The Cost of Capital

1. The Cost of Capital Chapter 14

2. Where do I get the money? Buy What? The financing decision The investment decision Assets Liabilities & Equity Current Assets Current Liabilities Fixed Assets Long-term Debt Preferred Stock Common Equity

3. Cost of Capital • For Investors, the rate of return on a security is a benefit of investing. • For Financial Managers, that same rate of return is a cost of raising funds that are needed to operate the firm. • In other words, the cost of raising funds is the firm’s cost of capital. Cost of raising funds = Cost of capital

4. Corporate Finance:(The Financing Decision) • Appropriately estimate a firm Cost of capital is important for a company to make correct decision on its Capital Structure (mixture between debts and equities)

5. Assets Liabilities & Equity Current assets Current Liabilities Long-term Debt Preferred Stock Common Equity } Capital Structure

6. How can the firm raise capital? • Bonds • Preferred Stock • Common Stock • Each of these offers a rate of return to investors. • This return is a cost to the firm. • “Cost of capital” actually refers to the weighted cost of capital - a weighted average cost of all financing sources.

7. Weighted Cost of Capital Capital Source Cost Structure debt 6% 20% preferred 10% 10% common 16% 70% Weighted cost of capital =.20 (6%) + .10 (10%) + .70 (16%) = 13.4%

8. Checkpoint 14.1 Calculating the WACC for Templeton Extended Care Facilities, Inc. (Cont.) Templeton contacted the firm’s investment banker to get estimates of the firm’s current cost of financing and was told that if the firm were to borrow the same amount of money today, it would have to pay lenders 8%; however, given the firm’s 25% tax rate, the after-tax cost of borrowing would only be 6% = 8%(1.25). Preferred stockholders currently demand a 10% rate of return, and common stockholders demand 15%. Templeton’s CFO knew that the WACC would be somewhere between 6% and 15% since the firm’s capital structure is a blend of the three sources of capital whose costs are bounded by this range.

9. Checkpoint 14.1

10. Checkpoint 14.1

11. Checkpoint 14.1

12. Cost of Debt (illustrating the tax-effect)

13. Cost of Debt For the issuing firm, the cost of debt is: • the rate of return required by investors, and • adjusted for taxes.

14. Example: Tax effects of financing with debt with stockwith debt EBIT 400,000 400,000 - interest expense 0(50,000) EBT 400,000 350,000 - taxes (34%) (136,000)(119,000) EAT 264,000 231,000 • Now, suppose the firm pays $50,000 in dividends to the stockholders.

15. Example: Tax effects of financing with debt with stockwith debt EBIT 400,000 400,000 - interest expense 0(50,000) EBT 400,000 350,000 - taxes (34%) (136,000)(119,000) EAT 264,000 231,000 - dividends (50,000) 0 Retained earnings 214,000 231,000

16. 1 = - After-tax Before-tax Marginal % cost of % cost of x tax Debt Debt rate Kd = kd (1 - T) .066 = .10 (1 - .34)

17. Example: Cost of Debt • Prescott Corporation issues a $1,000 par, 20 year bond paying 10% coupon. Coupons are semiannual. The bond will sell for $950 per bond. • What is the pre-tax and after-tax cost of debt for Prescott Corporation?

18. Pre-tax cost of debt: (using TVM) P/Y = 2 N = 40 PMT = -50 FV = -1000 PV = 950 solve: I = 10.61% = kd • After-tax cost of debt: Kd = kd (1 - T) Kd = .1061 (1 - .34) Kd = .07 = 7%

19. Pre-tax cost of debt: (using TVM) P/Y = 2 N = 40 PMT = -50 FV = -1000 So, a 10% bond PV = 950 costs the firm solve: I = 10.61% = kd only 7% • After-tax cost of debt: Kd = kd (1 - T) since the interest Kd = .1061 (1 - .34) is tax deductible. Kd = .07 = 7%

20. The Cost of Debt (cont.) It is not easy to find the market price of a specific bond as most bonds do not trade in the public market. Because of this, it is a standard practice to estimate the cost of debt using yield to maturity on a portfolio of bonds with similar credit rating and maturity as the firm’s outstanding debt.

23. Cost of Preferred Stock • Recall: kp = = Finding the cost of preferred stock is similar to finding the rate of return (from Chapter 10). Dividend Price D Po

24. Example: Cost of Preferred • If Prescott Corporation issues preferred stock, it will pay a dividend of $8 per year and should be valued at $74 per share. What is the cost of preferred stock for Prescott?

25. D Po Cost of Preferred Stock kp = = = = 10.81% Dividend Price 8.00 74.00

26. The Cost of Common Equity The cost of common equity is the rate of return investors expect to receive from investing in firm’s stock. This return comes in the form of cash distributions of dividends and cash proceeds from the sale of the stock.

27. The Cost of Common Equity (cont.) • Cost of common equity is harder to estimate since common stockholders do not have a contractually defined return (similar to interest on bonds or dividends on preferred stock). There are two approaches to estimating the cost of common equity: • Dividend growth model (introduced in chapter 10) • CAPM (introduced in chapter 8)

28. The Dividend Growth Model – Discounted Cash Flow Approach Using this approach, we estimate the expected stream of dividends as the source of future estimated cash flows. We use the estimated dividends and current stock price to calculate the internal rate of return on the stock investment. This return is used as an estimate of cost of equity.

30. Checkpoint 14.2 Estimating the Cost of Common Equity for Pearson plc Using the Dividend Growth Model Pearson plc (PSO) is an international media company that operates three business groups: Pearson Education, the Financial Times, and Penguin. In the spring of 2009, Pearson’s CFO called for an update of the firm’s cost of capital. The first phase of the estimation focused on the firm’s cost of common equity. How would the CFO determine the cost of the company’s equity, using the dividend growth model?

31. Checkpoint 14.2

32. Checkpoint 14.2

33. Checkpoint 14.2:Check Yourself Prepare two additional estimates of Pearson’s cost of common equity using the dividend growth model where you use growth rates in dividends that are 25% lower than the estimated 6.25% (i.e., for g equal to 5% and 7.81%)

34. Step 1: Picture the Problem • We are given the following: • Price of common stock (Pcs ) = $10.09 • Growth rate of dividends (g) = 5% and 7.81% • Dividend (D0) = $0.47 per share • Cost of equity is given by dividend yield + growth rate.

35. Solve At growth rate of 5% kcs = {$0.47(1.05)/$10.09} + .05 = .0989 or 9.89%

36. Step 3: Solve (cont.) At growth rate of 7.81% kcs = {$0.47(1.0781)/$10.09} + .0781 = .1283 or 12.83 %

37. Analyze Pearson’s cost of equity is estimated at 9.89% and 12.83% based on the different assumptions for growth rate. Thus growth rate is an important variable in determining the cost of equity. However, estimating the growth rate is not easy. There are many ways!!!

38. Estimating the Rate of Growth, g The growth rate can be obtained from various websites that post analysts forecasts of growth rates. We can also estimate the growth rate using the historical data and computing the arithmetic average or geometric average.

39. Putting it together: Weighted Cost of Capital • The weighted cost of capital is just the weighted average cost of all of the financing sources. Capital Source Cost Structure debt 6% 20% preferred 10% 10% common 16% 70%

40. Weighted Cost of Capital(20% debt, 10% preferred, 70% common) Weighted cost of capital = .20 (6%) + .10 (10%) + .70 (16%) = 13.4%

41. SKIP this section!!! 14.6 Floatation Costs and Project NPV

42. WACC, Floatation Costs and Project NPV Floatation costs are costs incurred by a firm when it raises money to finance new investments by selling bonds and stocks. For example, these costs may include fees paid to an investment banker, and costs incurred when securities are sold at a discount to the current market price.

43. WACC, Floatation Costs and Project NPV (cont.) Because of floatation costs, the firm will have to raise more than the amount it needs.

44. WACC, Floatation Costs and Project NPV (cont.) Example 14.3 If a firm needs $100 million to finance its new project and the floatation cost is expected to be 5.5%, how much should the firm raise by selling securities?

45. WACC, Floatation Costs and Project NPV (cont.) = $100 million ÷ (1-.055) = $105.82 million Thus the firm will raise $105.82 million, which includes floatation cost of $5.82 million.