1. 10-1 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Chapter 10: The Cost of Capital Copyright © 2000 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to the following address: Permissions Department, Harcourt, Inc., 6277 Sea Harbor Drive, Orlando, Florida 32887- 6777.

2. 10-2 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Cost of Capital èThe firm’s average cost of funds, which is the average return required by the firm’s investors èWhat must be paid to attract funds

3. 10-3 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. The Logic of the Weighted Average Cost of Capital The use of debt impacts on the ability to use equity, and vice versa, so the weighted average cost must be used to evaluate projects, regardless of the specific financing used to fund a particular project.

4. 10-4 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Basic Definitions 4 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)

5. 10-5 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. 4 WACC 4 WACC = weighted average cost of capital 4 Capital Structure 4 Capital Structure A combination of different types of capital used by a firm Basic Definitions

6. 10-6 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. After-Tax Cost of Debt èThe relevant cost of new debt èTaking into account the tax deductibility of interest èUsed 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)

7. 10-7 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Cost of Preferred Stock èRate of return investors require on the firm’s preferred stock èThe preferred dividend divided by the net issuing price

8. 10-8 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Cost of Retained Earnings l Rate of return investors require on the firm’s common stock

9. 10-9 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. The CAPM Approach

10. 10-10 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. The Bond-Yield-Plus-Premium Approach l Estimating a risk premium above the bond interest rate l Judgmental estimate for premium l “Ballpark” figure only

11. 10-11 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. The Discounted Cash Flow (DCF) Approach èPrice and expected rate of return on a share of common stock depend on the dividends expected on the stock

12. 10-12 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. The Discounted Cash Flow (DCF) Approach

13. 10-13 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Cost of Newly Issued Common Stock 4 External equity, k e 4 based on the cost of retained earnings 4 adjusted for flotation costs (the expenses of selling new issues )

14. 10-14 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Target Capital Structure èOptimal 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. 10-15 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Weighted Average Cost of Capital, WACC A weighted average of the component costs of debt, preferred stock, and common equity

16. 10-16 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Marginal Cost of Capital 4 MCC 4 The cost of obtaining another dollar of new capital 4 The weighted average cost of the last dollar of new capital raised

17. 10-17 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Marginal Cost of Capital Schedule 4 A graph that relates the firm’s weighted average of each dollar of capital to the total amount of new capital raised 4 Reflects changing costs depending on amounts of capital raised Marginal Cost of Capital

18. 10-18 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. MCC Schedule Weighted Average Cost of Capital (WACC) (%) New Capital Raised (millions of dollars) 100150 11.5 - 11.0 - 10.5 - WACC 1 =10.5% WACC 2 =11.0% WACC 3 =11.5%

19. 10-19 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Break Point 4 BP 4 The dollar value of new capital that can be raised before an increase in the firm’s weighted average cost of capital occurs

20. 10-20 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Weighted Average Cost of Capital (WACC) (%) New Capital Raised (millions of dollars) 100150 11.5 - 11.0 - 10.5 - WACC 1 =10.5% WACC 2 =11.0% WACC 3 =11.5% BP RE BP Debt MCC Schedule

21. 10-21 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. 4 Schedule and break points depend on capital structure used MCC Schedule

22. 10-22 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Weighted Average Cost of Capital (WACC) (%) Dollars of New Capital Raised 0 - WACC Smooth, or Continuous, Marginal Cost of Capital Schedule MCC Schedule

23. 10-23 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Combining the MCC and Investment Opportunity Schedules èUse the MCC schedule to find the cost of capital for determining projects’ net present values èInvestment Opportunity Schedule (IOS) è Graph of the firm’s investment opportunities ranked in order of the projects’ internal rate of return

24. 10-24 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Combining the MCC and Investment Opportunity Schedules IRR C = 12.0% IRR B = 11.6% IRR D = 11.5% IRR E = 11.3% IRR A = 10.8% Percent New Capital Raised and invested (millions of dollars) 20 40 60 80 100 120 140 160 180 12.0 - 11.5 - 11.0 - 10.5 - MCCIOS WACC 1 =10.5% WACC 3 =11.5% Optimal Capital Budget - $139 WACC 2 =11.0%

25. 10-25 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. End of Chapter 10 The Cost of Capital