1. Copyright ©2003 South-Western/Thomson Learning Chapter 11 The Cost of Capital

2. Introduction This chapter discusses the concept of the cost of capital and develops approaches used to measure it. Weighted cost of capital Risk vs. required return trade-off Individual components

3. Cost of Capital Determined in the capital markets Depends on the risk associated with the firm’s activities What the firm must pay for capital The return required by investors Minimum rate of return required on new investments Equal to the equilibrium rate of return demanded by investors in the capital markets for securities of that degree of risk

4. Weighted Average Cost of Capital: k a Discount rate used when computing the NPV of a project of average risk Hurdle rate used in conjunction with the IRR Based on the after-tax cost of capital Obtained from the weighted costs of the individual components Weights equal to the proportion of each of the components in the target capital structure

5. Calculating k a k = W(k e ) + W(k i ) + W(k p ) k = 60%(k e ) + 30%(k i ) + 10%(k p ) Example with $3 in bonds, $6 in equity, and $1 in preferred stock

6. Required return = r f + Risk premium r f = risk-free rate –Real rate of return determined by supply and demand Plus a premium for the effects of inflation Components of the risk premium –Business risk associated with the amount of operating leverage –Financial risk associated with the use of financial leverage –Marketability risk refers to the ability to quickly buy and sell –Interest rate risk arising from changes in interest rates –Seniority risk due to the priority of a security’s claim on assets

7. Risk-Return Trade-Off of Various Sources of Funds rfrf Risk Required Return % x Common Stock x Low Quality Corp Debt x High Quality P/S x High Quality Corp Debt x L-T Government Debt x S-T Government Debt

8. Component Costs k i = k d (1 – T) Interest is tax deductible k p = D p /P net Dividends are not Cost of internal equity capital –k e = D 1 /P 0 + g Cost of R/E using constant dividend g –k e = r f +  j (r m – r f ) CAPM –Risk premium on debt approach Add % Cost of external equity k e = D 1 /P net + g P net = P 0 (1 – f)

9. Growth Rate Information Institutional Brokers Estimate System –http://www.ibes.com/http://www.ibes.com/ Zacks Earnings Estimates –http://www.zacks.com/http://www.zacks.com/ Thomson Financial First Call Service –http://www.firstcall.com/index.shtmlhttp://www.firstcall.com/index.shtml Dividend growth model –http://www.finplan.com/invest/divgrowmo d.htmhttp://www.finplan.com/invest/divgrowmo d.htm

10. CAPM Check out this Web site to see how the CAPM is used to calculate a firm’s cost of equity: http://www.ibboston.com/

11. Divisional Costs of Capital Some divisions of a company have higher or lower systematic risk. The discount rates for these divisions should be higher or lower than the discount rate for the firm as a whole. Each division could have its own beta and discount rate. Should reflect both the differential risks and the differential normal debt ratios for each division.

12. MCC Schedule Step 1: Calculate the cost of capital for each component Step 2: Compute the MCC for each increment of capital raised Equal to the equilibrium rate of return demanded by investors in the capital markets for securities of that degree of risk

13. Determining the Optimal Capital Budget Compare the expected project returns to the company’s MCC schedule. Accomplished by plotting the returns expected from the proposed capital expenditure projects against the cumulative funds required Cost of funds may increase with the amount of financing required.

14. % $ MCC IRR A B C D E F Optimal Capital Budget Optimal capital budget contains all projects for which the expected return lies above the MCC

15. Depreciation Is a major source of funds Is equal to the firm’s weighted cost of capital based on R/E and the lowest cost of debt Availability of funds from depreciation shifts the MCC to the right by the amount of depreciation.

16. The Cost of Capital for Multinational Firms Some host countries offer preferential financing terms. Multinationals can shop the world for the lowest capital costs. Raise majority of equity in home country Raise substantial amount of debt in countries where they maintain significant operations –Is a hedge against exchange rate risk –May insulate the firm from expropriation

17. Small Firms Have a difficult time attracting capital Issuance costs are high (greater than 20% of issue) Often issue two classes of stock –One class sold to outsiders paying a higher dividend. –Second class held by founders with greater voting power. Limited sources of debt

18. Sources of Debt for Small Firms Owner’s own funds Loans from friends Loans from financial institutions SBA loans Commercial finance company loans Private placement Venture capital firms Leasing companies Creative financing –Warrants –Convertible debt