1. Cost of Capital
Chapter 13

2. Cost of Capital Defined
Cost of capital: percentage cost of permanent funds employed in business, or firm’s capital structure
Capital structure: mix of long-term debt and equity by firm for its permanent financing needs

3. Cost of Capital Defined
Sample Restructured Balance Sheet
(“mix” of company’s permanent financing)
Firm only has two categories of assets: net working capital and fixed assets
Net working capital is current assets minus current liabilities.
“Restructured” right-hand side represents firm’s capital structure such that there are two categories of financing for two categories of assets.
Net working
Capital
Long-term
debt
Fixed Assets
Equity

4. Cost of Capital Defined
Two costs of capital
Average cost of capital (ACC): weighted average after-tax cost of new capital raised during given year
Analysis of current financial decisions requires focus on current costs
Marginal cost of capital (MCC): represents incremental ACC as function of total dollar amount of capital raised
As increasing amounts of capital are raised, cost of capital begins to increase
Increased cost occurs at increments such that MC of additional dollar of capital is greater than AC of capital
AC increases more slowly than MC

5. Cost of Capital Defined
Consider an analogy of average and marginal tax rates. Example:
Corporate tax rate
15% on first $50,000 of income
25% on next $25,000
35% on all income above $75,000
If corporation earned $50,000 before taxes, both average and marginal tax rates are 15%.
At $60,000, average tax rate is 16.7% and marginal tax rate is 25%.
Above $75,000, marginal tax rate is 35%.

6. Cost of Capital Defined
Same general pattern holds for corporate cost of capital as in example.
As more capital is raised, cost increases at margin, increasing marginal cost in increments.
Average cost increases at slower rate and eventually approached marginal cost.
See exhibit 13.2

7. Marginal Cost and Capital Budgeting
MCC is the capital cost that should be used for making capital budgeting decisions.
Firm is inclined to make capital budgeting decisions based on comparison of cost of each additional dollar of capital raised with expected rate of return on each additional dollar of capital invested.
Firm should accept all investment projects where IRR ≥ MCC in order to maximize value of firm.
See exhibit 13.3

8. Calculating the Average Cost of Capital
Calculate after-tax cost of individual capital components.
Calculate average of component costs, weighted by percentage that each comprises of total capital structure.
Calculate cost of debt and preferred stock
Estimate cost of equity

9. Cost of Debt
Before-tax cost of debt: interest paid divided by principal amount borrowed
Convert to after-tax basis by multiplying before-tax cost by 1 minus firm’s effective tax rate
1 minus tax rate represents percentage of interest that is paid by firm after taking into account tax deductibility of interest payments
Tax rate multiplied by dollars of interest paid represents amount of interest that is “paid” through tax savings.

10. Cost of Debt Effective after-tax cost of debt Kd = I/P (1 – T)
where Kd = after-tax cost of debt
I = interest in dollars
P = principal amount borrowed
T = effective tax rate

11. Cost of Debt Kd = [(I/P(1-F)] (1-T)
If firm raises debt capital by selling bonds publicly, then it will incur some sales costs.
Flotation costs: cost of taking the issue public and include expenses such as legal research, underwriting expenses, salesperson’s commissions
Flotation costs (fixed costs) as a percentage of size of issue become larger as issue size becomes smaller.
Adjust after-tax cost of debt calculation to account for flotation costs. Let F equal flotation costs as percentage of face value of bond issue:
Kd = [(I/P(1-F)] (1-T)
Principal amount on which interest is calculated is reduced by amount of flotation costs

12. Cost of Debt Cost of Preferred Stock
Since preferred stock is an equity security, dividends represent profit distributions to owners of corporation and are not tax deductible to corporation.
Before-tax cost of preferred stick is the same as after-tax cost:
Kp = D/P
where Kp = cost of preferred stock
D = dividend in dollars
P = price of preferred stock

13. Cost of Debt Cost of Preferred Stock
Adjust for flotation costs for newly issued preferred stock that is publicly marketed:
Kp = D/[P(1-F)]

14. Cost of Debt Cost of Common Equity
Cost of common stock must be estimated
Common equity: rate of return stockholders require on equity capital
Rate of return on equity that firm must earn in order to maintain value of its own common stock
Expected rate of return necessary to induce investors to invest in firm’s common stock

15. Cost of Debt Cost of Common Equity
Two components of stockholders’ expected rate of return:
(Ke represents cost of equity)
Ke = Expected dividend yield + Expected capital gain

16. Cost of Debt Cost of Common Equity
Use company’s dividend divided by its price as dividend yield and expected growth rate of earnings and dividends as measure of expected capital gain:
Ke = (D/P) + g
where Ke = cost of equity
D = dividend in dollars
P = price of stock
g = expected growth rate
Adequate to measure cost of equity capital generated by reinvested earnings.
Measurement is cost of retained earnings portions of equity capital

17. Cost of Debt Cost of Common Equity
Adjust for flotation costs to measure cost of equity capital generated through new issues of common stock:
Ke = [D/(P(1-F)] + g

18. Cost of Debt A Computational Example
Calculate average cost of capital for firm having capital structure consisting of
40% debt
10% preferred stock
50% equity
Debt bears interest at 8%
Preferred stock sells for $100 (its par value) and pays dividend of $8
Common stock sells for $55 and pays dividend of $2.20
Expected growth rate of earnings and dividends is 9%
Firm’s effective tax rate is 34%
No flotation costs will be incurred
Newly issued debt and preferred stock will be privately placed
Required equity capital will be generated through reinvested earnings

19. Cost of Debt A Computational Example See exhibit 13.4
Cost of debt is 5.3% after tax
Cost of preferred stock is 8%
Cost of common equity is 13% (4% dividend yield plus 9% growth rate)
Weighted average cost of capital is 9.42% (calculated by multiplying each component cost by percentage of capital structure it comprises and summing results)

20. The Capital Asset Pricing Model
Capital asset pricing model (CAPM): stockholders’ required rate of return on equity capital is function of risk-free rate of return, rate of return earned on stocks in general (“market return”), and riskiness of particular stock in which investor may be considering investing
Ke = Risk-free rate + Risk premium
Risk premium is determined by riskiness of particular stock relative to market and by difference between market rate of return and risk-free rate.

21. The Capital Asset Pricing Model
Riskiness of individual stock is measured by stock’s beta factor: measure of volatility of stock relative to market
Beta of 1.0: stock has same volatility as market
Beta of 0.5: stock is about half as volatile as market
Beta of 2.0: stock is approximately twice as volatile as market
Stock’s beta is estimated by regressing stock’s price against level of some broad market index
Ex. Standard and Poor’s Index of 500 Common Stocks (S&P 500)
Beta factor is slope of regression line and measure of company’s systematic risk

22. The Capital Asset Pricing Model
CAPM in equation form:
Ke = Rf + (Rm – Rf)B
where Ke = cost of equity capital
Rf = risk-free rate of return
Rm = market rate of return
B = beta

23. Capital Structure Management
From perspective of capital markets, cost of equity capital must be greater than cost of debt.
Investors are averse to risk.
Investors must demand a higher rate of return on equity than on debt because investing in equity is riskier than investing in debt.
Capital structure management focuses on finding appropriate combination of debt and equity such that combined weighted average cost of capital is minimized.

24. Capital Structure Management
See exhibit 13.5
Ke and Kd are constant over a broad range, but at some point begin to increase as leverage gets higher.
Risk causes increase. As firm becomes increasingly debt heavy, increased risk of insolvency drives up both Kd (return to creditors) and Ke (return to stockholders).
If firm is 100% equity financed (leverage = 0), its ACC is at maximum.
If firm employs some debt financing, relatively expensive equity is combined with relatively inexpensive debt. This reduces weighted ACC.

25. Capital Structure Management
In theory, operate on minimum point of ACC curve.
In practice, ACC tends to be flat over fairly broad range so optimal-capital-structure theory is useful as broad policy guideline.
Effective capital structure management requires capital structure mix that is within “range of optimality.”

26. Capital Structure Management
Location of range of optimality varies with riskiness of particular industry.
In general, the higher the business risk in industry, the less leverage firm may employ before cost curves turn up.
Riskier firms will have higher cost curves to begin with.