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The Cost of Capital

The Cost of Capital. Corporate Finance. Dr. A. DeMaskey. Learning Objectives. Questions to be answered: What is the cost of capital? What are the component costs? What is the target capital structure? How is each of the component costs and weights estimated?

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The Cost of Capital

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  1. The Cost of Capital Corporate Finance Dr. A. DeMaskey

  2. Learning Objectives • Questions to be answered: • What is the cost of capital? • What are the component costs? • What is the target capital structure? • How is each of the component costs and weights estimated? • How is the weighted average cost of capital used?

  3. Basic Concepts • Minimum Acceptable Rate of Return • Discount Rate (NPV) • Hurdle Rate (IRR, MIRR) • Marginal Cost of Capital (MCC) • Weighted Average Cost of Capital (WACC)

  4. Basic Assumptions • Equal Risk • Target Capital Structure • Reflects Average Risk

  5. Capital Components • What types of long-term capital do firms use? • Long-term debt • Preferred stock • Common equity

  6. Component Costs • Should we focus on before-tax or after-tax capital costs? • Tax effects associated with financing can be incorporated either in capital budgeting cash flows or in cost of capital. • Most firms incorporate tax effects in the cost of capital. Therefore, focus on after-tax costs. • Only cost of debt is affected.

  7. Component Costs • Should we focus on historical (embedded) costs or new (marginal) costs? • The cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we should focus on marginal costs.

  8. Determining the Cost of Capital • Determine the proportion of each capital component. • Determine the marginal cost of each source of capital. • Calculate the weighted average cost of capital.

  9. The Weighted Average Cost of Capital (WACC) WACC = wdkd(1 - T) + wpskps + wsks where: wi = proportion of source of capital used in the capital structure; ki = marginal cost of source of capital; T = corporate tax rate.

  10. Determining the Proportion of Each Capital Component • Capital structure of the firm. • Future capital structure of the firm. • Optimal capital structure.

  11. Component Cost of Debt • Find either YTM or YTC as estimate of kd. • Interest is tax deductible, so kd,AT = kd,BT(1 - T). • Use nominal rate. • Flotation costs are small, so ignore.

  12. Component Cost of Preferred Stock • Solve for kps in the following formula: • Note: • Flotation costs for preferred are significant, so are reflected. Use net price. • Preferred dividends are not deductible, so no tax adjustment. Just kps. • Nominal kps is used.

  13. Common Equity • Companies can issue new shares of common stock. • Companies can reinvest earnings.

  14. Component Cost of Equity Three ways to determine the cost of equity, ks: 1. CAPM: ks = kRF + (kM - kRF)b = kRF + (RPM)b. 2. DCF: ks = D1/P0 + g. 3. Bond-Yield-Plus-Risk Premium: ks = kd + RP.

  15. Capital Asset Pricing Model • Investors are risk averse. • Investors hold diversified portfolios. • Drawbacks of the CAPM • Requires historical returns to determine beta. • Assumes beta will be the same in the future as it has been in the past. • Requires estimation of a riskfree rate of return.

  16. Dividend Valuation Model • The greater is the current dividend yield, the greater is the cost of equity. • The greater is the growth in dividends, the greater is the cost of equity. • Drawbacks of the DVM • Assumes constant growth in dividends. • Requires dividends in the near future. • Requires a market value for a share of stock.

  17. Retention Growth Rate Method • Suppose the company has been earning 15% on equity (ROE = 15%) and retaining 35% (dividend payout = 65%), and this situation is expected to continue. • What is the expected future g? • Retention growth rate:g = b(ROE) = 0.35(15%) = 5.25%.Here b = Fraction retained. • This is close to g = 5% given earlier.

  18. New Common Equity • 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 stock price. • Thus, the cost of internal equity from reinvested earnings is cheaper than the cost of issuing new common stock.

  19. Comments About 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.

  20. Factors That Affect a Firm’s WACC • Market conditions • Level of interest rates • Market risk premium • Tax rates • The firm’s capital structure and dividend policy. • The firm’s investment policy. Firms with riskier projects generally have a higher WACC.

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