Cost of Capital Chapter 11

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Cost of CapitalChapter 11
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Chapter Objectives

• Cost of Capital
• After-tax cost of debt, preferred stock and
  common stock
• Weighted average cost of capital
• PepsiCos cost of capital
• Cost of capital and new investments
• Economic profit

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Economic Value

• Created by earning a return greater than
  investors required return
• Destroyed by earning a return less than they
  require

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EVA Measurement

• Encourages management to make business decisions
  that create economic value through
• improved operating efficiency
• better asset utilization
• growth that generates returns which exceed the
  cost of capital

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Shareholder Value-Based Management

• Emphasis on EVA will more closely align the
  interests of employees and shareholders
• Rewards the firms employees in ways that
  continually encourage them to seek out new ways
  to create shareholder value

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Cost of Capital

• Link between financing decisions and investment
  decisions
• Rate that must be achieved by an investment
  before it will increase shareholder wealth
• Basis for evaluating division or firm performance

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Cost of Capital

• Also called
• Hurdle rate for new investment
• Discount rate
• Opportunity cost of funds
• Required rate of return

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Discount Rate

• Investors required rate of return
• or
• Minimum rate of return necessary to attract an
  investor to purchase or hold a security
• Considers opportunity cost

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Required Rate of Return and Cost of Capital

• Cost of capital incorporates
• Taxes or Tax Savings
• Flotation Costs
• Formula
• Required return / Net proceeds
• Net proceeds funds received flotation cost

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Cost of Capital

• If a firm sells new stock for 30.00 a share and
  incurs 5 in flotation costs, and the investors
  have a required rate of return of 12, what is
  the cost of capital?
• .12 x30 3.60
• 3.60 / (30-5) 14.40

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Financial Policy

• Policies regarding the sources of finances a firm
  plans to use and the particular mix in which they
  will be used
• Governs the use of debt and equity financing.
• The particular mixture of debt and equity a firm
  utilizes impacts the firms cost of capital.

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Weighted Average Cost of Capital

• Combined costs of all the sources of financing
  used by the firm.
• The weighted average of the after-tax costs of
  each of the sources of capital used
• Weights reflect the proportion of total financing
  from each source.

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Financing Instruments

• Debt
• Usually in the form of Notes Payable
• Preferred Stock
• Common Stock

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Cost of Debt

• After tax cost of debt kd(1-Tc)
• Before tax cost of capital less the effect of tax
  savings
• Example
• Debt at 9.75 and tax rate of 34
• After-tax cost of debt .0975(1-.34) 6.435

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Cost of Preferred Stock

• Cost of preferred stock Preferred Stock
  dividend/ Net proceeds per share
• Example Annual dividend 5, Stock price 65 and
  flotation costs of 1.50
• Cost 5/(65 - 1.50) 5/(63.50) .07874
• or
• Cost of preferred stock 7.874

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Common Equity

• Sources
• Retained Earnings
• Sales of new shares
• No Flotation costs on retained earnings

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Cost of Equity Capital

• First have estimate common stockholders required
  rate of return
• Dividend Growth Model
• Capital Asset Pricing Model

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Dividend Growth Model

• Investors required rate of return
• Kcs D1/Pcs g
• Dividends divided by price of stock plus growth
  rate
• Issue new common stock
• Kncs D1/NPcs g
• Dividends divided by net proceeds plus growth

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Dividend Growth Model

• Example A company expects dividends this year
  to be 2.20, based upon the fact that 2 were
  paid last year. The firm expects dividends to
  grow 10 next year and into the foreseeable
  future. Stock is trading at 50 a share.
• Cost of retained earnings
• Kcs D1/Pcs g
• 2.20/50 .10 14.4
• Cost of new stock
• Kncs D1/NPcs g
• 2.20/(50-7.50) .10 15.18

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Issues with the Dividend Growth Model

• Simplicity
• Assume constant growth rate
• Estimating rate of growth

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Capital Asset Pricing Model

• Combines
• Risk Free rate krf
• Systematic risk or Beta (B)
• Market Risk Premium or Expected rate of return
  for market or average security less the risk free
  rate km krf
• kc krf B(km krf)

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Capital Asset Pricing Model

• Example
• Beta is 1.4 Risk-free rate is 3.75 Expected
  market rate is 12
• .0375 1.4(.12 - .0375) 15.3

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Issues with the Capital Asset Pricing Model

• Simple/Easy to understand
• Variables available from public sources
• No reliance upon dividends or growth rate
  assumptions

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Weighted Average Cost of Capital

• Need cost of each of the sources of capital used
  and capital structure mix
• Capital Structure Mix proportions of each source
  of financing used by the firm
• WACoC (After tax cost of debt X proportion of
  debt financing) (Cost of equity X proportion of
  equity financing)

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Weighted Average Cost of Capital

• Example
• A firm borrows money at 6 after taxes and pays
  10 for equity. The company raises capital in
  equal proportions 50/50
• WACoC (.06 X .5) (.1 X .5) .08 or 8

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PepsiCo

• Calculated divisional cost of capital
• Different target ratios for debt/equity mix per
  division
• Different pretax cost of debt for each division

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PepsiCo

• Division Cost of Cost of WA
• Equity X Debt X COC
• ratio ratio
• Restaurant (12.20 X .7) (5.54 X .3) 10.2
• Snack Foods (11.56 X .8) (5.23 X .2) 10.29
• Beverages (11.77 X .74) (5.28 X .26) 10.08

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Cost of Capital and New Investment

• Cost of Capital can serve as the discount rate in
  evaluating new investment when the projects offer
  the same risk as the firm as a whole.
• If risk differs, may calculate a different cost
  of capital for each division.
• Generally, calculate the cost of capital per
  division, not per project.

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Market Value AddedMVA

• Difference in the current market value of the
  firm and the sum of all the funds that have been
  invested in the firm over its entire operating
  life
• MVA
• Total value of the firm Invested capital

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Economic Profit

• Accounting profit less a charge for use of
  capital
• Calculated by
• Net operating profit after tax (NOPAT) invested
  capital X cost of capital

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Kmart Example

• Economic Profit NOPAT Invested capital X cost
  of capital
• 568.979 950M (19,727M X .0770)
• Note return is 4.82 and cost of capital is
  7.70.
• Note Kmart declared bankruptcy in Jan 2002

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Economic Profit

• Increase economic profit by
• Identifying and eliminating operating
  deficiencies
• Investing in projects that earn returns in excess
  of cost of capital
• Reduce capital charge

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Incentive Based Compensation

• Way to align shareholder and manager interests
• Incentive Base Pay X Percentage X
  actual Eco pro
• compensation incentive Target Eco
  prof
• compensation

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Multinational Firms and Interest Rates

• In an international setting, there can be
  different rates of inflation among different
  countries.
• The Fisher Model indicates that the nominal
  interest rate in the home or domestic country is
  a function of real interest rates and anticipated
  rate of inflation