Copyright © 2002 by Harcourt, Inc.All rights reserved. CHAPTER 10 The Cost of Capital Sources of capital Component costs WACC Adjusting for flotation costs Adjusting for risk

Copyright © 2002 by Harcourt, Inc.All rights reserved. What sources of long-term capital do firms use? Long-Term Capital Preferred Stock Common Stock Long-TermDebt New Common Stock Retained Earnings

Copyright © 2002 by Harcourt, Inc.All rights reserved. WACC = w d k d (1 – T) + w p k p + w s k s WACC = w d k d (1 – T) + w p k p + w e k e How do you calculate the weighted average cost of capital? The w’s refer to the capital structure weights. The k’s refer to the cost of each component.

Copyright © 2002 by Harcourt, Inc.All rights reserved. Stockholders focus on A-T CFs. Therefore, we should focus on A-T capital costs, i.e., use A-T costs in WACC. Only k d needs adjustment, because interest is deductible. Should we focus on before-tax or after-tax capital costs?

Copyright © 2002 by Harcourt, Inc.All rights reserved. Should we focus on historical (embedded) costs or new (marginal) costs? The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on today’s marginal costs (for WACC).

Copyright © 2002 by Harcourt, Inc.All rights reserved. WACC = w d k d (1 – T) + w p k p + w s k s. WACC = w d k d (1 – T) + w p k p + w e k e. How do you determine the weights? Use market value Use optimal capital structure So if a company has $300 million in debt outstanding, $100 million in preferred stock, & $600 million of common stock, and this is considered optimal for the company :

Copyright © 2002 by Harcourt, Inc.All rights reserved. WACC = w d k d (1 – T) + w p k p + w s k s. WACC = w d k d (1 – T) + w p k p + w e k e. How do you determine the weights? 300/1000 = 30% debt w d =.3 100/1000 = 10% p.s. w ps =.1 600/1000 = 60% c.s. w cs =.6 Since this is considered optimal, then these weights will stay constant throughout the problem.

Copyright © 2002 by Harcourt, Inc.All rights reserved. WACC = w d k d (1 – T) + w p k p + w s k s. WACC = w d k d (1 – T) + w p k p + w e k e. Component Cost of Debt k d is the marginal cost of debt capital. The yield to maturity on outstanding LT debt is often used as a measure of k d. Why tax-adjust, i.e., why k d (1 - T)?

Copyright © 2002 by Harcourt, Inc.All rights reserved. A 15-year, 12% semiannual bond sells for $1, What is k d ? , i = ? % P/Y set to 2 NI/YRPVFV PMT -1, INPUTS OUTPUT

Copyright © 2002 by Harcourt, Inc.All rights reserved. Interest is tax deductible, so k d AT = k d BT (1 – T) = 10%(1 – 0.40) = 6%. Flotation costs small. Ignore. Component Cost of Debt

Copyright © 2002 by Harcourt, Inc.All rights reserved. WACC = w d k d (1 – T) + w p k p + w s k s. WACC = w d k d (1 – T) + w p k p + w e k e. Component Cost of Preferred Stock k p is the marginal cost of preferred stock. The rate of return investors require on the firm’s preferred stock.

Copyright © 2002 by Harcourt, Inc.All rights reserved %. What’s the cost of preferred stock? P p = $111.10; 10%Q; Par = $100. Use this formula: $ 10$ P D k p p p 

Copyright © 2002 by Harcourt, Inc.All rights reserved. Note: Preferred dividends are not tax deductible, so no tax adjustment. Just k p. Nominal k p is used. Our calculation ignores flotation costs.

Copyright © 2002 by Harcourt, Inc.All rights reserved. More risky; company not required to pay preferred dividend. However, firms try to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, (3) preferred stockholders may gain control of firm. Is preferred stock more or less risky to investors than debt?

Copyright © 2002 by Harcourt, Inc.All rights reserved. Why is yield on preferred lower than k d ? Corporations own most preferred stock, because 70% of preferred dividends are nontaxable to corporations. Therefore, preferred often has a lower B-T yield than the B-T yield on debt. The A-T yield to an investor, and the A-T cost to the issuer, are higher on preferred than on debt. Consistent with higher risk of preferred.

Copyright © 2002 by Harcourt, Inc.All rights reserved. WACC = w d k d (1 – T) + w p k p + w s k s. WACC = w d k d (1 – T) + w p k p + w e k e. Component Cost of Equity k s is the marginal cost of common equity using retained earnings. The rate of return investors require on the firm’s common equity using new equity is k e.

Copyright © 2002 by Harcourt, Inc.All rights reserved. Earnings can be reinvested or paid out as dividends. Investors could buy other securities, earn a return. Thus, there is an opportunity cost if earnings are retained. Why is there a cost for retained earnings?

Copyright © 2002 by Harcourt, Inc.All rights reserved. Opportunity cost: The return stockholders could earn on alternative investments of equal risk. They could buy similar stocks and earn k s, or company could repurchase its own stock and earn k s. So, k s is the cost of retained earnings.

Copyright © 2002 by Harcourt, Inc.All rights reserved. Three ways to determine cost of common equity, k s : 1.CAPM: k s = k RF + (k M – k RF )b. 2.DCF: k s = D 1 /P 0 + g. 3.Own-Bond-Yield-Plus-Risk Premium: k s = k d + RP.

Copyright © 2002 by Harcourt, Inc.All rights reserved. What’s the cost of common equity based on the CAPM? k RF = 7%, RP M = 6%, b = 1.2. k s = k RF + (k M – k RF )b. = 7.0% + (6.0%)1.2 = 14.2%.

Copyright © 2002 by Harcourt, Inc.All rights reserved. What’s the DCF cost of common equity, k s ? Given: D 0 = $4.19; P 0 = $50; g = 5%. D1P0D1P0 D 0 (1 + g) P 0 $4.19(1.05) $50 k s = + g = + g = = = 13.8%.

Copyright © 2002 by Harcourt, Inc.All rights reserved. Find k s using the own-bond-yield-plus- risk-premium method. (k d = 10%, RP = 4%.) This RP  CAPM RP. Produces ballpark estimate of k s. Useful check. k s = k d + RP = 10.0% + 4.0% = 14.0%

Copyright © 2002 by Harcourt, Inc.All rights reserved. What’s a reasonable final estimate of k s ? MethodEstimate CAPM 14.2% DCF 13.8% k d + RP 14.0% Average 14.0%

Copyright © 2002 by Harcourt, Inc.All rights reserved. 1.When a company issues new common stock they also have to pay flotation costs to the underwriter. 2.Issuing new common stock may send a negative signal to the capital markets, which may depress stock price. Why is the cost of retained earnings cheaper than the cost of issuing new common stock?

Copyright © 2002 by Harcourt, Inc.All rights reserved. Two approaches that can be used to account for flotation costs: Include the flotation costs as part of the project’s up-front cost. This reduces the project’s estimated return. Adjust the cost of capital to include flotation costs. This is most commonly done by incorporating flotation costs in the DCF model.

Copyright © 2002 by Harcourt, Inc.All rights reserved. Suppose new common stock had a flotation cost of 15%. What is k e ? k e = + g D 0 (1 + g) P 0 (1 – F) = + 5.0% = + 5.0% = 15.4%. $4.19(1.05) $50(1 – 0.15) $4.40 $42.50 The final realized profit from issuing new common stock will be given, you will not have to compute P 0 (1-F).

Copyright © 2002 by Harcourt, Inc.All rights reserved. Comments about Flotation Costs Flotation costs depend on the risk of the firm and the type of capital being raised. The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small.

Copyright © 2002 by Harcourt, Inc.All rights reserved. What are the firm’s WACC’s? WACC = w d k d (1 – T) + w p k p + w s k s = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1%. WACC = w d k d (1 – T) + w p k p + w e k e = 0.3(10%)(0.6) + 0.1(9%) + 0.6(15.4%) = 1.8% + 0.9% % = 11.94%.

Copyright © 2002 by Harcourt, Inc.All rights reserved. How to distinguish which WACC is applicable. Must find the break point, or turning point, for retained earnings: k s Find NI $50,000,000 Find Dividends paid out 50% ($50,000,000) * (.5) = $25,000,000 Find R/E available $25,000,000

Copyright © 2002 by Harcourt, Inc.All rights reserved. How to distinguish which WACC is applicable. R/E available $25,000,000 Break point = Addition to Retained Earnings /Equity fraction (weight) used in financing BP = $25,000,000/.6 BP = $41,666,667 Level of Capital Spending that would have to be reached to use up all the k s.

Copyright © 2002 by Harcourt, Inc.All rights reserved. How to distinguish which WACC is applicable. So if the company has acceptable capital projects amounting to less than $41,666,667, their weighted average cost of capital will be 11.1%, because they would use their internally generated funds to finance the projects, together with debt and preferred stock. If acceptable capital projects are greater than $41,666,667, their weighted average cost of capital will be 11.94%, and they would be issuing new common stock to finance the common equity portion of the projects, together with debt and preferred stock.