10-1 CHAPTER 10 The Cost of Capital Sources of capital Component costs WACC Adjusting for flotation costs

10-2 What sources of long-term capital do firms use? Long-Term Capital Long-Term Debt Preferred Stock Common Stock Retained Earnings New Common Stock

10-3 Calculating the weighted average cost of capital WACC = w d r d (1-T) + w p r p + w c r s The w’s refer to the firm’s capital structure weights. The r’s refer to the cost of each component.

10-4 WACC = wdrd(1-T) + wprp + wcrs The weights in the above equation are intended to represent a specific financing mix (where w i = % of debt, w p = % of preferred, and w s = % of common). Specifically, these weights are the target percentages of debt and equity that will minimize the firm’s overall cost of Using or raising new funds. The Weighted Average Cost of Capital Capital Structure Weights

10-5 Firm Capital Structure Weight Assume the capital structure weight of the firm is 30% debt, 10% preferred stock and 60% equity WACC = 0.3rd d (1-T) + 0.1r p + 0.6r s

10-6 Component cost of debt WACC = w d r d (1-T) + w p r p + w c r s r d is the cost of debt capital. The yield to maturity on outstanding L-T debt is often used as a measure of r d.

10-7 Borrowing firm = Yield to maturityCost of debt (rd) Coupon interestPar value “Tax deductible” - Partially subsidized r d (1-T)

10-8 A 15-year, 12% semiannual coupon bond sells for $1, What is the cost of debt (r d )? The bond pays a semiannual coupon, so r d = 5.0% x 2 = 10%. INPUTS OUTPUTN I/YR PMTPVFV

10-9 Component cost of debt Why tax-adjust, i.e. why r d (1-T)? WACC = w d r d (1-T) + w p r p + w c r s Interest is tax deductible Assume Corp tax is 40% Interest is tax deductible, so A-T r d = B-T r d (1-T) = 10% ( ) = 6%

10-10 Borrowing firm = Yield to maturity = 10% Cost of debt (rd)=6% Coupon interestPar value “Tax deductible” - Partially subsidized r d (1-T) = 10% ( ) = 6%

10-11 Component cost of preferred stock WACC = w d r d (1-T) + w p r p + w c r s r p is the cost of preferred stock, which is the return investors require on a firm’s preferred stock. Preferred dividends are not tax- deductible, so no tax adjustments necessary. Just use nominal r p.

10-12 What is the cost of preferred stock? The cost of preferred stock can be solved by using this formula: r p = D p / P p = $10 / $ = 9%

10-13 Is preferred stock more or less risky to borrowing firm? More risky; although the firm has the option not to pay preferred dividend under certain circumstances. However, under company law, if preferred dividend is not paid (1) firm cannot pay common dividend, & (2) difficult to raise additional external funds.

10-14 Component cost of equity WACC = w d r d (1-T) + w p r p + w c r s r s is the cost of common equity using retained earnings.

10-15 Why is there a cost for retained earnings? Earnings can be reinvested or paid out as dividends. Investors could buy other securities, earn a higher return. If earnings are retained, there is an opportunity cost (the return that stockholders could earn on alternative investments).

10-16 To determine the cost of common equity, r s CAPM: r s = r RF + (r M – r RF ) b

10-17 If the r RF = 7%, r M = 13%, and the firm’s beta is 1.2, what’s the cost of common equity based upon the CAPM? r s = r RF + (r M – r RF ) b = 7.0% + (6.0%)1.2 = 14.2% ~14%

10-18 Cost of issuing new common stock? When a company issues new common stock they also have to pay flotation costs to the underwriter.

10-19 Cost of issuing new common stock WACC = w d r d (1-T) + w p r p + w c r e r e is the cost of common equity of issuing new common stock

10-20 If issuing new common stock incurs a flotation cost of 15% of the proceeds, what is r e ? ≈ Flotation cost factor

10-21 Flotation costs Flotation costs are highest for common equity. However, since most firms issue equity infrequently, We will frequently ignore flotation costs when calculating the WACC.

10-22 Ignoring flotation costs, what is the firm’s WACC? WACC= w d r d (1-T) + w p r p + w c r s = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1%

10-23 The Marginal Cost & Investment Decisions The Weighted Marginal Cost of Capital (WMCC) The WACC typically increases as the volume of new capital raised within a given period increases. This is true because companies need to raise the return to investors in order to entice them to invest more in the company ( ie. to compensate them for the increased risk introduced by larger volumes of capital raised.

10-24 $2.5$4.0 Total Financing (millions) 11.75% 11.25% 11.50% WMCC 11.76% 11.66% 11.13% The Marginal Cost & Investment Decisions

10-25 The Marginal Cost & Investment Decisions The Weighted Marginal Cost of Capital (WMCC) In addition, the cost will eventually increase when the firm runs out of cheaper retained equity and is forced to raise new, more expensive equity capital.

10-26 WACC = k a = w i k i + w p k p + w s k r or n The Weighted Average Cost of Capital Capital Structure Weights For example, assume the market value of the firm’s debt is $40 million, the market value of the firm’s preferred stock is $10 million, and the market value of the firm’s equity is $50 million. Dividing each component by the total of $100 million gives us market value weights of 40% debt, 10% preferred, and 50% common.

10-27 Finding the break points in the WMCC schedule will allow us to determine at what level of new financing the WACC will increase due to the factors listed above. BP j = AF j /w j where: BP j = breaking point form financing source j AF j = amount of funds available at a given cost w j =target capital structure weight for source j The Marginal Cost & Investment Decisions (cont.) The Weighted Marginal Cost of Capital (WMCC) Finding Break Points

10-28 The Marginal Cost & Investment Decisions (cont.) The Weighted Marginal Cost of Capital (WMCC) Finding Break Points Assume that the firm has $2 million of retained earnings available. When it is exhausted, the firm must issue new (more expensive) equity. Furthermore, the company believes it can raise $1 million of cheap debt after which it will cost 7% (after-tax) to raise additional debt. Given this information, the firm can determine its break points as follows:

10-29 The Marginal Cost & Investment Decisions (cont.) The Weighted Marginal Cost of Capital (WMCC) Finding Break Points BP equity =$2,000,000/.50 = $4,000,000 BP debt =$1,000,000/.40 = $2,500,000 This implies that the firm can fund up to $4 million of new investment before it is forced to issue new equity and $2.5 million of new investment before it is forced to raise more expensive debt. Given this information, we may calculate the WMCC as follows:

10-30 The Marginal Cost & Investment Decisions (cont.)

10-31 $2.5$4.0 Total Financing (millions) 11.75% 11.25% 11.50% WMCC 11.76% 11.66% 11.13% The Marginal Cost & Investment Decisions (cont.) New Debt was issued New Equity was issued