Chapter 8 The Cost of Capital

The Cost of Capital The cost of capital acts as a link between the firm’s long-term investment decisions and the wealth of the owners as determined by investors in the marketplace. It is used to decide whether a proposed investment will increase or decrease the firm’s stock price. Formally, the cost of capital is the rate of return that a firm must earn on the projects in which it invests to maintain the market value of its stock.

The Firm’s Capital Structure The Firm’s Capital Structure Current Assets Fixed Current Liabilities Long-Term Debt Equity The Firm’s Capital Structure & Cost of Capital

The Weighted Average Cost of Capital Capital—refers to the long-term funds used by a firm to finance its assets. Capital components—the types of capital used by a firm—long-term debt and equity WACC—the average percentage cost, based on the proportion of each type of capital, of all the funds used by the firm to finance its assets.

The Cost of Debt The pretax cost of debt is equal to the the yield-to-maturity on the firm’s debt adjusted for flotation costs. Recall that a bond’s yield-to-maturity depends upon a number of factors including the bond’s coupon rate, maturity date, par value, current market conditions, and selling price. After obtaining the bond’s yield, a simple adjustment must be made to account for the fact that interest is a tax-deductible expense. This will have the effect of reducing the cost of debt.

computing the before - tax The Cost of Debt - Example Suppose a company could issue 9% coupon, 20 year debt face value of €1,000 for €980. Suppose that flotation costs will amount to 2% of par value. Find the after-tax cost of debt assuming the company is in the 40% tax bracket. EXCEL Formula for computing the before - tax cost of debt =RATE(B9,B8,B6,B2)

The Cost of Equity The cost of equity is based on the rate of return required by the firm’s stockholders. Cost of preferred stock - dividends received by preferred stockholders represent an annuity Cost of retained earnings (internal equity)—return that common stockholders require the firm to earn on the funds that have been retained, thus reinvested in the firm, rather than paid out as dividends Cost of new (external) equity—rate of return required by common stockholders after considering the cost associated with issuing new stock (flotation costs)

The Cost of Preferred Stock (kp) KP = DP/(PP - F) = DP/(NP) In the above equation, “F” represents flotation costs (in €). As was the case for debt, the cost of raising new preferred stock will be more than the yield on the firm’s existing preferred stock since the firm must pay investment bankers to sell (or float) the issue.

The Cost of Preferred Stock (kp) - Example KP = DP/(PP - F) A company can issue preferred stock that pays a €5 annual dividend, sell it for €55 per share, and have to pay €3 per share to sell it. Then, the cost of preferred stock would be: kP = €5/(€55 - €3) = 9.62% There is no tax adjustment, because dividends are not a tax-deductible expense.

The Cost of Retained Earnings The firm must earn a return on reinvested earnings that is sufficient to satisfy existing common stockholders’ investment demands. If the firm does not earn a sufficient return using retained earnings, then the earnings should be paid out as dividends so that stockholders can invest the funds outside the firm to earn an appropriate rate.

Discounted Cash Flow (DCF) approach The Cost of Retained Earnings (ks) Discounted Cash Flow (DCF) approach kS = (D1/P0) + g. For example, assume a firm has just paid a dividend of €2.50 per share, expects dividends to grow at 10% indefinitely, and is currently selling for €50 per share. First, D1 = 2.50(1+.10) = 2.75, and kS = (2.75/50) + .10 = 15.5%.

Security Market Line Approach The Cost of Retained Earnings (kE) Security Market Line Approach kE = rF + b(kM - RF). For example, if the 3-month government bond rate is currently 5.0%, the market risk premium is 9%, and the firm’s beta is 1.20, the firm’s cost of retained earnings will be: kE = 5.0 + 1.2(9) = 15.8%.

The Cost of Retained Earnings, ks—Bond-Yield-Plus-Risk-Premium Approach Studies have shown that the return on equity for a particular firm is approximately 3 to 5 percentage points higher than the return on its debt. As a general rule of thumb, firms often compute the YTM, or kd, for their bonds and then add 3 to 5 percent. In the current example, kd = 6.0%. As a rough estimate, then, we might say the cost of retained earnings is ks . kd + 4% = 6% + 4% = 10.0%

The Cost of New Equity Rate of return required by common stockholders after considering the costs associated with issuing new stock, which are called flotation costs. Because the firm has to provide the same gross return to new stockholders as existing stockholders, when the flotation costs associated with a common stock issue are considered, the cost of new common stock always must be greater than the cost of existing stock—that is, the cost of retained earnings. Modify the DCF approach for computing the cost of retained earnings to include flotation costs

Discounted Cash Flow (DCF) approach Kn = [D1/(P0 - F)] + g = D1/Nn - g The Cost of New Equity (kn) Discounted Cash Flow (DCF) approach Kn = [D1/(P0 - F)] + g = D1/Nn - g Αssume a firm has just paid a dividend of €2.50 per share, expects dividends to grow at 10% indefinitely, and is currently selling for €50 per share.Ηow much would it cost the firm to raise new equity if flotation costs amount to €4.00 per share? Kn = [2.75/(50 - 4)] + .10 = 15.97% or 16%.

WACC = ka = wiki + wpkp + wskr or n Capital Structure Weights The Weighted Average Cost of Capital WACC = ka = wiki + wpkp + wskr or n Capital Structure Weights The weights in the above equation are intended to represent a specific financing mix (where wi = % of debt, wp = % of preferred, and ws= % of common). Specifically, these weights are the target percentages of debt and equity that will minimize the firm’s overall cost of raising funds.

WACC = ka = wiki + wpkp + wskr or n Capital Structure Weights The Weighted Average Cost of Capital WACC = ka = wiki + wpkp + wskr or n Capital Structure Weights One method uses book values from the firm’s balance sheet. For example, to estimate the weight for debt, simply divide the book value of the firm’s long-term debt by the book value of its total assets. To estimate the weight for equity, simply divide the total book value of equity by the book value of total assets.

WACC = ka = wiki + wpkp + wskr or n Capital Structure Weights The Weighted Average Cost of Capital WACC = ka = wiki + wpkp + wskr or n Capital Structure Weights A second method uses the market values of the firm’s debt and equity. To find the market value proportion of debt, simply multiply the price of the firm’s bonds by the number outstanding. This is equal to the total market value of the firm’s debt. Next, perform the same computation for the firm’s equity by multiplying the price per share by the total number of shares outstanding.

WACC = ka = wiki + wpkp + wskr or n Capital Structure Weights The Weighted Average Cost of Capital WACC = ka = wiki + wpkp + wskr or n Capital Structure Weights Finally, add together the total market value of the firm’s equity to the total market value of the firm’s debt. This yields the total market value of the firm’s assets. To estimate the market value weights, simply divide the market value of either debt or equity by the market value of the firm’s assets .

WACC = ka = wiki + wpkp + wskr or n Capital Structure Weights The Weighted Average Cost of Capital WACC = ka = wiki + wpkp + wskr or n Capital Structure Weights For example, assume the market value of the firm’s debt is €40 million, the market value of the firm’s preferred stock is €10 million, and the market value of the firm’s equity is €50 million. Dividing each component by the total of €100 million gives us market value weights of 40% debt, 10% preferred, and 50% common.

WACC = ka = wiki + wpkp + wskr or n Capital Structure Weights The Weighted Average Cost of Capital WACC = ka = wiki + wpkp + wskr or n Capital Structure Weights Using the costs previously calculated along with the market value weights, we may calculate the weighted average cost of capital as follows: WACC = .4(5.67%) + .1(9.62%) + .5 (15.8%) = 11.13% This assumes the firm has sufficient retained earnings to fund any anticipated investment projects.