© 2004 by Nelson, a division of Thomson Canada Limited Contemporary Financial Management Chapter 8: The Cost of Capital

© 2004 by Nelson, a division of Thomson Canada Limited 2 Introduction  This chapter discusses: The cost of capital What is it How is it measured What is the Weighted Average Cost of Capital (WACC) Risk vs. required return trade-off

© 2004 by Nelson, a division of Thomson Canada Limited 3 Cost of Capital  The return required by investors to hold a company’s securities  Determined in the capital markets  Depends on the risk associated with the firm’s activities  Determines what the firm must pay to acquire new capital (sell new securities)  Firms must earn more than their cost of capital or they destroy shareholder wealth

© 2004 by Nelson, a division of Thomson Canada Limited 4 Concept of Capital Structure  A firm’s capital structure consists of the mix of debt and equity securities that have been issued to finance the firm’s activities.  Forms of financing include: Common stock Preferred stock Bonds (secured debt) Debentures (Unsecured debt)  Each different type of security has different risk characteristics and therefore will earn a different return in the market.

© 2004 by Nelson, a division of Thomson Canada Limited 5 Weighted Ave. Cost of Capital (WACC)  Discount rate used when computing the net present value of a project of average risk.  Calculated by weighting the cost of each form of security issued (Common stock, preferred stock, bonds, debentures).  Weights equal to the proportion of each of the components in the capital structure.

© 2004 by Nelson, a division of Thomson Canada Limited 6 Weighted Average Cost of Capital k a = Weighted Average Cost of Capital D = Market value of the firm’s Debt P f = Market value of the firm’s Preferred Shares E = Market value of the firm’s Common Equity k e = Marginal Cost of Common Share Capital k d = Marginal Pre-Tax Cost of Debt k p = Marginal Cost of Preferred Share Capital T = Corporate Tax Rate

© 2004 by Nelson, a division of Thomson Canada Limited 7 Example: A firm’s capital structure includes $3 Million in bonds, $6 Million in equity, and $1 Million in preferred stock (market values). The firm’s cost of equity is 15%, the cost of debt is 8% and the cost of preferreds is 10%. If the firm’s marginal tax rate is 50%, what is its WACC? Weighted Average Cost of Capital

© 2004 by Nelson, a division of Thomson Canada Limited 8 Required Rate of Return  Risk-free Rate of Return + Risk Premium  Risk-free Rate of Return: real rate of return (compensation for deferring consumption) plus compensation for expected inflation  Risk Premium: additional reward required for bearing the risk of an investment Composed of business risk, financial risk, marketability risk, interest rate risk and seniority risk.

© 2004 by Nelson, a division of Thomson Canada Limited 9 Risk-Return Trade-Offs Required Rate of Return Risk-Free Rate of Return Risk X Short-term Government Debt X Long-term Government Debt X High Quality Corporate Debt X High Quality Preferred Shares Low Quality Corporate X Debt Common Shares X

© 2004 by Nelson, a division of Thomson Canada Limited 10 Cost of Debt  The firm’s after-tax cost of debt (k i ) is found by multiplying the firm’s pre-tax cost of debt (k d ) by 1 minus the firm’s marginal tax rate (T).  Debt is the firm’s lowest cost source of funds, since interest is a tax-deductible expense.  As the amount of debt issued increases, the risk of default rises and so does the cost.

© 2004 by Nelson, a division of Thomson Canada Limited 11 Cost of Preferreds  The firm’s after-tax cost of preferreds (k p ) is equal to the pre-tax cost (D p /P net ), since dividends are not tax deductible (dividends are paid out of after-tax cash flow).

© 2004 by Nelson, a division of Thomson Canada Limited 12 Cost of Internal Equity Capital  The firm’s cost of internal equity is the return demanded by the existing shareholder.  The CAPM defines this return as:

© 2004 by Nelson, a division of Thomson Canada Limited 13 Cost of External Equity Capital  The cost of external equity is greater than the cost of internal equity due to the existence of Issue costs New issue discounts from market price

© 2004 by Nelson, a division of Thomson Canada Limited 14 Issue Costs & Discounts  Issue (flotation) costs are the costs associated with making a new issue of equity to the public.  To sell a new issue of shares, the sale price may have to be set below the current market price. Current market price represents an equilibrium between supply & demand Without new demand being created, the new supply will push down the market price

© 2004 by Nelson, a division of Thomson Canada Limited 15 Growth Rate Information  Institutional Brokers Estimate System   Zacks Earnings Estimates   Thomson Financial First Call Service   Dividend growth model 

© 2004 by Nelson, a division of Thomson Canada Limited 16 CAPM  Check out this Web site to see how the CAPM is used to calculate a firm’s cost of equity:

© 2004 by Nelson, a division of Thomson Canada Limited 17 Divisional Costs of Capital  Some divisions of a company have higher or lower systematic risk.  Discount rates for divisions are higher or lower than the discount rate for the firm as a whole.  Each division could have its own beta and discount rate.  Should reflect both the differential risks and the differential normal debt ratios for each division.

© 2004 by Nelson, a division of Thomson Canada Limited 18 Depreciation  A major source of funds  Equal to the firm’s weighted cost of capital based on retained earnings and the lowest cost of debt  Availability of funds from depreciation shifts the marginal cost of capital (MCC) to the right by the amount of depreciation

© 2004 by Nelson, a division of Thomson Canada Limited 19 Cost of Capital: Case Study  Major Foods Corporation is developing its cost of capital. The firm’s current & target capital structure is: 40% debt 10% preferred shares 50% common equity  The firm can raise the following funds Debt – up to $5 Million at 9% Debt – over $5 Million at 10% Preferred shares – 10%  The firm’s marginal tax rate is 40%

© 2004 by Nelson, a division of Thomson Canada Limited 20 Cost of Capital: Case Study (Cont’d)  Equity and internally generated funds The firm will generate $10 Million of retained earnings this year Current dividend is $2 per share Current share price is $25 New common shares can be sold at $24  Earnings and dividends growing at 7% per year  Payout ratio expected to remain constant

© 2004 by Nelson, a division of Thomson Canada Limited 21 Cost of Capital: Case Study Solution  Step #1:  Calculate the cost of capital for each component of financing  Cost of debt (up to $5 Million of new debt)  Cost of debt (over $5 Million of new debt)

© 2004 by Nelson, a division of Thomson Canada Limited 22 Cost of Capital: Case Study Solution  Step #1:  Calculate the cost of capital for each component of financing  Cost of Preferreds  Cost of Equity (internal)

© 2004 by Nelson, a division of Thomson Canada Limited 23 Cost of Capital: Case Study Solution  Step #1:  Calculate the cost of capital for each component of financing  Cost of Equity (external)

© 2004 by Nelson, a division of Thomson Canada Limited 24 Cost of Capital: Case Study Solution  Step #2:  Compute the weighted average cost of capital for each increment of capital raised. The firm wants to retain its target capital structure The firm should always raise its cheapest source of funds first. These are: Retained earnings (internal equity) Preferred shares Debt up to $5 Million

© 2004 by Nelson, a division of Thomson Canada Limited 25 Cost of Capital: Case Study Solution  Increment #1: Calculate total financing that can be acquired using 9% debt while retaining the target capital structure with 40% debt. The firm can raise a total of $12.5 Million of new financing (including $5 Million of 9% debt) before it has to begin issuing new debt at 10%.

© 2004 by Nelson, a division of Thomson Canada Limited 26 Cost of Capital: Case Study Solution  The WACC for increment #1 is:

© 2004 by Nelson, a division of Thomson Canada Limited 27 Cost of Capital: Case Study Solution  Increment #2: Calculate total financing that can be acquired using internally generated equity (retained earnings) while retaining the target capital structure with 50% equity. The firm can raise a total of $20 Million of new financing before it needs to issue new common stock.

© 2004 by Nelson, a division of Thomson Canada Limited 28 Cost of Capital: Case Study Solution  The WACC for increment #2 (total new funding between $12.5 Million & $20 Million is:

© 2004 by Nelson, a division of Thomson Canada Limited 29 Cost of Capital: Case Study Solution  Increment #3: Financing in excess of $20 Million will require both high-cost debt and issuing new common stock. The WACC for Increment #3 is:

© 2004 by Nelson, a division of Thomson Canada Limited 30 Cost of Capital: Case Study Solution Funds Raised Incremental WACC $12.5 M$20 M 10.96% 11.20% 11.35%

© 2004 by Nelson, a division of Thomson Canada Limited 31 Small Firms  Have a difficult time attracting capital  Issuance costs are high (> 20% of issue)  Often issue two classes of stock One class sold to outsiders paying a higher dividend Second class held by founders with greater voting power  Limited sources of debt

© 2004 by Nelson, a division of Thomson Canada Limited 32 Major Points  The Weighted Average Cost of Capital (WACC) is a weighted average cost of funding.  Equity is the most expensive form of funding; debt is the cheapest.  Debt has a tax advantage due to the tax- deductibility of interest