1. Cost of Capital = Asset Value CF 1 (1 + r) 1 ^ + CF 2 (1 + r) 2 ^ + … + CF n (1 + r) n ^ r = firm’s required rate of return, which represents the return investors receive for providing funds to the firm = Asset Value CF 1 (1 + r) 1 ^ + CF 2 (1 + r) 2 ^ + … + CF n (1 + r) n ^ 1

2. Chapter Essentials—The Questions  What types of capital do firms use to finance investments?  What is the cost of capital?  How is the cost of capital used to make financial decisions?  Why do funds generated through retained earnings have a cost?  Who determines a firm’s cost of capital? 2

3. Cost of Capital Introduction Cost of Debt, r dT Cost of Equity, r ps and (r s or r e ) Marginal Cost of Capital (MCC) MCC and Investment Opportunity (IOS) Schedules 3

4. Basic Definitions  Capital—refers to the long-term funds used by a firm to finance its assets.  Capital components—the types of capital used by a firm—long- term debt and equity  Cost of capital—the cost associated with the various types of capital used by the firm, which is based on the rate of return required by the investors who provide the funds to the firm.  Weighted average cost of capital, WACC—the average percentage cost, based on the proportion of each type of capital, of all the funds used by the firm to finance its assets.  Capital structure—the mix of the types of capital used by the firm to finance its assets.  Optimal capital structure—the mix of capital that minimizes the firm’s WACC, thus maximizes its value. 4

5. Weighted Average Cost of Capital (WACC)—Logic  A firm generally uses different types of funds to finance its assets—that is, debt and equity.  Costs associated with different types of capital (funds) usually are not the same—e.g., debt generally is cheaper than equity.  The overall cost, or average, should be weighted based on the proportion of each type of funds used by the firm.  Example: A firm is financed with debt and equity with the following characteristics: Cost Proportion Debt r debt =8%10% Equity r stock =12%90% The average cost of each dollar of financing is: Weighted average = 8%(0.1) + 12%(0.9) = 11.6% 5

6. Cost of Capital  Investors who are the participants in the financial markets determine the firm’s costs of funds.  The firm’s costs of funds change when  conditions in the financial markets change  investors’ general risk aversion changes  firm’s risk changes 6

7. Cost of Debt, r dT  r d —the before-tax cost of debt is simply the yield to maturity (YTM) of the debt  YTM—bondholders’ required rate of return = r d  r dT —the after-tax cost of debt T = marginal tax rate 7

8. Cost of Debt, r dT —Example A firm has debt with the following characteristics: Maturity value, M$1,000.00 Coupon rate, C8.0% (paid semiannually) Years to maturity6 yrs Market price$1,099.50 Marginal tax rate40.0% Based on this information, we know that the following relationship exists: Solving for r d gives us the YTM for this bond 8

9. Cost of Debt, r dT —Example Solve using:  Trial-and-error process (numerical solution)  approximation equation  Financial calculator  Spreadsheet 9

10. Cost of Debt, r dT —Example r d approximation r d /2 = 2.97% per six-month period (interest payment) r d = 2.97% x 2 = 5.94% ≈ 6% 10

11. Cost of Debt, r dT —Example Financial calculator solution: N=12=6 years x 2 PV=-1,099.50 PMT=40= (0.08 x 1,000)/2 FV=1,000 I/Y=? = 3.0% per six-month period r d =3.0% x 2= 6.0% per year = YTM 11

12. Cost of Debt, r dT —Example  Bondholders/investors demand a 6 percent rate of return to invest in this firm’s long-term debt.  r d = YTM = 6% is the rate of return paid to bondholders.  The firm pays $80 interest per year, which is a tax deductible expense.  r d is a before-tax amount that needs to be adjusted so as to represent the actual after-tax cost to the firm—that is, the cost of the bond to the firm isn’t really 6 percent. 12

13. Cost of Debt, r T Tax Deductibility of Interest Example: The firm issues a new $1,000 face value bond with a 6 percent coupon rate, thus interest equal to $60 is paid each year. If the firm’s taxable income before considering the interest payment is $500 and its marginal tax rate is 40 percent, then the tax liability with and without the interest expense is: Tax without interest = $500(0.40) = $200 Tax with interest = ($500 - $60)( 0.40) = $176 Savings = $24 = $60(0.4) Net interest after tax savings = $60 - $24 = $36 After-tax cost of the new bond = $36/$1,000 = 3.6% r dT = r d x (1 – T) = 6% x (1 – 0.4) = 3.6% 13

14. Cost of Debt, r dT r dT = r d x (1 – T) = YTM x (1 – T) r d = before-tax cost of debt T = marginal tax rate 14

15. Cost of Equity The cost of equity is based on the rate of return required by the firm’s stockholders.  Cost of preferred stock—dividends received by preferred stockholders represent an annuity  Cost of retained earnings (internal equity)—return that common stockholders require the firm to earn on the funds that have been retained, thus reinvested in the firm, rather than paid out as dividends  Cost of new (external) equity—rate of return required by common stockholders after considering the cost associated with issuing new stock (flotation costs) 15

16. Cost of Equity—Preferred Stock  Most preferred stocks pay constant dividends, thus the dividend stream represents a perpetuity.  Valuing preferred stock as a perpetuity gives:  Solving for the required rate of return, r ps, gives:  Because flotation (issuing) costs have to be paid when preferred stock is issued, the cost of preferred stock is: NP 0 = net proceeds from issue F= flotation costs (percent) 16

17. Cost of Preferred Stock, r ps —Example  A firm has preferred stock with the following characteristics: Market price, P 0 $75.00 Dividend, D ps $5.76 Flotation cost, F4.0 % = 0.08 = 8.0%  No tax adjustment, because dividends are not a tax- deductible expense. 17

18. Cost of Equity—Retained Earnings, r s  The firm must earn a return on reinvested earnings that is sufficient to satisfy existing common stockholders’ investment demands.  If the firm does not earn a sufficient return using retained earnings, then the earnings should be paid out as dividends so that stockholders can invest the funds outside the firm to earn an appropriate rate. 18

19. Cost of Equity—Retained Earnings, r s Assuming the stock market is at or near equilibrium, we know that the following relationship exists: r RF = risk-free rate r M = market return  s = stock’s beta coefficient = next expected dividend g= constant growth rate 19

20. Cost of Retained Earnings, r s CAPM Approach  Assumes the firm’s stockholders are very well diversified; if not, then beta probably is not the appropriate measure of risk for determining the firm’s cost of retained earnings.  r RF generally is associated with with Treasury securities; there are many different rates for Treasuries that have different terms to maturity. If r RF = 4%, r M = 9%, and  s = 1.4 r s = 4% + (9% - 4%)1.4 = 11.0% 20

21. Cost of Retained Earnings, r s Bond-Yield-Plus-Risk-Premium Approach  Studies have shown that the return on equity for a particular firm is approximately 3 to 5 percentage points higher than the return on its debt.  As a general rule of thumb, firms often compute the YTM, or r d, for their bonds and then add 3 to 5 percent.  In the current example, r d = 6.0%. As a rough estimate, then, we might say the cost of retained earnings is r s ≈ r d + 4% = 6% + 4% = 10.0% 21

22. Cost of Retained Earnings, r s Discounted Cash Flow (DCF) Approach  If the firm is expected to grow at a constant rate, then we have the following relationship:  Example: The firm, which is growing at a constant rate of 5 percent, just paid a dividend equal to $1.20; its stock currently sells for $18. = 0.07 + 0.05 = 0.12 = 12.0% 22

23. Cost of Retained Earnings, r s  The three approaches we used to determine the cost of retained earnings give three different results.  The three approaches are based on different assumptions:  CAPM approach assumes investors are extremely well diversified  DCF approach assumes the firms grows at a constant rate  Bond-yield-plus-risk-premium approach assumes that the return on equity is related to the return on the firm’s debt  Ideally all three approaches should give the same result; if not, however, we might average the results: r s = (11% + 10% + 12%)/3 = 11% 23

24. Cost of Equity Newly Issued Common Stock, r e  Rate of return required by common stockholders after considering the costs associated with issuing new stock, which are called flotation costs.  Because the firm has to provide the same gross return to new stockholders as existing stockholders, when the flotation costs associated with a common stock issue are considered, the cost of new common stock always must be greater than the cost of existing stock—that is, the cost of retained earnings.  Modify the DCF approach for computing the cost of retained earnings to include flotation costs 24

25. Cost of Newly Issued Common Stock (External Equity), r e NP 0 = net proceeds from the sale of the stock If flotation costs equal 6 percent, then r e in our example is 25

26. Cost of Newly Issued Common Stock, r e Rationale Assume a firm (different than in our example) has:  total assets equal to $50,000  is financed with common stock only (5,000 shares)  pays all earnings as dividends, thus g = 0  cost of retained earnings, r s = 10% = ROE 26

27.  The firm sells new common stock:  800 shares, so that 5,800 shares are outstanding after the sale  market price, P 0 = $10.00  net proceeds received by the firm, NP 0 = $9.50  total amount received by the firm = $9.50 x 800 = $7,600  total assets after stock sale = $50,000 + $7,600 = $57,600  Cost of new equity, r e Cost of Newly Issued Common Stock, r e Rationale 27

28.  Total assets after stock sale = $57,600  If the firm earns r s = 10% on all investments Cost of Newly Issued Common Stock, re Rationale 28

29.  Total assets after stock sale = $57,600  If the firm earns r e = 10.53% on new investments  Stock price would remain at $10, because investors require a 10 percent return; but, the firm must earn 10.53 on new investments to generate 10 percent to investor (due to flotation costs) Cost of Newly Issued Common Stock, re Rationale 29

30. Weighted Average Cost of Capital, WACC To make decisions about capital budgeting projects, we need to combine the various costs of capital— debt, preferred stock, and common stock—into a single required rate of return. Weighted average cost of capital, or WACC—the weighted average of the component costs of capital using as the weights the proportion each type of financing makes up of the total financing of the firm. 30

31. Weighted Average Cost of Capital, WACC Suppose our illustrative firm has the following capital structure: Debt, d40.0 Preferred stock, ps10.0 Common equity, s 50.0 100.0 3.6% 8.0 11.0 or 12.45 Percent Type of Financingof total PercentAfter-Tax Type of Financingof total Cost, r  If the firm can use retained earnings to finance new projects WACC = 0.4(3.6%) + 0.1(8.0%) + 0.5(11.0%) = 7.74%  If the firm has to issue new common stock to finance new projects WACC = 0.4(3.6%) + 0.1(8.0%) + 0.5(12.45%) = 8.47% 31

32. Marginal Cost of Capital, MCC  Weighted average cost of raising additional funds.  Generally, MCC often is greater than the existing WACC—that is, the cost of new funding increases— because the  firm’s risk increases, which causes investors to require a higher rate of return  costs of issuing new funds increase  MCC schedule—a graph that shows the average cost of funds at various levels of new financing 32

33. MCC Schedule  If the firm expects to retain $200,000 this year 400,000 7.7 Total of New Funds Raised ($) 0 New WACC = MCC (%) WACC 1 CE = 400,000 x 0.5 = 200,000 8.5 WACC 2 Break Point 33

34. MCC Schedule—Break Points  Break points occur when WACC increases, which is caused by an increase in any of the component costs of capital  debt—when r d1 < r d2 < … < r dn  preferred stock—when r ps1 < r ps2 < … < r psn  common equity—retained earnings or new common stock  There is a break point when retained earnings generated in the current period is exhausted.  Once the current addition to retained earnings is exhausted, then the firm must issue new common stock to satisfy additional common equity financing requirements.  Costs of funds often increase as the firm uses significantly higher amounts—risk increases. 34

35. MCC Schedule—Break Points 35

36. MCC Schedule Break Points—Example  Assume the firm faces the following situation this year:  Debt (40%): Amount of Funds Cost of Debt, r dT $ 0 -$100,0006.0% 100,001-200,0006.5 200,001-7.0  Preferred Stock (10%): r ps = 8.0%, no matter the amount needed  Common Equity (50%):  Retained earnings generated during the year = $200,000  Cost of retained earnings (internal equity), r s = 11.0%  Cost of new common stock (external equity), r e = 12.4%, no matter how much is needed 36

37. MCC Schedule Break Points—Example  Debt (40%): Amount of Funds Cost of Debt, r dT $ 0 -$100,0006.0% 100,001-200,0007.0 200,001-7.5 If the firm needs total funds equal to $250,000, 40%, or $100,000 would be debt. If the firm needs total funds equal to $500,000, 40%, or $200,000 would be debt. 37

38. MCC Schedule Break Points—Example  Preferred Stock (10%): r ps = 8.0%, no matter the amount needed Constant cost—no break due to preferred stock  Common Equity (50%):  Retained earnings generated during the year = $200,000  Cost of retained earnings (internal equity), r s = 11.0%  Cost of new common stock (external equity), r e = 12.4%, no matter how much is needed If the firm needs total funds equal to $400,000, 50%, or $200,000 would be RE. 38

39. MCC Schedule—Example Funds = $0 - $250,000 Amount atAfter-Tax $250,000Weightx Cost, k=WACC Debt Preferred Stock Common Equity Funds = $250,001 - $400,000 Amount atAfter-Tax $400,000Weightx Cost, r=WACC Debt Preferred Stock Common Equity $100,000 25,000 125,000 250,000 0.4 0.1 0.5 1.0 2.4 0.8 5.5 8.7% = WACC 1 $160,000 40,000 200,000 400,000 0.4 0.1 0.5 1.0 6.0 8.0 11.0 7.0 8.0 11.0 2.8 0.8 5.5 9.1% = WACC 2 Funds = $0 - $250,000 Amount atAfter-Tax $250,000Weightx Cost, r=WACC Debt Preferred Stock Common Equity 39

40. Funds = $400,001 - $500,000 Amount atAfter-Tax $500,000Weightx Cost, k=WACC Debt Preferred Stock Common Equity Funds = above $500,000 Amount atAfter-Tax $600,000Weightx Cost, r=WACC Debt Preferred Stock Common Equity $200,000 50,000 250,000 500,000 0.4 0.1 0.5 1.0 2.8 0.8 6.2 9.8% = WACC 3 $240,000 60,000 300,000 600,000 0.4 0.1 0.5 1.0 7.0 8.0 12.4 7.5 8.0 12.4 3.0 0.8 6.2 10.0% = WACC 4 Funds = $400,001 - $500,000 Amount atAfter-Tax $500,000Weightx Cost, r=WACC Debt Preferred Stock Common Equity MCC Schedule—Example 40

41. MCC Schedule BP 1 = 250 400 Total Funds Raised ($000) 0 MCC (%) 300200100500 8.0 9.0 10.0 11.0 WACC 1 = 8.7 WACC 2 = 9.1 WACC 3 = 9.8 WACC 4 = 10.0 BP 2 BP 3 41

42. MCC Schedule and Investment Opportunity (IOS) Schedule The firm’s capital budgeting analysis results are: Project Cost IRR A$150,00011.0% B200,00010.5 C200,00010.1 D100,0009.5 42

43. IOS Schedule 400 Total Funds Raised ($000) 0 IRR (%) 300200100500 8.0 9.0 10.0 11.0 600700 IRR A = 11.0 IRR B = 10.5 IRR C = 10.1 IRR D = 9.5 43

44. MCC Schedule 400 Total Funds Raised ($000) 0 MCC (%) 300200100500 8.0 9.0 10.0 11.0 WACC 1 = 8.7 WACC 2 = 9.1 WACC 3 = 9.8 WACC 4 = 10.0 44

45. MCC & IOS Schedules 400 Total Funds Raised ($000) 0 IRR/MCC (%) 300200100500 8.0 9.0 10.0 11.0 600700 IRR A = 11.0 IRR B = 10.5 IRR C = 10.1 IRR D = 9.5 Optimal Capital Budget = 550 WACC 1 = 8.7 WACC 2 = 9.1 WACC 3 = 9.8 WACC 4 = 10.0 45

46.  What types of capital do firms use to finance investments?  Either debt (bond issues) or equity (preferred stock and common equity)  What is the cost of capital?  The average price a firm pays for the funds it uses to purchase assets  How is the cost of capital used to make financial decisions?  A firm should invest in projects that are expected to provide returns greater than its WACC Chapter Essentials—The Answers 46

47.  Why do funds generated through retained earnings have a cost?  Firms may retain earnings only as long as it can reinvest the earnings at a higher rate than stockholders can earn elsewhere  Who determines a firm’s cost of capital?  Investors Chapter Essentials—The Answers 47