Chapter 12: The Cost of Capital

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Chapter 9
Oct 13, 2009
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Learning Goals

• Determining the value of K
• Sources of capital funding (Debt, Equity)
• Cost of each source of capital funding
• Calculation of the weighted average cost of
  capital (WACC), (which is the firms Required
  Rate of Return K)
• Construction and use of the marginal cost of
  capital schedule (MCC) in decision making

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Cost of Capital

• Capital is the term used by firms for funds
  needed for investment purposes,
• (not for day to day operating needs)
• This capital carries a cost because the investors
  want a return on their investment (fixed assets,
  technology,)
• To properly evaluate investment decisions, the
  firm must know how much it will cost them to
  raise capital funds

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Sources of Capital

• Borrowing, such as Bonds, bank loans, etc.
• Issuing Preferred stock
• Issuing Common stock
• Net Income (earnings)
• Each of these sources carries a different cost
  based on the required rate of return of each
  provider (source) of these funds

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Optimal Capital Structure

• The capital structure of a firm is how the firm
  has elected to finance its assets
• It is the level or percentage of total assets
  financed by debt, preferred stock and common
  equity (common stock and retained earnings)
• Each firm has an optimal level of debt and equity
  at which it can operate most efficiently and
  profitability

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Weighted Cost of Capital Model

• Compute the cost of each source of capital debt,
  preferred stock, common stock, and earnings.
• Determine percentage to total assets of each
  source of capital from the optimal capital
  structure
• Calculate Weighted Average Cost of Capital (WACC)

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1. Compute Cost of Debt

• Required rate of return for creditors
• e.g. Suppose that a company issues bonds with an
  interest rate of 10 (pre-tax cost).
• Since interest payments are tax deductible, the
  true cost of the debt to the company is the after
  tax cost. AT kd K(1-T), where T tax rate
• If the companys tax rate (state and federal
  combined) is, say, 40, the after tax cost of
  debt AT kd 10(1-.40) 6.
• Show example

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Flotation Costs cost of issuing securities to
the general public

• Accounting
• Legal
• Printing (prospectus)
• Underwriting (investment banker)
• Filing Fees (SEC)

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2. Compute Cost Preferred Stock

• Cost to raise a dollar of preferred stock
  derived from same formula as a perpetuity.

• Example You can issue preferred stock for 45
  (Market Price). However, if Flotation costs are
  3, then the firm only gets 42 and if the
  preferred stock pays a 5 dividend, then

• The cost of preferred stock

11.90
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3. Compute Cost of Common Equity

• Two Types of Common Equity Financing
• Retained Earnings (internal common equity)
• Issuing new shares of common stock (external
  common equity)

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3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Management should retain earnings only if they
  can earn as much as stockholders next best
  investment opportunity at the same level of
  risk.
• Method to determine stockholders next best
  investment opportunity
• Dividend Growth Model
• Internal retained earnings
• External new common stock

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3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Dividend Growth Model

Ks cost of internal common equity D1 the next
dividend to be paid Po the current market price
of the stock g the projected rate of growth of
the company
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3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Dividend Growth Model

Example The market price (Po) of a share of
common stock is 60. The prior dividend paid (D0)
was 3, and the expected growth rate (g) is 10.
(Discuss D0 vs D1 )
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3. Compute Cost of Common Equity

• Cost of Internal Common Equity
• Dividend Growth Model

Example The market price of a share of common
stock is 60. The prior dividend is 3, and the
expected growth rate is 10. Use the growth rate
to calculate D1. D1 Do (1 g)
15.5
.155
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3. Compute Cost of Common Equity

• Cost of External Equity - New Common Stock
• Must adjust the Dividend Growth Model equation
  for Floatation costs of the new common shares.

Example If additional shares are issued
floatation costs will be 12 of the Market Price.
D0 3.00 and estimated growth is 10, Price is
60 as before.
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3. Compute Cost of Common Equity

• Cost of External Equity - New Common Stock
• Must adjust the Dividend Growth Model equation
  for floatation costs of the new common shares.

Example If additional shares are issued
floatation costs will be 12. D0 3.00 and
estimated growth is 10, Price is 60 as before.
(Flotation 12 x 60 7.20)
.1625
16.25
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Weighted Average Cost of Capital
Gallagher Corporation estimates the following
costs for each component in its capital structure
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Weighted Average Cost of Capital

• If using retained earnings (Internal Equity) to
  finance the equity portion

WACC weighted average cost of capital WT
the weight, or percentage of each element of
capital ( of debt, preferred and common stock
to total assets) ATkd after tax cost of debt Kp
Cost of preferred stock Ks Cost of equity
(Internal retained earnings)
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Weighted Average Cost of Capital

• If using retained earnings (Internal Equity) to
  finance the equity portion

• Assume that Gallaghers desired capital
  structure is 40 debt, 10 preferred and 50
  common equity.

WACC Cost of Debt .40 x 6 2.40
Cost of Preferred .10 x 11.9 1.19 Cost
of Common .50 x 15.5 7.75 1.00
11.34
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Weighted Average Cost of Capital

• If using new common stock (External Equity) to
  finance the common stock portion

Then we must use the cost of stock adjusted for
the Flotation costs
WACC Cost of Debt .40 x 6.0 2.40
Cost of Pref .10 x 11.9 1.19 Cost of
common .50 x 16.25 8.13 11.72
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Marginal Cost of Capital

• The weighted average cost will change if any
  component (debt, preferred or common equity) cost
  of capital changes.
• This may occur when a firm raises a particularly
  large amount of capital such that investors think
  that the firm is riskier.
• The WACC of the next dollar of capital raised is
  called the marginal cost of capital (MCC).

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Raising/Spending Capital

• The assumption is that the capital money is spent
  or raised in direct proportion to the optimal
  capital structure.
• If we raise or spend 100,000, it would be in the
  following proportions
• Capital Structure Raise Spend
• Debt 40 40,000 40,000
• Preferred 10 10,000 10,000
• Common 50 50,000 50,000

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Calculating the Breakpoint

• Assume now that Gallagher Corporation has
  100,000 in retained earnings with which to
  finance its capital budget.
• We can calculate the point at which they will
  need to issue new equity (common stock) since we
  know that Gallaghers desired capital structure
  calls for 50 common equity.

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Calculating the Breakpoint
Breakpoint (100,000)/.5 200,000

• What this means is that once we spend 200,000
  total on
• capital projects, we will have used up our
  retained earnings of 100,000 (internal equity).
• Therefore, if we spend over 200,000, we will
  need additional financing from the issue of new
  shares of stock since 50 of our spending must
  come from Equity.
• The cost of new shares is greater than internal
  equity due to flotation costs.

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Making Decisions Using MCC
Using external (new) common equity
Using internal common equity
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Making Decisions Using MCC

• Graph IRRs of potential projects

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Making Decisions Using MCC

• Graph IRRs of potential projects

• Graph MCC Curve

11.72
11.34
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Making Decisions Using MCC

• Graph IRRs of potential projects
• Graph MCC Curve

• Choose projects whose IRR is above the weighted
  marginal cost of capital

Accept Projects 1 2
11.72
11.34
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MCC and Capital Budgeting Decisons

• See pages 225 230 (250 255)
• Calculate the breakpoints
• Calculate the new MCCs
• Plot MCCs and Investment Projects
• See Figures 9-5 and 9-6 for results
• Do all the Self-test problems before doing the
  homework