Chapter 14 Cost of Capital Updated 2-2015

Cost of Capital: An Overview Most firms raise capital with a combination of debt (bank loans & bonds), preferred stocks & common stocks . Cost of capital is the weighted average of the returns of the securities that are used to finance the firm. We refer to this as the firm’s Weighted Average Cost of Capital (WACC). WACC includes the rates of return of the firm’s lenders & investors and the weights of financing sources that the firm uses.

Cost of Capital: An Overview (cont.) WACC is useful in a number of settings: WACC is used to value the firm. WACC is used as a discount rate to evaluate the projects the firm is considering to undertake (i.e. to calculate projects’ NPV) NPV = Net Present Value WACC is used to compare with the projects’ IRR Undertake the project if IRR > WACC IRR = Internal Rate of Return

Three Steps for Estimating WACC Define firm’s capital structure & the weight of each financing source. Estimate the cost of each financing source. Calculate the weighted average of the costs of each financing source . Step 1 Step 2 Step 3

Determining Firm’s Capital Structure Weights The weights are based on the following sources of capital: Debt (long-term) Preferred stock & common equity Liabilities such as accounts payable & accrued expenses are not included in capital structure. Ideally, the weights should be based on observed market values. However, we generally use book values if market values are not available.

Checkpoint 1 Calculating WACC for Templeton Inc. In the spring of 2013, Templeton wanted to estimate its own WACC. Templeton’s capital structure consists of the following:

Checkpoint 1 Calculating WACC for Templeton (Cont.) Templeton contacted the firm’s investment banker to get estimates of the firm’s current cost of financing and was told that if the firm were to borrow the same amount of money today, it would have to pay lenders 8% (before-tax cost of borrowing); however, given the firm’s 25% tax rate, the after-tax cost of borrowing would only be 6% = 8%(1-25%). Preferred stockholders currently demand a 10% rate of return, and common stockholders demand 15%.

Checkpoint 1 Long term

Checkpoint 1 Step 1 Step 2 Step 3

Cost of Debt Cost of debt: The rate of return the firm’s lenders demand when they loan money to the firm. However, the rate of return is not the coupon rate, which is the rate contractually set at the time of issue. But the Before-tax cost of debt is the yield to maturity. After-tax cost of debt = Yield (1-Tax rate) Interest payments are tax-deductible expenses.

Cost of Debt (cont.) What will be the yield to maturity on a debt that has par value of $1,000, a coupon interest rate of 7%, time to maturity of 20 years and is currently trading at $945? What will be the cost of debt if the tax rate is 40%? 945 = 70(PVIFA YTM, 20) + 1000(PVIF YTM, 20) YTM = 7.54%  Before-tax cost of debt After-tax cost of debt = Yield (1- Tax Rate) = 7.54% (1-40%) = 4.52%

Cost of Preferred Equity Cost of preferred equity is the rate of return investors require when they purchase preferred stock. Cost of preferred stock is not adjusted for taxes since dividends are paid to preferred stockholders from income after-tax. Dividend payments are non-tax-deductible expenses.

Cost of Preferred Equity (cont.) Consider the preferred shares issued by Alabama Power Company that are trading at $23.35 per share. What will be the cost of preferred equity if these stocks have a par value of $25 and pay annual dividend of 5.3%? kps = $1.325 ÷ $23.35 = 5.67%

Cost of Common Equity Cost of common equity is the rate of return investors expect to receive from investing in firm’s stock. Two methods to estimate cost of common equity: Constant Dividend Growth Rate model (introduced in chapter 10) Capital Asset Pricing Model (CAPM) – Skip for FIN3701

Checkpoint 2 Estimating Cost of Common Equity for Pearson plc Using Dividend Growth Model Pearson’s common stock price is $19.39 per share Dividend recently paid (D0) was $0.49 per share Stock analyst estimates 6.25% for growth rate of future dividend kcs = [$0.49(1+6.25%)/$19.39] + 6.25% = 2.69% + 6.25% = 8.94% Cost of Equity (kcs ) Dividend Yield D1 ÷ P0 Growth Rate (g)

Exercises (End of Chapter) Q. 27: Assume coupon interest paid on annual basis

Exercises (End of Chapter) Q. 28: Assume coupon interest paid on annual basis

Personal Summary Write down one thing you learned in this chapter that is interesting, new, or useful to you. ____________________________________________________________________________________________________________________________________________