CHAPTER 9 The Cost of Capital
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Transcript CHAPTER 9 The Cost of Capital
CHAPTER 11
The Cost of Capital
Sources of capital
Component costs
WACC
9-1
Cost of Capital
The cost of capital represents the overall cost of
financing to the firm
The overall cost of capital is a weighted average of
the various sources, including debt, preferred
stock, and common equity (retained earnings):
WACC = Weighted Average Cost of Capital
WACC = After-tax cost x weights
9-2
What sources of long-term
capital do firms use?
Long-Term Capital
Long-Term Debt
Preferred Stock
Common Stock
Retained Earnings
New Common Stock
9-3
Calculating the weighted
average cost of capital
WACC = wdrd(1-T) + wpsrps + wers
The w’s refer to the firm’s capital
structure weights.
The r’s refer to the cost
of each component.
9-4
Should our analysis focus on
before-tax or after-tax capital costs?
Stockholders focus on After-Tax CFs.
Therefore, we should focus on A-Tax
capital costs.
Only cost of debt needs adjustment,
because interest is tax deductible.
9-5
Should our analysis 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).
9-6
How are the weights determined?
WACC = wdrd(1-T) + wprp + wers
As a percentage of total financing
9-7
Weighting example
Bonds
40
Pref. Stock
100
Common
100
Ret. Earn.
160
Total L & E
400
What is weight of each component?
9-8
Weighting example
Bonds
Pref. Stock
Common
Ret. Earn.
Total L & E
40
100
100
160
400
Bonds = 40/400 = 10%
Pref. Stock = 100/400 = 25%
9-9
Component cost of debt
WACC = wdrd(1-T) + wprp + wers
rd is the marginal cost of debt capital.
The yield to maturity on outstanding
L-T debt is often used as a measure
of rd.
Why tax-adjust, i.e. why rd(1-T)?
9-10
10% before tax = 6% after tax
Sales
1,000
1,000
Interest
100*
0
EBT
900
1,000
Tax 40%
360
400
EAT
540
600
60 difference
*10% coupon rate for one bond
9-11
Component cost of debt
Interest is tax deductible, so
A-T rd = B-T rd (1-T)
= 10% (1 - 0.40) = 6%
T = tax rate = 40%
9-12
Component cost of preferred
stock
WACC = wdrd(1-T) + wprp + wers
rp is the marginal cost of preferred
stock.
The rate of return investors require on
the firm’s preferred stock.
9-13
What is the cost of preferred
stock?
The cost of preferred stock can be
solved by using this formula:
rp = Dp / Pp
= $10 / $111.10
= 9%
9-14
Component cost of preferred
stock
Preferred dividends are not taxdeductible, so no tax adjustments
necessary. Just use rp.
9-15
Component cost of equity
WACC = wdrd(1-T) + wprp + wers
rs is the marginal cost of common
equity using retained earnings.
Issuing new stock would cost a little
more due to flotation (selling) costs.
9-16
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.
If earnings are retained, there is an
opportunity cost (the return that
stockholders could earn on alternative
investments of equal risk).
Investors could buy similar stocks and earn rs.
Firm could repurchase its own stock and earn rs.
Therefore, rs is the cost of retained earnings.
9-17
Two ways to determine the
cost of common equity, ks
CAPM: rs = rRF + β(rM – rRF)
DCF:
rs = (D1 / P0)+ g
9-18
If the rRF = 7%, rM = 13% and the firm’s
beta is 1.2, what’s the cost of common
equity based upon the CAPM?
rs = rRF + (rM – rRF) β
= 7.0% + (6.0%)1.2 = 14.2%
(rm- rRF) = market risk premium
9-19
If D0 = $4.19, P0 = $50, and g = 5%,
what’s the cost of common equity based
upon the DCF approach?
D1 = D0 (1+g)
D1 = $4.19 (1 + .05)
D1 = $4.4
rs = (D1 / P0)+ g
= ($4.4 / $50) + 0.05
= 13.8%
9-20
What is a reasonable final
estimate of rs?
Method
CAPM
DCF
Average
Estimate
14.2%
13.8%
14.0%
9-21
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.
To adjust rs = (D1/(P0 – F)) + g
9-22
Calculate WACC
If 40% of your financing is from debt at
an after tax cost of 8% and 60% is
from pref. stock at 10%, what is the
WACC?
It will be between what two numbers?
9-23
40% (.08) + 60% (.10)
.032 + .06 = .092
9.2%
9-24
Balance Sheet
Cash
5,000
LT Debt
3,000
Equipment
5,000
Pref. Stock
1,000
Stock
6,000
Tot. Debt & Eq.
10,000
Tot. Assets
10,000
9-25
Ignoring floatation costs, what is
the firm’s WACC?
WACC =
=
=
=
wdrd(1-T) + wprp + wers
0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
1.8% + 0.9% + 8.4%
11.1%
9-26
Should the company use the
composite WACC as the hurdle rate
for each of its projects?
NO! The composite WACC reflects the risk
of an average project undertaken by the
firm. Therefore, the WACC only represents
the “hurdle rate” for a typical project with
average risk.
Different projects have different risks. The
project’s WACC should be adjusted to
reflect the project’s risk.
9-27
Optimum Capital Structure
The optimal (best) situation is associated
with the minimum overall cost of capital:
Optimum capital structure means the lowest
WACC
Usually occurs with 30-50% debt in a firm’s
capital structure
WACC is also referred to as the required
rate of return or the discount rate
9-28
Optimal Capital Structure
Cost
Financial Plan A:
Debt…………………………
Equity……………………….
Cost (After-tax)
Weights
Weighted
6.5%
12.0
20%
80
1.3%
9.6
10.9%
Financial Plan B:
Debt…………………………
Equity……………………….
7.0%
12.5
40%
60
2.8%
7.5
10.3%
Financial Plan C:
Debt…………………………
Equity……………………….
9.0%
15.0
60%
40
5.4%
6.0
11.4%
9-29
Draw a graph representing the
cost of debt and equity
Cost of Capital
10%
5%
0
40%
Debt to Asset Mix
80%
9-30
Cost of capital curve
9-31