1. FIN303 Vicentiu Covrig 1 Cost of Capital (chapter 10)

2. FIN303 Vicentiu Covrig 2 What sources of capital do firms use? Capital Debt Notes Payable Long-Term Debt Preferred Stock Common Equity Retained Earnings New Common Stock

3. FIN303 Vicentiu Covrig 3 Should our analysis focus on before-tax or after- tax capital costs? Stockholders focus on A-T CFs. Therefore, we should focus on A-T capital costs, i.e. use A-T costs of capital in WACC. Only r d needs adjustment, because interest is tax deductible.

4. FIN303 Vicentiu Covrig 4 How are the weights determined? WACC = w d r d (1 – T) + w p r p + w c r s d is for debt; s is for common equity and p is for the preferred stock

5. FIN303 Vicentiu Covrig 5 Overview of Coleman Technologies Firm calculating cost of capital for major expansion program. - Tax rate = 40%. - 15-year, 12% coupon, semiannual payment noncallable bonds sell for $1,153.72. New bonds will be privately placed with no flotation cost. - 10%, $100 par value, quarterly dividend, perpetual preferred stock sells for $111.10. - Common stock sells for $50. D 0 = $4.19 and g = 5%. - b = 1.2; r RF = 7%; RP M = 6%. - Bond-Yield Risk Premium = 4%. - Target capital structure: 30% debt, 10% preferred, 60% common equity.

6. FIN303 Vicentiu Covrig 6 Component Cost of Debt WACC = w d r d (1 – T) + w p r p + w c r s r d is the marginal cost of debt capital. The yield to maturity on outstanding L-T debt is often used as a measure of r d. Why tax-adjust; i.e., why r d (1 – T)?

7. FIN303 Vicentiu Covrig 7 A 15-year, 12% semiannual coupon bond sells for $1,153.72. What is the cost of debt (r d )? Remember, the bond pays a semiannual coupon, so r d = 5.0% x 2 = 10%. INPUTS OUTPUT NI/YRPMTPVFV 30 5 -1153.72 601000 Interest is tax deductible, so A-T r d = B-T r d (1 – T) = 10%(1 – 0.40) = 6%

8. FIN303 Vicentiu Covrig 8 Component Cost of Preferred Stock WACC = w d r d (1 – T) + w p r p + w c r s r p is the marginal cost of preferred stock, which is the return investors require on a firm’s preferred stock. Preferred dividends are not tax-deductible, so no tax adjustments necessary. Just use nominal r p.

9. FIN303 Vicentiu Covrig 9 What is the cost of preferred stock? The cost of preferred stock can be solved by using this formula: r p = D p /P p = $10/$111.10 = 9%

10. FIN303 Vicentiu Covrig 10 Is preferred stock more or less risky to investors than debt? More risky; company not required to pay preferred dividend. However, firms try to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, (3) preferred stockholders may gain control of firm.

11. FIN303 Vicentiu Covrig 11 Component Cost of Equity WACC = w d r d (1 – T) + w p r p + w c r s r s is the marginal cost of common equity The rate of return investors require on the firm’s common equity using new equity is r e.

12. FIN303 Vicentiu Covrig 12 Two Ways to Determine the Cost of Common Equity, r s CAPM: r s = r RF + (r M – r RF )b The r RF = 7%, RP M = 6%, and the firm’s beta is 1.2. r s = r RF + (r M – r RF )b = 7.0% + (6.0%)1.2 = 14.2%

13. FIN303 Vicentiu Covrig 13 What factors influence a company’s composite WACC? Market conditions. The firm’s capital structure and dividend policy. The firm’s investment policy. Firms with riskier projects generally have a higher WACC. 10- 13

14. FIN303 Vicentiu Covrig 14 Should the company use the composite WACC as the hurdle rate for each of its projects? NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the “hurdle rate” for a typical project with average risk. Different projects have different risks. The project’s WACC should be adjusted to reflect the project’s risk. Next slide illustrates importance of risk-adjusting cost of capital.

15. FIN303 Vicentiu Covrig 15 Component cost of equity WACC = w d r d (1-T) + w c r s r s is the cost of common equity CAPM: k s = k RF + (k M – k RF ) β If the k RF = 7%, RP M = 6%, and the firm’s beta is 1.2, what’s the cost of common equity based upon the CAPM? 14.2% DCF:k s = D 1 / P 0 + g [ This formula above is a rearrangement of ] If D 0 = $4.19, P 0 = $50, and g = 5%, what’s the cost of common equity based upon the DCF approach? 13.8%

16. FIN303 Vicentiu Covrig 16 Exam type question Wyden Brothers has no retained earnings. The company uses the CAPM to calculate the cost of equity capital. The company’s capital structure consists of common stock and debt. Which of the following events will reduce the company’s WACC? a.A reduction in the market risk premium. * b.An increase in the company’s credit risk. c.An increase in the company’s beta. d.An increase in expected inflation.

17. FIN303 Vicentiu Covrig 17 Exam type question Billick Brothers is estimating its WACC. The company has collected the following information: Its capital structure consists of 40 percent debt and 60 percent common equity. The company has 20-year bonds outstanding with a 9 percent annual coupon that are trading at par. The company’s tax rate is 40 percent. The risk-free rate is 5.5 percent. The market risk premium is 5 percent. The stock’s beta is 1.4. What is the company’s WACC? a. 9.71% b. 9.66% * c. 8.31% d.11.18%

18. FIN303 Vicentiu Covrig 18 Learning objectives Know how to calculate the WACC based on the equity and debt components Discuss several factors that can affect the composite cost of capital (see slide 8) Floatation costs and sections 10-5b, 10-5c and 10.6 will NOT be on the exam Recommended end-of-chapter problems: 10-1,10-3, 10-4 (without floatation), 10-8