Chapter 16 – Cost of Capital

 Capital definition: Mix of long-term financing sources, primarily debt and equity, used by the company

Opportunity Cost Concept

 Cost of capital is an opportunity cost  The opportunity cost is the return investors could have expected by investing somewhere else at equal risk

Weighted Average Concept

 The cost of capital is an average of the opportunity costs of stockholders and creditors  The average is weighted by the proportion of funds provided by each source

Marginal Cost Concept

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

Cost of Debt

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

After-tax Cost of Debt

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

Cost of Preferred Stock

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

Cost of Common Stock

 No direct way to observe the return required by common stockholders; must estimate  Use  Dividend growth model  Earnings yield  CAPM

Dividend Growth Model

 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  Applies when dividend growth is stable

Earnings Yield Model

 K e = Earnings per share  Price  Sometimes used, but  Ignores growth  Not based on cash flow

Mean-variance CAPM



K e = R f

Where + 

s,m [E(R m )

-

R f ]

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  Widely used  E(R m ) is still widely debated  Can use similar company betas for a stock that is not publicly traded

Cost of Existing Equity

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

Cost of new Equity

 No dividend growth anticipated:

K ne = K e /(1 – f)

where f is flotation cost as a percent of market price  With dividend growth anticipated:

K ne = D 1 /[P/(1 – f)] + g

Weight for Weighted Average Cost

 Market value weights are recommended  Target capital structure is typically used if the the company is moving toward that target

Additional Issues

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

Additional Issues

 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)  Convertibles: treat as a straight bond and an option  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

Risk Differences and WACC

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

International Investments

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