1. Chapter 16 – Cost of Capital u Capital definition: Mix of long-term financing sources, primarily debt and equity, used by the company

2. Opportunity Cost Concept u Cost of capital is an opportunity cost u The opportunity cost is the return investors could have expected by investing somewhere else at equal risk

3. Weighted Average Concept u The cost of capital is an average of the opportunity costs of stockholders and creditors u The average is weighted by the proportion of funds provided by each source

4. Marginal Cost Concept u The marginal cost of capital is the rate of return that must be earned on new capital to satisfy investors u The marginal cost of capital is the weighted average cost of capital that must be earned on new investments u The marginal cost of capital is the change in the amount needed to satisfy investors, divided by the amount of new capital raised

5. Cost of Debt u Cost of debt is the interest rate the company would be required to pay on new debt, adjusted upward for flotation costs u Yield to maturity on bonds frequently measures the marginal cost of debt u To sell new bonds, you must pay at least the yield to maturity for new bonds u To justify reinvesting existing funds, your internal investments must be better than the return earned by buying back your existing debt in the marketplace

6. After-tax Cost of Debt u Payment of interest results in a tax savings u After-tax cost of debt: K d = before-tax cost of debt X (1 – Tax rate)

7. Cost of Preferred Stock u Most preferred stock is perpetual; it has no maturity date u Cost of preferred stock: K p = Dividend per share  Market price per share u The cost of new preferred stock requires the use of a net price, the amount that the company will net after paying flotation costs

8. Cost of Common Stock u No direct way to observe the return required by common stockholders; must estimate u Use u Dividend growth model u Earnings yield u CAPM

9. Dividend Growth Model u K e = (D 1 /P) + g Where D 1 = Expected dividend at the end of the next year P = Current price of the stock g = Anticipated growth rate of dividends u Applies when dividend growth is stable

10. Earnings Yield Model u K e = Earnings per share  Price u Sometimes used, but u Ignores growth u Not based on cash flow

11. Mean-variance CAPM u K e = R f +  s,m [E(R m ) - R f ] Where Rf = Risk-free rate  s,m = Beta of the company’s stock with regard to the market portfolio E(R m ) = Expected return on the market portfolio u Widely used u E(R m ) is still widely debated u Can use similar company betas for a stock that is not publicly traded

12. Cost of Existing Equity u Also called the cost of retained earnings u Some authors argue that the cost of retained earnings is K e (1 – stockholders’ tax rate on dividends) u Much stock is held by pension funds and charitable endowments that do not pay taxes on dividends

13. Cost of new Equity u No dividend growth anticipated: K ne = K e /(1 – f) where f is flotation cost as a percent of market price u With dividend growth anticipated: K ne = D 1 /[P/(1 – f)] + g

14. Weight for Weighted Average Cost u Market value weights are recommended u Target capital structure is typically used if the the company is moving toward that target

15. Additional Issues u Deferred taxes: typically not considered a source of funds because deferred tax reconciles difference between accounting records and cash flows u Accounts payable and accrued expenses: typically not considered a source of funds because they reconcile the difference between accounting and cash flow u Short-term debt is included if it is used as permanent capital

16. Additional Issues u Leases: often used as a direct substitute for debt, and therefore the implied amount and cost of debt is included in the WACC calculation (covered in Ch. 21) u Convertibles: treat as a straight bond and an option u Depreciation-generated funds: It makes sense to talk about internally generated funds, which have the cost of existing capital, but not to look separately at depreciation

17. Risk Differences and WACC u The WACC calculations typically assume that projects for a company are all of similar risk u When risks are different, they often vary by division u Companies often use division cost of capital, estimating the betas and cost of equity for each division if it were a stand-alone company u Large individual projects are sometimes evaluated as if they were funded as a stand-alone company

18. International Investments u Cost of capital should reflect the risk of the project u Cost of capital should be denominated in the same currency used to denominate cash flows for capital investment analysis u Equity residual method, discussed in Chapter 20, is sometimes used to evaluate international investments with multi-country financing.