Chapter 8 The Cost of Capital © 2005 Thomson/South-Western

2 Cost of Capital  Firm’s average cost of funds, which is the average return required by firm’s investors  What must be paid to attract funds

3 Required Rate of Return (Opportunity Cost Rate)  The return that must be raised on invested funds to cover the cost of financing such investments

4 The Logic of the Weighted Average Cost of Capital = WACC The use of debt impacts the ability to use equity, and vice versa. The weighted average cost must be used to evaluate projects, regardless of the specific financing used to fund a particular project.

5 Basic Definitions  Capital Component  Types of capital used by firms to raise money  k d = before tax interest cost  k dT = k d (1-T) = after tax cost of debt  k ps = cost of preferred stock  k s = cost of retained earnings  k e = cost of external equity (new stock)

6 Basic Definitions  WACC Weighted Average Cost of Capital  Capital Structure A combination of different types of capital (debt and equity) used by a firm

7 After-Tax Cost of Debt  The relevant cost of new debt  Takes into account the tax deductibility of interest  Used to calculate the WACC k dT = bondholders’ required rate of return minus tax savings k dT = k d - (k d x T) = k d (1-T)

8 Cost of Preferred Stock  Rate of return investors require on the firm’s preferred stock  The preferred dividend divided by the net issuing price

9 Cost of Retained Earnings  Rate of return investors require on the firm’s common stock

10 The CAPM Approach s  RF k- M k k s k  ()

11 The Discounted Cash Flow Approach  Price and expected rate of return on a share of common stock depend on the dividends expected on the stock.  Can use when growth (g) is constant

12 The Bond-Yield-Plus-Premium Approach  Estimating a risk premium above the bond interest rate  Judgmental estimate for premium  “Ballpark” figure only

13 Cost of Newly Issued Common Stock  External equity, k e  Based on the cost of retained earnings  Adjusted for flotation costs (the expenses of selling new issues)

14 Target Capital Structure  Optimal Capital Structure  Percentage of debt, preferred stock, and common equity in the capital structure that will maximize the price of the firm’s stock

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

16 Marginal Cost of Capital  MCC  Cost of obtaining another dollar of new capital  Weighted average cost of the last dollar of new capital raised

17 Marginal Cost of Capital  Marginal Cost of Capital Schedule  A graph that relates the firm’s weighted average of each dollar of capital to the total amount of new capital raised  Reflects changing costs, depending on amounts of capital raised

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

19 Break Point  BP  The dollar value of new capital that can be raised before an increase in the firm’s weighted average cost of capital occurs

20 Break Point Formulas  BP debt = debt/% debt  BP ret earn = retained earnings/% equity  If the capital budget $ > breakpoint $, the cost of capital will be at the next higher interest rate

21 MCC Schedule Weighted 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

22 MCC Schedule  Schedule and break points depend on capital structure used.

23 Combining the MCC and Investment Opportunity Schedules  Use the MCC schedule to find the cost of capital for determining projects’ net present values.  Investment Opportunity Schedule (IOS)  Graph of the firm’s investment opportunities ranked in order of the projects’ internal rate of return

24 Optimal Capital Budget - $115 Combining the MCC and Investment Opportunity Schedules New Capital Raised and invested (millions of dollars) IRR C = 12.1% IRR B = 11.7% IRR D = 11.5% IRR E = 11.3% IRR A = 10.2% Percent MCC IOS WACC 1 =10.0% WACC 3 =11.0% WACC 2 =10.5%

25 Before Next Class: 1.Review Chapter 8 2.Do chapter 8 homework 3.Prepare for Chapter 8 quiz 4.Read chapter 9