1. 1 Chapter 11 – Cost of Capital Key Sections: The concept of cost of capital –Impacts of taxes and flotation costs –Weighted average and incremental cost –How it is used by corporations Calculate cost of various capital sources

2. 2 The Concept The link between financing and investment decisions –Sets the hurdle rate that must be achieved on an investment so it increases shareholder wealth –Must satisfy investors’ required rate of return Does the required rate equal cost of capital? –Accounts for most of it but it must include flotation costs

3. 3 Factors Affecting Cost General economic conditions Market conditions Risk –Business risk – variability of returns –Financial risk (increased variability from debt)

4. 4 Concepts Continued If IRR is greater than C of C, shareholder wealth is increased Financial policy – mix of sources used – debt and equity. Mix can affect cost Weighted costs – weighted average of after-tax cost of each source used Marginal C of C – cost of next dollar of financing if new source used

5. 5 Cost of Debt Bond yield calculation plus two added factors: tax effects and flotation costs Bond yield – same steps for calculating a bond’s YTM covered in Chapter 7 However: yield must be converted to after-tax basis: –Before-tax rate * (1 - TR) = after-tax cost –9.75 * (1 -.34) = 6.435 after-tax

6. 6 New Debt If new debt is used, must consider selling costs (flotation costs) paid to investment bk. In solving for before-tax yield, substitute net proceeds received for market price and solve for YTM and adjust for taxes. Flotation costs = 1% of par = $10/$1,000 –Company receives $990, not $1,000 –Solve for yield

7. 7 Preferred Stock Par value $100, market value = $96, dividend 8% of par. Flotation cost for new stock = $1/share Outstanding stock: $8/$96 = 8.33% New stock = $8/(96 – 1) = 8.42% No tax adjustment needed

8. 8 Common Equity Hard to estimate – required rate not observable From retaining earnings or new stock Required Rate = Next Dividend + Growth Market Price New stocks cost = Next Dividend + Growth Net Proceeds Received

9. 9 Weighted Average Cost Total of: After-tax cost of debt * Proportion from debt Plus Cost of preferred* Proportion from Pfd Plus Cost of common* Proportion from com

10. 10 Weighted Cost of Capital TypeShareA-T Cost Debt30%5%1.5% Preferred10121.2 Common60169.6 Total100%12.3%

11. 11 Weights and Use Cost of capital can serve as discount rate for calculating NPV of a project –If doesn’t earn more than cost = bad deal Cost should also reflect project’s riskiness Because capital structure varies year to year, use targeted structure.

12. 12 Global Finance Issues Why aren’t interest rates the same in all countries? –Differences in anticipated inflation Examples: Argentina and Brazil –Political and other risk considerations