COST OF CAPITAL CHAPTER 10 Weighted Average Cost of Capital Cost of Capital Components.

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COST OF CAPITAL CHAPTER 10 Weighted Average Cost of Capital Cost of Capital Components

Types of Capital Long-Term Debt Preferred Stock Common Equity Retained Earnings New Common Stock

SOURCES OF LONG-TERM CAPITAL A.From Most to Least Used Sources 1.Retained Earnings 2.Sale of Corporate Bonds 3.Sale of Common Stock 4.Sale of Preferred Stock B.Cost of capital determined by firm's capital structure (RHS of B/S). Capital consists of: 1.Debt (bonds) 2.Equity (preferred and common stocks) 3.Retained Earnings

SOURCES OF LONG-TERM CAPITAL C.Market-based weighted-average of these costs (WACC) is also termed the hurdle rate. WACC = W d K d (1-t) + W p K p + W e K e D.How are the weights Wi determined? 1.Use accounting numbers (easiest – uses book values) 2.Use market value of issued securities (preferred method) 3.Firm’s cost of capital is set by market forces via investor pricing activity [implied risk assessment] a.High risk: lower prices (low P/E ratios) b.Low risk: higher prices (high P/E ratios)

HURDLE RATE [WACC or k a ] A.Some Observations: 1.Approximately 80% of all investment projects are financed internally (from retained earnings and tax-shielded cash flows such as depreciation). 2.Approximately 15% are financed by selling debt. 3.Approximately 5% are financed by selling stock.

COST OF NEW CAPITAL A.The Cost of New Debt: K d 1.K d = [YTM / (1 - F)] (1 - T) 2.Where: a.YTM = current market yields to maturity for seasoned bonds. b.F = flotation costs as a decimal (percentage). c.T = the marginal tax rate of the firm

COST OF NEW CAPITAL B.The cost of Preferred Stock; K pfd 1.K pfd = D pfd / [P pfd * (1 - F)] 2.Where: a.D p = the dividend (to be) paid on the preferred stock. b.P p = the (current) market price of preferred. c.F = Flotation costs as a percentage.

COST OF NEW CAPITAL C. Cost of Equity (common & ret’d earns); K e K e = D 1 / (P o - F) + g 1.Where: a.D 1 = the expected dividend at the end of year 1. b.P o = the current price of common. c.F = Flotation cost in dollars per share. d.g = the anticipated rate of growth in dividends.

HURDLE RATE [WACC or k a ] A. Ceteris paribus A.Hurdle rate; minimum rate of return a project must earn. Ceteris paribus… If just the hurdle rate is earned, then value of firm is maintained If less that the hurdle rate is earned, then value of firm declines If more that the hurdle rate is earned, then value of firm increases.

HOMEWORK CHAPTER 10 A.Questions You Should Be Able To Answer 1.Why is the hurdle rate an important concept in capital budgeting? 2.What important considerations must we make when computing the cost of capital? 3.What factors should managers consider when planning a capital structure strategy? B.Homework Assignment 1.Self-test: ST-1, parts b, e, f 2.Questions: 10-1, parts a, b, h, i 3.Problems: 10-1, 10-3, 10-11

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