Ch. 12 Cost of Capital

1. Ch. 12Cost of Capital  2002, Prentice Hall, Inc.

2. Where we’ve been... • Basic Skills: (Time value of money, Financial Statements) • Investments: (Stocks, Bonds, Risk and Return) • Corporate Finance: (The Investment Decision - Capital Budgeting)

3. Assets Liabilities & Equity Current assets Current Liabilities Fixed assets Long-term debt Preferred Stock Common Equity

4. The investment decision Assets Liabilities & Equity Current assets Current Liabilities Fixed assets Long-term debt Preferred Stock Common Equity

5. Where we’re going... • Corporate Finance:(The Financing Decision) Cost of capital Leverage Capital Structure Dividends

6. Assets Liabilities & Equity Current assets Current Liabilities Fixed assets Long-term debt Preferred Stock Common Equity

7. The financing decision Assets Liabilities & Equity Current assets Current Liabilities Fixed assets Long-term debt Preferred Stock Common Equity

8. Assets Liabilities & Equity Current assets Current Liabilities Long-term debt Preferred Stock Common Equity

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

10. Ch. 12 - 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.

11. 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 financing sources.

12. Cost of Debt

13. Cost of Debt For the issuing firm, the cost of debt is: • the rate of return required by investors, • adjusted for flotation costs (any costs associated with issuing new bonds), 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

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 • Now, suppose the firm pays $50,000 in dividends to the stockholders.

16. 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

17. 1 = - After-tax Before-tax Marginal % cost of % cost of x tax Debt Debt rate

18. 1 = - After-tax Before-tax Marginal % cost of % cost of x tax Debt Debt rate Kd = kd (1 - T)

19. 1 = - After-tax Before-tax Marginal % cost of % cost of x tax Debt Debt rate Kd = kd (1 - T) .066 = .10 (1 - .34)

20. Example: Cost of Debt • Prescott Corporation issues a $1,000 par, 20 year bond paying the market rate of 10%. Coupons are semiannual. The bond will sell for par since it pays the market rate, but flotation costs amount to $50 per bond. • What is the pre-tax and after-tax cost of debt for Prescott Corporation?

21. 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%

22. 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% (with • After-tax cost of debt: flotation costs) Kd = kd (1 - T) since the interest Kd = .1061 (1 - .34) is tax deductible. Kd = .07 = 7%

23. Cost of Preferred Stock • Finding the cost of preferred stock is similar to finding the rate of return, (from Chapter 8) except that we have to consider the flotation costs associated with issuing preferred stock.

24. Cost of Preferred Stock • Recall:

25. Cost of Preferred Stock Dividend Price • Recall: kp = = D Po

26. Cost of Preferred Stock Dividend Price • Recall: kp = = • From the firm’s point of view: D Po

27. D NPo Cost of Preferred Stock Dividend Price • Recall: kp = = • From the firm’s point of view: kp = = D Po Dividend Net Price

28. D NPo Cost of Preferred Stock Dividend Price • Recall: kp = = • From the firm’s point of view: kp = = NPo = price - flotation costs! D Po Dividend Net Price

29. Example: Cost of Preferred • If Prescott Corporation issues preferred stock, it will pay a dividend of $8 per year and should be valued at $75 per share. If flotation costs amount to $1 per share, what is the cost of preferred stock for Prescott?

30. Cost of Preferred Stock

31. D NPo Cost of Preferred Stock Dividend Net Price kp = =

32. D NPo Cost of Preferred Stock Dividend Net Price kp = = = = 8.00 74.00

33. D NPo Cost of Preferred Stock Dividend Net Price kp = = = = 10.81% 8.00 74.00

34. Cost of Common Stock • There are 2 sources of Common Equity: 1) Internal common equity (retained earnings), and 2) External common equity (new common stock issue) Do these 2 sources have the same cost?

35. Cost of Internal Equity • Since the stockholders own the firm’s retained earnings, the cost is simply the stockholders’ required rate of return. • Why? • If managers are investing stockholders’ funds, stockholders will expect to earn an acceptable rate of return.

36. Cost of Internal Equity

37. Cost of Internal Equity 1) Dividend Growth Model

38. D1 Po Cost of Internal Equity 1) Dividend Growth Model kc = + g

39. D1 Po Cost of Internal Equity 1) Dividend Growth Model kc = + g 2) Capital Asset Pricing Model (CAPM)

40. D1 Po b Cost of Internal Equity 1) Dividend Growth Model kc = + g 2) Capital Asset Pricing Model (CAPM) kj = krf + j (km - krf )

41. Cost of External Equity

42. Cost of External Equity Dividend Growth Model

43. D1 NPo Cost of External Equity Dividend Growth Model knc = + g

44. D1 NPo Net proceeds to the firm after flotation costs! Cost of External Equity Dividend Growth Model knc = + g

45. Weighted Cost of Capital • The weighted cost of capital is just the weighted average cost of all of the financing sources.

46. Weighted Cost of Capital Capital Source Cost Structure debt 6% 20% preferred 10% 10% common 16% 70%

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