Transcript Chapter 9 THE COST OF CAPITAL

10 - 1
CHAPTER 10
The Cost of Capital
Sources of capital
Component costs
WACC
Adjusting for flotation costs
Adjusting for risk
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What sources of long-term capital do
firms use?
Long-Term
Capital
Long-Term
Debt
Preferred Stock
Retained
Earnings
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Common Stock
New Common
Stock
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How do you calculate the weighted
average cost of capital?
WACC = wdkd(1 – T) + wpkp + wsks
WACC = wdkd(1 – T) + wpkp + weke
The w’s refer to the capital structure
weights.
The k’s refer to the cost of each
component.
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Should we focus on before-tax or
after-tax capital costs?
Stockholders focus on A-T CFs.
Therefore, we should focus on
A-T capital costs, i.e., use A-T
costs in WACC. Only kd needs
adjustment, because interest is
deductible.
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Should we focus on historical
(embedded) costs or new (marginal)
costs?
The cost of capital is used primarily
to make decisions that involve
raising new capital. So, focus on
today’s marginal costs (for WACC).
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How do you determine the weights?
WACC = wdkd(1 – T) + wpkp + wsks.
WACC = wdkd(1 – T) + wpkp + weke.
 Use market value
 Use optimal capital structure
 So if a company has $300 million in debt
outstanding, $100 million in preferred stock, &
$600 million of common stock, and this is
considered optimal for the company:
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How do you determine the weights?
WACC = wdkd(1 – T) + wpkp + wsks.
WACC = wdkd(1 – T) + wpkp + weke.
300/1000 = 30% debt wd = .3
100/1000 = 10% p.s.
wps = .1
600/1000 = 60% c.s.
wcs = .6
Since this is considered optimal, then these
weights will stay constant throughout the
problem.
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Component Cost of Debt
WACC = wdkd(1 – T) + wpkp + wsks.
WACC = wdkd(1 – T) + wpkp + weke.
kd is the marginal cost of debt
capital.
The yield to maturity on outstanding
LT debt is often used as a measure
of kd.
Why tax-adjust, i.e., why kd(1 - T)?
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10 - 9
A 15-year, 12% semiannual bond sells
for $1,153.72. What is kd?
0
1
2
30
i=?
...
60
-1,153.72
INPUTS
30
N
OUTPUT
60
-1153.72 60
I/YR
10%
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PV
PMT
60 + 1,000
1000
FV
P/Y set to 2
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Component Cost of Debt
Interest is tax deductible, so
kd AT = kd BT(1 – T)
= 10%(1 – 0.40) = 6%.
Flotation costs small. Ignore.
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Component Cost of Preferred Stock
WACC = wdkd(1 – T) + wpkp + wsks.
WACC = wdkd(1 – T) + wpkp + weke.
kp is the marginal cost of preferred
stock.
The rate of return investors require
on the firm’s preferred stock.
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What’s the cost of preferred stock?
Pp = $111.10; 10%Q; Par = $100.
Use this formula:
Dp
$10
=
= 0.090 = 9.0%.
kp =
Pp $111 .10
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Note:
Preferred dividends are not tax
deductible, so no tax adjustment.
Just kp.
Nominal kp is used.
Our calculation ignores flotation
costs.
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Is preferred stock more or less risky to
investors than debt?
More risky; company not required to
pay preferred dividend.
However, firms try to pay preferred
dividend. Otherwise, (1) cannot pay
common dividend, (2) difficult to
raise additional funds, (3) preferred
stockholders may gain control of
firm.
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Why is yield on preferred lower than kd?
Corporations own most preferred stock,
because 70% of preferred dividends are
nontaxable to corporations.
Therefore, preferred often has a lower
B-T yield than the B-T yield on debt.
The A-T yield to an investor, and the A-T
cost to the issuer, are higher on
preferred than on debt. Consistent with
higher risk of preferred.
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Component Cost of Equity
WACC = wdkd(1 – T) + wpkp + wsks.
WACC = wdkd(1 – T) + wpkp + weke.
ks is the marginal cost of common
equity using retained earnings.
The rate of return investors require
on the firm’s common equity using
new equity is ke.
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Why is there a cost for retained
earnings?
Earnings can be reinvested or paid
out as dividends.
Investors could buy other securities,
earn a return.
Thus, there is an opportunity cost if
earnings are retained.
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Opportunity cost: The return
stockholders could earn on
alternative investments of equal
risk.
They could buy similar stocks
and earn ks, or company could
repurchase its own stock and
earn ks. So, ks is the cost of
retained earnings.
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Three ways to determine cost of
common equity, ks:
1. CAPM: ks = kRF + (kM – kRF)b.
2. DCF: ks = D1/P0 + g.
3. Own-Bond-Yield-Plus-Risk
Premium: ks = kd + RP.
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What’s the cost of common equity
based on the CAPM?
kRF = 7%, RPM = 6%, b = 1.2.
ks = kRF + (kM – kRF )b.
= 7.0% + (6.0%)1.2 = 14.2%.
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What’s the DCF cost of common
equity, ks? Given: D0 = $4.19;
P0 = $50; g = 5%.
D1
D0(1 + g)
ks =
+g=
+g
P0
P0
$4.19(1.05)
=
+ 0.05
$50
= 0.088 + 0.05
= 13.8%.
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Find ks using the own-bond-yield-plusrisk-premium method.
(kd = 10%, RP = 4%.)
ks = kd + RP
= 10.0% + 4.0% = 14.0%
This RP  CAPM RP.
Produces ballpark estimate of ks.
Useful check.
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What’s a reasonable final estimate
of ks?
Method
Estimate
CAPM
14.2%
DCF
13.8%
kd + RP
14.0%
Average
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14.0%
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Why is the cost of retained earnings
cheaper than the cost of issuing new
common stock?
1. When a company issues new
common stock they also have to pay
flotation costs to the underwriter.
2. Issuing new common stock may
send a negative signal to the capital
markets, which may depress stock
price.
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Two approaches that can be used to
account for flotation costs:
Include the flotation costs as part of
the project’s up-front cost. This
reduces the project’s estimated return.
Adjust the cost of capital to include
flotation costs. This is most
commonly done by incorporating
flotation costs in the DCF model.
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Suppose new common stock had a
flotation cost of 15%. What is ke?
D0(1 + g)
ke =
+g
P0(1 – F)
$4.19(1.05)
=
+ 5.0%
$50(1 – 0.15)
$4.40
=
+ 5.0% = 15.4%.
$42.50
The final realized profit from issuing new common stock
will be given, you will not have to compute P0(1-F).
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Comments about Flotation Costs
Flotation costs depend on the risk of
the firm and the type of capital being
raised.
The flotation costs are highest for
common equity. However, since
most firms issue equity infrequently,
the per-project cost is fairly small.
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10 - 28
What are the firm’s WACC’s?
WACC = wdkd(1 – T) + wpkp + wsks
= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4% = 11.1%.
WACC = wdkd(1 – T) + wpkp + weke
= 0.3(10%)(0.6) + 0.1(9%) + 0.6(15.4%)
= 1.8% + 0.9% + 9.24% = 11.94%.
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10 - 29
How to distinguish which WACC is
applicable.
Must find the break point, or turning point,
for retained earnings: ks
Find NI
Find Dividends paid out
$50,000,000
50%
($50,000,000) * (.5) =
$25,000,000
Find R/E available
$25,000,000
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10 - 30
How to distinguish which WACC is
applicable.
R/E available
$25,000,000
Break point = Addition to Retained
Earnings /Equity fraction (weight) used in
financing
BP = $25,000,000/.6
BP = $41,666,667 Level of Capital
Spending that would have to be reached to
use up all the ks.
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10 - 31
How to distinguish which WACC is
applicable.
So if the company has acceptable capital projects
amounting to less than $41,666,667, their weighted
average cost of capital will be 11.1%, because they
would use their internally generated funds to finance the
projects, together with debt and preferred stock.
If acceptable capital projects are greater than
$41,666,667, their weighted average cost of capital will
be 11.94%, and they would be issuing new common
stock to finance the common equity portion of the
projects, together with debt and preferred stock.
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