1. Copyright © 2003 Pearson Education, Inc. Slide 10-0 Ch 10 Learning Goals 1.Concept of cost of capital 2.Determine the annual percentage cost of individual sources of capital. 3.Calculate the weighted average cost of capital (WACC).

2. Copyright © 2003 Pearson Education, Inc. Slide 10-1 The cost of capital is the annual % cost of financing projects in the capital budget. It is the required rate of return that must be earned on investment projects of _______________________. If the project under consideration has high or low risk, the cost of capital must be adjusted to determine the risk adjusted discount rate ____________________. Overview of the Cost of Capital

3. Copyright © 2003 Pearson Education, Inc. Slide 10-2 Firm’s Capital Structure Current Assets Fixed Assets Current Liabilities Long- Term Debt Equity The Firm’s Capital

4. Copyright © 2003 Pearson Education, Inc. Slide 10-3 Key Considerations The relevant cost of capital is the annual percentage cost of __________ financing on a ___________________ basis.

5. Copyright © 2003 Pearson Education, Inc. Slide 10-4 After-Tax Cost of Debt (k i ) The pretax cost of debt (k d ) is the interest rate the firm must pay on new debt financing. The before tax interest rate must be adjusted for the fact that interest expense is __________________________________. This ___________________ the cost of debt. Cost of Specific Sources of Capital

6. Copyright © 2003 Pearson Education, Inc. Slide 10-5 k i = k d (1-t) For example, if the interest rate on new debt is 9% and the firm is in the 40% tax bracket: k i = 9% (1-.40) = 5.4% The annual percentage cost (after-tax) of debt financing is 5.4%. After-Tax Cost of Debt (k i ) Cost of Specific Sources of Capital

7. Copyright © 2003 Pearson Education, Inc. Slide 10-6 Cost of Preferred Stock (k p ) K P = D P /(N P ) In the above equation, D P is the annual dividend per share of preferred stock and N P is the per share net proceeds from the sale of preferred. Cost of Specific Sources of Capital

8. Copyright © 2003 Pearson Education, Inc. Slide 10-7 For example, if a company can sell preferred stock with a $5 annual dividend for $58 per share, and has flotation costs of $3 per share to sell it, the annual percentage cost of preferred stock is: k P = $5/($58 - $3) = 9.1% Cost of Preferred Stock (k p ) K P = D P /N P Cost of Specific Sources of Capital

9. Copyright © 2003 Pearson Education, Inc. Slide 10-8 Cost of Common Equity Cost of Specific Sources of Capital There are two sources of common stock financing: ____________________________ and new issues of ______________________. In addition, there are two ways to estimate the cost of common equity: the dividend valuation model, and the capital asset pricing model (CAPM).

10. Copyright © 2003 Pearson Education, Inc. Slide 10-9 Constant Dividend Growth Model k s = (D 1 /P 0 ) + g. For example, the firm has just paid a dividend of $2.50 per share, expects dividends to grow at 8%, and the stock is selling for $50 per share. First, D 1 = 2.50(1+.08) = 2.70, and k S = (2.70/50) +.08 = 13.4%. Cost of Retained Earnings (k r ) Cost of Specific Sources of Capital

11. Copyright © 2003 Pearson Education, Inc. Slide 10-10 CAPM Approach Cost of Retained Earnings (k r = k s ) k s = r F + b(k M - R F ). For example, if the T-bill rate is currently 3.0%, the market risk premium is 9%, and the firm’s beta is 1.2, the firm’s cost of retained earnings will be: k s = 3.0 + 1.2(9) = 13.8%. Cost of Specific Sources of Capital

12. Copyright © 2003 Pearson Education, Inc. Slide 10-11 The previous example indicates that our estimate of the cost of retained earnings is somewhere between 13.4% and 13.8%. At this point, we could choose one or average the two (13.6%). Cost of Common Equity Cost of Retained Earnings (k s ) Cost of Specific Sources of Capital

13. Copyright © 2003 Pearson Education, Inc. Slide 10-12 Cost of New Common Stock (k n ) Cost of new common stock financing (k n ) k n = (D 1 / N n )+ g Where: D 1 is the dividend expected in the coming year. N n = net proceeds from the sale of new common stock

14. Copyright © 2003 Pearson Education, Inc. Slide 10-13 Cost of New Common Stock (k n ) Example: D 1 = 2.70 N n = $40 g = 8% k n = (D 1 / N n )+ g k n = (2.70 / 40) +.08 =.1475 = 14.8%

15. Copyright © 2003 Pearson Education, Inc. Slide 10-14 Capital Structure Weights WACC = k a = w i k i + w p k p + w s (k S or k n ) The weights in the above equation represent a specific financing mix (where w i = % of financing from debt, w p = % of financing from preferred, and w s = % of financing from common). The Weighted Average Cost of Capital

16. Copyright © 2003 Pearson Education, Inc. Slide 10-15 Capital Structure Weights WACC = k a = w i k i + w p k p + w s (k S or k n ) The weights can be determined by: Firm’s policy (target weights) Market values of firm’s debt and equity Book values of firm’s debt and equity The Weighted Average Cost of Capital

17. Copyright © 2003 Pearson Education, Inc. Slide 10-16 For example, the market value of the firm’s debt is $40 million, the market value of the firm’s preferred stock is $10 million, and the market value of the firm’s equity is $50 million. Dividing each component by the total of $100 million gives us market value weights of 40% debt, 10% preferred, and 50% common. The Weighted Average Cost of Capital Capital Structure Weights WACC = k a = w i k i + w p k p + ws(kS or kn)

18. Copyright © 2003 Pearson Education, Inc. Slide 10-17 Using the costs previously calculated along with the market value weights, if retained earnings is the source of common equity the weighted average cost of capital as follows: WACC =.4(5.4%) +.1(9.1%) +.5 (13.6%) = 9.9% The Weighted Average Cost of Capital WACC = k a = w i k i + w p k p +WACC = k a = w i k i + w p k p + ws(kS or kn)

19. Copyright © 2003 Pearson Education, Inc. Slide 10-18 Retained Earnings Breakpoint The retained earnings breakpoint is the maximum amount of _______________ that can be raised without selling new common stock. To finance additional projects, new common stock must be sold.

20. Copyright © 2003 Pearson Education, Inc. Slide 10-19 Retained Earnings Breakpoint REBP = ($ of retained earnings) / w s Example: firm expects to add $1 mil to retained earnings this year. w s =.50 REBP = $1 mil /.5 = $2 mil The firm can finance a capital budget of $2 mil without selling new common stock.

21. Copyright © 2003 Pearson Education, Inc. Slide 10-20 Using the costs previously calculated along with the market value weights, if new common stock is the source of common equity the weighted average cost of capital as follows: WACC =.4(5.4%) +.1(9.1%) +.5 (14.8%) = 10.5% The Weighted Average Cost of Capital WACC = k a = w i k i + w p k p +WACC = k a = w i k i + w p k p + ws(kS or kn)