Essentials of Managerial Finance

1
Chapter 8 The Cost of Capital
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The Cost of Capital

• The cost of capital acts as a link between the
  firms long-term investment decisions and the
  wealth of the owners as determined by investors
  in the marketplace.
• It is used to decide whether a proposed
  investment will increase or decrease the firms
  stock price.
• Formally, the cost of capital is the rate of
  return that a firm must earn on the projects in
  which it invests to maintain the market value of
  its stock.

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The Firms Capital Structure
The Firms Capital Structure
Current Assets Fixed Assets
Current Liabilities Long-Term Debt Equity
The Firms Capital Structure Cost of Capital


4
The Weighted AverageCost of Capital

• Capitalrefers to the long-term funds used by a
  firm to finance its assets.
• Capital componentsthe types of capital used by a
  firmlong-term debt and equity
• WACCthe average percentage cost, based on the
  proportion of each type of capital, of all the
  funds used by the firm to finance its assets.

5
The Cost of Debt

• The pretax cost of debt is equal to the the
  yield-to-maturity on the firms debt adjusted for
  flotation costs.
• Recall that a bonds yield-to-maturity depends
  upon a number of factors including the bonds
  coupon rate, maturity date, par value, current
  market conditions, and selling price.
• After obtaining the bonds yield, a simple
  adjustment must be made to account for the fact
  that interest is a tax-deductible expense.
• This will have the effect of reducing the cost of
  debt.

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The Cost of Debt - Example
Suppose a company could issue 9 coupon, 20 year
debt face value of 1,000 for 980. Suppose
that flotation costs will amount to 2 of par
value. Find the after-tax cost of debt assuming
the company is in the 40 tax bracket.
EXCEL Formula for computing the before - tax
cost of debt RATE(B9,B8,B6,B2)
7
The Cost of Equity

• The cost of equity is based on the rate of return
  required by the firms stockholders.
• Cost of preferred stock - dividends received by
  preferred stockholders represent an annuity
• Cost of retained earnings (internal
  equity)return that common stockholders require
  the firm to earn on the funds that have been
  retained, thus reinvested in the firm, rather
  than paid out as dividends
• Cost of new (external) equityrate of return
  required by common stockholders after considering
  the cost associated with issuing new stock
  (flotation costs)

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The Cost of Preferred Stock (kp)
KP DP/(PP - F) DP/(NP)
In the above equation, F represents flotation
costs (in ). As was the case for debt, the cost
of raising new preferred stock will be more than
the yield on the firms existing preferred stock
since the firm must pay investment bankers to
sell (or float) the issue.
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The Cost of Preferred Stock (kp) - Example
KP DP/(PP - F)
A company can issue preferred stock that pays a
5 annual dividend, sell it for 55 per share,
and have to pay 3 per share to sell it. Then,
the cost of preferred stock would be kP
5/(55 - 3) 9.62 There is no tax
adjustment, because dividends are not a
tax-deductible expense.


10
The Cost of Retained Earnings

• The firm must earn a return on reinvested
  earnings that is sufficient to satisfy existing
  common stockholders investment demands.
• If the firm does not earn a sufficient return
  using retained earnings, then the earnings should
  be paid out as dividends so that stockholders can
  invest the funds outside the firm to earn an
  appropriate rate.

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The Cost of Retained Earnings (ks)
Discounted Cash Flow (DCF) approach
kS (D1/P0) g.
For example, assume a firm has just paid a
dividend of 2.50 per share, expects dividends to
grow at 10 indefinitely, and is currently
selling for 50 per share. First, D1
2.50(1.10) 2.75, and kS (2.75/50) .10
15.5.
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The Cost of Retained Earnings (kE)
Security Market Line Approach
kE rF b(kM - RF).
For example, if the 3-month government bond rate
is currently 5.0, the market risk premium is 9,
and the firms beta is 1.20, the firms cost of
retained earnings will be kE 5.0 1.2(9)
15.8.
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The Cost of Retained Earnings, ksBond-Yield-Plus-
Risk-Premium Approach

• Studies have shown that the return on equity for
  a particular firm is approximately 3 to 5
  percentage points higher than the return on its
  debt.
• As a general rule of thumb, firms often compute
  the YTM, or kd, for their bonds and then add 3 to
  5 percent.
• In the current example, kd 6.0. As a rough
  estimate, then, we might say the cost of retained
  earnings is
• ks . kd 4 6 4 10.0

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The Cost of New Equity

• Rate of return required by common stockholders
  after considering the costs associated with
  issuing new stock, which are called flotation
  costs.
• Because the firm has to provide the same gross
  return to new stockholders as existing
  stockholders, when the flotation costs associated
  with a common stock issue are considered, the
  cost of new common stock always must be greater
  than the cost of existing stockthat is, the cost
  of retained earnings.
• Modify the DCF approach for computing the cost of
  retained earnings to include flotation costs

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The Cost of New Equity (kn)
Discounted Cash Flow (DCF) approach
Kn D1/(P0 - F) g D1/Nn - g
?ssume a firm has just paid a dividend of 2.50
per share, expects dividends to grow at 10
indefinitely, and is currently selling for 50
per share.?ow much would it cost the firm to
raise new equity if flotation costs amount to
4.00 per share? Kn 2.75/(50 - 4) .10
15.97 or 16.
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The Weighted Average Cost of Capital
WACC ka wiki wpkp wskr or n
Capital Structure Weights
The weights in the above equation are intended to
represent a specific financing mix (where wi
of debt, wp of preferred, and ws of
common). Specifically, these weights are the
target percentages of debt and equity that will
minimize the firms overall cost of raising
funds.
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The Weighted Average Cost of Capital
WACC ka wiki wpkp wskr or n
Capital Structure Weights
One method uses book values from the firms
balance sheet. For example, to estimate the
weight for debt, simply divide the book value of
the firms long-term debt by the book value of
its total assets. To estimate the weight for
equity, simply divide the total book value of
equity by the book value of total assets.
18
The Weighted Average Cost of Capital
WACC ka wiki wpkp wskr or n
Capital Structure Weights
A second method uses the market values of the
firms debt and equity. To find the market value
proportion of debt, simply multiply the price of
the firms bonds by the number outstanding. This
is equal to the total market value of the firms
debt. Next, perform the same computation for
the firms equity by multiplying the price per
share by the total number of shares outstanding.

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The Weighted Average Cost of Capital
WACC ka wiki wpkp wskr or n
Capital Structure Weights
Finally, add together the total market value of
the firms equity to the total market value of
the firms debt. This yields the total market
value of the firms assets. To estimate the
market value weights, simply divide the market
value of either debt or equity by the market
value of the firms assets .
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The Weighted Average Cost of Capital
WACC ka wiki wpkp wskr or n
Capital Structure Weights
For example, assume the market value of the
firms debt is 40 million, the market value of
the firms preferred stock is 10 million, and
the market value of the firms equity is 50
million. Dividing each component by the total of
100 million gives us market value weights of 40
debt, 10 preferred, and 50 common.
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The Weighted Average Cost of Capital
WACC ka wiki wpkp wskr or n
Capital Structure Weights
Using the costs previously calculated along with
the market value weights, we may calculate the
weighted average cost of capital as follows WACC
.4(5.67) .1(9.62) .5 (15.8)
11.13 This assumes the firm has
sufficient retained earnings to fund any
anticipated investment projects.