Cost of Capital How much does it cost to borrow money? It depends on the source It depends on the source Mom and Dad – no interest, no principal repayment Grandparents – no interest, repay principal Bank – interest and repay principal Loan Sharks – very high interest and repay principal Companies have choices on where to borrow Companies have choices on where to borrowOwners Fixed Claims (Banks and Bondholders) Cash Flow Manipulation Prior Earnings

Cost of Capital Why is it important to find the Cost of Capital of a firm? Used to determine acceptable projects Used to determine acceptable projects Adjusted to fit the riskiness of projects Adjusted to fit the riskiness of projects WACC – Weighted Average Cost of Capital NPV = CF 0 – ∑ CF N / (1 + WACC) N NPV = CF 0 – ∑ CF N / (1 + WACC) N WACC is the cost to borrow… W E x R E + W PS x R PS + W D x R D ( 1 – T C )

Cost of Capital The Cost of Debt The corporate borrowing rate The corporate borrowing rate from Banks (they tell you the rate) from the capital debt markets (bond market) R D, the required rate of return for bond holders R D, the required rate of return for bond holders Solving for the Yield to Maturity Price = FV x (1/(1+k) n ) + Coupon x [1 - 1/(1+k) n ]/k and the k that solves the above is R D Taxes matter on interest, R D is adjusted by (1 - T C ) Taxes matter on interest, R D is adjusted by (1 - T C )

Cost of Capital Cost of Debt with flotation costs The first approach of just finding the yield to maturity may understate the cost of debt The first approach of just finding the yield to maturity may understate the cost of debt The cost to issue a bond should also be included and so an IRR approach is used The cost to issue a bond should also be included and so an IRR approach is used The cash inflow is at the beginning and the outflows later so it does not fit the standard cash flow pattern required of IRR Adjust direction of the cash flows Approximating the Cost (page 394) Why approximate when you can get the actual cost? Why approximate when you can get the actual cost? Problems 2 and 3 (use IRR or TVM for actual)

Cost of Capital The Cost of Equity Two Models Two Models Gordon’s Growth Model (Preferred Stock) Security Market Line (Common Stock) SML is R E, The required rate of return for equity holders SML is R E, The required rate of return for equity holders E(R E ) = R f +  (E(R m ) - R f ) The shareholders always have the option to invest in the market...

Cost of Capital Preferred Stock Cost Matches well with the Dividend Pricing Model Matches well with the Dividend Pricing Model Set cash dividends (timing and amount) No promise to repay principal Looks like a perpetuity R PS = Div / Price where Price is the net proceeds Problems 4 & 5 with and without flotation costs Problems 4 & 5 with and without flotation costs Common Stock Cost (Problem 6) Matches well with Security Market Line Matches well with Security Market Line R E = R f + β (R m - R f )

Cost of Capital Calculating a tax adjusted WACC Step one: Required Return for Equity Holders Step one: Required Return for Equity Holders SML: R E = R f +  ( R m - R f ) Step two: Required Return for Bond Holders Step two: Required Return for Bond Holders YTM on bonds: Solve the YTM on a bond for R D Step three: Required Return on Preferred Stock Step three: Required Return on Preferred Stock Dividend Model: R PS = Div / Price Step four: % Equity, % PS and % Debt Funding Step four: % Equity, % PS and % Debt Funding Market value of Equity, PS and Debt: V = E + D + PS WACC = E/V R E + PS/V R PS + D/V R D (1-T C ) WACC = E/V R E + PS/V R PS + D/V R D (1-T C )

Cost of Capital Problem 12 Cost of Debt (TVM keys) R D I/Y = 10.84% Cost of Debt (TVM keys) R D I/Y = 10.84% P/Y C/Y N I/Y PV PMT FV ? , ? ,000 Cost of Preferred Stock R PS = 12.70% Cost of Preferred Stock R PS = 12.70% R PS = (0.08 x $100) / ($65 - $2) = 12.70% R PS = (0.08 x $100) / ($65 - $2) = 12.70% Cost of Equity (CAPM or SML) R E = 16.64% Cost of Equity (CAPM or SML) R E = 16.64% R E insufficient data must use Growth Formula R E insufficient data must use Growth Formula R E = $4 / ($50 -$8) % = 16.64% R E = $4 / ($50 -$8) % = 16.64% g is the growth rate of dividends at 7.1% (average growth) g is the growth rate of dividends at 7.1% (average growth) WACC WACC 16.64% (.5) % (.1) % (.4) ( 1 -.4) = 12.19%

Cost of Capital Adjusting Problem 12 with new information The market is currently demanding a 13.7% return and the risk-free rate is 4%. The company beta is 1.3. What is the required return on equity financing? R E = R f +  ( R m - R f ) = 4% ( 9.7%) = 16.61% Adding some complexity…funding with Retained Earnings What is the cost of using internal funds? What is the cost of using internal funds? How should the shareholders view this “reinvestment” of their money?Consider their tax implications… How should the shareholders view this “reinvestment” of their money?Consider their tax implications… Marginal WACC and Breaking Points

Cost of Capital Homework - Adjustment to Problem 13 Debt is semi-annual with an 8% coupon rate Debt is semi-annual with an 8% coupon rate Par Value of the Preferred Stock is $100 Par Value of the Preferred Stock is $100 Company beta is 1.2 Company beta is 1.2 Risk-free interest rate is currently 4.5% Risk-free interest rate is currently 4.5% Expected return for the market is 12.8% Expected return for the market is 12.8% Ignore Retained Earnings as part of WACC Ignore Retained Earnings as part of WACC Calculate R E, R PS, R D, and WACC with source of Capital in table and tax rate of 40% Calculate R E, R PS, R D, and WACC with source of Capital in table and tax rate of 40%