1. Chapter 11

2. Cost of Capital

3. Chapter Objectives Cost of Capital After-tax cost of debt, preferred stock and common stock Weighted average cost of capital PepsiCo’s cost of capital Cost of capital and new investments Economic profit Equivalent interest rates for different countries

4. Economic Value Created by earning a return greater than investors’ required return Destroyed by earning a return less than they require

5. EVA Measurement Encourages management to make business decisions that create economic value through improved operating efficiency, better asset utilization, and growth that generates returns which exceed the cost of capital

6. Shareholder Value-Based Management Rewards the firm’s employees in ways that continually encourage them to seek out new ways to create shareholder value

7. EVA Emphasis on EVA will more closely align the interests of employees and shareholders

8. Cost of Capital Link between financing decisions and investment decisions Hurdle rate that must be achieved by an investment before it will increase shareholder wealth Basis for evaluating division or firm performance

9. Cost of Capital Also called: Hurdle rate for new investment Discount rate Opportunity cost of funds Required rate of return

10. Discount Rate Investors’ required rate of return or Minimum rate of return necessary to attract an investor to purchase or hold a security Considers opportunity cost

11. Required Rate of Return and Cost of Capital Cost of capital incorporates – Taxes or Tax Savings – Flotation Costs

12. Cost of Capital If a firm sells new stock for $30.00 a share and incurs $5 in flotation costs, and the investors have a required rate of return of 12%, what is the cost of capital?.12 x30 = $3.60 3.60 / (30-5) = 14.40%

13. Financial Policy Policies regarding the sources of finances a firm plans to use and the particular mix in which they will be used Governs the use of debt and equity financing. The particular mixture of debt and equity a firm utilizes impacts the firm’s cost of capital.

14. Weighted Average Cost of Capital Combined costs of all the sources of financing used by the firm. The weighted average of the after-tax costs of each of the sources of capital used by a firm to finance a project where the weights reflect the proportion of total financing from each source.

15. Financing Instruments Debt Preferred Stock Common Stock

16. Cost of Debt After tax cost of debt = k d (1-T c ) Before tax cost of capital less the effect of tax savings Example Debt at 9.75% and tax rate of 34% After-tax cost of debt =.0975(1-.34) = 6.435%

17. Cost of Preferred Stock Cost of preferred stock = Preferred Stock dividend/ Net proceeds per share Example: Annual dividend $5, Stock price $65 and flotation costs of $1.50 Cost = 5/(65 - 1.50) = 5/(63.50) =.07874 or Cost of preferred stock = 7.874%

18. Common Equity Sources: – Retained Earnings – Sales of new shares No Flotation costs on retained earnings

19. Cost of Equity Capital First estimate common stockholders’ required rate of return: Dividend Growth Model Capital Asset Pricing Model

20. Dividend Growth Model Investors’ required rate of return: K cs = D 1 /P cs + g Dividends divided by price of stock; plus growth rate Issue new common stock K ncs = D 1 /NP cs + g Dividends divided by net proceeds; plus growth

21. Dividend Growth Model Example: A company expects dividends this year to be $2.20, based upon the fact that $2 were paid last year. The firm expects dividends to grow 10% next year and into the foreseeable future. Stock is trading at $50 a share. Cost of retained earnings: K cs = D 1 /P cs + g 2.20/50+.10 = 14.4% Cost of new stock: K ncs = D 1 /NP cs + g 2.20/(50-7.50) +.10 = 15.18%

22. Issues with the Dividend Growth Model Simplicity Assume constant growth rate Estimating rate of growth

23. Capital Asset Pricing Model Combines: Risk Free rate k rf Systematic risk or Beta (B) Market Risk Premium or Expected rate of return for market or average security less the risk free ratek m – k rf k c = k rf + B(k m – k rf )

24. Capital Asset Pricing Model Example: Beta is 1.4; Risk-free rate is 3.75%; Expected market rate is 12%.0375 + 1.4(.12 -.0375) = 15.3%

25. Issues with the Capital Asset Pricing Model Simple/Easy to understand Variables available from public sources No reliance upon dividends or growth rate assumptions

26. Weighted Average Cost of Capital Need cost of each of the sources of capital used and capital structure mix Capital Structure Mix –proportions of each source of financing used by the firm WACoC = (After tax cost of debt X proportion of debt financing) + (Cost of equity X proportion of equity financing)

27. Weighted Average Cost of Capital Example: A firm borrows money at 6% after taxes and pays 10% for equity. The company raises capital in equal proportions – 50/50 WACoC = (.06 X.5) + (.1 X.5) =.08 or 8%

28. PepsiCo Calculated divisional cost of capital Different target ratios for debt/equity mix per division Different pretax cost of debt for each division

29. PepsiCo DivisionCost ofCost ofWA Equity XDebt XCOCratio Restaurant(12.20 X.7)(5.54 X.3)10.2 Snack Foods(11.56 X.8)(5.23 X.2)10.29 Beverages(11.77 X.74)(5.28 X.26)10.08

30. Cost of Capital and New Investment Cost of Capital can serve as the discount rate in evaluating new investment when the projects offer the same risk as the firm as a whole. If risk differs, may calculate a different cost of capital for each division. Generally, calculate the cost of capital per division, not per project.

31. Market Value Added MVA Difference in the current market value of the firm and the sum of all the funds that have been invested in the firm over its entire operating life MVA = Total value of the firm – Invested capital

32. Economic Profit Accounting profit less a charge for use of capital Calculated by: Net operating profit after tax (NOPAT) – invested capital X cost of capital

33. Kmart Example Economic Profit = NOPAT – Invested capital X cost of capital 568.979 = 950M – (19,727M X.0770) Note: return is 4.82% and cost of capital is 7.70%. Note: Kmart declared bankruptcy in Jan 2002

34. Economic Profit Increase economic profit by: Identifying and eliminating operating deficiencies Investing in projects that earn returns in excess of cost of capital Reduce capital charge

35. Incentive Based Compensation Way to align shareholder and manager interests Incentive= Base Pay X PercentageX actual Eco pro compensationincentive Target Eco prof compensation

36. Multinational Firms and Interest Rates In an international setting, there can be different rates of inflation among different countries. The Fisher Model indicates that the nominal interest rate in the home or domestic country is a function of real interest rates and anticipated rate of inflation

37. Fisher Model and Domestic Interest Rates r n,h = (1 + r r,h )(1 + i h ) – 1 or Nominal rate of interest= (1 plus real interest rate) (1 plus inflation rate) Example: Real interest rate is 5% and inflation rate is 10% (1.05)(1.10) – 1 = 15.5%

38. International or Foreign Rates and Fisher Effect r n,h - r n,f = i h – i f Differences in observed nominal rates of interest between two countries should equal the difference in expected rates of inflation between the two countries

39. Interest Rates and Currency Exchange Rates Interest Rate Parity Theorem 1 + r n,h = E 1 1 + r n,f E 0 r n,h D omestic one period rate of interest r n,f Corresponding rate in foreign country E j Exchange rates corresponding to current period I.e. spot rate E 0 and one-period forward -- Nominal interest rates are tied to exchange rates -- Differences in nominal interest rates are tied to expected rates of inflation

40. Interest Rates and Currency Exchange Rates Example: Domestic interest rate is 15.5% and the Japanese interest rate is 5% 1 +.155 / 1 +.05 = 1.10