Cost of Capital Rate of return required by firm’s investors Cost of capital is required rate of return for projects with same level of risk as overall firm Required rate of return must be adjusted to reflect anticipated risk of project Cost of Capital

Cost of Capital Cost of Capital = Average cost of debt and equity The Big Picture…. Cost of Capital Cost of Capital = Average cost of debt and equity For now, assume ratio of debt to equity constant As debt increases, required will start to increase at some point Cost of Capital

Cost of debt After-tax YTM on debt Includes flotation costs Cost of Capital

Cost of Debt Rate of return required by firm’s investors YTM (required return) on IBM’s bonds is 10% (Ms. Investor demands a 10% rate of return) However, IBM’s after-tax cost of debt is 7% Assuming IBM has a 30% tax rate $100 Interest (10%) - 30 Tax Savings = 70 After-Tax Interest Cost (7%) Cost of Capital

Cost of Debt Rate of return required by firm’s investors Coupon rate on debt is not relevant 12% coupon bond, trading at $1,117 has a 9% YTM Would issue additional debt at 9% (before tax) This would be 6.3% after-tax (assume 30% tax rate) Cost of Capital

Calculating Required Rate of Return (Yield to Maturity) Bond has 6.5% coupon rate, 7 years to maturity and has net price of $870. What is yield to maturity? Required rate of return (YTM) = 9.09% After-tax rate required rate of return = 9.09% - (38% x 9.09%) = 5.64% Cost of Capital

Cost of Preferred Stock Cost of preferred stock = annual dividend / net price of preferred stock Net price is after flotation costs Cost of Capital

Cost of Equity Must be estimated. No stated rate like YTM on bonds or loans. Calculate cost for both: Retained earnings Issuing new equity Cost of Capital

Cost of Equity Dividend Growth Model NP = D1 / (RR – G) RR = (D1/NP) + G Calculate cost of retained earnings Price (P) , Dividend (D) are known. Can estimate growth rate (G). Then solve for required return (RR) Use Net Price after flotation costs for P Cost of Capital

Cost of Equity Dividend Growth Model NP = D1 / (RR – G) RR = (D1/NP) + G P = $32, D = $2.20, G = 4%, NP = $32.00, D1 = $2.29 RR = ($2.29/$32.00)+4% RR = 11.15% Cost of Capital

Cost of Equity Dividend Growth Model Advantage: Issues: Simple Must estimate growth rate Some companies don’t pay dividends Take into account risk? Cost of Capital

Cost of Equity Capital Asset Pricing Model (CAPM) RR = RF + (RM – RF) X Beta Risk-free rate of return (RF) is known Beta is generally known Required Return for Market (RM) must be estimated Cost of Capital

Cost of Equity Capital Asset Pricing Model (CAPM) RR = RF + (RM – RF) X Beta Advantages Adjusts for risk Can be used for companies with no dividends Cost of Capital

Cost of Equity Capital Asset Pricing Model (CAPM) RR = RF + (RM – RF) X Beta Issues: Calculating Market Risk Premium (RM – RF) One study: 9.2% for large cap stocks Another study: 9.5% for large cap stocks Another study: 4-6% for large cap stocks Cost of Capital

Cost of Equity Bond-yield plus equity risk RR = YTM + (RM – RF) Advantage Uses YTM for company’s bonds as starting point Can be used to compare with other two methods Cost of Capital

WACC Market Value Company = Equity Value + Debt Value Equity Value = Market cap Number of shares x Price of stock Debt Value Number of bonds x Value of Bonds Cost of Capital

WACC WACC = (Debt Value x Cost of Debt) + (Equity Value x Cost of Equity) Due to risk premium for equity, generally equity will have a larger cost than debt But required return on debt will increase if very little equity Cost of Capital

WACC: cost of capital Debt: usually cheapest after-tax cost Deduct interest Barclays 2006 study: Investment grade: 4.0%; high-yield: 5.6% Preferred stock Less risk than common stock Internal equity (retained earnings) No flotation costs External equity (issue new stock) Usually most expensive Barclays 2006 study: 9% Cost of Capital

WACC Value of firm maximized when WACC is minimized Should reduce Required Return This would increase NPV of projects WACC is not Required Return for all projects Adjust Required Return based on risk of project If use WACC for all projects, will accept risky projects and decline safe projects Since safe projects will generally have low IRR Cost of Capital