Contemporary Financial Management

Contemporary Financial Management Chapter 8: The Cost of Capital

Introduction • This chapter discusses: • The cost of capital • What is it • How is it measured • What is the Weighted Average Cost of Capital (WACC) • Risk vs. required return trade-off

Cost of Capital • The return required by investors to hold a company’s securities • Determined in the capital markets • Depends on the risk associated with the firm’s activities • Determines what the firm must pay to acquire new capital (sell new securities) • Firms must earn more than their cost of capital or they destroy shareholder wealth

Concept of Capital Structure • A firm’s capital structure consists of the mix of debt and equity securities that have been issued to finance the firm’s activities. • Forms of financing include: • Common stock • Preferred stock • Bonds (secured debt) • Debentures (Unsecured debt) • Each different type of security has different risk characteristics and therefore will earn a different return in the market.

Weighted Ave. Cost of Capital (WACC) • Discount rate used when computing the net present value of a project of average risk. • Calculated by weighting the cost of each form of security issued (Common stock, preferred stock, bonds, debentures). • Weights equal to the proportion of each of the components in the capital structure.

Weighted Average Cost of Capital ka = Weighted Average Cost of Capital D = Market value of the firm’s Debt Pf = Market value of the firm’s Preferred Shares E = Market value of the firm’s Common Equity ke = Marginal Cost of Common Share Capital kd = Marginal Pre-Tax Cost of Debt kp = Marginal Cost of Preferred Share Capital T = Corporate Tax Rate

Weighted Average Cost of Capital Example: A firm’s capital structure includes $3 Million in bonds, $6 Million in equity, and $1 Million in preferred stock (market values). The firm’s cost of equity is 15%, the cost of debt is 8% and the cost of preferreds is 10%. If the firm’s marginal tax rate is 50%, what is its WACC?

Required Rate of Return • Risk-free Rate of Return + Risk Premium • Risk-free Rate of Return: • real rate of return (compensation for deferring consumption) plus compensation for expected inflation • Risk Premium: additional reward required for bearing the risk of an investment • Composed of business risk, financial risk, marketability risk, interest rate risk and seniority risk.

Risk-Return Trade-Offs Required Rate of Return Common Shares X Low QualityCorporate X Debt XHigh QualityPreferred Shares XHigh QualityCorporate Debt XLong-term Government Debt Risk-Free Rate of Return XShort-term Government Debt Risk

Cost of Debt • The firm’s after-tax cost of debt (ki) is found by multiplying the firm’s pre-tax cost of debt (kd) by 1 minus the firm’s marginal tax rate (T). • Debt is the firm’s lowest cost source of funds, since interest is a tax-deductible expense. • As the amount of debt issued increases, the risk of default rises and so does the cost.

Cost of Preferreds • The firm’s after-tax cost of preferreds (kp) is equal to the pre-tax cost (Dp/Pnet), since dividends are not tax deductible (dividends are paid out of after-tax cash flow).

Cost of Internal Equity Capital • The firm’s cost of internal equity is the return demanded by the existing shareholder. • The CAPM defines this return as:

Cost of External Equity Capital • The cost of external equity is greater than the cost of internal equity due to the existence of • Issue costs • New issue discounts from market price

Issue Costs & Discounts • Issue (flotation) costs are the costs associated with making a new issue of equity to the public. • To sell a new issue of shares, the sale price may have to be set below the current market price. • Current market price represents an equilibrium between supply & demand • Without new demand being created, the new supply will push down the market price

Growth Rate Information • Institutional Brokers Estimate System • www.firstcall.com/ • Zacks Earnings Estimates • www.zacks.com/ • Thomson Financial First Call Service • www.firstcall.com/index.html • Dividend growth model • www.finplan.com/invest/divgrowmod.htm

CAPM • Check out this Web site to see how the CAPM is used to calculate a firm’s cost of equity: http://www.ibbotson.com/

Divisional Costs of Capital • Some divisions of a company have higher or lower systematic risk. • Discount rates for divisions are higher or lower than the discount rate for the firm as a whole. • Each division could have its own beta and discount rate. • Should reflect both the differential risks and the differential normal debt ratios for each division.

Depreciation • A major source of funds • Equal to the firm’s weighted cost of capital based on retained earnings and the lowest cost of debt • Availability of funds from depreciation shifts the marginal cost of capital (MCC) to the right by the amount of depreciation

Cost of Capital: Case Study • Major Foods Corporation is developing its cost of capital. The firm’s current & target capital structure is: • 40% debt • 10% preferred shares • 50% common equity • The firm can raise the following funds • Debt – up to $5 Million at 9% • Debt – over $5 Million at 10% • Preferred shares – 10% • The firm’s marginal tax rate is 40%

Cost of Capital: Case Study (Cont’d) • Equity and internally generated funds • The firm will generate $10 Million of retained earnings this year • Current dividend is $2 per share • Current share price is $25 • New common shares can be sold at $24 • Earnings and dividends growing at 7% per year • Payout ratio expected to remain constant

Cost of Capital: Case Study Solution • Step #1: • Calculate the cost of capital for each component of financing • Cost of debt (up to $5 Million of new debt) • Cost of debt (over $5 Million of new debt)

Cost of Capital: Case Study Solution • Step #1: • Calculate the cost of capital for each component of financing • Cost of Preferreds • Cost of Equity (internal)

Cost of Capital: Case Study Solution • Step #1: • Calculate the cost of capital for each component of financing • Cost of Equity (external)

Cost of Capital: Case Study Solution • Step #2: • Compute the weighted average cost of capital for each increment of capital raised. • The firm wants to retain its target capital structure • The firm should always raise its cheapest source of funds first. These are: • Retained earnings (internal equity) • Preferred shares • Debt up to $5 Million

Cost of Capital: Case Study Solution • Increment #1: Calculate total financing that can be acquired using 9% debt while retaining the target capital structure with 40% debt. The firm can raise a total of $12.5 Million of new financing (including $5 Million of 9% debt) before it has to begin issuing new debt at 10%.

Cost of Capital: Case Study Solution • The WACC for increment #1 is:

Cost of Capital: Case Study Solution • Increment #2: Calculate total financing that can be acquired using internally generated equity (retained earnings) while retaining the target capital structure with 50% equity. The firm can raise a total of $20 Million of new financing before it needs to issue new common stock.

Cost of Capital: Case Study Solution • The WACC for increment #2 (total new funding between $12.5 Million & $20 Million is:

Cost of Capital: Case Study Solution • Increment #3: Financing in excess of $20 Million will require both high-cost debt and issuing new common stock. The WACC for Increment #3 is:

Cost of Capital: Case Study Solution Incremental WACC 11.35% 11.20% 10.96% $12.5 M $20 M Funds Raised

Small Firms • Have a difficult time attracting capital • Issuance costs are high (> 20% of issue) • Often issue two classes of stock • One class sold to outsiders paying a higher dividend • Second class held by founders with greater voting power • Limited sources of debt

Major Points • The Weighted Average Cost of Capital (WACC) is a weighted average cost of funding. • Equity is the most expensive form of funding; debt is the cheapest. • Debt has a tax advantage due to the tax-deductibility of interest

Contemporary Financial Management