Intro to Financial Management Cost of Capital

Review Exam

Cost of Capital = k The minimum required rate of return on a new investment. –A weighted return –Costs of financing from each of the sources Includes –Required returns –Risk premium –Cost of financing Firm evaluates potential investments relative to the cost of capital –Also known as “hurdle rate”

Cost of Capital Related to required rate of return –Have to account for taxes. Bond interest is tax deductible, dividends are not Use factor (1 – tax rate) –Have to account for transaction costs Deduct the cost of issuing the stock or bond from the nominal price and compute Use the net proceeds from the sale in place of the price in the calculations

Cost of Capital Debt 1.Solve for I/Y where PV = net proceeds E.g. if sell $1,000 bonds may get only $980, use as PV 2.Then take result and adjust for tax treatment k = interest rate * (1 – tax rate) Preferred stock –Use net proceeds instead of stock price k = dividend / net proceeds

Debt Example Investors’ ViewFirm’s View Interest paid (PMT)$50 Price$987$955 (net proceeds) N10 Calculate I/Y (yield to maturity) r = 5.17%k = 5.6% Tax rateNA35% Required rate of returnr = 5.17%k =.056 * (1 – tax) = 3.64%

Cost of Common Stock No permanent dividend or interest paid Incur cost when float stock No transaction costs on retaining earnings Dividend growth model – use when float stock k = (D / net proceeds) + g CAPM – use when retain earnings k = r f + β (r m – r f ) Assumes no transaction costs

Common Stock Example Investors’ ViewFirm’s View Dividend$2.50 Price$50$42 (net proceeds) Growth rate10% Calculater = (2.5 / 50) +.10k = (2.5 / 42) +.10 Returnr = 15%k = 15.9%

Weighted Average Cost of Capital Take the cost of each source of funding and weight it by it’s percent of the total –Weight x k –Add all the (weight x k)’s Used by firm in investment decisions –The expected return must be greater than the cost of capital In practice –Weights may change each year –Use the firm’s target capital structure

Divisional Cost of Capital Firm may be in many businesses –Each may have different risk characteristics Adjust k for risk in each division Evaluate each division using it’s own k