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Cost of Capital1 Rate of return required by firm’s investors  Cost of capital is required rate of return for projects with same level of risk as overall.

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Presentation on theme: "Cost of Capital1 Rate of return required by firm’s investors  Cost of capital is required rate of return for projects with same level of risk as overall."— Presentation transcript:

1 Cost of Capital1 Rate of return required by firm’s investors  Cost of capital is required rate of return for projects with same level of risk as overall firm  Required rate of return must be adjusted to reflect anticipated risk of project

2 Cost of Capital2 Cost of Capital = Average cost of debt and equity  For now, assume ratio of debt to equity constant As debt increases, required will start to increase at some point The Big Picture….

3 Cost of Capital3 Cost of debt After-tax YTM on debt Includes flotation costs

4 Cost of Capital4 Cost of Debt Rate of return required by firm’s investors  YTM (required return) on IBM’s bonds is 10% (Ms. Investor demands a 10% rate of return)  However, IBM’s after-tax cost of debt is 7% Assuming IBM has a 30% tax rate $100 Interest (10%) - 30 Tax Savings = 70 After-Tax Interest Cost (7%)

5 Cost of Capital5 Cost of Debt Rate of return required by firm’s investors  Coupon rate on debt is not relevant 12% coupon bond, trading at $1,117 has a 9% YTM Would issue additional debt at 9% (before tax) This would be 6.3% after-tax (assume 30% tax rate)

6 Cost of Capital6 Calculating Required Rate of Return (Yield to Maturity) Bond has 6.5% coupon rate, 7 years to maturity and has net price of $870. What is yield to maturity?  Required rate of return (YTM) = 9.09%  After-tax rate required rate of return = 9.09% - (38% x 9.09%) = 5.64%

7 Cost of Capital7 Cost of Preferred Stock Cost of preferred stock = annual dividend / net price of preferred stock Net price is after flotation costs

8 Cost of Capital8 Cost of Equity Must be estimated. No stated rate like YTM on bonds or loans. Calculate cost for both:  Retained earnings  Issuing new equity

9 Cost of Capital9 Cost of Equity Dividend Growth Model NP = D1 / (RR – G) RR = (D1/NP) + G Calculate cost of retained earnings  Price (P), Dividend (D) are known.  Can estimate growth rate (G).  Then solve for required return (RR) Use Net Price after flotation costs for P

10 Cost of Capital10 Cost of Equity Dividend Growth Model NP = D1 / (RR – G) RR = (D1/NP) + G P = $32, D = $2.20, G = 4%, NP = $32.00, D1 = $2.29 RR = ($2.29/$32.00)+4% RR = 11.15%

11 Cost of Capital11 Cost of Equity Dividend Growth Model Advantage:  Simple Issues:  Must estimate growth rate  Some companies don’t pay dividends  Take into account risk?

12 Cost of Capital12 Cost of Equity Capital Asset Pricing Model (CAPM) RR = RF + (RM – RF) X Beta  Risk-free rate of return (RF) is known  Beta is generally known  Required Return for Market (RM) must be estimated

13 Cost of Capital13 Cost of Equity Capital Asset Pricing Model (CAPM) RR = RF + (RM – RF) X Beta  Advantages Adjusts for risk Can be used for companies with no dividends

14 Cost of Capital14 Cost of Equity Capital Asset Pricing Model (CAPM) RR = RF + (RM – RF) X Beta  Issues: Calculating Market Risk Premium (RM – RF)  One study: 9.2% for large cap stocks  Another study: 9.5% for large cap stocks  Another study: 4-6% for large cap stocks

15 Cost of Capital15 Cost of Equity Bond-yield plus equity risk RR = YTM + (RM – RF)  Advantage Uses YTM for company’s bonds as starting point Can be used to compare with other two methods

16 Cost of Capital16 WACC Market Value Company = Equity Value + Debt Value  Equity Value = Market cap Number of shares x Price of stock  Debt Value Number of bonds x Value of Bonds

17 Cost of Capital17 WACC WACC =  (Debt Value x Cost of Debt) +  (Equity Value x Cost of Equity) Due to risk premium for equity, generally equity will have a larger cost than debt But required return on debt will increase if very little equity

18 Cost of Capital18 WACC: cost of capital Debt: usually cheapest after-tax cost  Deduct interest  Barclays 2006 study: Investment grade: 4.0%; high-yield: 5.6% Preferred stock  Less risk than common stock Internal equity (retained earnings)  No flotation costs External equity (issue new stock)  Usually most expensive  Barclays 2006 study: 9%

19 Cost of Capital19 WACC Value of firm maximized when WACC is minimized Should reduce Required Return  This would increase NPV of projects WACC is not Required Return for all projects  Adjust Required Return based on risk of project  If use WACC for all projects, will accept risky projects and decline safe projects Since safe projects will generally have low IRR


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