The Cost of Capital Chapter 12

Cost of Capital uThe firm’s average cost of funds, which is the average return required by the firm’s investors uWhat must be paid to attract funds

uThe use of debt impacts a fim’s ability to use equity, and vice versa, so the weighted average cost must be used to evaluate projects, regardless of the specific financing used to fund a particular project The Logic of the Weighted Average Cost of Capital

Basic Definitions uCapital component F types of capital used by firms to raise money F k d = before tax interest cost F k dT = k d (1-T) = after tax cost of debt F k ps = cost of preferred stock F k s = cost of retained earnings F k e = cost of external equity (new stock)

Basic Definitions uWACC = weighted average cost of capital uCapital structure F combination of different types of capital used by a firm

After-Tax Cost of Debt uThe relevant cost of new debt—its yield to maturity (YTM) uTaking into account the tax deductibility of interest uUsed to calculate the WACC uk dT = bondholders’ required rate of return minus tax savings uk dT = k d - (k d  T) = k d (1-T)

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

Cost of Retained Earnings uRate of return investors require on the firm’s common stock Three solutions: 1. CAPM 2. Bond yield plus risk premium 3. Discounted cash flow (DCF)

The CAPM Approach

The Bond-Yield-Plus- Premium Approach uEstimate a risk premium above the bond interest rate uJudgmental estimate for premium u“Ballpark” figure only

The Discounted Cash Flow (DCF) Approach uPrice and expected rate of return on a share of common stock depend on the dividends expected on the stock

DCF Approach uInternal equity, k s F based on the fact that investors demand the firm use funds that are retained to earn an appropriate rate of return

Cost of Newly Issued Common Stock uExternal equity, k e F based on the cost of retained earnings F adjusted for flotation costs (the expenses of selling new issues)

uOptimal capital structure F percentage of debt, preferred stock, and common equity that will maximize the price of the firm’s stock Target Capital Structure

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

Marginal Cost of Capital uMCC F the cost of obtaining another dollar of new capital F the weighted average cost of the last dollar of new capital raised

MCC Schedule uMarginal cost of capital schedule F a graph that relates the firm’s weighted average of each dollar of capital to the total amount of new capital raised F reflects changing costs depending on amounts of capital raised

uWeighted Average Cost of Capital (WACC) (%) New Capital Raised (millions of dollars) WACC 1 =10.5% WACC 2 =11.0% WACC 3 =11.5% MCC Schedule

Break Point uBP F the dollar value of new capital that can be raised before an increase in the firm’s weighted average cost of capital occurs

uWeighted Average Cost of Capital (WACC) (%) New Capital Raised (millions of dollars) WACC 1 =10.5% WACC 2 =11.0% WACC 3 =11.5% BP RE BP Debt MCC Schedule

uSchedule and break points depend on capital structure used

uWeighted Average Cost of Capital (WACC) (%) Dollars of New Capital Raised 0 - WACC Smooth, or Continuous, Marginal Cost of Capital Schedule MCC Schedule

Combining the MCC and Investment Opportunity Schedules uUse the MCC schedule to find the cost of capital for determining whether a project should be purchased uInvestment Opportunity Schedule (IOS) F graph of the firm’s investment opportunities ranked in order of the projects’ rates of return

Percent New Capital Raised and invested (millions of dollars) MCCIOS WACC 1 =10.5% WACC 2 =11.0% WACC 3 =11.5% Return C = 12.0% Return B = 11.6% Return D = 11.5% Return E = 11.3% IRR A = 10.8% Optimal Capital Budget - $139 Combining the MCC and Investment Opportunity Schedules

End of Chapter 12 The Cost of Capital