Chapter 11 - Cost of Capital

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Chapter 11 - Cost of Capital

• Concept of the Cost of Capital
• Computing a Firms Cost of Capital
• Cost of Individual Sources of Capital
• Optimal Capital Structure
• Marginal Cost of Capital
• Combining the MCC and IOS

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Concept of the Cost of Capital

• When a firm invests money in a project, it should
  earn at least as much as it cost the firm to
  acquire the funds. Therefore, the cost of capital
  may be defined as the minimum acceptable rate of
  return.
• The term cost of capital has also been referred
  to as the firms required rate of return, the
  hurdle rate, and the opportunity cost.

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Computing a Firms Cost of Capital

• Weighted Cost of Capital
• For a given amount of investment capital to be
  raised, the cost of capital is a weighted average
  of the after-tax costs of the individual sources
  of financing.
• Example Assume a firm wishes to raise 10
  million using 40 debt, 10 preferred stock, and
  50 common equity financing. Given the following,
  calculate the firms cost of capital.
• Source of Financing After-Tax Cost
  Weight
• Debt
  8 .4
• Preferred Stock 10
  .1
• Common Equity 14
  .5
• Weighted Average Cost of Capital
• .4(8) .1(10) .5(14) 11.2

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Computing a Firms Cost of Capital (Continued)

• Questions to be Addressed
• 1. What are the costs of the individual
  sources of capital?
• 2. What set of weights (i.e., the capital
  structure) is appropriate?
• 3. What is the relationship between the cost of
  capital and the amount of investment capital to
  be raised?

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Cost of Individual Sources of Capital

• Cost of Debt (kd)
• Note Flotation costs on new debt (if any) have
  been ignored since the majority of debt is
  privately placed and has no flotation cost. If,
  however, bonds are publicly placed and involve
  flotation costs, an adjustment could be made to
  the before-tax cost of debt.

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Cost of Individual Sources (Continued)

• Cost of Preferred Stock (kp)

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Using the Constant Growth in Dividends Model
to Estimate the Cost of Common Equity

• Cost of Common Equity
• The rate of return required by the firms common
  stockholders. An opportunity cost concept (i.e.,
  what rate of return could the stockholders earn
  if they invested the funds in other alternatives
  of comparable risk.) An extremely difficult
  number to estimate.
• Cost of Retained Earnings (ke)

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• Cost of New Common Stock (kn)
• (Using the constant growth in dividends
  model)
• Note If it were not for flotation costs, the
  cost of newly issued common stock would be equal
  to the cost of retained earnings. (They are both
  sources of common equity).

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Using the Capital Asset Pricing Model (CAPM) to
Estimate the Cost of Common Equity

• where
• Rf risk-free rate of return
• Km required return on the market
• b beta coefficient

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Beta Coefficient(Measure of Market Risk)

• The extent to which the returns on a given asset
  move with the overall market

Higher betas mean greater risk. For example, a
beta of 2.0 indicates that an assets return
should increase 2 for every 1 increase in the
market. Conversely, the assets return should
decrease 2 for every 1 decrease in the market.
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The CAPM
ke
The Market
Rf
b
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Optimal Capital Structure

• What is the appropriate combination of debt and
  equity? If a firm were 100 equity financed (debt
  ratio 0), financial risk would be zero (only
  business risk would exist), and the weighted
  average cost of capital (ka) would be equal to
  the cost of equity (ke). Initially, the use of
  debt may reduce (ka) as a lower cost of debt is
  combined with a higher cost of equity. Beyond
  some point, however, as added financial risk
  drives up both the cost of debt and the cost of
  equity, (ka) will increase.
• Problem At what level of financial leverage will
  (ka) be minimized?

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Cost of Capital
ke
ka
kd
Debt/Asset Ratio
14
Stock Price
Debt/Asset Ratio
15
Expected EPS
Debt/Asset Ratio
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Marginal Cost of Capital (MCC)

• MCC is the cost of obtaining an additional dollar
  of new capital. If, during a given period of
  time, a firm tries to raise more and more
  capital, a higher cost of capital may result.
  Whenever any of the costs of the individual
  sources increase, the weighted average cost of
  capital (ka) must be recalculated to reflect the
  cost of obtaining additional capital (MCC).

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Marginal Cost of Capital (MCC)(Continued)

• To develop a MCC schedule, all break points must
  be determined, and at each point ka must be
  recalculated.
• A break point is a level of financing at which ka
  increases because one of the individual costs
  increased.
• In the example that follows only retained
  earnings break points will be illustrated. In
  practice, however, changes in the costs of all
  components (e.g., debt, preferred stock) must be
  taken into account.

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MCC Schedule
MCC
Break Point
ka 2
ka 1
Amount of New Capital ( millions)
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Combining the MCC and Investment Opportunities
Schedule (IOS)

• A firm should continue to invest funds as long as
  the rates of return received on the investments
  exceed the firms cost of acquiring the
  investment capital. In the following graph the
  firm should accept projects A and B, and reject
  project C. The point of intersection determines
  the firms optimal capital budget, and the firms
  cost of capital for its average risk projects.

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MCC and IOS Schedules
Percent
A
B
MCC
C
IOS
Amount of New Capital ( millions)