Copyright © 2009 Pearson Prentice Hall. All rights reserved. Chapter 10 The Cost of Capital
10-2 Learning Goals 1.Concept of cost of capital 2.Determine the annual percentage cost of individual sources of capital. 3.Calculate the weighted average cost of capital (WACC).
10-3 Learning Goals (cont.) 4.Determine break points and the marginal cost of capital (MCC). 5.Use the marginal cost of capital (MCC) and the investment opportunities schedule (IOS) to make financing and investment decisions.
An Overview of the Cost of Capital The cost of capital is the annual % cost of financing projects in the capital budget. The relevant cost of capital is the annual percentage cost of new, long-term financing on an after-tax basis. 10-4
10-5 Key Considerations The firm’s cost of capital is the required return on investment projects of average risk. If the project under consideration has high or low risk, the cost of capital must be adjusted to determine the risk adjusted discount rate (RADR).
Cost of Capital To calculate the cost of capital, we must: –Calculate the annual percentage cost of financing from each source of capital –Determine the percentage of financing from each source (the “weights”) 10-6
Sources of capital The sources of capital are long-term and permanent financing: –Long-term debt –Preferred stock –Common equity 10-7
10-8 Specific Sources of Capital: The Cost of Common Equity There are two sources of common equity financing: retained earnings and new issues of common stock.
Specific Sources of Capital: The Cost of Retained Earnings The cost of retained earnings is an opportunity cost: the earnings belong to the shareholders. Unless the firm can invest those earnings at a rate of return acceptable to the shareholders, they should be paid out as dividends. The cost of retained earnings is the required return on the firm’s common stock (r s ). 10-9
10-10 WACC = r a = w i r i + w p r p + w s r s or r n The weights in the above equation represent a specific financing mix (where w i = % of debt, w p = % of preferred, and w s = % of common). Specifically, these weights should be the target percentages of debt and equity that will minimize the firm’s overall cost of raising funds. The Weighted Average Cost of Capital Capital Structure Weights
Weighted Average Cost of Capital In some cases, the target weights are not available, and we must use alternatives. The weights can be determined by: –Firm’s policy (target weights) –Market values of firm’s debt and equity –Book values of firm’s debt and equity 10-11
10-12 The Marginal Cost & Investment Decisions The Marginal Cost of Capital (MCC) –The WACC typically increases as the volume of new capital raised within a given period increases. –This is true because companies need to raise the return to investors in order to entice them to invest to compensate them for the increased risk introduced by larger volumes of capital raised. –In addition, the cost will eventually increase when the firm runs out of cheaper retained equity and is forced to raise new, more expensive equity capital.
10-13 Table 10.2 Weighted Average Cost of Capital for Ranges of Total New Financing for Duchess Corporation
10-14 Figure 10.1 MCC Schedule
10-15 Table 10.3 Investment Opportunities Schedule (IOS) for Duchess Corporation
10-16 Figure 10.2 IOS and WMCC Schedules