© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. The Cost of Capital Chapter

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. What sources of capital do firms use? 10-2 Capital Debt Notes Payable (Short- Term Debt) Long-Term Debt Preferred Stock Common Equity Retained Earnings New Common Stock

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. What is the “Cost” of Capital? When we talk about the “cost” of capital, we are talking about the required rate of return on invested funds It is also referred to as a “hurdle” rate because this is the minimum acceptable rate of return Any investment which does not cover the firm’s cost of funds will reduce shareholder wealth (just as if you borrowed money at 10% to make an investment which earned 7% would reduce your wealth)

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Calculating the Weighted Average Cost of Capital WACC = w d r d (1 – T) + w p r p + w c r s Where: WACC= weighted average cost of capital r d = cost of debtr p = cost of preferred stock r s = cost of equity (common stock and retained earnings) w d = weight of debtw p = weight of preferred stockw e = weight of equity T= tax rate The cost of capital is calculated as a weighted average, or composite, of the various types of funds used over time, regardless of the specific financing used in a given year. 10-4

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Other facts about WACC - Should our analysis focus on before-tax or after-tax capital costs? Stockholders focus on A-T CFs. Therefore, we should focus on A-T capital costs, i.e. use A-T costs of capital in WACC. Only r d needs adjustment, because interest is tax deductible. 10-5

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Finding the Weights WACC = w d r d (1 – T) + w p r p + w c r s The weights that we use to calculate the WACC will obviously affect the result

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Component Cost of Debt WACC = w d r d (1 – T) + w p r p + w c r s 10-7 r d is the marginal cost of debt capital. The yield to maturity on outstanding L-T debt is often used as a measure of r d. Why tax-adjust; i.e., why r d (1 – T)?

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. A 15-year, 12% annual coupon bond sells for $1, What is the cost of debt (k d )? Annual coupon Payment: $1000 X 12% = $120 k d = $120/$ = 10.40%. HOWEVER, during problem solving (most of the time), we will use YTM as cost of debt Interest is tax deductible, If the tax rate is 40%, then A-T k d = B-T k d (1-T) = 10.40% ( ) = 6.24%

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Component Cost of Preferred Stock WACC = w d r d (1 – T) + w p r p + w c r s r p is the marginal cost of preferred stock, which is the return investors require on a firm’s preferred stock. Preferred dividends are not tax-deductible, so no tax adjustments necessary. Just use nominal r p. Our calculation ignores possible flotation costs. The cost of preferred stock can be solved by using this formula: r p = D p /P p = $10/$ = 9% 10-9

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Component Cost of Equity WACC = w d r d (1 – T) + w p r p + w c r s r s is the marginal cost of common equity using retained earnings. The rate of return investors require on the firm’s common equity using new equity is r e. 2 - Ways to Determine the Cost of Common Equity, r s 1. CAPM: r s = r RF + (r M – r RF )b 2. Dividend model:r s = (D 1 /P 0 ) + g

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. If the r RF = 7%, RP M = 6%, and the firm’s beta is 1.2, what’s the cost of common equity based upon the CAPM? r s = r RF + (r M – r RF ) β = 7.0% + (6.0%)1.2 = 14.2% If D 0 = $4.19, P 0 = $50, and g = 5%, what’s the cost of common equity based upon the DCF approach? D 1 = D 0 (1+g) D 1 = $4.19 (1 +.05) D 1 = $ r s = D 1 / P 0 + g = $ / $ = 13.8% Range = 13.8%-14.2%, might use midpoint of range, 14%. Component Cost of Equity MethodEstimate CAPM14.2% DCF13.8

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Flotation costs Flotation costs depend on the risk of the firm and the type of capital being raised. The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small. We will frequently ignore flotation costs when calculating the WACC. If new common stock issue incurs a flotation cost of 15% of the proceeds, what is r e ?

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Ignoring flotation costs, what is the firm’s WACC? WACC= w d r d (1 – T) + w p r p + w c r s = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1% 10-13

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. What is the expected future growth rate? The firm has been earning 15% on equity (ROE = 15%) and retaining 35% of its earnings (dividend payout = 65%). This situation is expected to continue. g= ( 1 – Dividend Payout ratio ) (ROE) = Retention ratio * ROE = (0.35) (15%) = 5.25%

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. What factors influence a company’s composite WACC? Market conditions. The firm’s capital structure and dividend policy. The firm’s investment policy. Firms with riskier projects generally have a higher WACC