Chapter 9: The Cost of Capital 1

The Cost of Capital:

Chapter Outline: The Purpose of the Cost of Capital Capital Components Calculating Component Costs of Capital Calculating the WACC Factors that affect the cost of capital Problem areas in cost of capital

The Purpose of the Cost of Capital: The cost of capital—the average rate paid for the use of capital. Primarily used in capital budgeting Used as the ‘hurdle rate,’ or benchmark for projects Compare IRR to this rate Discount cash flows at this rate to find NPV If a project cannot earn above this return, it is not worthwhile

The Purpose of the Cost of Capital: It is important to estimate the cost of capital as accurately as possible in order to effectively manage the firm Firm’s cost of capital can be viewed as its required rate of return on projects of average risk

Required Rate of Return (Opportunity Cost Rate): The return that must be raised on invested funds to cover the cost of financing such investments

Capital Components: Components of firm’s capital are: Debt: Borrowed money, either loans or bonds Common equity: From sale of common shares or from retained earnings Preferred shares: Cross between debt and common equity

Capital Components: Capital structure is mix of three capital components Target Capital Structure Mix of capital components that management considers optimal and strives to maintain

Basic Definitions: Capital Component: Types of capital used by firms to raise money kd = before tax interest cost kdT = kd(1-T) = after tax cost of debt kps = cost of preferred stock ke = cost of retained earnings ks = cost of issuing new stocks

Basic Definitions: WACC: Weighted Average Cost of Capital Capital Structure: A combination of different types of capital(debt and equity) used by a firm

After-Tax Cost of Debt: The relevant cost of new debt Taking into account the tax deductibility of interest Used to calculate the WACC kdT = bondholders’ required rate of return minus tax savings kdT = kd(1-T).

Cost of Debt: Interest is tax deductible, so kdT = kd (1-T) = 10% (1 - 0.40) = 6% Use nominal rate. Flotation costs are small, so ignore them.

Cost of Preferred Stock: Rate of return investors require on the firm’s preferred stock The preferred dividend divided by the net issuing price

Cost of Preferred Stock: The cost of preferred stock can be solved by using this formula: kp = Dp / Pp = $10 / $111.10 = 9%

Cost of Retained Earnings: Rate of return investors require on the firm’s common stock

Why there is a cost for retained earnings? Earnings can be reinvested or paid out as dividends. Investors could buy other securities, earn a return. If earnings are retained, there is an opportunity cost (the return that stockholders could earn on alternative investments of equal risk). Investors could buy similar stocks and earn ks. Firm could repurchase its own stock and earn ks. Therefore, ks is the cost of retained earnings.

Three ways to determine the cost of common equity: The CAPM Approach. The Discounted Cash Flow Approach. The Bond-Yield-Plus-Premium Approach.

( ) b k - + = The CAPM Approach: ks = kRF + (kM – kRF) β = 7.0% + (6.0%)1.2 = 14.2%

The Discounted Cash Flow Approach: Price and expected rate of return on a share of common stock depend on the dividends expected on the stock.

The Discounted Cash Flow Approach:

The Discounted Cash Flow Approach: ks = D1 / P0 + g = $4.3995 / $50 + 0.05 = 13.8%

The Bond-Yield-Plus-Premium Approach: Estimating a risk premium above the bond interest rate Judgmental estimate for premium “Ballpark” figure only

The Bond-Yield-Plus-Premium Approach: ks = kd + RP ks = 10.0% + 4.0% = 14.0%

Cost of Newly Issued Common Stock: External equity, ke Based on the cost of retained earnings Adjusted for flotation costs (the expenses of selling new issues)

Flotation costs: Flotation costs depend on the risk of the firm and the type of capital being raised. The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small. We will frequently ignore flotation costs when calculating the WACC.

The Weighted Average Cost of Capital—The WACC: A firm’s WACC is the average of the costs of the separate sources weighted by the proportion of each source used To compute a WACC, we need two things: the mix of the capital components in use and the cost of each component

Weighted Average Cost of Capital, WACC: A weighted average of the component costs of debt, preferred stock, and common equity

Example 15.1: Computing the WACC: Q: Calculate the WACC given the following capital structure. A: First calculate the capital structure weights. For debt this weight is $60,000  $200,000 = 30%. Next, multiply each component’s cost by its weight. $200,000 10 90,000 Common shares 4 50,000 Preferred shares 6% $60,000 Debt Cost Value Capital Component WACC = 100% 45% 25% 30% Weight 7.3% 4.5% 1.0% 1.8%

Factors influence a company’s composite WACC: The Level of Interest Rates. Tax Rate. The firm’s capital structure policy. Dividend policy. The firm’s investment policy.

Problem areas in cost of capital: Depreciation-generated funds Privately owned firms Measurement problems Adjusting costs of capital for different risk Capital structure weights