14-0 Cost of Capital Chapter 14 Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Chapter Outline The Cost of Common Equity The Costs of Debt The Cost of Preferred Stock The Weighted Average Cost of Capital (WACC) Flotation Costs 1

Cost of Common Equity The cost of common equity is the return required by common stock holders. There are two major methods for determining the cost of equity: –1. Dividend growth model –2. CAPM 2

Dividend Growth Model: Estimating the Dividend Growth Rate One method for estimating the growth rate is to use the historical average –YearDividendPercent Change – – – – – Average g = 3

Example: Cost of Equity Assume that a firm’s average past dividend growth rate is 5%. The firm just paid a $3 dividend and its stock is trading at $40 per share. The current T-bill rate is 1%. The firm’s beta is 1.5 and the market risk premium is 7%. What is your best estimate of the cost of equity for the firm? 4

Cost of Debt The cost of debt is the required return on our company’s debt. The required return is best estimated by computing the yield-to-maturity (YTM) on the existing debt. Since interest is a tax deductible expense, we use the after tax cost of debt: R D (1-T) 5

Example: Cost of Debt Assume that a firm has bonds outstanding with 25 years left to maturity that make semi- annual payments. The current price of the bonds is $1,090 and the coupon rate is 6% APR. What is the firm’s cost of debt? 6

Cost of Preferred Stock The cost of preferred stock is the return required by the preferred stock holders. P = D / R P => R P = D / P 7

Example: Cost of Preferred Stock Assume a firm has preferred stock outstanding that pays a $6 dividend and currently trades at $80. What is the firm’s cost of preferred stock? 8

The Weighted Average Cost of Capital WACC=(D/V)R D (1-T) + (E/V)R E +(P/V)R P WACC= w D R D (1-T) + w E R E + w P R P E = market value of common equity = # of outstanding shares times price per share of common stock D = market value of debt = # of outstanding bonds times bond price P = market value of preferred stock = # of outstanding shares times price per share of preferred stock V = market value of the firm = D + E + P w E = E/V = percent financed with common stock w D = D/V = percent financed with debt w P = P/V = percent financed with preferred stock T = tax rate 9

Example 1: Capital Structure Weights Assume that a firm carries debt, common stock and preferred stock. The firm’s debt has a total market value of $4,000,000. The firm’s common stock currently trades at $5 per share and there are 1 million common stock shares outstanding, and the firm’s preferred stock trades at $2 per share and there are 500,000 preferred stock shares outstanding. What are the firm’s capital structure weights? 10

Example 2: Capital Structure Weights Assume that a firm only carries debt and common stock. The firm’s D/E ratio is 0.5. What are the firm’s capital structure weights for debt and equity? 11

Example I: Weighted Average Cost of Capital Assume a company has 1.2 million shares outstanding, the stock sells for $25 per share. The face value of debt is $4 million, but is priced in the market at 98% of face value. The yield to maturity of debt is currently 14%, the T-bill rate is 5% and the market risk premium is 8%. If the beta is 1.3 and the company’s tax rate is 34% what is the WACC? 12

Example II: Weighted Average Cost of Capital Assume a company has bonds outstanding that sell for $950, have a $1,000 face value, have a 6% coupon rate and 18 years left to maturity. The bonds make annual payments. The firm’s stock has a beta of 1.4. The growth rate is 3% and the dividend yield is 5%. The T-bill rate is 4% and the return of the S&P500 index is 10%. If the D/E ratio is 0.6 and company’s tax rate is 34%, what is the WACC? 13

Other Considerations WACC depends on type of project the firm invests in (the use of funds) not on financing decisions (source of funds). The project’s risk class should be consistent with the firm’s risk class. Use the subjective approach to adjust the WACC for risk. Use a pure play approach if a firm is involved in different divisions. 14

Flotation Costs Def: The expenses incurred upon the issue, or float, of new bonds or stocks. Sources: 1. spread 2. direct expenses 3. indirect expenses 4. stock price drop when new stock is issued 5. underpricing 6. green shoe option Weighted average flotation cost = f A = (D/V) f D + (E/V) f E + (P/V) f P cost of project with f = cost of project without f / (1- flotation cost) 15

Flotation Costs Example A firm has 75% equity and 25% debt. The flotation costs of equity are 18%, the flotation costs for debt are 5%. If a project costs $50 million without considering flotation costs, how much money actually has to be raised (actual costs) when flotation costs are considered? 16