Cost of Capital Chapter 10

Cost of Capital No company can function without funds. To start functioning at a basic level a company needs funds. Now a question arises that where do these funds come form?

The funds needed by an organization comes from a number of sources: Sources of Capital External Sources Debt Equity Internal Sources Retained Earnings

We can say the cost of capital in actuality is the cost of raising capital for the company. Now, Can the cost of capital for the business can be considered a return for the provider for the capital? Yes. Cost of Capital is cost from fund user’s perspective whereas from fund provider’s perspective it is a cost.

Explained through illustration.

What is the cost of capital for debt and equity? Sources of Capital External Sources Debt Cost of raising debt capital is ‘i’ Equity Cost of raising equity capital is ‘dividend + capital gains yield’ Internal Sources Retained Earnings Cost of raising funds through retained earnings is the ‘opportunity cost’ of retaining these earnings (shareholder’s required return)

Investment Opportunity WACC Now we have an idea as to what is the cost of capital, it is the cost of raising money/capital for the business. A firm can raise funds from different sources. Now after funds are raised suppose the firm looks now to make an investment where the expected rate of return is 12%. So how would my organization decide to make this investment or not? 10% Debt Organization ($500 million) Investment Opportunity 15% 12% Equity 13% Preferred Stock

WACC (continued) Since the organization has raised funds from different sources it needs to introduce a measure that takes into account all these different types of costs. This single rate must accumulate the cost of raising capital from different sources. This single rate is called the WACC.

WACC (continued) Formula: WACC = wdrd (1-T) + wprp + wsrs Question: Suppose my organization has raised $100 million out of which $30 million has been raised through debt, $10 million through preferred stock and $60 million through equity. The cost of raising debt capital is 10%, cost of raising capital by issuing shares of preferred stock is 13% and the cost of raising capital by issuing shares of common stock is 15%. Calculate WACC. (Take rd = 15% for this question)

1. Cost of Debt Formula rd = rd (1-T) Borrowing saves taxes. Use of tax provides tax shield. Interest is a tax deductible expense. Net cost of debt is actually the interest paid less the tax savings resulting from tax deductible interest payment.

1. Cost of Debt (continued) Example

1. Cost of Debt (continued) The Cost of Debt represents the after-tax cost of debt capital to a company. It is important that the rate you use (rd) is the current yield to maturity (YTM) rather than the nominal cost of debt. The nominal or coupon rate (which is based on the face amount of the debt) determines the interest payment, but it does not necessarily reflect the actual cost of the corporation's debt today. The yield to maturity, not the nominal rate, fully reflects the current return demanded by debt holders and the rate at which debt should be replaced.

2. Cost of Equity Formula rS = D1 + g Po

rS = D1 + Po g Cost of Equity Dividend Yield + Capital gains Yield ~ ROR on your investment ~ Recall basic investment calculation = return on investment / basic investment. ~ D1 = Expected dividend to be paid on one share. ~ Po = Current market price of one share. ~ We need D1, if DO is given in a question first we’ll calculate D1 from the formula: D1 = DO (1+g) This approach to calculating required rate of return on common equity is called ‘Discounted Cash Flow (DCF) Approach’ or ‘Dividend Yield plus Growth Rate Approach’. ~ Gain achieved by appreciation in price of asset. ~ Increase in share price = P1 - Po ~ P1 = Current price of share ~ Po = Old price of share

2. Cost of Equity (continued) Impact of Flotation Cost Flotation cost: The cost of issuing new common stock. If there are flotation cost the issuing firm receives only a portion of the capital provided by the investors, with the remainder going to the underwriter. The formula for cost of equity will then be modified as: rS = D1 + g Po (1-F)

3. Cost of Preferred Stock rp = Dp Pp In the above formula Dp stands for fixed dividend payment. Pp stands for the price of preferred stock.

4. Cost of Retained Earnings Formula Cost of retained earnings = D1 + g Po When a company decides to retain earnings it is done at the cost of shareholder’s required return.

Formulas We made a chart of all the formulas (to be used in solving numericals of this chapter) in the class, please make use of that chart.