1. Chapter 8 The Cost of Capital Fin 320 Dr. B. Asiri © 2005 Thomson/South-Western

2. 2 Cost of Capital  Firm’s average cost of funds, which is the average return required by firm’s investors  What must be paid to attract funds

3. 3 Required Rate of Return (Opportunity Cost Rate)  The return that must be raised on invested funds to cover the cost of financing such investments

4. 4 The Logic of the Weighted Average Cost of Capital The use of debt impacts 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.

5. 5 Basic Definitions  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)

6. 6 Basic Definitions  WACC Weighted Average Cost of Capital  Capital Structure A combination of different types of capital(debt and equity) used by a firm

7. 7 After-Tax Cost of Debt  The relevant cost of new debt  Taking into account the tax deductibility of interest  Used to calculate the WACC k dT = bondholders’ RRR minus tax savings k dT = k d - (k d x T) = k d (1-T)

8. 8 Cost of Preferred Stock  Rate of return investors require on the firm’s preferred stock  The preferred dividend divided by the net issuing price

9. 9 Cost of Retained Earnings  Rate of return investors require on the firm’s common stock

10. 1. The CAPM Approach s  RF k- M k k s k  () 2. The Discounted CF Approach  Price and E(k) on a share of common stock depend on the dividends expected on the stock.

11. 3. The Bond-Yield-Plus-Premium Approach  Estimating a risk premium above the bond interest rate  Judgmental estimate for premium

12. Cost of Newly Issued Common Stock  External equity, k e  Based on the cost of retained earnings  Adjusted for flotation costs (the expenses of selling new issues)

13. 13 Target Capital Structure  Optimal Capital Structure  Percentage of debt, preferred stock, and common equity in the capital structure that will maximize the price of the firm’s stock

14. 14 Weighted Average Cost of Capital, WACC  A weighted average of the component costs of debt, preferred stock, and common equity

15. Marginal Cost of Capital  MCC  Cost of obtaining another dollar of new capital  Weighted average cost of the last dollar of new capital raised  Marginal Cost of Capital Schedule  A graph that relates the firm’s weighted average of each dollar of capital to the total amount of new capital raised  Reflects changing costs, depending on amounts of capital raised

16. 16 Break Point  BP  The dollar value of new capital that can be raised before an increase in the firm’s weighted average cost of capital occurs

17. 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% BP RE BP Debt  Schedule and break points depend on capital structure used.

18. 18 0 - Dollars of New Capital Raised WACC Smooth, or Continuous, Marginal Cost of Capital Schedule MCC Schedule  Weighted Average Cost of Capital (WACC) (%)

19. 19 Combining the MCC and Investment Opportunity Schedules  Use the MCC schedule to find the cost of capital for determining projects’ net present values.  Investment Opportunity Schedule (IOS)  Graph of the firm’s investment opportunities ranked in order of the projects’ internal rate of return

20. 20 Optimal Capital Budget - $115 Combining the MCC and Investment Opportunity Schedules New Capital Raised and invested (millions of dollars) IRR C = 12.1% IRR B = 11.7% IRR D = 11.5% IRR E = 11.3% IRR A = 10.2% Percent 20 40 60 80 100 120 140 160 12.0 - 11.0 - 10.0 - MCC IOS WACC 1 =10.0% WACC 3 =11.0% WACC 2 =10.5%