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CHAPTER 11 The Cost of Capital

CHAPTER 11 The Cost of Capital. Sources of capital Component costs WACC. Cost of Capital . The cost of capital represents the overall cost of financing to the firm

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CHAPTER 11 The Cost of Capital

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  1. CHAPTER 11The Cost of Capital Sources of capital Component costs WACC

  2. Cost of Capital • The cost of capital represents the overall cost of financing to the firm • The overall cost of capital is a weighted average of the various sources, including debt, preferred stock, and common equity (retained earnings): WACC = Weighted Average Cost of Capital WACC = After-tax cost x weights

  3. What sources of long-term capital do firms use?

  4. Calculating the weighted average cost of capital WACC = wdrd(1-T) + wpsrps + wers • The w’s refer to the firm’s capital structure weights. • The r’s refer to the cost of each component.

  5. Should our analysis focus on before-tax or after-tax capital costs? • Stockholders focus on After-Tax CFs. Therefore, we should focus on A-Taxcapital costs. • Only cost of debt needs adjustment, because interest is tax deductible.

  6. 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).

  7. How are the weights determined? WACC = wdrd(1-T) + wprp + wers • As a percentage of total financing

  8. Weighting example Bonds 40 Pref. Stock 100 Common 100 Ret. Earn. 160 Total L & E 400 What is weight of each component?

  9. Weighting example Bonds 40 Pref. Stock 100 Common 100 Ret. Earn. 160 Total L & E 400 Bonds = 40/400 = 10% Pref. Stock = 100/400 = 25%

  10. Component cost of debt WACC = wdrd(1-T) + wprp + wers • rd is the marginal cost of debt capital. • The yield to maturity on outstanding L-T debt is often used as a measure of rd. • Why tax-adjust, i.e. why rd(1-T)?

  11. 10% before tax = 6% after tax 60 difference *10% coupon rate for one bond

  12. Component cost of debt • Interest is tax deductible, so A-T rd = B-T rd (1-T) = 10% (1 - 0.40) = 6% T = tax rate = 40%

  13. Component cost of preferred stock WACC = wdrd(1-T) + wprp + wers • rp is the marginal cost of preferred stock. • The rate of return investors require on the firm’s preferred stock.

  14. What is the cost of preferred stock? • The cost of preferred stock can be solved by using this formula: rp = Dp / Pp = $10 / $111.10 = 9%

  15. Component cost of preferred stock • Preferred dividends are not tax-deductible, so no tax adjustments necessary. Just use rp.

  16. Component cost of equity WACC = wdrd(1-T) + wprp + wers • rs is the marginal cost of common equity using retained earnings. • Issuing new stock would cost a little more due to flotation (selling) costs.

  17. 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, rs is the cost of retained earnings.

  18. Two ways to determine the cost of common equity, ks • CAPM: rs = rRF + β(rM – rRF) • DCF: rs = (D1 / P0)+ g

  19. If the rRF = 7%, rM = 13% 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% (rm- rRF) = market risk premium

  20. If D0 = $4.19, P0 = $50, and g = 5%, what’s the cost of common equity based upon the DCF approach? D1 = D0 (1+g) D1 = $4.19 (1 + .05) D1 = $4.4 rs = (D1 / P0)+ g = ($4.4 / $50) + 0.05 = 13.8%

  21. What is a reasonable final estimate of rs? MethodEstimate CAPM 14.2% DCF 13.8% Average 14.0%

  22. 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. • To adjust rs = (D1/(P0 – F)) + g

  23. Calculate WACC • If 40% of your financing is from debt at an after tax cost of 8% and 60% is from pref. stock at 10%, what is the WACC? • It will be between what two numbers?

  24. 40% (.08) + 60% (.10) • .032 + .06 = .092 • 9.2%

  25. Balance Sheet

  26. Ignoring floatation costs, what is the firm’s WACC? WACC = wdrd(1-T) + wprp + wers = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1%

  27. Should the company use the composite WACC as the hurdle rate for each of its projects? • NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the “hurdle rate” for a typical project with average risk. • Different projects have different risks. The project’s WACC should be adjusted to reflect the project’s risk.

  28. Optimum Capital Structure • The optimal (best) situation is associated with the minimum overall cost of capital: • Optimum capital structure means the lowest WACC • Usually occurs with 30-50% debt in a firm’s capital structure • WACC is also referred to as the required rate of return or the discount rate

  29. Optimal Capital Structure Cost (After-tax) Weights Weighted Cost Financial Plan A: Debt………………………… 6.5% 20% 1.3% Equity………………………. 12.0 80 9.6 10.9% Financial Plan B: Debt………………………… 7.0% 40% 2.8% Equity………………………. 12.5 60 7.5 10.3% Financial Plan C: Debt………………………… 9.0% 60% 5.4% Equity………………………. 15.0 40 6.0 11.4%

  30. Draw a graph representing the cost of debt and equity Cost of Capital 10% 5% 0 40% 80% Debt to Asset Mix

  31. Cost of capital curve

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