11 Chapter Cost of Capital

Chapter 11 - Outline Cost of Capital Cost of Debt Cost of Preferred Stock Cost of Common Equity: Common Stock Retained Earnings Optimum Capital Structure Marginal Cost of Capital Summary and Conclusions

Cost of Capital The cost of capital represents the overall cost of future financing to the firm The cost of capital is normally the relevant discount rate to use in analyzing an investment It represents the minimal acceptable return from the investment If your cost of funds is 10%, you must earn at least 10% on your investments to break even! The cost of capital is a weighted average of the various sources of funds in the form of debt and equity WACC = Weighted Average Cost of Capital

Kd (cost of debt) = yield/ interest rate x (1 - tax rate) The cost of debt to the firm is the effective yield to maturity (or interest rate) paid to its bondholders Since interest is tax deductible to the firm, the actual cost of debt is less than the yield to maturity Kd (cost of debt) = yield/ interest rate x (1 - tax rate) Example : Prime Finance Ltd. has decided to issue 10 percent coupon bond to support its financing requirement. Now find out the after tax cost of bond if corporate tax rate is 40 percent.

Cost of Preferred Stock Dp : Preferred Dividend Pp: Price of Preferred Stock Flotation costs: selling and distribution costs (such as sales commissions) for the new securities Example: ABC Bank Ltd. plans to issue preferred stock that pays $10 dividend per share and sells for $100 per share in the market. If the bank issued new shares of preferred stock, it would incur an underwriting (or flotation) cost of 2.5 percent or 2.5 percent per share. What will be the cost of preferred stock?

Cost of Common Equity D1 = First year common dividend A. Cost of Common Equity/ Retained Earnings D1 = First year common dividend P0 = price of common stock g = growth rate Example: Suppose the market price (P0) of common stock is $50 per share. The firm expects to pay a dividend (D1) of $ 4 at the end of the coming year, 1998. The dividend is expected to grow at a rate of 5 percent a year over the foreseeable future. Calculate the cost of common stock.

Cost of Common Equity B. Cost of New Common Stock: D1 = First year common dividend P0 = price of common stock g = growth rate F = Flotation costs Example: ABC Co. has decided to issue new common stock. The current market price of the stock (P0) is $50, the expected dividend (D1), $4, and the expected growth rate of dividend, (g) is 5%. It is also found that, the company has to incur underwriting fee of $2.5 per share. Find out the cost of new issues of common stock?

Optimum Capital Structure The optimum (best) situation is associated with the minimum overall cost of capital: Optimum capital structure means the lowest WACC Usually occurs with 40-70% debt in a firm’s capital structure WACC is also referred to as the required rate of return or the discount rate Based upon the market value rather than the book value of the firm’s debt and equity

Weighted Average Cost of Capital, WACC A weighted average of the component costs of debt, preferred stock, and common equity Example: Suppose Goodwill Technologies has determined that in the future it will raise new capital according to the following proportions: 40 percent debt, 15 percent preferred stock and 45 percent common equity (retained earnings plus new common stock). In the preceding sections, it is found that it’s before tax cost of debt, is 10 percent and the marginal tax rate is 40 percent; its cost of preferred stock, is 10.5 percent; and its cost of common equity, is 13 percent if all of its equity financing comes from retained earnings. Calculate the Goodwill Technologies’ weighted average cost of capital (WACC)?

Figure 11-1 Cost of capital curve Cost of capital (percent) Cost of equity Weighted average cost of capital U-shaped Cost of debt Minimum point for cost of capital 40 80 Debt-equity mix (percent)

Table 11-7 Cost of components in the capital structure Yield = 10.74% T = Corporate tax rate, 39% Dp = Preferred dividend, $10.50 Pp = Price of preferred stock, $100 F = Flotation costs, $4 D1 = First year common dividend, $2 Pc = price of common stock, $40 g = growth rate, 7% Same as above, with Pn =$36.00 F = Flotation costs, $4, 1. Cost of debt Kd = Yield (1-T) = 6.55% 2. Cost of preferred stock 3. Cost of common equity (retained earnings) 4. Cost of new common stock

Summary and Conclusions The cost of debt is the effective interest rate (yield to maturity) the cost of preferred stock is the dividend rate (yield) that must be paid to investors The cost of common shares is the current dividend rate (yield) plus the anticipated future rate of growth The cost of capital from retained earnings is the required rate of return on the common stock The marginal cost of capital is the cost of the next dollar of financing required The cost of capital represents the overall cost of future financing to the firm It is a weighted average of the costs of the various source of funds available It represents the minimum acceptable return from an investment