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2 Learning Outcomes Chapter 11 Compute the component cost of capital for (a) debt, (b) preferred stock, (c) retained earnings, and (d) new common equity. Describe the weighted average cost of capital (WACC) and discuss the logic of using WACC to make informed financial decisions. Describe how the marginal cost of capital (MCC) is used to make capital budgeting decisions. Discuss the relationship between the firm’s weighted average cost of capital (WACC) and investor’s’ required rates of return.

3 Cost of Capital Firm’s average cost of funds, which is the average return required by firm’s investors What must be paid to attract funds

4 Required Rate of Return (Opportunity Cost Rate) The return that must be raised on invested funds to cover the cost of financing such investments

5 Basic Definitions Capital Component Types of capital used by firms to raise money r d = before tax interest cost r dT = r d (1-T) = after tax cost of debt r ps = cost of preferred stock r s = cost of retained earnings r e = cost of external equity (new stock)

6 WACC Weighted Average Cost of Capital Capital Structure A combination of different types of capital(debt and equity) used by a firm Basic Definitions

After-Tax Cost of Debt The relevant cost of new debt Taking into account the tax deductibility of interest Used to calculate the WACC 7

8 Cost of Preferred Stock Rate of return investors require on the firm’s preferred stock The preferred dividend divided by the net issuing price F = percentage flotation costs as a decimal NP 0 = per share net proceeds firm receives from the issue

9 Cost of Retained Earnings Rate of return investors require on the firm’s common stock r s = required rate of returnRP s = risk premium for Stock S = expected rate of returng= constant growth rate r RF = risk-free rate of returnP 0 = current stock price = next period’s expected dividend

10 The CAPM Approach r s = cost of retained earnings r RF = risk-free rate of return r M = risk-free rate of return RP s = risk premium for Stock S β s = beta coefficient for Stock S

11 The Discounted Cash Flow Approach (Expected Rate of Return) Price and expected rate of return on a share of common stock depends on the dividends expected on the stock. r s = cost of retained earningsP 0 = current stock price = expected rate of returng= constant growth rate = next period’s expected dividend

12 The Bond-Yield-Plus-Premium Approach Estimating a risk premium above the bond interest rate Judgmental estimate for premium “Ballpark” figure only

Cost of Newly Issued Common Stock External equity, r e Based on the cost of retained earnings Adjusted for flotation costs (the expenses of selling new issues) 13 r e = cost of new equity g= constant growth rate = next period’s expected dividend F= percentage flotation cost stated as a decimal P 0 = current stock price

14 Target Capital Structure Optimal Capital Structure Percentage of debt, preferred stock, and common equity in the capital structure that will maximize the price of the firm’s stock

15 Weighted Average Cost of Capital, WACC A weighted average of the component costs of debt, preferred stock, and common equity w d = proportion of debt in firm’s capital structure w ps = proportion of preferred stock in firm’s capital structure w s = proportion of common stock in firm’s capital structure

Taxes and the WACC We are concerned with after-tax cash flows, so the effect of taxes on the various costs of capital has to be considered Interest expense reduces tax liability Reduction in taxes reduces cost of debt After-tax cost of debt = R D (1-T C ) Dividends are not tax deductible, so there is no tax impact on the cost of equity 16

Taxes and the Value of the Firm The value of the firm increases by the present value of the annual interest tax shield Value of a levered firm = value of an unlevered firm + PV of interest tax shield Value of equity = Value of the firm – Value of debt R U - unlevered cost of capital; D –face value of debt V U = EBIT(1-T) / R U V L = V U + DT C 17

Taxes and the Value of the Firm-Use of Leverage EBIT = $25 million; Tax rate = 35%; Debt = $75 million; Cost of debt = 9%; Unlevered cost of capital = 12% The WACC decreases as D/E increases because of the government subsidy on interest payments WACC ↓ Value ↑ 18

WACC (1) Equity Information 50 million shares $80 per share Beta = 1.15 Market risk premium = 9% Risk-free rate = 5% Debt Information $1 billion in outstanding debt (face value) Current quote = 110 Coupon rate = 9%, semiannual coupons 15 years to maturity Tax rate = 40% 19

WACC (2) 1. What is the cost of equity? 2. What is the cost of debt? 3. What is the after-tax cost of debt? 20

WACC (3) What are the capital structure weights? What is the WACC? 21

22 The Logic of the Weighted Average Cost of Capital The use of debt impacts the ability to use equity, and vice versa, so the weighted average cost must be used to evaluate projects, regardless of the specific financing used to fund a particular project.

23 Marginal Cost of Capital Marginal Cost of Capital Schedule A graph that relates the firm’s weighted average of each dollar of capital to the total amount of new capital raised Reflects changing costs, depending on amounts of capital raised

24 MCC Schedule for Unilate Textiles

Break Point (BP) The dollar value of new capital that can be raised before an increase in the firm’s weighted average cost of capital occurs 25

26 MCC Schedule Using Retained Earnings, New Common Stock and Higher-Cost Debt

27 Combining the MCC and Investment Opportunity Schedules Use the MCC schedule to find the cost of capital for determining projects’ net present values. Investment Opportunity Schedule (IOS) Graph of the firm’s investment opportunities ranked in order of the projects’ internal rate of return

28 Combining the MCC and Investment Opportunity Schedules