1 The Cost of Capital Corporate Finance Dr. A. DeMaskey

2 Learning Objectives Questions to be answered: What is the cost of capital? What are the component costs? What is the target capital structure? How is each of the component costs and weights estimated? How is the weighted average cost of capital used?

3 Basic Concepts Minimum Acceptable Rate of Return Discount Rate (NPV) Hurdle Rate (IRR, MIRR) Marginal Cost of Capital (MCC) Weighted Average Cost of Capital (WACC)

4 Basic Assumptions Equal Risk Target Capital Structure Reflects Average Risk

5 Capital Components What types of long-term capital do firms use? Long-term debt Preferred stock Common equity

6 Component Costs Should we focus on before-tax or after-tax capital costs? Tax effects associated with financing can be incorporated either in capital budgeting cash flows or in cost of capital. Most firms incorporate tax effects in the cost of capital. Therefore, focus on after- tax costs. Only cost of debt is affected.

7 Component Costs Should we focus on historical (embedded) costs or new (marginal) costs? The cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we should focus on marginal costs.

8 Determining the Cost of Capital ¬Determine the proportion of each capital component. ­Determine the marginal cost of each source of capital. ®Calculate the weighted average cost of capital.

9 The Weighted Average Cost of Capital (WACC) WACC= w d k d (1 - T) + w ps k ps + w s k s where: w i = proportion of source of capital used in the capital structure; k i = marginal cost of source of capital; T = corporate tax rate.

10 Determining the Proportion of Each Capital Component Capital structure of the firm. Future capital structure of the firm. Optimal capital structure.

11 Component Cost of Debt Find either YTM or YTC as estimate of k d. Interest is tax deductible, so k d,AT = k d,BT (1 - T). Use nominal rate. Flotation costs are small, so ignore.

12 Component Cost of Preferred Stock Solve for k ps in the following formula: Note: Flotation costs for preferred are significant, so are reflected. Use net price. Preferred dividends are not deductible, so no tax adjustment. Just k ps. Nominal k ps is used.

13 Common Equity Companies can issue new shares of common stock. Companies can reinvest earnings.

14 Component Cost of Equity Three ways to determine the cost of equity, k s : 1.CAPM: k s = k RF + (k M - k RF )b = k RF + (RP M )b. 2.DCF: k s = D 1 /P 0 + g. 3.Bond-Yield-Plus-Risk Premium: k s = k d + RP.

15 Capital Asset Pricing Model Investors are risk averse. Investors hold diversified portfolios. Drawbacks of the CAPM Requires historical returns to determine beta. Assumes beta will be the same in the future as it has been in the past. Requires estimation of a riskfree rate of return.

16 Dividend Valuation Model The greater is the current dividend yield, the greater is the cost of equity. The greater is the growth in dividends, the greater is the cost of equity. Drawbacks of the DVM Assumes constant growth in dividends. Requires dividends in the near future. Requires a market value for a share of stock.

17 Retention Growth Rate Method Suppose the company has been earning 15% on equity (ROE = 15%) and retaining 35% (dividend payout = 65%), and this situation is expected to continue. What is the expected future g? Retention growth rate: g = b(ROE) = 0.35(15%) = 5.25%. Here b = Fraction retained. This is close to g = 5% given earlier.

18 New Common Equity When a company issues new common stock they also have to pay flotation costs to the underwriter. Issuing new common stock may send a negative signal to the capital markets, which may depress stock price. Thus, the cost of internal equity from reinvested earnings is cheaper than the cost of issuing new common stock.

Comments About 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.

Factors That Affect a Firm’s WACC Market conditions Level of interest rates Market risk premium Tax rates The firm’s capital structure and dividend policy. The firm’s investment policy. Firms with riskier projects generally have a higher WACC.