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Cost of Capital Chapter 13

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Cost of Capital Defined Cost of capital: percentage cost of permanent funds employed in business, or firm’s capital structure Capital structure: mix of long-term debt and equity by firm for its permanent financing needs

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Cost of Capital Defined Sample Restructured Balance Sheet (“mix” of company’s permanent financing) Firm only has two categories of assets: net working capital and fixed assets Net working capital is current assets minus current liabilities. “Restructured” right-hand side represents firm’s capital structure such that there are two categories of financing for two categories of assets. Net working Capital Long-term debt Fixed Assets Equity

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Cost of Capital Defined Two costs of capital 1.Average cost of capital (ACC): weighted average after-tax cost of new capital raised during given year Analysis of current financial decisions requires focus on current costs 2.Marginal cost of capital (MCC): represents incremental ACC as function of total dollar amount of capital raised As increasing amounts of capital are raised, cost of capital begins to increase Increased cost occurs at increments such that MC of additional dollar of capital is greater than AC of capital AC increases more slowly than MC

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Cost of Capital Defined Consider an analogy of average and marginal tax rates. Example: – Corporate tax rate 15% on first $50,000 of income 25% on next $25,000 35% on all income above $75,000 – If corporation earned $50,000 before taxes, both average and marginal tax rates are 15%. – At $60,000, average tax rate is 16.7% and marginal tax rate is 25%. – Above $75,000, marginal tax rate is 35%.

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Cost of Capital Defined Same general pattern holds for corporate cost of capital as in example. – As more capital is raised, cost increases at margin, increasing marginal cost in increments. – Average cost increases at slower rate and eventually approached marginal cost. – See exhibit 13.2

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Marginal Cost and Capital Budgeting MCC is the capital cost that should be used for making capital budgeting decisions. Firm is inclined to make capital budgeting decisions based on comparison of cost of each additional dollar of capital raised with expected rate of return on each additional dollar of capital invested. Firm should accept all investment projects where IRR ≥ MCC in order to maximize value of firm. See exhibit 13.3

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Calculating the Average Cost of Capital 1.Calculate after-tax cost of individual capital components. 2.Calculate average of component costs, weighted by percentage that each comprises of total capital structure. 3.Calculate cost of debt and preferred stock 4.Estimate cost of equity

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Cost of Debt Before-tax cost of debt: interest paid divided by principal amount borrowed Convert to after-tax basis by multiplying before- tax cost by 1 minus firm’s effective tax rate – 1 minus tax rate represents percentage of interest that is paid by firm after taking into account tax deductibility of interest payments Tax rate multiplied by dollars of interest paid represents amount of interest that is “paid” through tax savings.

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Cost of Debt Effective after-tax cost of debt K d = I/P (1 – T) where K d = after-tax cost of debt I = interest in dollars P = principal amount borrowed T = effective tax rate

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Cost of Debt If firm raises debt capital by selling bonds publicly, then it will incur some sales costs. – Flotation costs: cost of taking the issue public and include expenses such as legal research, underwriting expenses, salesperson’s commissions Flotation costs (fixed costs) as a percentage of size of issue become larger as issue size becomes smaller. Adjust after-tax cost of debt calculation to account for flotation costs. Let F equal flotation costs as percentage of face value of bond issue: K d = [(I/P(1-F)] (1-T) Principal amount on which interest is calculated is reduced by amount of flotation costs

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Cost of Debt Cost of Preferred Stock Since preferred stock is an equity security, dividends represent profit distributions to owners of corporation and are not tax deductible to corporation. Before-tax cost of preferred stick is the same as after- tax cost: K p = D/P where K p = cost of preferred stock D = dividend in dollars P = price of preferred stock

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Cost of Debt Cost of Preferred Stock Adjust for flotation costs for newly issued preferred stock that is publicly marketed: K p = D/[P(1-F)]

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Cost of Debt Cost of Common Equity Cost of common stock must be estimated Common equity: rate of return stockholders require on equity capital – Rate of return on equity that firm must earn in order to maintain value of its own common stock – Expected rate of return necessary to induce investors to invest in firm’s common stock

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Cost of Debt Cost of Common Equity Two components of stockholders’ expected rate of return: (K e represents cost of equity) K e = Expected dividend yield + Expected capital gain

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Cost of Debt Cost of Common Equity Use company’s dividend divided by its price as dividend yield and expected growth rate of earnings and dividends as measure of expected capital gain: K e = (D/P) + g where K e = cost of equity D = dividend in dollars P = price of stock g = expected growth rate Adequate to measure cost of equity capital generated by reinvested earnings. Measurement is cost of retained earnings portions of equity capital

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Cost of Debt Cost of Common Equity Adjust for flotation costs to measure cost of equity capital generated through new issues of common stock: K e = [D/(P(1-F)] + g

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Cost of Debt A Computational Example Calculate average cost of capital for firm having capital structure consisting of 40% debt 10% preferred stock 50% equity Debt bears interest at 8% Preferred stock sells for $100 (its par value) and pays dividend of $8 Common stock sells for $55 and pays dividend of $2.20 Expected growth rate of earnings and dividends is 9% Firm’s effective tax rate is 34% No flotation costs will be incurred – Newly issued debt and preferred stock will be privately placed – Required equity capital will be generated through reinvested earnings

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Cost of Debt A Computational Example See exhibit 13.4 – Cost of debt is 5.3% after tax – Cost of preferred stock is 8% – Cost of common equity is 13% (4% dividend yield plus 9% growth rate) – Weighted average cost of capital is 9.42% (calculated by multiplying each component cost by percentage of capital structure it comprises and summing results)

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The Capital Asset Pricing Model Capital asset pricing model (CAPM): stockholders’ required rate of return on equity capital is function of risk-free rate of return, rate of return earned on stocks in general (“market return”), and riskiness of particular stock in which investor may be considering investing K e = Risk-free rate + Risk premium Risk premium is determined by riskiness of particular stock relative to market and by difference between market rate of return and risk-free rate.

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The Capital Asset Pricing Model Riskiness of individual stock is measured by stock’s beta factor: measure of volatility of stock relative to market – Beta of 1.0: stock has same volatility as market – Beta of 0.5: stock is about half as volatile as market – Beta of 2.0: stock is approximately twice as volatile as market Stock’s beta is estimated by regressing stock’s price against level of some broad market index Ex. Standard and Poor’s Index of 500 Common Stocks (S&P 500) Beta factor is slope of regression line and measure of company’s systematic risk

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The Capital Asset Pricing Model CAPM in equation form: K e = R f + (R m – R f )B where K e = cost of equity capital R f = risk-free rate of return R m = market rate of return B = beta

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Capital Structure Management From perspective of capital markets, cost of equity capital must be greater than cost of debt. Investors are averse to risk. Investors must demand a higher rate of return on equity than on debt because investing in equity is riskier than investing in debt. Capital structure management focuses on finding appropriate combination of debt and equity such that combined weighted average cost of capital is minimized.

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Capital Structure Management See exhibit 13.5 – K e and K d are constant over a broad range, but at some point begin to increase as leverage gets higher. – Risk causes increase. As firm becomes increasingly debt heavy, increased risk of insolvency drives up both K d (return to creditors) and K e (return to stockholders). – If firm is 100% equity financed (leverage = 0), its ACC is at maximum. – If firm employs some debt financing, relatively expensive equity is combined with relatively inexpensive debt. This reduces weighted ACC.

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Capital Structure Management In theory, operate on minimum point of ACC curve. In practice, ACC tends to be flat over fairly broad range so optimal-capital-structure theory is useful as broad policy guideline. – Effective capital structure management requires capital structure mix that is within “range of optimality.”

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Capital Structure Management Location of range of optimality varies with riskiness of particular industry. In general, the higher the business risk in industry, the less leverage firm may employ before cost curves turn up. – Riskier firms will have higher cost curves to begin with.

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