THE COST OF CAPITAL © 2000 South-Western College Publishing Chapter 11 THE COST OF CAPITAL © 2000 South-Western College Publishing

COST OF CAPITAL The return an investor receives on debt, preferred stock, or common equity is a cost to the company Costs are returns adjusted for taxes and transactions cost Overall cost is a weighted average of these Component Costs TM 11-1 Slide 1 of 2

The mix of capital components in use The Target Capital Structure Debt $30,000 30% Preferred Stock $10,000 10% Equity $60,000 60% Total Capital $100,000 100%. RELATED CONCEPTS The Target Capital Structure Raising Money in the Proportions of the Capital Structure TM 11-1 Slide 2 of 2

THE WEIGHTED AVERAGE CALCULATION - THE WACC A firm's overall cost of capital is the average of the costs of its separate sources weighted by the proportion of each source used Example of Calculation Capital Component Value Weight Cost Debt $60,000 .30 x 9% = 2.70% Preferred Stock $50,000 .25 x 11% = 2.75% Common Stock $90,000 .45 x 14% = 6.30% $200,000 1.00 WACC = 11.75% TM 11-2

CAPITAL STRUCTURE AND COST - BOOK VS MARKET VALUES A Source of Confusion: Both capital structure and component costs can be viewed in terms of either the book or market values of the underlying capital 1. CAPITAL STRUCTURE Initial Capital Structure - Book and Market Values Equal $ % Equity 10,000 shrs x $10 = $100,000 50% Debt 100 bonds x $1,000 = $100,000 50% Total $200,000 100% Now imagine that stock price increases to $12, while interest rates climb driving the price of the bonds down to $850 -Book Values Don't Change- TM 11-3 Slide 1 of 3

Market-Value-Based Capital Structure $ % Equity 10,000 shrs x $12 = $120,000 58.5% Debt 100 bonds x $850 = $ 85,000 41.5% Total $205,000 100.0% (From Tables 11-1 and 2) 2. COMPONENT RETURNS Every security has a return on the money initially invested to buy it and a current return that's available to new investors in the secondary market. For example, a bond pays its coupon rate on the original investment of its face value and the market yield to a new buyer. TM 11-3 Slide 2 of 3

Structure: Maintain the existing structure based on market prices, or 3. THE APPROPRIATE PERSPECTIVE FOR THE WACC CALCULATION Book Values - Existing Capital - Already Committed Market Values - New Capital - Next Year's Projects IRR and NPV Evaluate Newly Proposed Projects Therefore, Market Values Are Appropriate 4. THE CUSTOMARY APPROACH Structure: Maintain the existing structure based on market prices, or strive for a target structure based on market prices. Component Costs: Based on market prices TM 11-3 Slide 3 of 3

CALCULATING THE WACC Three Steps 1. Develop a market value based capital structure. 2. Adjust market returns to reflect component costs of capital. 3. Calculate WACC. TM 11-4

STEP ONE: DEVELOPING MARKET VALUE BASED CAPITAL STRUCTURES EXAMPLE 11-2 Debt: Two thousand bonds were issued five years ago at a coupon rate of 12%. They had thirty year terms and $1,000 face values. They are now selling to yield 10%. Preferred Stock: Four thousand shares of preferred are outstanding each of which pays an annual dividend of $7.50. They originally sold to yield 15% of their $50 face value. They're now selling to yield 13%. Equity: 200,000 shares of common stock are outstanding currently selling at $15 per share. TM 11-5 Slide 1 of 3

Debt: Preferred Stock: SOLUTION: Pb = PMT[PVFAk,n] + FV[PVFk,n] = $60[PVFA5,50] + $1,000[PVF5,50] = $60(18.2559) + $1,000(.0872) = $1,182.55 Market Value = $1,182.55 x 2,000 = $2,365,100 Preferred Stock: Market Value = $57.69 x 4,000 = $230,760 TM 11-5 Slide 2 of 3

Market Value Based Weights: Common Equity: Market Value = $15.00 x 200,000 = $3,000,000 Market Value Based Weights: $ % Debt $2,365,100 42.3% Preferred 230,760 4.1% Equity 3,000,000 53.6% $5,595,860 100.0% TM 11-5 Slide 3 of 3

STEP TWO: CALCULATING COMPONENT COSTS OF CAPITAL Adjustments To Investor's Returns Reflect The Effect Of Financial Markets and Taxes Taxes Reduce the Effective Cost of Debt kd(1-T) Flotation Costs Increase the Effective Cost of a Component Component cost of capital TM 11-6

DEBT: Cost of debt = kd (1 - T) ILLUSTRATIONS DEBT: Cost of debt = kd (1 - T) EXAMPLE 11-3 Blackstone Inc. has bonds outstanding which yield 8% to investors buying them now. The marginal tax rate is 37% SOLUTION: Cost of debt = kd (1 - T) = .08 (1-.37) = 5.4% PREFERRED STOCK: Cost of Preferred Stock EXAMPLE 11-4 Francis Corporation's preferred stock yields new investors 9%. Flotation costs are 11%. SOLUTION: Cost of TM 11-7

COMMON EQUITY - RETAINED EARNINGS: No Adjustments: Internally Generated and Not Tax Deductible The CAPM Approach - The Required Rate of Return kX = kRF + (kM - kRF)bX The Dividend Growth Approach - The Expected Rate of Return The Risk Premium Approach ke = kd + rpe TM 11-8 Slide 1 of 2

COMMON EQUITY - NEW STOCK: Cost of New Equity EXAMPLE 11-8 Periwinkle Inc.'s last annual dividend was $1.65, its stock sells for $33.60, and it is expected to grow at 7.5%. SOLUTION: Cost of new Equity TM 11-8 Slide 2 of 2

THE MARGINAL COST OF CAPITAL (MCC) A graph showing how the WACC changes as a firm raises more capital during a planning period, usually a year A Typical MCC Schedule WACC Total Capital Raised The MCC breaks upward when the cost of a capital component increases. The first break usually occurs when retained earnings runs out and outside equity is raised at higher cost. TM 11-9

ILLUSTRATION OF MCC CONSTRUCTION Capital Capital Structure Component Weights Cost With equity from RE Debt .4 x 8% = 3.2% Equity .6 x 10% = 6.0% WACC = 9.2% With equity from new stock Debt .4 x 8% = 3.2% Equity .6 x 12% = 7.2% WACC = 10.4% If expected RE = $3M and the capital structure is 60% equity, the first break in the WACC occurs at $3M / .60 = $5M Table 11-4 (modified) TM 11-10 Slide 1 of 2

The Marginal Cost of Capital (MCC) Schedule WACC $5M $10M Figure 11-1 The Brighton Company The Marginal Cost of Capital (MCC) Schedule TM 11-10 Slide 2 of 2 10.4% 9.2%

COMBINING THE MCC AND THE INVESTMENT OPPORTUNITY SCHEDULE (IOS) WACC Project IOS IRRs MCC WACC=10.4% 9.2% $5M $10M Figure 11-2 The Marginal Cost of Capital (MCC) Schedule and The Investment Opportunity Schedule (IOS) TM 11-11 A B C D E