©2009 McGraw-Hill Ryerson Limited 1 of Cost of Capital Prepared by: Michel Paquet SAIT Polytechnic ©2009 McGraw-Hill Ryerson Limited

2 of 40 Chapter 11 - Outline What is the Cost of Capital? Components and Calculation of Cost of Capital Optimal Capital Structure Use of Cost of Capital Capital Asset Pricing Model (CAPM) Summary and Conclusions

©2009 McGraw-Hill Ryerson Limited 3 of 40 Learning Objectives 1.Explain that the cost of capital represents the overall cost of financing to the firm. (LO1) 2.Define the cost of capital as the discount rate normally used to analyze an investment. It is an evaluation tool. (LO2) 3.Calculate the cost of capital based on the various valuation techniques from Chapter 10 as applied to bonds, preferred stock and common shares. (LO3)

©2009 McGraw-Hill Ryerson Limited 4 of 40 Learning Objectives 4.Describe how a firm attempts to find a minimum cost of capital by varying the mix of its sources of financing. (LO4) 5.Explain the marginal cost of capital concept. (LO5)

©2009 McGraw-Hill Ryerson Limited 5 of 40 Cost of Capital The cost of capital is a measure of the overall cost of financing to a firm. It is the discount rate used to discount future cash flows from an investment. It is the minimal rate of return that an investment of the same risk as the firm should earn. Using the cost of capital to make investment decisions eliminates inconsistency. LO1/LO2

©2009 McGraw-Hill Ryerson Limited 6 of 40 Cost of Capital The cost of capital is a weighted average cost of the various sources of capital, including debt, preferred stock, and common equity (retained earnings): WACC = Weighted Average Cost of Capital WACC = The sum of the weighted (aftertax) cost of each source of capital If a firm changes its financial leverage (capital structure), its cost of capital will also change accordingly. LO1/LO2

©2009 McGraw-Hill Ryerson Limited 7 of 40 Table 11-1 Cost of capital–Baker Corporation (1) (2) (3) Cost Weights Weighted (after tax) Cost Debt K d 6.55% 30%1.97% Preferred stock.... K p Common equity (retained earnings)...K e Weighted average cost of capital.....K a 10.26% LO3

©2009 McGraw-Hill Ryerson Limited 8 of 40 Components and Calculation of Cost of Capital 1. Cost of Debt -The cost of debt to the firm is the effective yield to maturity (or interest rate) paid to its bondholders. -Two adjustments must be made to the yield: tax and flotation costs. -Aftertax cost of debt: LO3

©2009 McGraw-Hill Ryerson Limited 9 of 40 Components and Calculation of Cost of Capital 2. Cost of Preferred Stock -Preferred stock: has a fixed dividend (similar to debt) has no maturity date dividends are not tax deductible to the firm and are expected to be perpetual or infinite -Cost of preferred stock: LO3

©2009 McGraw-Hill Ryerson Limited 10 of 40 Components and Calculation of Cost of Capital 3. Cost of Common Equity – Common stock equity is available through retained earnings (R/E) or by issuing new common stock: Common equity = R/E + New common stock A. Cost of Retained Earnings The cost of common equity in the form of retained earnings is equal to the required rate of return on the firm’s common stock (this is the opportunity cost): LO3

©2009 McGraw-Hill Ryerson Limited 11 of 40 Components and Calculation of Cost of Capital B. Cost of New Common Stock – The cost of new common stock is higher than the cost of retained earnings because of flotation costs – Cost of new common stock: or Cost of common equity can also be determined with the Capital Asset Pricing Model (CAPM) LO3

©2009 McGraw-Hill Ryerson Limited 12 of 40 Components and Calculation of Cost of Capital C. Capital Asset Pricing Model (CAPM) – An alternative model for calculating the required rate of return on common stock to the dividend model – Based on a relationship between risk and return: Required return = risk-free rate + risk premium – Cost of retained earnings – Cost of new common stock or LO3

©2009 McGraw-Hill Ryerson Limited 13 of 40 Optimum Capital Structure The optimum (best) situation is associated with the minimum overall cost of capital (WACC): –Costs of individual components of financing weighed by their proportions (weights) in the firm’s capital structure produce WACC –Optimum capital structure means the lowest WACC –Usually occurs with 40-70% debt in a firm’s capital structure –Based upon the market value rather than the book value of the firm’s debt and equity LO4

©2009 McGraw-Hill Ryerson Limited 14 of 40 FIGURE 11-1 Cost of capital curve LO4

©2009 McGraw-Hill Ryerson Limited 15 of 40 Debt/Assets, Selected Companies with Industry DesignationPercent AbitibiBowater (forest products)AXB Air Canada (airlines) AC.A Bank of Montreal (financials)BMO Canadian Tire (consumer discretion)CTC Encana (energy)ECA Nortel (networks)NT Melcor (real estate)MRD Potash (fertilizers)POT Loblaw(consumer staples) L RIM (wireless solutions)RIM Teck Cominco (mining)TCK.A Table 11-3 Debt (total) to total assets, mid-2008 LO4 Source:

©2009 McGraw-Hill Ryerson Limited 16 of 40 FIGURE 11-2 Cost of capital over time LO4

©2009 McGraw-Hill Ryerson Limited 17 of 40 Use of The Cost of Capital The cost of capital (WACC) represents the overall rate of return required by a firm’s investors – bondholders, preferred shareholders and common shareholders. Investments must be judged against this benchmark regardless of the particular source of funds the firm is using for a particular investment. If investments are matched with their financing, investments with lower return may be accepted while those with higher return would be rejected. LO4

©2009 McGraw-Hill Ryerson Limited 18 of 40 Figure 11-3 Cost of capital and investment projects for the Baker Corporation Percent Amount of capital ($ millions) 10.26% Weighted average cost of capital KaKa A B C D E F G H LO2/LO4

©2009 McGraw-Hill Ryerson Limited 19 of 40 Table 11-4 Investment projects available to the Baker Corporation A %$10 B C D E F G H $95 ExpectedCost ProjectsReturns($ millions) LO2/LO4

©2009 McGraw-Hill Ryerson Limited 20 of 40 Marginal Cost of Capital A firm’s cost of debt or preferred stock or common stock increases as it uses more debt or preferred stock or common stock. This will lead to a higher cost of capital even if a given capital structure (the weights) is maintained. The marginal cost of capital measures a firm’s overall cost of receiving extra dollar from investors. LO5

©2009 McGraw-Hill Ryerson Limited 21 of 40 First $39 Million Next $11 Million A/T Weighted A/T Weighted CostWts. Cost Cost Wts. Cost Debt....K d 6.55% %Debt... K d 6.55% % Preferred..K p Preferred.K p Common equity *..K e equity †..K n K a = 10.26% K mc = 11.06% *Retained earnings † New common equity Table 11-5 Cost of capital for different amounts of financing LO5

©2009 McGraw-Hill Ryerson Limited 22 of 40 Over $50 Million Cost Weighted (after tax) Weights Cost Debt (higher cost) K d 7.90% % Preferred stock K p Common equity (new common stock) K n K mc =11.46% Table 11-6 Cost of capital for increasing amounts of financing LO5

©2009 McGraw-Hill Ryerson Limited 23 of 40 Figure 11-4 Marginal cost of capital and Baker Corporation investment alternatives Percent Amount of capital ($ millions) 11.46% Marginal cost of capital K mc A B C D E F G H 11.06% 10.26% LO5

©2009 McGraw-Hill Ryerson Limited 24 of 40 Table 11-7 Cost of components in the capital structure 1. Cost of debt K d = Yield (1-T) = 6.55% 2. Cost of preferred stock 3. Cost of common equity (retained earnings) 4. Cost of new common stock Yield = 10.74% T = Corporate tax rate, 39% D p = Preferred dividend, $10.50 P p = Price of preferred stock, $100 F = Flotation costs, $4 D 1 = First year common dividend, $2 P c = price of common stock, $40 g = growth rate, 7% Same as above, with P n =$36.00 F = Flotation costs, $4, LO3

©2009 McGraw-Hill Ryerson Limited 25 of 40 Capital Asset Pricing Model (CAPM) Relates the risk-return trade-offs of individual assets to market returns. Suggests that as some portion of risk can be diversified away, the extra return should only be based on the remaining portion of risk that can not be diversified away. mathematically, APP-11A

©2009 McGraw-Hill Ryerson Limited 26 of 40 TABLE 11A-1 Performance of PAI and the market APP-11A

©2009 McGraw-Hill Ryerson Limited 27 of 40 FIGURE 11A-1 Linear regression of returns between PAI and the market APP-11A

©2009 McGraw-Hill Ryerson Limited 28 of 40 YearK j R m %10% %18% %16% %10% % 8% 70%62%  K j R m  K j  R m  R m 2 (  R m ) , ,844  n  K j R m –  K j R m 5(936) - 4,340  j    n  R m 2 – (  R m ) 2 5(844) - 3,844  K j –   R m (62)    n 5 Figure 11A-1b Linear regression of returns between PAI and the market APP-11A

©2009 McGraw-Hill Ryerson Limited 29 of 40 Figure 11A-1c Linear regression of returns between PAI and the market Calculator Mode: Stat Input 10 (x,y) 12 Data 18 (x,y) 16 Data 16 (x,y) 20 Data 10 (x,y) 16 Data 8 (x,y) 6 Data 2ndF a gives ndF b gives.90 2ndF r gives.74 Note that the values for the x axis(R m ) are input first This is the alpha coefficient This is the beta coefficient This is the correlation coefficient, a measure of how well the formula describes the relationship. The closer to 1.00, the better the fit APP-11A

©2009 McGraw-Hill Ryerson Limited 30 of 40 FIGURE 11A-2 The security market line (SML) APP-11A

©2009 McGraw-Hill Ryerson Limited 31 of 40 FIGURE 11A-3 The security market line and changing interest rates APP-11A

©2009 McGraw-Hill Ryerson Limited 32 of 40 FIGURE 11A-4 The security market line and changing investor expectations APP-11A

©2009 McGraw-Hill Ryerson Limited 33 of 40 Capital Structure Theory Net Income (NI) Approach Net Operating Income (NOI) Approach Modigliani and Miller Model APP-11B

©2009 McGraw-Hill Ryerson Limited 34 of 40 Cost of capital (percent) Debt/value ratio (percent) Value of the firm ($) Debt/value ratio (percent) K e = Cost of Equity: K d = Cost of debt; K a = Cost of capital Value is the market value of the firm KdKd KeKe KaKa Figure 11B-1 Net Income (NI) Approach APP-11B

©2009 McGraw-Hill Ryerson Limited 35 of 40 Figure 11B-2 Net Operating Income (NOI) Approach Cost of capital (percent) Value of the firm ($) Debt/value ratio (percent) KeKe KaKa KdKd APP-11B

©2009 McGraw-Hill Ryerson Limited 36 of 40 Figure 11B-3 Traditional approach as described by Durand Ke Ke KaKa KdKd APP-11B Cost of capital (percent) Debt/value ratio (percent) Value of the firm ($) Debt/value ratio (percent)

©2009 McGraw-Hill Ryerson Limited 37 of 40 Figure 11B-4 Modigliani and Miller with corporate taxes Cost of capital (percent) Value of the firm ($) Debt/value ratio (percent) Cost of debt adjusted for the tax effect of interest KeKe KaKa KdKd VLVL VUVU APP-11B

©2009 McGraw-Hill Ryerson Limited 38 of 40 Figure 11B-5a Combined impact of the corporate tax effect and bankruptcy effect on valuation and cost of capital 0100 K a (M +M with tax effect and bankruptcy effect) K a (original M + M) K a (M + M with tax effect) APP-11B A. Cost of capital (percent) Debt/value ratio (percent)

©2009 McGraw-Hill Ryerson Limited 39 of 40 Figure 11B-5b Combined impact of the corporate tax effect and bankruptcy effect on valuation and cost of capital V L (M + M with tax effect) V U (original M +M) (M + M with tax effect and bankruptcy effect) APP-11B B. Value of the firm ($) Debt/value ratio (percent)

©2009 McGraw-Hill Ryerson Limited 40 of 40 Summary and Conclusions The cost of capital is calculated as the weighted average of costs from various sources of financing (WACC). The weightings are based on the market value of the existing capital structure. Firms choose the weights to minimize WACC. The cost of capital is used as an evaluation tool to analyze investment proposals.