The Cost of Capital

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The Cost of Capital
Chapter 12
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Cost of Capital

• The firms average cost of funds, which is the
  average return required by the firms investors
• What must be paid to attract funds

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The Logic of the Weighted Average Cost of Capital

• The use of debt impacts a fims ability to use
  equity, and vice versa, so the weighted average
  cost must be used to evaluate projects,
  regardless of the specific financing used to fund
  a particular project

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Basic Definitions

• Capital component
• types of capital used by firms to raise money
• kd before tax interest cost
• kdT kd(1-T) after tax cost of debt
• kps cost of preferred stock
• ks cost of retained earnings
• ke cost of external equity (new stock)

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Basic Definitions

• WACC weighted average cost of capital
• Capital structure
• combination of different types of capital used by
  a firm

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After-Tax Cost of Debt

• The relevant cost of new debtits yield to
  maturity (YTM)
• Taking into account the tax deductibility of
  interest
• Used to calculate the WACC
• kdT bondholders required rate of return minus
  tax savings
• kdT kd - (kd ? T) kd(1-T)

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Cost of Preferred Stock

• Rate of return investors require on the firms
  preferred stock
• the preferred dividend divided by the net issuing
  price

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Cost of Retained Earnings

• Rate of return investors require on the firms
  common stock

Three solutions 1. CAPM 2. Bond yield plus risk
premium 3. Discounted cash flow (DCF)
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The CAPM Approach
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The Bond-Yield-Plus-Premium Approach

• Estimate a risk premium above the bond interest
  rate
• Judgmental estimate for premium
• Ballpark figure only

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The Discounted Cash Flow (DCF) Approach

• Price and expected rate of return on a share of
  common stock depend on the dividends expected on
  the stock

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DCF Approach

• Internal equity, ks
• based on the fact that investors demand the firm
  use funds that are retained to earn an
  appropriate rate of return

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Cost of Newly Issued Common Stock

• External equity, ke
• based on the cost of retained earnings
• adjusted for flotation costs (the expenses of
  selling new issues)

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Target Capital Structure

• Optimal capital structure
• percentage of debt, preferred stock, and common
  equity that will maximize the price of the firms
  stock

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Weighted Average Cost of Capital, WACC

• A weighted average of the component costs of
  debt, preferred stock, and common equity

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Marginal Cost of Capital

• MCC
• the cost of obtaining another dollar of new
  capital
• the weighted average cost of the last dollar of
  new capital raised

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MCC Schedule

• Marginal cost of capital schedule
• a graph that relates the firms weighted average
  of each dollar of capital to the total amount of
  new capital raised
• reflects changing costs depending on amounts of
  capital raised

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MCC Schedule

• Weighted Average Cost of Capital (WACC) ()

WACC311.5
11.5 - 11.0 - 10.5 -
WACC211.0
WACC110.5
New Capital Raised (millions of dollars)
100
150
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Break Point

• BP
• the dollar value of new capital that can be
  raised before an increase in the firms weighted
  average cost of capital occurs

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MCC Schedule

• Weighted Average Cost of Capital (WACC) ()

WACC311.5
11.5 - 11.0 - 10.5 -
WACC211.0
WACC110.5
New Capital Raised (millions of dollars)
100
150
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MCC Schedule

• Schedule and break points depend on capital
  structure used

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MCC Schedule

• Weighted Average Cost of Capital (WACC) ()

Smooth, or Continuous, Marginal Cost of Capital
Schedule
WACC
0 -
Dollars of New Capital Raised
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Combining the MCC and Investment Opportunity
Schedules

• Use the MCC schedule to find the cost of capital
  for determining whether a project should be
  purchased
• Investment Opportunity Schedule (IOS)
• graph of the firms investment opportunities
  ranked in order of the projects rates of return

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Combining the MCC and Investment Opportunity
Schedules
Percent
12.0 - 11.5 - 11.0 - 10.5 -
20 40 60 80 100 120 140
160 180
New Capital Raised and invested (millions of
dollars)
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End of Chapter 12

• The Cost of Capital