Transcript No Slide Title

Chapter
11
The Cost of Capital
Copyright ©2003 South-Western/Thomson Learning
Introduction
• This chapter discusses the concept of
the cost of capital and develops
approaches used to measure it.
• Weighted average cost of capital
(WACC)
• Risk vs. required return trade-off
• Individual components
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
Notation
•
•
•
•
•
rf denotes riskless rate of return.
kd denotes pretax cost of debt.
ki denotes after-tax cost of debt.
kp denotes cost of preferred stock.
ke denotes cost of internal common
equity.
• ke’ denotes cost of external common
equity.
Notation
• ka denotes weighted (marginal) cost of
capital.
• p0 denotes the current market price of a
security.
• pnet denotes the net proceeds to the firm
from the sale of a security.
• pf denotes market value of a firm’s
preferred stock.
Notation
• E denotes market value of a firm’s
common equity.
• B denotes market value of a firm’s debt
in its capital structure.
• rm denotes expected return on the
“market” portfolio.
•  denotes the beta (systematic risk) of a
company’s stock.
Weighted Average Cost of Capital
• The weighted average cost of capital
is the discount rate used when
computing the net present value (NPV)
of a project of average risk.
• Similarly, the weighted average cost of
capital is the hurdle rate used in
conjunction with the internal rate of
return (IRR) approach to project
evaluation (for a project of average risk).
Weighted Average Cost of Capital
• Thus, the appropriate after-tax cost of
capital figure to be used in capital
budgeting not only is based on the next
(marginal) capital to be raised, but also
is weighted by the proportions of the
capital components in the firm’s longrange target capital structure. Therefore,
this figure is called the weighted
average cost of capital (WACC).
Weighted Average Cost
of Capital (WACC): ka
• The general expression for calculating
the WACC as follows:
E
B
ka  (
)(ke )  (
)(kd )(1  T )
E  B  Pf
E  B  Pf
Pf
(
)(kp )
E  B  Pf
Weighted Average Cost
of Capital (WACC): ka
• In the absence of preferred stock in a
firm’s capital structure, the calculation of
the WACC can be simplified to:
E
B
ka  (
)(ke )  (
)(kd )(1  T )
EB
EB
WACC: Example
• Firm A has a target capital structure
consisting of 47 percent common equity,
51 percent debt, and 2 percent preferred
stock. Firm A plans to finance future
capital investments in these proportions.
All common equity is expected to be
derived internally from additions to
retained earnings.
WACC: Example
• The marginal cost of internal common
equity has been estimated to be 10.4
percent using the dividend valuation
approach. The marginal cost of preferred
stock is 8.1 percent and the pretax
marginal cost of debt is 8 percent. The
marginal tax rate is 40 percent.
WACC: Example
• Using these figures, the WACC for Firm
A can be computed as follows:
ka = 0.47*10.4% + 0.51*8.0%*(1  0.4) +
0.02*8.1%
= 7.5%
This is the rate that Firm A should use to
evaluate investment projects of average
risk over the coming year.
Required return = rf + Risk
premium
• rf = risk-free rate
• The risk-free rate of return has two
components:
– real rate of return determined by supply and
demand
– a premium for the effects of inflation
Required return = rf + Risk
premium
• Components of the risk premium (Ch. 5)
– Business risk is associated with the
amount of operating leverage.
– Financial risk is associated with the use
of financial leverage.
– Marketability risk refers to the ability to
quickly buy and sell a company’s
security without a significant loss of
value.
– Interest rate risk arises from changes in
interest rates.
– Seniority risk is due to the priority of a
security’s claim on assets.
Relative Costs of Capital
• Figure 11.1 illustrates the general riskreturn trade-off between investors’
required rates of return and various
sources of funds.
Relative Costs of Capital
• If capital markets are to clear (that is,
supply equals demand), the firm must
offer returns consistent with investor
requirements.
• In other words, the cost of capital to the
firm is equal to the equilibrium rate of
return demanded by investors in the
capital markets for securities with that
degree of risk.
Relative Costs of Capital
• Suppose, for example, that a firm offers
a security for sale in the capital markets
at a return that is less than investors
generally require. Obviously, not enough
buyers will come forth. Unless the firm
increases the return (by dropping the
price, raising the interest or dividend
rate, and so on), the securities will
remain unsold, and the firm will not be
able to raise its capital.
Marginal Costs
• Firms calculate their cost of capital in
order to determine a discount rate to use
for evaluating proposed capital
expenditure projects.
• Recall that the purpose of capital
expenditure analysis is to determine
which proposed projects the firm should
actually undertake.
Marginal Costs
• Therefore, it is logical that the capital
whose cost is measured and compared
with the expected benefits from the
proposed projects should be the next or
marginal capital the firm raises.
• As we saw in Chapter 8, the capital
budgeting process involves an extension
of the marginal analysis principle from
economics.
Marginal Costs
• The marginal revenue (internal rate of
return) from a project is compared with
the marginal cost of funds needed to
finance the project.
• The marginal cost of funds is the cost of
the next increments of capital raised by
the firm. Hence, the costs of the various
capital funding components (debt,
preferred stock, and common equity)
must be their marginal costs.
Marginal Costs
• Historic average capital costs are not
relevant for making new (marginal)
resource allocation decisions.
Cost of Debt
• The cost of debt capital to the firm is the
rate of return required by a firm’s
creditors.
Cost of Debt
• For a debt issue, this rate of return, kd,
equates the present value of all
expected future receipts—interest, I, and
principal repayment, M—with the net
proceeds, pnet, of the debt security:
n
I
M
Pnet  

t
n
(1  kd )
t 1 (1  kd )
Pnet  I (PVIFA kd ,n )  M (PVIFkd ,n )
Cost of Debt
• The pre-tax cost of debt, kd, is calculated
in the same way as the yield to maturity,
shown in Chapter 6. The only difference
in the calculation is that when making
yield-to-maturity calculations, the price of
the bond is the current market price.
When computing the pretax cost of debt
to a company, the price of the bond is
the net proceeds the company receives
after considering all issuance costs.
Cost of Debt
• Interest payments made to investors are
deductible from the firm’s taxable
income. Therefore, the after-tax cost of
debt, ki, is computed by multiplying the
pre-tax cost of debt, kd, by 1 minus the
firm’s marginal tax rate, T: ki = kd(1 – T)
– The tax benefits of interest deductibility are
available only to firms that are making
profits.
– For a firm losing money, the after-tax cost,
ki, is the same as the pretax cost, kd.
Cost of Debt: Example
• Assume that KMI sells $100 million of
20-year 7.8 percent coupon rate bonds.
The net proceeds to KMI after issuance
costs are $980 for each $1,000 bond.
KMI’s pretax cost, kd, of this debt offering
can be calculated as follows:
980  $78(PVIFAkd ,20 )  $1,000(PVIFkd ,20 )
Cost of Debt: Example
• The calculation of kd can be done either
by trial and error using Tables IV and II
or with the aid of a financial calculator.
– By trial and error, try 8 percent:
$980 = $78(9.818) + $1,000(0.215)
– 20 → N
-980 → PV
78 → PMT
1000 → FV
Compute
i% (= 8.00)
Cost of Debt: Example
• Assuming a 40 percent marginal tax
rate, the after-tax cost of debt for KMI is:
ki = kd(1 – T) = 8%(1 – 0.4) = 4.8%
Cost of Preferred Stock
• The cost of preferred stock to the firm is
the rate of return required by investors
on preferred stock issued by the
company.
Cost of Preferred Stock
• The cost of preferred stock, kp, can be
derived as follows:
P0 
Dp
kp
 kp 
Dp
P0
 kp 
Dp
Pnet
where Pnet is the proceeds from the sale
of the stock after subtracting issuance
costs.
Cost of Preferred Stock: Example
• Suppose KMI has just issued 3 million
shares of a preferred stock that pay an
annual dividend of $4.05. The preferred
stock was sold to the public at a price of
$52 per share. With issuance costs of $2
per share, the marginal cost of preferred
stock is calculated as follows:
$4.05
kp 
 0.081 or 8.1%
$52  $2
Cost of Preferred Stock
• Because payments by the firm to
preferred stockholders are in the form of
dividends, they are not tax deductible;
therefore, the after-tax cost of preferred
stock is equal to the pretax cost.
Cost of Preferred Stock
• An increasing number of preferred stock
issues are callable, have a sinking fund
redemption provision, or have a fixed
maturity. In these cases, the computation
of the cost of preferred stock financing is
similar to that for bond.
Cost of Preferred Stock: Example
• Progress Energy plans an offering of $50
par value preferred stock that will pay a
$5.00 dividend per year. The preferred
stock is expected to yield Progress
Energy net proceeds of $46.40 per share
after all issue costs. The preferred stock
must be retired at its par value in 15
years.
Cost of Preferred Stock: Example
• The cost of this preferred stock issue
can be computed by solving for kp in the
following valuation model:
Pnet  $46.40
 $5(PVIFA kp ,15 )  $50(PVIFkp ,15 )
Cost of Preferred Stock: Example
• 15 → N
-46.40 → PV
5 → PMT
50 → FV
Compute
i% (= 11%)
Cost of Internal Equity Capital
• The cost of equity capital to the firm is
the equilibrium rate of return required by
the firm’s common stock investors. Firms
raise equity capital in two primary ways:
– Internally, through retained earnings
– Externally, through the sale of new
common stock
Cost of Internal Equity Capital
• The cost of internal equity is not zero.
When funds are generated through the
earnings of the firm, either managers
can pay out these funds as dividends to
common stockholders, or the funds can
be retained and reinvested in the firm.
Cost of Internal Equity Capital
• If the funds were paid out to
stockholders, they could reinvest the
funds elsewhere to earn an appropriate
return, given the risk of the investment.
Cost of Internal Equity Capital
• Therefore, if managers decide to retain
earnings and reinvest them in the firm,
there must be investment opportunities
in the firm offering a return equivalent to
the returns available to common
stockholders, on a risk-adjusted basis, in
alternative investments.
Cost of Internal Equity Capital
• The cost of internal equity to the firm is
less than the cost of new common stock
because the sale of new stock requires
the payment of issuance costs.
st of Internal Equity Capital: Dividend
luation Model Approach
• The general dividend valuation model (or
the dividend capitalization model) for
common stock valuation is as follows:

Dt
P0  
t
t 1 (1  ke )
where P0 is the stock’s present value or
current market price; Dt, the dividend
received in period t; and ke, the return
required by investors.
st of Internal Equity Capital: Dividend
luation Model Approach
• The above equation shows that in
efficient capital markets, ke, the required
return and thus the cost of equity capital,
equates the present value of all
expected future dividends with the
current market price of the stock.
st of Internal Equity Capital: Dividend
luation Model Approach
• In principle, the cost of equity capital can
be calculated by solving for ke.
• In practice, however, the expected future
dividends are not known and cannot be
estimated with the same degree of
confidence as preferred stock dividends
and debt interest. As such, the general
form of the dividend valuation model is
not directly useful in calculating the cost
of equity capital.
st of Internal Equity Capital: Dividend
luation Model Approach
• If the firm’s future per-share dividends
are expected to grow each period
perpetually at a constant rate, g, the
dividend valuation model can be written
as follows:
D1
P0 
ke  g
where D1 = D0(1 + g) and D0 is the current
period dividend (t = 0).
Note that ke must be greater than g.
st of Internal Equity Capital: Dividend
luation Model Approach
• As discussed in Chapter 7, the constant
growth valuation model assumes that
a firm’s earnings, dividends, and stock
price will grow at rate g. Thus, g equates
to the yearly price appreciation (capital
gain). But the total return to
stockholders, ke, is composed of both the
price appreciation and the dividend yield.
Therefore, g cannot be greater than or
equal to ke because it is only one of two
components making up k .
st of Internal Equity Capital: Dividend
luation Model Approach
• Assuming that dividends are expected to
grow perpetually at a rate g per year, the
cost of equity can be calculated as
follows:
D1
ke 
g
P0
st of Internal Equity Capital: Dividend
luation Model Approach - Example
• Suppose KMI’s common stock is
currently selling for $56 a share. Its
present dividend, D0, is $0.20 a share,
and the expected long-term earnings
and dividend growth rate is 10 percent.
The cost of internal equity capital, ke, is
calculated as follows:
$0.20(1  0.10)
ke 
 0.10  0.104 or 10.4%
$56
st of Internal Equity Capital:
onconstant Dividend Growth Model
• The dividend valuation model can also
be used to compute the cost of equity for
common stocks expected to pay
dividends that grow at variable rates in
the future. An approach similar to the
nonconstant growth dividend valuation
model illustrated in Chapter 7 can be
used.
st of Internal Equity Capital:
onconstant Dividend Growth Model
• For example, Avtec Corporation is a
rapidly growing producer of microcircuit
boards used in the aerospace industry.
Its stock is currently selling for $10.95
per share. Current dividends, D0, are
$1.00 per share and are expected to
grow at a rate of 10 percent per year
over the next four years and 6 percent
annually thereafter.
st of Internal Equity Capital:
onconstant Dividend Growth Model
• Avtec’s cost of internal equity, ke, can be
found as follows:
$1.10 $1.10(1  0.1)1 $1.10(1  0.1)2
$10.95 


1
2
(1  ke )
(1  ke )
(1  ke )3
$1.10(1  0.1)3
1
$1.55



4
4
(1  ke )
(1  ke ) ke  0.06
$10.95  $1.10(PVIFke ,1 )  $1.21(PVIFke ,2 )  $1.33(PVIFke ,3 )
$1.55
 $1.46(PVIFke ,4 )  (PVIFke ,4 )
ke  0.06
Note that the last term in this expression, $1.55/(ke –
0.06), is equal to the expected stock price at the
st of Internal Equity Capital:
onconstant Dividend Growth Model
• The valuation expression above must be
solved for ke, the cost of equity capital,
using a trial-and-error procedure. A trial
value of 17 percent for ke yields the
following:
$10.95 = $1.10(0.855) + $1.21(0.731) +
$1.33(0.624) + $1.46(0.534) +
0.354[$1.55/(0.17  0.06)]
= $10.95
Thus, Avtec’s cost of equity is 17%.
Cost of Internal Equity Capital:
CAPM Approach
• Recall from Chapter 5 that the security
market line is defined as follows:
kj = rf + j(rm – rf)
–
–
–
–
–
kj = the required rate of return on any security j
rf = the expected risk-free rate
j = the beta (systematic risk) measure for security j
rm = the expected return on the market portfolio.
The value (rm – rf) equals the market risk premium
(the slope of the SML), or the risk premium
applicable to a stock of average (beta = 1.0) risk.
Cost of Internal Equity Capital:
CAPM Approach - Example
• Suppose KMI’s beta is 0.70 and the
return of the market portfolio is 12.1%. If
short-term Treasury bills are yielding 3.0
percent, KMI’s cost of equity capital may
be computed using the short-term SML
as follows:
ke = rf + j(rm – rf)
= 3.0% + 0.7(12.1% – 3.0%)
= 9.4%
Cost of Internal Equity Capital:
CAPM Approach
• Recall from Chapter 5 that the beta
measure of risk considers only the
systematic risk or market risk of a stock.
Poorly diversified investors may be more
interested in total risk than in systematic
risk. When this is true, the CAPM may
understate returns required by those
investors.
Cost of Internal Equity Capital:
Non-Dividend-Paying Stocks
• For stocks that do not pay dividends, the
dividend capitalization model is
obviously an inappropriate valuation
model and therefore cannot be used to
determine an accurate cost of equity
capital.
• Investors in non-dividend-paying stocks
expect to sell the stock in the future at a
higher price than the present price,
realizing a capital gain.
Cost of Internal Equity Capital:
Non-Dividend-Paying Stocks
• Investors’ expectations about the future
price are incorporated into the following
valuation model:
Pt
P0 
t
(1  ke )
where Pt is the expected stock price at
time t.
Cost of Internal Equity Capital:
Non-Dividend-Paying Stocks
• In principle, a firm could use this
valuation model to determine its cost of
equity capital. In practice, however, this
would be difficult to do, because the
company probably has no way of
confidently determining the Pt
expectations of investors.
Cost of Internal Equity Capital:
Non-Dividend-Paying Stocks
• Instead, the cost of equity capital for
non-dividend-paying stocks normally is
determined either by using the Capital
Asset Pricing Model, the risk premium
on debt approach, or by estimating ke for
comparable dividend-paying stocks in
their industry.
Cost of External Equity Capital
• The cost of external equity is greater
than the cost of internal equity for the
following reasons:
– Issuance (flotation) costs associated with
new shares are usually high enough that
they cannot realistically be ignored.
Cost of External Equity Capital
– The selling price of the new shares to the
public is normally set less than the market
price of the stock before the announcement
of the new issue. Before any
announcement, the current market price of
a stock usually represents an equilibrium
between supply and demand. If supply is
increased (all other things being equal), the
new equilibrium price will be lower.
Cost of External Equity Capital
• When a firm’s future dividend payments
are expected to grow at a constant rate
of g per period forever, the cost of
external equity, ke’, is defined as follows:
D1
k 
g
Pnet
'
e
where Pnet is the net proceeds to the firm
on a per-share basis.
Cost of External Equity Capital:
Example
• Suppose NICOR pays a current annual
dividend of $1.68 per share. Its current
stock price is $39 per share. The
consensus forecast from security
analysis is that earnings and dividend
will grow at an annual rate of 6.5 percent
per annum for the foreseeable future.
Cost of External Equity Capital:
Example
• The cost of internal equity capital for
NICOR using a constant growth dividend
valuation model is:
$1.68(1  0.065)
ke 
 0.065  0.111 or 11.1%
$39
Cost of External Equity Capital:
Example
• The cost of external equity capital,
assuming that new shares of stock could
be sold to net the company $37 per
share, is:
D1
k 
g
Pnet
'
e
$1.68(1  0.065)

 0.065
$37
 0.113 or 11.3%
Growth Rate Information
• Institutional Brokers Estimate System
– http://www.ibes.com/
• Zacks Earnings Estimates
– http://www.zacks.com/
• Thomson Financial First Call Service
– http://www.firstcall.com/index.shtml
• Dividend growth model
– http://www.finplan.com/invest/divgrowmo
d.htm
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/
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.
• Divisional costs of capital reflect both the
differential risks and the differential
normal debt ratios for each division.
Weighted (Marginal) Cost of
Capital Schedule
• Suppose the Major Foods Corporation is
developing its capital expenditure plans
for the coming year. The company’s
schedule of potential capital expenditure
projects for next year is as follows:
Weighted (Marginal) Cost of
Capital Schedule
Project
A
B
C
D
E
F
Amount
(in Millions of
Dollars)
$4.0
8.0
6.0
5.0
8.0
4.0
Internal Rate of
Return
13.8%
13.5
12.5
12.0
11.0
10.0
Weighted (Marginal) Cost of
Capital Schedule
• The projects are closely related to the
company’s present business and have
the same degree of risk as its existing
assets.
• The firm’s current capital structure (as
well as its targeted future capital
structure) consists of 40 percent debt, 10
percent preferred stock, and 50 percent
common equity in the capital structure.
Weighted (Marginal) Cost of
Capital Schedule
• Table 11.3 shows the current balance
sheet for Major Foods.
TABLE 11.3 Balance Sheet for Major Foods (in Millions of Dollars
Assets
Current assets
Fixed assets
Total assets
Liabilities and Equity
$100 Current liabilities
$50
30 Long-term debt
32 (40%)
$130 Preferred stock
8 (10%)
Common equity
40 (50%)
Total liabilities and equity $130
Weighted (Marginal) Cost of
Capital Schedule
• Major Foods can raise up to $5 million in
debt funds at a pre-tax cost of 9 percent;
debt amounts exceeding $5 million will
cost 10 percent.
• Preferred stock can be sold at an aftertax cost of 10 percent.
• Major Foods’ marginal tax rate is 40
percent.
Weighted (Marginal) Cost of
Capital Schedule
• Major Foods expects to generate $10
million of retained earnings over the
coming year. Its present dividend rate,
D0, is $2 per share. The firm’s common
stock is now selling at $25 per share,
and new common stock can be sold to
net the firm $24 per share.
Weighted (Marginal) Cost of
Capital Schedule
• Over the past several years, Major
Foods’ earnings and dividends have
grown at an average of 7 percent per
year, and this growth rate is expected to
continue for the foreseeable future. The
company’s dividend payout ratio has
been, and is expected to remain, more
or less constant.
Weighted (Marginal) Cost of
Capital Schedule
• Given this information, Major Foods’
weighted (marginal) cost of capital can
be calculated for the coming year as
shown in the following several slides:
Weighted (Marginal) Cost of
Capital Schedule
• Step 1: Calculate the cost of capital
for each individual component—the
cost of debt, the cost of preferred
stock, and the cost of equity.
Weighted (Marginal) Cost of
Capital Schedule
• Cost of debt:
– Ki = kd(1  T) = 9.0*0.6 = 5.4% for the
first $5 million of debt
– Ki = kd(1  T) = 10.0*0.6 = 6.0% for
debt exceeding $5 million of debt
• Cost of preferred stock:
kp = 10% (given)
Weighted (Marginal) Cost of
Capital Schedule
• Cost of common equity:
– Internal (for amounts of retained
earnings up to $10 million):
ke = [D0(1 + g)/P0] + g
= [$2(1.07)/$25] + 0.07
= 0.156 or 15.6%
Weighted (Marginal) Cost of
Capital Schedule
• Cost of common equity:
– External (for amounts of new common
stock greater than $10 million):
ke’ = [D0(1 + g)/Pnet] + g
= [$2(1.07)/$24] + 0.07
= 0.159 or 15.9%
Weighted (Marginal) Cost of
Capital Schedule
• Step 2: Compute the weighted
(marginal) cost of capital for each
increment of capital raised.
Weighted (Marginal) Cost of
Capital Schedule
• Major Foods should raise funds in
proportion to its target capital structure
from its lowest cost sources first. In this
case, these sources are retained
earnings (15.6 percent after-tax cost),
preferred stock (10 percent after-tax
cost), and the first $5 million in debt (5.4
percent after-tax cost).
Weighted (Marginal) Cost of
Capital Schedule
• When these sources are exhausted, the
company should consider using the
higher cost sources—external equity
(15.9 percent after-tax cost) and
additional debt (6.0 percent after-tax
cost)—together with preferred stock (10
percent after-tax cost).
Weighted (Marginal) Cost of
Capital Schedule
• How much total financing through
combining retained earnings, preferred
stock, and debt can be done before $5
million in low-cost debt is exhausted and
Major must acquire additional debt funds
at the higher cost?
Weighted (Marginal) Cost of
Capital Schedule
• Because we know that the target capital
structure consists of 40 percent debt, the
total financing, X, that this will support is
equal to the amount of low-cost debt
available divided by debt fraction in the
capital structure:
X = (Amount of low-cost debt available)
 (Debt fraction of capital structure)
= ($5 million)  0.40 = $12.5 million
Weighted (Marginal) Cost of
Capital Schedule
This $12.5 million level represents a
break point in the marginal cost of capital
schedule. Break points delineate the
levels of financing where the weighted
cost of capital increases due to an
increase in the cost of one component
source of capital.
Weighted (Marginal) Cost of
Capital Schedule
• Break points can be determined by
dividing the amount of funds available
from each financing source at a fixed
cost by the target capital structure
proportion for that financing source.
• Thus, we saw in the Major Foods
example that the $5 million of debt, with
an after-tax cost of 5.4 percent, would
support total financing of $12.5 million.
Weighted (Marginal) Cost of
Capital Schedule
• Beyond $12.5 million in total financing,
the weighted (marginal) cost of capital
will rise because higher-cost debt (6.0
percent) must now be used.
• Of this $12.5 million in total financing, $5
million (40 percent of the total) will be
debt, $1.25 million (10 percent of the
total) will be preferred stock, and $6.25
million (50 percent of the total) will be
retained earnings.
Weighted (Marginal) Cost of
Capital Schedule
• The cost of this first block of funds is
calculated as follows:
Ka = 0.50*15.6% + 0.40*5.4% + 0.10*10%
= 10.96%
Weighted (Marginal) Cost of
Capital Schedule
• The amount of available retained
earnings also determines a break point.
The $10 million of retained earnings will
support total financing of $20 million
($10 million/0.5). Therefore, a new break
point occurs at a total financing level of
$20 million. Beyond that point, the
weighted cost of capital increases due to
the higher cost (15.9 percent) of external
equity.
Weighted (Marginal) Cost of
Capital Schedule
• Thus, the second block of financing
totals $7.5 million ($20 million equity
break point minus $12.5 million debt
financing break point). This $7.5 million
block of funds represents the size of the
second lowest-cost block of funds.
Weighted (Marginal) Cost of
Capital Schedule
• Of this $7.5 million in financing, $3.75
million (= $7.5 million*50%) will be
retained earnings, $0.75 million (= $7.5
million*10%) will be preferred stock, and
$3 million (= $7.5 million*40%) will be
debt.
Weighted (Marginal) Cost of
Capital Schedule
• The cost of this second block of funds
will be as follows:
Ka = 0.50*15.6% + 0.40*6.0% + 0.10*10%
= 11.20%
Weighted (Marginal) Cost of
Capital Schedule
• Beyond the second block, all additional
funds raised will be with high-cost debt,
new common stock, and preferred stock.
The weighted cost of these funds is as
follows:
Ka = 0.50*15.9% + 0.40*6.0% + 0.10*10%
= 11.35%
Weighted (Marginal) Cost of
Capital Schedule
• The weighted (marginal) cost of capital
schedule now can be used to determine
the optimal capital budget for Major
Foods. This procedure is illustrated in
the next section.
Determining the Optimal Capital
Budget
• The optimal capital budget can be
determined by comparing the expected
project returns to the company’s
marginal cost of capital schedule. This is
accomplished by first plotting the returns
expected from the proposed capital
expenditure projects against the
cumulative funds required. The resulting
graph is called an investment
opportunity curve.
Determining the Optimal Capital
Budget
• Next, the previously calculated ka for the
three capital “packages” are combined to
determine the company’s marginal cost
of capital curve. The optimal capital
budget is indicated by the point at which
the investment opportunity curve and the
marginal cost of capital curve intersect,
as shown in Figure 11.4.
Optimal Capital Budget
%
A
B
C
MCC
D
E
F
IRR
$
Optimal capital budget contains all projects for
which the expected return lies above the MCC
Optimal Capital Budget
• Specifically, the Major Foods
Corporation’s optimal capital budget
totals $23 million and includes Projects
A, B, C, and D. Projects E and F are
excluded, because their returns are
expected to be below the 11.35 percent
cost of funds. Acceptance of Projects E
and F would result in a decrease in the
firm’s value. In principle, the optimal
capital budget maximizes the value of
the firm.
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.
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
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
Sources of Debt for Small Firms
• Owner’s own funds
• Private placement
• Loans from friends
• Venture capital
• Loans from
financial institutions
• SBA loans
• Commercial finance
company loans
firms
• Leasing companies
• Creative financing
– Warrants
– Convertible debt