MGT 326 Ch 13: The Cost of Capital (bdh2e)v1.1 1 The Cost of Capital What is Capital?  In the finance world, capital refers to the sources of financing available to a firm  This is usually debt, stock (equity) and other types of securities  When investors (individuals & other corporations) provide a corporation with funds, they expect the company to generate a return on these funds…..  to at least compensate them for opportunity cost and inflation  to compensate them for various risks (i.e. default, interest rate and reinvestment risks, etc.)  to justify their investment in this specific firm versus investing in other firms or other types of investments (i.e. Opportunity Costs) Point: These are the cost firms pay to use capital; these are the costs of financing  Firm’s generate returns for their investors by using funds to expand and improve operations/NI  stock returns are generated through dividends and increased stock value (opportunity for capital gains)  bond returns in the form interest (Note: any capital gain resulting from falling r d is not the result of any specific firm)  lowered risk derived from a firm’s increased ability to cover debt (thru increased NI) Point: This is how firms meet the cost of financing  What we want is a single number that expresses the overall cost of financing the firm. This is the Weighted Average Cost of Capital (WACC) 2e created Summer 11

MGT 326 Ch 13: The Cost of Capital (bdh2e)v1.1 2  Bonds and stocks(common and preferred) are referred to as capital components  The required ROR of each component from the investor’s perspective are referred to as a component cost from the firm’s point of view  Capital Structure: the proportions of debt and equity(common & preferred) used to finance a firm Example: Diamond Jim’s Inc.’s assets are financed 60% by debt, 35% by common stock and 5% by preferred stock. The capital structure is: A = D + SE (Share Holder’s Equity) Capital Structure: 60% 35% CS + 5% PS Capital Component Costs: Cost of Debt(r dT or r EFF ):  Recall from Ch 5 that the cost of debt to a firm (or an individual) is the interest paid on any borrowed funds  The firm’s cost of debt is the interest rate the firm would have to pay to refinance it’s existing debt  Thus a firm’s cost of debt is the current market interest rate / YTM  r d is the “before tax” cost of debt  Interest payments are usually federal tax-deductible  The tax deduction lowers the total cost of debt  it lowers the actual cash costs of debt by the amount deducted  it effectively lowers the interest rate (from the borrower’s perspective)  Thus the actual relevant cost of debt is the “after tax” or “effective” rate; r dT  After tax cost/effective of debt = r dT = r EFF = r d (1 - T C ) Example: ATT&T annually pays $3.4m to service its debt with an average interest rate of 8%. If the firm’s marginal tax rate is 40%, what is it after tax cost of debt? r dT = r d (1 - T C ) = 8%( ) = 4.8%

MGT 326 Ch 13: The Cost of Capital (bdh2e)v1.1 3 Capital Component Costs: (continued) Cost of Debt: (continued) Consider a firm that has $150m in debt and has an average cost of debt of 8%. Its annual sales are $600m and annual COGS is $475m. The firm is subject to a 35% marginal tax rate Find the firm’s NI under the following two cases: Case 1: The fed allows interest payments to be deducted prior to computing taxes Case 2: The fed doesn’t allow interest payment deductions: ($ x 1m) Sales$ COGS$ EBIT$ Interest$12.00 EBT$ Taxes$39.55 NI$73.45 ($ x 1m) Sales$ COGS$ EBIT$ Taxes$43.75 EAT$81.25 Interest$12.00 NI$69.25 ($ x 1m) Sales$ COGS$ EBIT$ Taxes$43.75 EAT$81.25 Interest$7.80 NI$73.45 Case 2a: The fed doesn’t allow interest payment deductions but you compute interest using r EFF : r EFF = r d (1-T C ) = 8%(1-0.35) = 5.2% = $150m x 0.08 = $113m x 0.35 = $150m x 0.08 = $125m x 0.35 = $150m x 0.052

MGT 326 Ch 13: The Cost of Capital (bdh2e)v1.1 4 Capital Component Costs: (continued) Cost of Debt: (continued) What to do if the firm has debt costing several different interest rates? (i.e. several different bond issues) Answer: compute a weighted average interest rate Example: 40% of a firm’s debt costs 6%, 30% costs 6.5% and 30% costs 6.7%. The firm’s marginal tax rate is 40%. What is the firm’s after-tax cost of debt? 1) Find weighted average r d : 0.40(6%) (6.5) (6.7%) = 6.36% 2) Find r dT : r d (1 - T C ) = 6.36%( ) = 3.81% Cost of Preferred Stock (r ps ):  Recall that preferred stock usually pays a fixed dividend on a specified schedule (it’s kind of like a perpetuity)  r ps = D ps / (P 0 - Flotation Costs)  Flotation Costs: the cost (per share) to issue the stock Example: A share of a firm’s preferred stock cost $100 and it will pay a $10 dividend annually. It cost the firm $3 per share to issue this stock. What is the cost of the firm’s preferred stock? r ps = D ps / (P 0 - Flotation Costs) = $10/($100 -$3) = 10.3%

MGT 326 Ch 13: The Cost of Capital (bdh2e)v1.1 5 The Cost of Common Stock (r s ):  r s is the required ROR from an investor’s perspective and thus it’s a cost from the firm’s perspective  r dT is easy to determine and accurately reflects cost of debt based on the contractual nature of borrowing/lending  r s is harder to determine since its based on overall expectations rather than contractual obligations  Three methods to estimate r s :  CAPM (Ch 10): r s = r RF + (r M - r RF )  s  Discounted Cash Flow (DCF) (Ch 7): r s = r s =D 1 /P 0 + g  Bond-Yield-plus-Risk Premium approach  they produce different estimates for r s  these methods are not mutually exclusive;  one can average them or..  make an educated guess based on confidence of the data used to choose one method over the others  The CAPM method is most commonly used  Provides a r s that reflects a correspondingly appropriate amount of risk   measures a stock’s price volatility relative to that of the market portfolio   is a measure of a security’s sensitivity to changes in the market  Betas may not totally reflect true risk characteristics but they are at least widely and consistently used Capital Component Costs: (continued)

CE 350 The Cost of Capital 6 Weighted Average Cost of Capital (WACC):  What we want is a single number that expresses the overall cost of financing the firm. This is the Weighted Average Cost of Capital (WACC)  Definition: the weighted average of the component costs of capital  It is the overall cost of financing the firm WACC = w d r dT + w ps r ps + w s r s Component Costs  Recall: Capital Structure: A = D + SE These are the weights CS + PS Example: A firm’s common stock cost $23.50 per share and it has a  of 1.3. The firm’s preferred stock costs $75 per share, pays an annual dividend of $7 and cost $0.50 per share to issue. The firm’s average cost of debt is 7%. The firm’s marginal tax rate is 35%. Its capital structure is 60% debt, 35% common stock and 5% preferred stock. The firm’s common stock trades on the NASDAQ which is currently has had an average return of 7% for the last 24 months. A 30-day T bill has returned an average of 2.7% for the last 24 months. What is the firm’s WACC? Capital Structure: 60%D 35% CS + 5% PS a) Find r dT : r dT = r d (1 - T C ) = 0.07( ) = % b) Find r s : r s = r RF + (r M - r RF )  = 2.7% + (7% - 2.7%)1.3 = % c) Find r ps : r ps = D ps / (P 0 - Flotation Costs) = $7 / ($75-$0.5) = % d) Find WACC: WACC = w d (r dT ) + w s (r s ) + w ps (r ps ) = 0.60(4.5%) (8.29%) (9.4%) = % Note: Use decimal numbers for proportions (weights)

MGT 326 Ch 13: The Cost of Capital (bdh2e)v1.1 7 Weighted Average Cost of Capital (WACC): (continued) Factors that Affect WACC:  Factors that the firm cannot control:  debt market interest rates (r d )  stock market risk premium  tax rates  Factors that the firm can control:  capital structure policy (i.e. the proportion of debt and equity)  dividend policy (affects firm’s ability to meet investor’s r s )  its own risk position  affects bond rating  affects r s (firm specific risk component)  measured by financial ratios, and other metrics Some Problem Areas in determining WACC:  r s of privately owned firms: since stocks from these firms are not publicly traded, the concept of investor expectation as a cost of stock is meaningless  most small businesses are privately owned  Accuracy of  and g (as previously discussed) Why should we care about WACC?  WACC is the required ROR of the entire firm.  ROA = NI / Ave. Total Assets = ROR firm  A firm’s ROA (ROR) must be at least equal to its WACC or the firm is losing money  WACC is often used in NPV calculations (Chapter 8) as the discount rate for finding the present value of future cash flows  the ROR of the project must at least equal the cost of capital (the cost of financing the project) or the firm loses money  thus WACC is often used as a project’s required ROR  WACC is often used to do Financial Planning & Control