Cost of Capital Chapter 12 © 2003 South-Western/Thomson Learning

2 The Purpose of the Cost of Capital The cost of capital is the average rate paid for the use of capital funds Primarily used in capital budgeting Use as the ‘hurdle rate,’ or benchmark for projects Compare IRR to this rate Discount cash flows at this rate to find NPV If a project cannot earn above this return, it is not worthwhile

3 The Purpose of the Cost of Capital A firm can only estimate what it will cost to raise future funds, so cost of capital will always be subject to uncertainty Important to estimate this cost as accurately as possible in order to effectively manage the firm The firm’s cost of capital can be viewed as the firm’s required rate of return on projects of average risk

4 Capital Components Components of a firm’s capital are Debt Borrowed money, either loans or bonds Common equity Ownership interest Preferred stock Cross between debt and equity Capital structure is the mix of the three capital components

5 Capital Structure Target Capital Structure A mix of components that management considers optimal and strives to maintain Raising Money in the Proportions of the Capital Structure An exact capital structure can’t be maintained constantly Sometimes, if interest rates are low, a firm might issue more debt (to take advantage of the low cost) Increases the weight of debt relative to equity Next time need more capital, issue equity to bring mix back into balance

6 Capital Structure However, cost of capital calculations assume that capital is raised in the exact proportions of some capital structure Assumption is unrealistic but produces little distortion

7 Returns on Investments and the Costs of Capital Components Investors provide capital to companies by purchasing their securities The returns to investors represent the costs to the firms in which investments are made Opposite sides of the same coin Since equity is riskier than debt, generally the return on an equity investment is higher than that of debt (or preferred stock), thus the cost to the firm is higher Cost and return are not exactly equal, but are related

8 The Weighted Average Calculation—The WACC A firm’s WACC is the average of the costs of the separate sources weighted by the proportion of each source used

9 Capital Structure and Cost— Book Versus Market Value Book values reflect the cost of capital already spent Market value estimates the cost of capital to be raised in the near future Market values are appropriate because new projects are generally funded with newly- raised equity

10 Calculating the WACC Step 1: Develop a market-based capital structure Step 2: Adjust the market returns on the securities underlying the capital components to reflect the company's true component costs of capital Step 3: Put the values obtained in Steps 1 and 2 together to determine the WACC Developing Market-Value-Based Capital Structures Involves determining the percentage each source of capital makes up of the firm's overall capital structure based on market values

11 Calculating Component Costs of Capital We'll look at the market return received by new investors in each component Then make adjustments to reflect practical reality Adjustments—The Effect of Financial Markets and Taxes The amounts effectively paid to investors and received by a corporation when raising capital are impacted by taxes and transaction costs Taxes—interest expense on debt is tax deductible which makes the debt cheaper than it would be otherwise Thus, a dollar paid in interest results in a lower taxable income and lower taxes Therefore, the after-tax cost of debt is Interest  (1 - tax rate)

12 Calculating Component Costs of Capital Flotation costs—administrative fees and expenses incurred in the process of issuing and selling securities Lower the amount received when a security is issued, increasing the cost of the capital raised Thus, when a firm issues securities it will only net a portion of the total amount issued, as the remainder must be paid as issuance costs A firm's component cost of capital will be higher than the investor's return by the ratio of 1  (1 - flotation cost percentage)

13 The Cost of Debt The cost of debt is the investor's return adjusted for the tax deductibility of interest payments Most debt is placed privately (not initially sold to the public) and flotation costs are minimal The cost of debt is the market return on debt (k d ) net of taxes or K d × (1 - tax rate)

14 The Cost of Preferred Stock The cost of preferred stock is the investor's return adjusted for flotation costs A preferred stockholder's return is the dividend received divided by the current price of the stock Adjusting this for the fact that a firm will only net the portion of the issuing price after flotation costs (f) results in D p  (1 - f)P p or k p  (1 - f)

15 The Cost of Common Equity Debt and preferred stock offer investors known stream of payments so calculating returns are easy The cost of equity is imprecise because of the uncertainty of future cash flows Thus, market return on an equity investment has to be estimated We'll use the CAPM, the Gordon model and risk premiums Equity sources include stock sales and retained earnings, which have different costs

16 The Cost of Retained Earnings Retained earnings (RE) are not free to the company because they represent reinvested earnings for the stockholders Thus, retained earnings represent money stockholders could have spent if it had been paid out as dividends Stockholders deserve a return on retained earnings The market return on new shares is an appropriate starting point for estimating the cost of retained earnings No adjustments are needed between the return earned by new buyers and the cost of RE because RE are generated internally—no need to adjust for flotation costs or taxes

17 The Cost of Retained Earnings The CAPM Approach—The Required Rate of Return The market return on a stock can be approximated by estimating the required or expected return CAPM offers a method of estimating the required return using beta as a measure of risk K x = K RF + (K m - K RF ) b X The Dividend Growth Approach—The Expected Rate of Return The Gordon model is normally used to calculate the intrinsic value of a stock However, we can use the Gordon model to solve for the expected return by plugging in the current price of the stock P 0 = D 0 (1 + g) × ( k e – g) Use actual price Solve for k e, which represents expected return.

18 The Cost of Retained Earnings The Risk Premium Approach It's possible to estimate the return on a firm's equity by adding 3 to 5 percentage points to the market return on its debt, or K e = k d + equity risk premium

19 The Cost of New Common Stock Firms often need to raise more equity than that generated by retained earnings Accomplish this by issuing new common stock Equity from new stock is just like equity from RE, with the exception that raising it involves incurring flotation costs Thus the market return estimates for RE must be adjusted for flotation costs to determine the cost of issuing new common stock Easiest to do with the Gordon model because the price of the stock appears in that equation k e = [D 0 (1 + g)  (1 – f)P 0 ] + g

20 Putting the Weights and Costs Together Once the component costs are calculated and the target weights are determined, the calculation of the weighted average cost of capital is simple

21 The Marginal Cost of Capital (MCC) A firm's WACC is not independent of the amount of capital raised WACC typically rises as the firm raises more capital The Marginal Cost of Capital (MCC) is graph of the WACC showing abrupt increases as larger amounts of capital are raised in a planning period

22 The Break in MCC When Retained Earnings Run Out Breaks (jumps) in the MCC occur when a cheap source of financing are used up First increase in MCC usually occurs when the firm runs out of RE and starts raising external equity by selling stock Locating the Break The first breakpoint is always found by dividing the amount of RE available by the fractional proportion of equity in the capital structure

23 The MCC Schedule Other Breaks in the MCC Schedule For most companies the WACC is reasonably constant aside from the break into external equity However, low-cost funds cannot be raised without limit For instance, as more debt is issued the firm becomes more risky and the investors' required rates of return rise Combining the MCC and IOS The investment opportunity schedule (IOS) is a plot of the IRRs of available projects arranged in descending order The MCC and IOS plotted together show which projects should be undertaken Because it represents the cost of raising funds relative to the expected return of the projects Interpreting the MCC The firm's WACC for the planning period is at the intersection of the MCC and the IOS

24 A Potential Mistake—Handling Separately Funded Projects Sometimes a project is funded entirely by a single source of capital Should the cost of capital used to evaluate that project be the cost of the single source, or the firm's overall WACC? It should be the firm's overall WACC because firms cannot continue to raise a single source of capital indefinitely, such as cheap debt