1.0% Common shares 90,000 45% 10 4.5% $200,000 100% WACC = 7.3% Example 15.1: Computing the WACC:

29. Factors influence a company’s composite WACC: • The Level of Interest Rates. • Tax Rate. • The firm’s capital structure policy. • Dividend policy. • The firm’s investment policy.

30. Problem areas in cost of capital: • Depreciation-generated funds • Privately owned firms • Measurement problems • Adjusting costs of capital for different risk • Capital structure weights