1. Copyright © 2009 Pearson Prentice Hall. All rights reserved. Chapter 10 The Cost of Capital

2. 10-2 Learning Goals 1.Concept of cost of capital 2.Determine the annual percentage cost of individual sources of capital. 3.Calculate the weighted average cost of capital (WACC).

3. 10-3 Learning Goals (cont.) 4.Determine break points and the marginal cost of capital (MCC). 5.Use the marginal cost of capital (MCC) and the investment opportunities schedule (IOS) to make financing and investment decisions.

4. An Overview of the Cost of Capital The cost of capital is the annual % cost of financing projects in the capital budget. It is the required rate of return that must be earned on investment projects of ______________________________________. If the project under consideration has high or low risk, the cost of capital must be adjusted to determine the risk adjusted discount rate (RADR). 10-4

5. 10-5 The Firm’s Capital Structure

6. 10-6 Key Considerations The relevant cost of capital is the annual percentage cost of ___________________ financing on an _____________________ basis.

7. After-Tax Cost of Debt (r i ) The pretax cost of debt (r d ) is the interest rate the firm must pay on new debt financing. The before tax interest rate must be adjusted for the fact that interest expense is tax- deductible. This _____________________ the cost of debt. Specific Sources of Capital: The Cost of Long-Term Debt 10-7

8. 10-8 Find the after-tax cost of debt if the interest rate on new debt is 9.4% and the tax rate is 40%: r i = 9.4% (1-.40) = 5.6% The after-tax cost of debt capital is 5.6%. Specific Sources of Capital: The Cost of Long-Term Debt (cont.)

9. Cost of Preferred Stock (r p ) r P = D P /N P In the above equation, D P is the annual dividend per share of preferred stock and N P is the per share net proceeds from the sale of preferred. Cost of Specific Sources of Capital 10-9

10. 10-10 The corporation is contemplating the issuance of 10% preferred stock that is expected to sell for its $87 par share. The cost of issuing and selling the stock is expected to be $5 per share. The dividend is $8.70 (10% x $87). The net proceeds price (N p ) is $82 ($87 - $5). r P = D P /N p = $8.70/$82 = 10.6% Specific Sources of Capital: The Cost of Preferred Stock

11. 10-11 Specific Sources of Capital: The Cost of Common Equity There are two forms of common stock financing: retained earnings and new issues of common stock. There are two different ways to estimate the cost of retained earnings: the constant growth dividend valuation model, and the capital asset pricing model (CAPM).

12. 10-12 r S = (D 1 /P 0 ) + g r S = r F + b(r M - r F ). We can also estimate the cost of retained earnings using the CAPM: Specific Sources of Capital: The Cost of Retained Earnings Using the constant growth model:

13. 10-13 r s = D 1 /P 0 + g For example, assume a firm has just paid a dividend of $2.31 per share, expects dividends to grow at 8% indefinitely, and is currently selling for $50.00 per share. First, D 1 = $2.315(1+.08) = $2.50, and r S = ($2.50/$50.00) +.08 = 13%. Specific Sources of Capital: The Cost of Retained Earnings (cont.) Cost of Retained Earnings (r S ) –Constant Dividend Growth Model

14. 10-14 r s = r F + b(r M - r F ). For example, if the 3-month T-bill rate is currently 5.5%, the market risk premium is 6%, and the firm’s beta is 1.25, the firm’s cost of retained earnings will be: r s = 5.5% + 1.25 (6.0%) = 13%. Cost of Retained Earnings (r S ) –CAPM Approach Specific Sources of Capital: The Cost of Retained Earnings (cont.)

15. Cost of New Common Stock (r n ) Cost of new common stock financing (r n ) r n = (D 1 / N n ) + g Where: D 1 is the dividend expected in the coming year. N n = net proceeds from the sale of new common stock 10-15

16. Cost of New Common Stock (r n ) Continuing with the previous example, how much would it cost the firm to raise new equity by selling new shares of common stock if flotation costs are $8.33 per share? r n = D 1 / N n + g = 2.50 / 41.67 +.08 =.06 +.08 =.14 = 14% 10-16

17. 10-17 WACC = r a = w i r i + w p r p + w s r r or n The weights in the above equation represent a specific financing mix (where w i = % of debt, w p = % of preferred, and w s = % of common). Specifically, these weights should be the target percentages of debt and equity that will minimize the firm’s overall cost of raising funds. The Weighted Average Cost of Capital Capital Structure Weights

18. Weighted Average Cost of Capital In some cases, the target weights are not available, and we must use alternatives. The weights can be determined by: –Firm’s policy (target weights) –Market values of firm’s debt and equity –Book values of firm’s debt and equity 10-18

19. 10-19 WACC = r a = w i r i + w p r p + w s r r or n The Weighted Average Cost of Capital Capital Structure Weights For example, assume the market value of the firm’s debt is $40 million, the market value of the firm’s preferred stock is $10 million, and the market value of the firm’s equity is $50 million. Dividing each component by the total of $100 million gives us market value weights of 40% debt, 10% preferred, and 50% common.

20. 10-20 WACC = r a = w i r i + w p r p + w s r r or n The Weighted Average Cost of Capital Capital Structure Weights Using the costs previously calculated along with the market value weights, we may calculate the weighted average cost of capital as follows: WACC =.40(5.6%) +.10(10.6%) +.50(13%) = 9.8% This assumes the firm has sufficient retained earnings to fund any anticipated investment projects.

21. 10-21 Table 10.1 Calculation of the Weighted Average Cost of Capital

22. 10-22 The Marginal Cost & Investment Decisions The Marginal Cost of Capital (MCC) –The WACC typically increases as the volume of new capital raised within a given period increases. –This is true because companies need to raise the return to investors in order to entice them to invest to compensate them for the increased risk introduced by larger volumes of capital raised. –In addition, the cost will eventually increase when the firm runs out of cheaper retained equity and is forced to raise new, more expensive equity capital.

23. 10-23 Finding the break points in the WMCC schedule will allow us to determine at what level of new financing the WACC will increase due to the factors listed above. BP j = AF j /w j where: BP j = breaking point form financing source j AF j = amount of funds available at a given cost w j =target capital structure weight for source j The Marginal Cost & Investment Decisions (cont.) The Marginal Cost of Capital (MCC) –Finding Break Points

24. 10-24 The Marginal Cost & Investment Decisions (cont.) The Marginal Cost of Capital (WMCC) –Finding Break Points Assume that in the example we have been using that the firm has $300,000 of retained earnings available. When it is exhausted, the firm must issue new (more expensive) equity. Furthermore, the company believes it can raise $400,000 of cheap debt after which it will cost 8.4% (after-tax) to raise additional debt. Given this information, the firm can determine its break points as follows:

25. 10-25 The Marginal Cost & Investment Decisions (cont.) The Marginal Cost of Capital (WMCC) –Finding Break Points BP equity =$300,000/.50 = $600,000 BP debt =$400,000/.40 = $1,000,000 This implies that the firm can fund up to $600,000 of new investment before it is forced to issue new equity and $1 million of new investment before it is forced to raise more expensive debt. Given this information, we may calculate the MCC as follows:

26. 10-26 Table 10.2 Weighted Average Cost of Capital for Ranges of Total New Financing for Duchess Corporation

27. 10-27 Figure 10.1 MCC Schedule

28. 10-28 Table 10.3 Investment Opportunities Schedule (IOS) for Duchess Corporation

29. 10-29 Figure 10.2 IOS and WMCC Schedules