Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Cost of Capital 11

11-2 Chapter Outline Cost of capital and its importance. Discount rates used to analyze investments. Valuation and application to bonds, preferred stock, and common stock. Minimum cost of capital. Increase in cost of capital with increase in utilization of finances.

11-3 Cost of Capital In corporate finance, an investment made is for an anticipated return in future. –Knowing the appropriate discount rate is vital. Return on investments must, in the least garner a return equaling the costs incurred to acquire it – the minimum acceptable return.

11-4 The Overall Concept An investment: –Should not be judged against the specific means of financing used to implement it. This would make investment selection decisions inconsistent. –With a low-cost debt, must be chosen carefully. May result in increase of the overall risk. May make all eventual forms of financing more expensive.

11-5 Cost of Capital – Baker Corporation

11-6 Cost of Debt Measured by interest rate, or yield, paid to bondholders. –Example: $1000 bond paying $100 annual interest – 10% yield. –Calculation is complex discount rate or premium from par value bonds. To determine the cost of a new debt in the marketplace: –The firm will compute the yield on its currently outstanding debt.

11-7 Approximate Yield to Maturity (Y') Annual interest payment + Number of years to maturity 0.6 (Price of the bond) (Principal payment) Assuming: Y' = $ ($940) +.4 ($1,000) = $ $564 + $400 = $ = $ = 10.84% $964 $964 Principal payment – Price of the bond $1,000 - $940 60

11-8 Adjusting Yield for Tax Considerations Yield to maturity indicates how much the firm has to pay on a before-tax basis. Interest payment on a debt is a tax- deductible expense. –Due to this, the true cost is less than the stated cost.

11-9 Adjusting Yield for Tax Considerations (cont’d) The after-tax cost of debt is calculated as shown below: Assuming:

11-10 Cost of Preferred Stock A constant annual payment with no maturity date for the principal payment. –Computed by dividing dividend payment by net price or proceeds received. Represents the rate of return to preferred stockholders and annual cost to corporation for issue. –Preferred stock dividend is not a tax-deductible expense, with no downward tax adjustment. The proceeds to the firm equals selling price in the market minus flotation costs.

11-11 Cost of Preferred Stock (cont’d) The cost of preferred stock is as follows: Where, = Cost of preferred stock; = Annual dividend on preferred stock; = Price of preferred stock; F = Floatation, or selling cost Assuming the annual dividend as $10.50, the preferred stock is $100, and the flotation, or selling cost is $4. The effective cost is: = $10.50 = $10.50 = 10.94% $100 - $4 $96

11-12 Cost of Common Equity – Valuation Approach In determining the cost of common stock, the firm must be sensitive to the pricing and performance demands of current and future stockholders. Dividend valuation model: Where, = Price of the stock today; = Dividend at the end of the year (or period); = Required rate of return; g = Constant growth rate in dividends. Assuming = $2; = $40 and g = 7%, is; = $2 + 7% = 5% + 7% = 12% $40

11-13 Alternate Calculation of the Required Rate on Common Stock Capital asset pricing model (CAPM) Where: = Required return on common stock; = Risk-free rate of return, usually the current rate on Treasury bill securities; = Beta coefficient (measures the historical volatility of an individual stock’s return relative to a stock market index; = return in the market as measured by an approximate index. Assuming = 5.5%, = 12%, = 1.0, would be: = 5.5% (12% - 5.5%) = 5.5% (6.5%) = 5.5% + 6.5% = 12%

11-14 Cost of Retained Earnings Sources of capital for common stock equity: –Purchaser of the new shares – external source. –Retained earnings – internal source. Represent the present and past earnings of the firm minus previously distributed dividends. Belong to the current stockholders – may be paid in the form of dividends or reinvested in the firm. Reinvestments represent a source of equity capital supplied by the current stockholders. An opportunity cost is involved.

11-15 Cost of Retained Earnings (cont’d) The cost of retained earnings is equivalent to the rate of return on the firm’s cost of common cost representing the opportunity cost. Thus represents both the required rate of return on common stock, and the cost of equity in the form of retained earnings. For ease of reference, = Cost of common equity in the form of retained earnings. = Dividend at the end of the first year, $2. = Price of stock today, $40. g = Constant growth rate in dividends, 7%. = $2 + 7% = 5% + 7% = 12% $40

11-16 Cost of New Common Stock A slightly higher return than, representing the required rate of return of present stockholders, is expected. –Needed to cover the distribution costs of the new securities. Common stock New common stock

11-17 Cost of New Common Stock (cont’d) Assuming = $2, = $40, F (Flotation or selling costs) = $4 and g = 7%; = $2 + 7% $40 - $4 = $2 + 7% $32 = 5.6% + 7% = 12.6%

11-18 Overview of Common Stock Costs

11-19 Optimal Capital Structure – Weighting Costs The desire to achieve a minimum overall capital cost of capital. –Calculated decisions are required on the appropriate weights for: Debt Preferred stock Common stock financing. –Capital mix is determined by: Considering the present capital structure. Ascertaining if the current position is optimal.

11-20 Optimal Capital Structure – Weighting Costs (cont’d) Assessment of different plans (next slide): –Firm is able to initially reduce the weighted average cost of capital with debt financing –Beyond Plan B, the continued use of debt becomes unattractive and greatly increases the costs of the sources of financing.

11-21 Optimal Capital Structure – Weighting Costs (cont’d) Cost (After-tax) Weights Weighted Cost Financial Plan A: Debt………………………… 6.5% 20% 1.3% Equity……………………… % Financial Plan B: Debt………………………… 7.0% 40% 2.8% Equity……………………… % Financial Plan C: Debt………………………… 9.0% 60% 5.4% Equity……………………… %

11-22 Cost of Capital Curve

11-23 Debt as a Percentage of Total Assets (2006)

11-24 Capital Acquisition and Investment Decision Making Financial capital consists of bonds, preferred and common stock. –Money raised by sales of these securities and retained earnings is invested in: The real capital of the firm, the long-term productive assets of plant and equipment. –To minimize cost of equity a firm may sell common stock when prices are relatively high. –A balance between debt and equity is required to achieve minimum cost of capital.

11-25 Cost of Capital Over Time

11-26 Cost of Capital in the Capital Budgeting Decision Current costs of capital for each source of funds is important for capital budgeting decision. –The required rate of return, will be the weighted average cost of capital. –The common stock value of the firm will be maintained or increase, as long as the firm earns its cost of capital.

11-27 Investment Projections Available to the Baker Corporation

11-28 Cost of Capital and Investment Projects for the Baker Corporation

11-29 The Marginal Cost of Capital The market may demand a higher cost of capital for each amount of fund required if a large amount of financing is required. –Equity (ownership) capital is represented by retained earnings. Retained earnings cannot grow indefinitely as the firm’s capital needs to expand. Retained earning is limited to the amount of past and present earning that can be redeployed into investments.

11-30 The Marginal Cost of Capital (cont’d) Assumptions: –60% is the amount of equity capital a firm must maintain to keep a balance between fixed income securities and ownership interest. –Baker Corporation has million of retained earning available for investment. There is adequate retained earning to support the capital structure as shown below: Assuming: X = Retained earnings ; Percent of retained earnings in the capital structure Where X represents the size of the capital structure that retained earnings will support. X = $23.40 million = $39 million..60

11-31 Cost of Capital for Different Amounts of Financing

11-32 Increasing Marginal Cost of Capital Both and represent the cost of capital. –The mc subscript after K indicates the increase in cost of capital Increase is because common equity is now in the form of new common stock rather than retained earnings. The after-tax cost of the new common stock is more expensive than retained earnings because of flotation costs.

11-33 Increasing Marginal Cost of Capital (cont’d) Equation for the cost of new common stock: = $2 + 7% = $2 + 7% = 5.6% + 7% = 12.6% $40 - $4 $36 The $50 million figure can be derived thus: Z = Amount of lower-cost debt ; Percent of debt in the capital structure Z = $15 million = $50 million.30 Where Z represents the size of the capital structure in which lower-cost debt can be used.

11-34 Cost of Capital for Increasing Amounts of Financing

11-35 Changes in the Marginal Costs of Capital

11-36 Marginal Cost of Capital and Baker Corporation Projects

11-37 Cost of Components in the Capital Structure

11-38 Performance of PAI and the Market

11-39 Linear Regression of Returns Between PAI and the Market

11-40 The Security Market Line (SML)

11-41 The Security Market Line and Changing Interest Rates

11-42 The Security Market Line and the Changing Investor Expectations