Copyright © 2003 Pearson Education, Inc. Slide 10-0 Ch 10 Learning Goals 1.Concept of cost of capital 2.Determine the annual percentage cost of individual sources of capital. 3.Calculate the weighted average cost of capital (WACC).

Copyright © 2003 Pearson Education, Inc. Slide 10-1 The cost of capital is the annual % cost of financing projects in the capital budget. It is the required rate of return that must be earned on investment projects of _______________________. If the project under consideration has high or low risk, the cost of capital must be adjusted to determine the risk adjusted discount rate ____________________. Overview of the Cost of Capital

Copyright © 2003 Pearson Education, Inc. Slide 10-2 Firm’s Capital Structure Current Assets Fixed Assets Current Liabilities Long- Term Debt Equity The Firm’s Capital

Copyright © 2003 Pearson Education, Inc. Slide 10-3 Key Considerations The relevant cost of capital is the annual percentage cost of __________ financing on a ___________________ basis.

Copyright © 2003 Pearson Education, Inc. Slide 10-4 After-Tax Cost of Debt (k i ) The pretax cost of debt (k d ) is the interest rate the firm must pay on new debt financing. The before tax interest rate must be adjusted for the fact that interest expense is __________________________________. This ___________________ the cost of debt. Cost of Specific Sources of Capital

Copyright © 2003 Pearson Education, Inc. Slide 10-5 k i = k d (1-t) For example, if the interest rate on new debt is 9% and the firm is in the 40% tax bracket: k i = 9% (1-.40) = 5.4% The annual percentage cost (after-tax) of debt financing is 5.4%. After-Tax Cost of Debt (k i ) Cost of Specific Sources of Capital

Copyright © 2003 Pearson Education, Inc. Slide 10-6 Cost of Preferred Stock (k p ) K P = D P /(N P ) In the above equation, D P is the annual dividend per share of preferred stock and N P is the per share net proceeds from the sale of preferred. Cost of Specific Sources of Capital

Copyright © 2003 Pearson Education, Inc. Slide 10-7 For example, if a company can sell preferred stock with a $5 annual dividend for $58 per share, and has flotation costs of $3 per share to sell it, the annual percentage cost of preferred stock is: k P = $5/($58 - $3) = 9.1% Cost of Preferred Stock (k p ) K P = D P /N P Cost of Specific Sources of Capital

Copyright © 2003 Pearson Education, Inc. Slide 10-8 Cost of Common Equity Cost of Specific Sources of Capital There are two sources of common stock financing: ____________________________ and new issues of ______________________. In addition, there are two ways to estimate the cost of common equity: the dividend valuation model, and the capital asset pricing model (CAPM).

Copyright © 2003 Pearson Education, Inc. Slide 10-9 Constant Dividend Growth Model k s = (D 1 /P 0 ) + g. For example, the firm has just paid a dividend of $2.50 per share, expects dividends to grow at 8%, and the stock is selling for $50 per share. First, D 1 = 2.50(1+.08) = 2.70, and k S = (2.70/50) +.08 = 13.4%. Cost of Retained Earnings (k r ) Cost of Specific Sources of Capital

Copyright © 2003 Pearson Education, Inc. Slide CAPM Approach Cost of Retained Earnings (k r = k s ) k s = r F + b(k M - R F ). For example, if the T-bill rate is currently 3.0%, the market risk premium is 9%, and the firm’s beta is 1.2, the firm’s cost of retained earnings will be: k s = (9) = 13.8%. Cost of Specific Sources of Capital

Copyright © 2003 Pearson Education, Inc. Slide The previous example indicates that our estimate of the cost of retained earnings is somewhere between 13.4% and 13.8%. At this point, we could choose one or average the two (13.6%). Cost of Common Equity Cost of Retained Earnings (k s ) Cost of Specific Sources of Capital

Copyright © 2003 Pearson Education, Inc. Slide Cost of New Common Stock (k n ) Cost of new common stock financing (k n ) k n = (D 1 / N n )+ g Where: D 1 is the dividend expected in the coming year. N n = net proceeds from the sale of new common stock

Copyright © 2003 Pearson Education, Inc. Slide Cost of New Common Stock (k n ) Example: D 1 = 2.70 N n = $40 g = 8% k n = (D 1 / N n )+ g k n = (2.70 / 40) +.08 =.1475 = 14.8%

Copyright © 2003 Pearson Education, Inc. Slide Capital Structure Weights WACC = k a = w i k i + w p k p + w s (k S or k n ) The weights in the above equation represent a specific financing mix (where w i = % of financing from debt, w p = % of financing from preferred, and w s = % of financing from common). The Weighted Average Cost of Capital

Copyright © 2003 Pearson Education, Inc. Slide Capital Structure Weights WACC = k a = w i k i + w p k p + w s (k S or k n ) The weights can be determined by: Firm’s policy (target weights) Market values of firm’s debt and equity Book values of firm’s debt and equity The Weighted Average Cost of Capital

Copyright © 2003 Pearson Education, Inc. Slide For example, 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. The Weighted Average Cost of Capital Capital Structure Weights WACC = k a = w i k i + w p k p + ws(kS or kn)

Copyright © 2003 Pearson Education, Inc. Slide Using the costs previously calculated along with the market value weights, if retained earnings is the source of common equity the weighted average cost of capital as follows: WACC =.4(5.4%) +.1(9.1%) +.5 (13.6%) = 9.9% The Weighted Average Cost of Capital WACC = k a = w i k i + w p k p +WACC = k a = w i k i + w p k p + ws(kS or kn)

Copyright © 2003 Pearson Education, Inc. Slide Retained Earnings Breakpoint The retained earnings breakpoint is the maximum amount of _______________ that can be raised without selling new common stock. To finance additional projects, new common stock must be sold.

Copyright © 2003 Pearson Education, Inc. Slide Retained Earnings Breakpoint REBP = ($ of retained earnings) / w s Example: firm expects to add $1 mil to retained earnings this year. w s =.50 REBP = $1 mil /.5 = $2 mil The firm can finance a capital budget of $2 mil without selling new common stock.

Copyright © 2003 Pearson Education, Inc. Slide Using the costs previously calculated along with the market value weights, if new common stock is the source of common equity the weighted average cost of capital as follows: WACC =.4(5.4%) +.1(9.1%) +.5 (14.8%) = 10.5% The Weighted Average Cost of Capital WACC = k a = w i k i + w p k p +WACC = k a = w i k i + w p k p + ws(kS or kn)