Cost of Capital Chapter 10

Cost of Capital No company can function without funds. To start functioning at a basic level a company needs funds. Now a question arises that where do these funds come form?

Cost of Capital The cost of capital is the cost of using the funds of creditors and owners. Creating value requires investing in capital projects that provide a return greater than the project’s cost of capital. When we view the firm as a whole, the firm creates value when it provides a return greater than its cost of capital. The cost of capital is the rate of return that the suppliers of capital—bondholders and owners—require as compensation for their contributions of capital. The cost of capital is a marginal cost: the cost of raising additional capital. The weighted average cost of capital (WACC) is the cost of raising additional capital, with the weights representing the proportion of each source of financing that is used. Also known as the marginal cost of capital (MCC).

Sources of Capital The funds needed by an organization comes from a number of sources: Sources of Capital External Sources Debt New Common Stock Internal Sources Retained Earnings

We can say the cost of capital in actuality is the cost of raising capital for the company. Now, Can the cost of capital for the business can be considered a return for the provider for the capital? Yes. Cost of Capital is cost from fund user’s perspective whereas from fund provider’s perspective it is a return.

Explained through illustration.

Cost of raising debt capital is ‘i’ What is the cost for raising debt and equity capital? Sources of Capital External Sources Debt Cost of raising debt capital is ‘i’ New Common Stock Cost of raising new common stock is ‘dividend yield + capital gains yield’ Internal Sources Retained Earnings Cost of raising funds through retained earnings is the ‘opportunity cost’ of retaining these earnings (shareholder’s required return)

Investment Opportunity WACC Now we have an idea as to what is the cost of capital, it is the cost of raising money/capital for the business. A firm can raise funds from different sources. Now after funds are raised suppose the firm looks now to make an investment where the expected rate of return is 12%. So how would my organization decide to make this investment or not? 10% Debt Organization ($500 million) Investment Opportunity 15% 12% Equity 13% Preferred Stock

WACC (continued) Since the organization has raised funds from different sources it needs to introduce a measure that takes into account all these different types of costs. This single rate must accumulate the cost of raising capital from different sources. This single rate is called the WACC.

WACC WACC = wdrd (1  t) + wprp + wsrs (3-1)   where wd is the proportion of debt that the company uses when it raises new funds rd is the before-tax marginal cost of debt t is the company’s marginal tax rate wp is the proportion of preferred stock the company uses when it raises new funds rp is the marginal cost of preferred stock ws is the proportion of equity that the company uses when it raises new funds rs is the marginal cost of equity

WACC (continued) Formula: WACC = wdrd (1-T) + wprp + wsrs Question: Suppose my organization has raised $100 million out of which $30 million has been raised through debt, $10 million through preferred stock and $60 million through equity. The cost of raising debt capital is 10%, cost of raising capital by issuing shares of preferred stock is 13% and the cost of raising capital by issuing shares of common stock is 15%. Calculate WACC. (Take rd = 15% for this question)

Example: WACC Suppose the Widget Company has a capital structure composed of the following, in billions: If the before-tax cost of debt is 9%, the required rate of return on equity is 15%, and the marginal tax rate is 30%, what is Widget’s weighted average cost of capital? Solution: WACC = [(0.20)(0.09)(1 – 0.30)] + [(0.8)(0.15)] = 0.0126 + 0.120 = 0.1325, or 13.25% Debt €10 Common equity €40 Calculate and interpret the weighted average cost of capital (WACC) of a company. Example: WACC Calculations Weight of debt = €10  (€10 + €40) = 0.20 or 20% Weight of common equity = €40  (€10 + €40) = 0.80 or 80%

Example: WACC Interpretation: When the Widget Company raises €1 more of capital, it will raise this capital in the proportions of 20% debt and 80% equity, and its cost will be 13.25%. Calculate and interpret the weighted average cost of capital (WACC) of a company. Example: WACC

Taxes and the Cost of capital Interest on debt is tax deductible; therefore, the cost of debt must be adjusted to reflect this deductibility. We multiply the before-tax cost of debt (rd) by the factor (1 – t), with t as the marginal tax rate. Thus, rd × (1  t) is the after-tax cost of debt. Payments to owners are not tax deductible, so the required rate of return on equity (whether preferred or common) is the cost of capital.

1. (After-tax) Cost of Debt Formula rd = rd (1-T) Borrowing saves taxes. Net cost of debt is actually the interest paid less the tax savings resulting from tax deductible interest payment. After-Tax Cost of Debt - Debt has a cost advantage because interest payments are a tax deductible expense while dividends are not. For instance, if a corporation's debt has an annual interest rate of 10% and the corporation's combined federal and state income tax rate is 30%, the after-tax cost of debt is 7%. The computation is: [10% interest rate X (100% minus 30% tax rate)] = [10% X 70%] = 7%.

1. Cost of Debt (continued) Example Here is the example in dollars. If the corporation has a loan of $100,000 with an annual interest rate of 10%, the interest paid to the lender will be $10,000 per year. This interest expense will reduce the corporation's taxable income by $10,000 thereby saving the corporation $3,000 in income taxes (30% tax rate on $10,000 reduction in taxable income). The after-tax cost of the debt is computed as follows: $10,000 paid to the lender minus $3,000 of income tax savings equals a net cost of $7,000 per year on the $100,000 loan. This means the after-tax cost is 7% ($7,000 divided by $100,000).

2. Cost of Equity New common equity is raised in two ways: Formula By retaining some of the current year’s earnings Formula rS = D1 + g Po By issuing new common stock Flotation cost: The cost of issuing new common stock. If there is flotation cost the issuing firm receives only a portion of the capital provided by the investors, with the remainder going to the underwriter. Formula re = D1 + g Po (1-F)

3. Cost of Preferred Stock rp = Dp and rp = Dp Pp Pp (1-F) In the above formula Dp stands for fixed dividend payment. Pp stands for the price of preferred stock.

Formulas We made a chart of all the formulas (to be used in solving numericals of this chapter) in the class, please make use of that chart.