Cost of capital (Chapter 9)

Topics Target capital structure – Chapter 15 Component cost Optimal capital structure – the percentages of debt, preferred stock, and common stock that maximize the firm’s value Weights of capital source that management plans to use when raising new capital in the future Component cost Cost of debt Cost of preferred stock Cost of common stock Weighted Average Cost of Capital (WACC)

Cost of Capital Businesses require capital to develop new products, build factories and distribution centers, install information technology, expand internationally, and acquire other companies. For each of these actions, a company must estimate the total investment required and then decide whether the expected rate of return exceeds the cost of the capital.

Capital Structure

Weighted Average Cost of Capital Read definitions on page 325

Cost of Debt Acer Inc. has outstanding bonds with an 8% annual coupon rate, 22 years remaining to maturity and a par value of $1,000. The bonds make semiannual coupon payments and current market price of $904.91. Tax =40%.

Flotation costs paid to investment bankers Cost of Debt Flotation cost & cost of debt: Acer Inc. can issue 30-year bond at its $1,000 par with annual coupon rate of 9%, with coupons paid semiannually. Flotation costs (F) are 1% of the value of the issue. Assume tax =40%, nominal after-tax cost of debt adjusted for flotation costs [rd(1-T)]=? Flotation costs paid to investment bankers

Cost of Preferred Stock Acer Inc. has preferred stock that pays an $8 dividend per share and sells for $100 each. If the company issued new preferred shares then it would incur an underwriting or flotation cost of 2.5% of the proceeds.

Cost of Common Stock CAPM Approach: Risk-free rate: 10-year government bonds Market risk premium: Historical realized return on stock index minus risk-free rate Beta: Slope coefficient of a regression, with company's stock returns on y-axis and market returns on the x-axis

Cost of Common Stock CAPM Approach: Assume rRF=5%, RPM=5.5%, and Acer Inc.’s bi=1.2

Cost of Common Stock Dividend-yield-plus-growth / Discounted cash flow (DCF) Approach: Acer Inc.’s stock sells for $32, its next expected dividend is $1.82, and its expected growth rate is 5.5%.

Cost of Common Stock Dividend-yield-plus-growth / Discounted cash flow (DCF) Approach: Current stock price Current dividend Marginal investor’s expected dividend growth rate Historical growth rate Retention ratio Analysts’ forecasts

Cost of Common Stock Over-own-bond-yield-plus-judgmental-risk Approach: Acer Inc.’s bond yield 9.0%, if its over-own-bond-yield judgmental risk premium is estimated as 3%.

Cost of New Common Stock Adjusting for flotation costs: Use the same inputs as when we estimated Acer Inc.’s cost of common equity using DCF approach but assuming that the company incurs a flotation cost of 12.5% to sell new common stock.

Weighted Average Cost of Capital Acer Inc. has a target capital structure with 30% debt, 10% preferred stock, and 60% common equity. Its before-tax cost of debt is 9%, cost of preferred stock is 8.2% and cost of common equity is 11.6%. Marginal tax rate is 40% and all of its new equity will come from reinvested earnings.

Self-Reading 9.12: Factors affecting WACC (pp. 346-348) 9.13: Privately owned firms & small businesses (pp. 351-352) 9.14: Four mistakes to avoid (p. 352)