Chapter 11 The Cost of Capital

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Chapter 11The Cost of Capital
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Cost of Capital

• Determined in the capital markets
• Depends on the risk associated with the firms
  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.

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Why Calculate the Cost of Capital?

• Acceptance Criteria for Capital Investments
• Minimize the Cost of Capital for the Firm
• Use in Other Decisions, such as Leasing and
  Utility Commissions

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Weighted Cost of Capital ka

• Discount rate used when computing the NPV of a
  project of average risk
• Hurdle rate used in conjunction with the IRR
• Based on the after-tax cost of capital
• Obtained from the weighted costs of the
  individual components
• Weights to the proportion of each of the
  components in the target capital structure

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Calculating ka

• ka (ke)
  (ki) ( kp)
• ka we(ke) wi(ki) wp(kp)

Pf
B
E
BEPf
BEPf
BEPf

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Required return rf Risk premium

• rf risk-free rate (I prefer the 20 year US bond
  rate.)
• Real rate of return determined by supply and
  demand
• Plus a premium for the effects of inflation
• Components of the risk premium
• Business risk refers to amount of operating
  leverage
• Financial risk refers to the use of financial
  leverage
• Marketability Risk refers to the ability to
  quickly buy and sell
• Liquidity Risk refers to the ability not to lose
  money on the sale
• Interest rate risk arising from changes in
  interest rates
• Seniority risk due to the priority of a
  securitys claim on assets

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Risk-Return Trade-Off of Various Sources of Funds

• Required Return
• 
  x
• 
  x Common Stock
• 
  x Low Quality Corporate Debt
• x
  High Quality P/S (No Taxes Considered)
• x
  High Quality Corporate Debt
• x L-T Government
  Debt
• S-T Government Debt
• 
  

rf
Risk

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Effects of the Dividends Received Deduction by
Corporations
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Component Costs

• ki kd ( 1 - T ) Interest is tax deductible
• kp Dp/ Pnet Dividends are not tax
  deductible
• Cost of internal equity capital
• ke D1/P0 g (Cost of R/E using constant
  dividend g)
• ke rf ?( rm - rf ) (CAPM)
• Risk premium on debt approach (Add perhaps
  4)
• Cost of external equity
• k/e D1/Pnet g

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Other Considerations

• It is generally incorrect to associate any
  particular source of financing with a particular
  project. The investment and the financing
  decisions typically should be separate.
• When calculating the weighted average cost of
  capital, use marginal costs and market or target
  weights.
• Use the next incremental cost of capital from
  that particular source.
• Typically, do not use book weights or proportions.

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Example of Yield to Maturity
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Example of Yield to Call
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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 discount rate
  and perhaps beta.
• Should reflect both the differential risks and
  the differential normal debt ratios for each
  division

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MCC Schedule

• Step 1 Calculate the cost of capital for each
  
• component
• Step 2 Compute the MCC for each increment
• of capital raised
• Break points delineate the increments of
  financing and can be determined by dividing that
  amount of funds available from each source by the
  target capital structure proportion for that
  financing source

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Break Point Calculation
Amount of Funds Available from Each Financing
Source
Break Point

Target Capital Structure Proportion for that
Source
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Asymmetric Information Theoryor Pecking Order
Theory

• Pecking Order
• Retained Earnings
• Debt
• Common Stock
• Typically, firms do not keep the same proportions
  of the sources of financing.
• Managers know more than investors.

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Determining the Optimal Capital Budget

• Compare the expected project returns to the
  companys MCC schedule
• Accomplished by plotting the returns expected
  from the proposed capital expenditure projects
  against the cumulative funds required
• Cost of funds may increase with the amount of
  financing required
• ( See next
  slide)

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Reasons for Increases in Marginal Cost of Capital

• Need to Raise External Equity
• Floatation Costs Increase
• Concern of Investors Regarding Increasing Amounts
  of Capital

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Optimal Capital Budget

• Optimal capital budget contains all projects for
  which the expected return lies above the MCC

A
B
C
MCC
D
E
F
IRR


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Depreciation

• Is a major source of funds
• Is equal to the firms weighted cost of capital
  based on R/E and the lowest cost of debt (if no
  preferred stock is outstanding)
• Availability of funds from depreciation shifts
  the MCC to the right by the amount of depreciation

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The Cost of Capital for Multinational Firms

• Some host countries offer preferential financing
  terms, even in some locations
• Multinationals can shop the world for the lowest
  capital costs - Where in the World...
• 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

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Small Firms

• Have a difficult time attracting capital
• Stock issuance costs are high ( gt 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

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Sources of Debt for Small Firms

• Owners own funds
• Loans from friends
• Loans from financial institutions
• Loans from governmental entities
• SBA loans
• Commercial finance company loans

• Private placement
• Venture capital firms
• Leasing companies
• Creative financing
• Warrants
• Convertible debt

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Conclusion

• Weighted Average Cost of Capital
• Cost of Debt
• Cost of Preferred Stock
• Cost of Equity
• Retained Earnings
• New Common
• Weighted (Marginal) Cost of Capital Schedule