# Cost of Capital Minggu 10 Lecture Notes.

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Cost of Capital Minggu 10 Lecture Notes

Learning Objectives Explain the concept and purpose of determining a firm’s cost of capital. Identify the factors that determine a company’s cost of capital. Describe the assumptions made in computing a firm’s weighted average cost of capital. Calculate a corporation’s weighted cost of capital. Explain how PepsiCo calculates its cost of capital. Compute the cost of capital for an individual project when the firm’s weighted cost of capital is not appropriate as the discount rate.

Required Rates on Projects
An important part of capital budgeting is setting the required rate for the individual project Example: Consider the following project +1,100 -1,000 NPV = -1,000 + 1,100 ( ) = \$9.17 If Required Rate = 9%: Accept Project since NPV > 0 Remember: NPV = PV of Cash Inflows - PV of Cash Outflows (or Initial Outlay)

Required Rates on Projects
An important part of capital budgeting is setting the required rate for the individual project Example: Consider the following project -1,000 +1,100 1,100 ( ) If Required Rate = 9%: NPV = -1,000 + = \$9.17 Accept Project since NPV > 0 NPV = -1,000 + 1,100 ( ) = –\$9.01 If Required Rate = 11%: Reject Project since NPV < 0

Required Rates on Projects
An important part of capital budgeting is setting the required rate for the individual project Example: Consider the following project -1,000 +1,100 1,100 ( ) If Required Rate = 9%: NPV = -1,000 + = \$9.17 Accept Project since NPV > 0 1,100 ( ) If Required Rate = 11%: NPV = -1,000 + = –\$9.01 In order to estimate correct required rate, companies must find their own unique cost of raising capital

Factors Determining Cost of Capital
General Economic Conditions Affect interest rates Market Conditions Affect risk premiums When the economy is doing well, most companies do well. This reduces the risk that the company will fail. When the economy is doing poorly, many companies will also do poorly. This increases the risk that a company will fail. Operating and Financing Decisions Affect business risk Affect financial risk Amount of Financing Affect flotation costs and market price of security

Model Assumptions Weighted Cost of Capital Model Constant Business Risk The company is not undertaking any new projects that will substantially change the risk of the company. Constant Financial Risk The financing mix of the company will not substantially change. Constant Dividend Policy Assume that there are no major changes in Dividend policy.

Computing Weighted Cost of Capital
Weighted Cost of Capital Model 1. Compute the cost of each source of capital Ex: cost of debt, cost of equity, cost of preferred stock. 2. Determine the weight of each source of capital in the total company’s financing mix. 3. Calculate Weighted Average Cost of Capital (WACC)

Computing Cost of Each Source
1. Compute Cost of Debt Required rate of return for creditors Same cost found in Chapter 6 as “required rate for debtholders (kd)” P0 = + \$M (1+kd)n where: It = Dollar Interest Payment Po = Market Price of Debt M = Maturity Value of Debt

Computing Cost of Each Source
1. Compute Cost of Debt Example Investors are willing to pay \$985 for a bond that pays \$90 a year for 10 years. Fees for issuing the bonds bring the net price (NP0) down to \$ What is the before tax cost of debt? P0 = + \$M (1+kd)n \$1,000 (1+kd)10 = +

Computing Cost of Each Source
1. Compute Cost of Debt Example Investors are willing to pay \$985 for a bond that pays \$90 a year for 10 years. Fees for issuing the bonds bring the net price (NP0) down to \$ What is the before tax cost of debt? 10.00 N I% PV PMT FV 10 ? \$M (1+kd)n P0 = + \$1,000 (1+kd)10 = +

Computing Cost of Each Source
1. Compute Cost of Debt Example Investors are willing to pay \$985 for a bond that pays \$90 a year for 10 years. Fees for issuing the bonds bring the net price (NP0) down to \$ What is the before tax cost of debt? The before tax cost of debt is 10% 10.00 N I% PV PMT FV 10 ?

Computing Cost of Each Source
1. Compute Cost of Debt Example Investors are willing to pay \$985 for a bond that pays \$90 a year for 10 years. Fees for issuing the bonds bring the net price (NP0) down to \$ What is the before tax cost of debt? The before tax cost of debt is 10% Interest is tax deductible

Computing Cost of Each Source
1. Compute Cost of Debt Example Investors are willing to pay \$985 for a bond that pays \$90 a year for 10 years. Fees for issuing the bonds bring the net price (NP0) down to \$ What is the before tax cost of debt? The before tax cost of debt is 10% Interest is tax deductible Marginal Tax Rate = 40% After tax cost of bonds = kd(1 - T)

Computing Cost of Each Source
1. Compute Cost of Debt Example Investors are willing to pay \$985 for a bond that pays \$90 a year for 10 years. Fees for issuing the bonds bring the net price (NP0) down to \$ What is the before tax cost of debt? The before tax cost of debt is 10% Interest is tax deductible Marginal Tax Rate = 40% After tax cost of bonds = kd(1 - T) = 10.0%(1– 0.40) = 6 %

Computing Cost of Each Source
2. Compute Cost Preferred Stock Cost to raise a dollar of preferred stock. Dividend (D) Market Price (P0) Required rate kps = However, there are floatation costs of issuing preferred stock: Cost of Preferred Stock with floatation costs Dividend (D) Net Price (NP0) kps =

Computing Cost of Each Source
2. Compute Cost Preferred Stock Example Your company can issue preferred stock for a price of \$45, but it only receives \$42 after floatation costs. The preferred stock pays a \$5 dividend. Cost of Preferred Stock \$5.00 \$42.00 = % kps = No adjustment is made for taxes as dividends are not tax deductible.

Computing Cost of Each Source
3. Compute Cost of Common Equity Cost of Internal Common Equity Management should retain earnings only if they earn as much as stockholder’s next best investment opportunity. Cost of Internal Equity = opportunity cost of common stockholders’ funds. Cost of internal equity must equal common stockholders’ required rate of return. Three methods to determine Dividend Growth Model Capital Asset Pricing Model Risk Premium Model

Computing Cost of Each Source
3. Compute Cost of Common Equity Cost of Internal Common Equity Dividend Growth Model Assume constant growth in dividends Cost of internal equity--dividend growth model D1 P0 kcs = + g Example The market price of a share of common stock is \$60. The dividend just paid is \$3, and the expected growth rate is 10%. 3(1+0.10) 60 kcs = + .10 = .155 = 15.5% The main limitation in this method is estimating growth accurately.

Computing Cost of Each Source
3. Compute Cost of Common Equity Cost of Internal Common Equity Capital Asset Pricing Model Estimate the cost of equity from the CAPM kcs = rrf + (rm – rrf) Cost of internal equity--CAPM Example The estimated Beta of a stock is 1.2. The risk-free rate is 5% and the expected market return is 13%. kcs = 5% + 1.2(13% – 5%) = 14.6%

Computing Cost of Each Source
3. Compute Cost of Common Equity Cost of Internal Common Equity Risk Premium Approach Adds a risk premium to the bondholder’s required rate of return. kcs = kd + RPc Cost of internal equity--Risk Premium Where: RPc = Common stock risk premium Example If the risk premium is 5% and kd is 10% kcs = 10% + 5% = 15%

Computing Cost of Each Source
3. Compute Cost of Common Equity Cost of New Common Stock If retained earnings cannot provide all the equity capital that is needed, firms may issue new shares of common stock. Using Dividend Growth Model, must adjust for floatation costs of the new common shares. Cost of new common stock D1 NP0 kcs = + g NP0 = Current stock price - Cost of issuing securities

Computing Cost of Each Source
3. Compute Cost of Common Equity Cost of New Common Stock Cost of new common stock D1 NP0 knc = + g Example Using the above example. Common stock price is currently \$60. If additional shares are issued floatation costs will be 12%. D0 = \$3.00 and estimated growth is 10%. NP0 = \$60.00 – (.12x 60) = \$52.80 Floatation Costs

Computing Cost of Each Source
3. Compute Cost of Common Equity Cost of New Common Stock Cost of new common stock D1 NP0 knc = + g Example Using the above example. Common stock price is currently \$60. If additional shares are issued floatation costs will be 12%. D0 = \$3.00 and estimated growth is 10%. NP0 = \$60.00 – (.12x 60) = \$52.80 3(1+0.10) 52.80 kcs = + .10 = = 16.25%

Capital Structure Weights
Long Term Liabilities and Equity Weights of each source should reflect expected financing mix Assume a stable financial mix–so use Balance Sheet percentages to calculate the weighted average cost of capital. In reality, most companies don’t issue debt, preferred, and equity to finance every project. They usually just issue one. However, most companies DO have a target capital structure and will stagger the issuance of securities so as to maintain that target.

Capital Structure Weights
Long Term Liabilities and Equity Balance Sheet Green Apple Company Assets Liabilities Current Assets \$5,000 Current Liabilities \$2,000 Plant & Equipment 7,000 Bonds 4,000 Total Assets \$12,000 Preferred Stock 1,000 Common Stock 5,000 Total Liabilities and Owners Equity \$12,000 Firm Raises \$10,000 of capital from long term sources

Capital Structure Weights
Long Term Liabilities and Equity Balance Sheet Green Apple Company Assets Liabilities Current Assets \$5,000 Current Liabilities \$2,000 Plant & Equipment 7,000 Bonds 4,000 Total Assets \$12,000 Preferred Stock 1,000 Common Stock 5,000 Total Liabilities and Owners Equity \$12,000 Compute Firm’s Capital Structure (% of each source) Amount of Bonds 4,000 10,000 Bonds: = 40% Total Capital Sources

Balance Sheet Green Apple Company
Capital Structure Weights Long Term Liabilities and Equity Balance Sheet Green Apple Company Assets Liabilities Current Assets \$5,000 Current Liabilities \$2,000 Plant & Equipment 7,000 Bonds 4,000 Total Assets \$12,000 Preferred Stock 1,000 Common Stock 5,000 Total Liabilities and Owners Equity \$12,000 Compute Firm’s Capital Structure (% of each source) Amount of Preferred Stock 1,000 10,000 Preferred Stock: = 10% Total Capital Sources

Balance Sheet Green Apple Company
Capital Structure Weights Long Term Liabilities and Equity Balance Sheet Green Apple Company Assets Liabilities Current Assets \$5,000 Current Liabilities \$2,000 Plant & Equipment 7,000 Bonds 4,000 Total Assets \$12,000 Preferred Stock 1,000 Common Stock 5,000 Total Liabilities and Owners Equity \$12,000 Compute Firm’s Capital Structure (% of each source) Amount of Common Stock 5,000 10,000 Common Stock: = 50% Total Capital Sources

Balance Sheet Green Apple Company
Capital Structure Weights Long Term Liabilities and Equity Balance Sheet Green Apple Company Assets Liabilities Current Assets \$5,000 Current Liabilities \$2,000 Plant & Equipment 7,000 Bonds 4,000 Total Assets \$12,000 Preferred Stock 1,000 Common Stock 5,000 Total Liabilities and Owners Equity \$12,000 40% 10% 50% When money is raised for capital projects, approximately 40% of the money comes from selling bonds, 10% comes from selling preferred stock and 50% comes from retaining earnings or selling common stock

Computing WACC Green Apple Company estimates the following costs for each component in its capital structure: Source of Capital Cost Bonds kd = 10% Preferred Stock kps = 11.9% Common Stock Retained Earnings kcs = 15% New Shares knc = 16.25% Green Apple’s tax rate is 40%

Computing WACC If using retained earnings to finance the common stock portion the capital structure WACC= k0 = %Bonds x Cost of Bonds x (1-T) + %Preferred x Cost of Preferred + %Common x Cost of Common Stock Where: %Bonds = Weight of Debt in company %Preferred = Weight of Preferred in company %Common = Weight of Common Stock in co.

Computing WACC - using Retained Earnings
Balance Sheet Assets Liabilities Current Assets \$5,000 Current Liabilities \$2,000 Plant & Equipment 7,000 Bonds (9%) 4,000 Total Assets \$12,000 Preferred Stock (10%) 1,000 Common Stock(13%) 5,000 Tax Rate = 40% Total Liabilities and Owners Equity \$12,000 40% 10% 50% WACC= k0 = %Bonds x Cost of Bonds x (1-T) + %Preferred x Cost of Preferred + %Common x Cost of Common Stock

Computing WACC - using Retained Earnings
Balance Sheet Assets Liabilities Current Assets \$5,000 Current Liabilities \$2,000 Plant & Equipment 7,000 Bonds (10%) 4,000 Total Assets \$12,000 Preferred Stock (11.9%) 1,000 Common Stock(15%) 5,000 Tax Rate = 40% Total Liabilities and Owners Equity \$12,000 40% 10% 50% WACC= k0 = %Bonds x Cost of Bonds x (1-T) + %Preferred x Cost of Preferred + %Common x Cost of Common Stock WACC = x 10% (1-.4)

Computing WACC - using Retained Earnings
Balance Sheet Assets Liabilities Current Assets \$5,000 Current Liabilities \$2,000 Plant & Equipment 7,000 Bonds (10%) 4,000 Total Assets \$12,000 Preferred Stock (11.9%) 1,000 Common Stock(15%) 5,000 Tax Rate = 40% Total Liabilities and Owners Equity \$12,000 40% 10% 50% WACC= k0 = %Bonds x Cost of Bonds x (1-T) + %Preferred x Cost of Preferred + %Common x Cost of Common Stock WACC = x 10% (1-.4) + .10 x 11.9%

Computing WACC - using Retained Earnings
Balance Sheet Assets Liabilities Current Assets \$5,000 Current Liabilities \$2,000 Plant & Equipment 7,000 Bonds (10%) 4,000 Total Assets \$12,000 Preferred Stock (11.9%) 1,000 Common Stock(15%) 5,000 Tax Rate = 40% Total Liabilities and Owners Equity \$12,000 40% 10% 50% WACC= k0 = %Bonds x Cost of Bonds x (1-T) + %Preferred x Cost of Preferred + %Common x Cost of Common Stock WACC = x 10% (1-.4) + .10 x 11.9% + .50 x 15%

Computing WACC - using Retained Earnings
Balance Sheet Assets Liabilities Current Assets \$5,000 Current Liabilities \$2,000 Plant & Equipment 7,000 Bonds (10%) 4,000 Total Assets \$12,000 Preferred Stock (11.9%) 1,000 Common Stock(15%) 5,000 Tax Rate = 40% Total Liabilities and Owners Equity \$12,000 40% 10% 50% WACC= k0 = %Bonds x Cost of Bonds x (1-T) + %Preferred x Cost of Preferred + %Common x Cost of Common Stock WACC = x 10% (1-.4) + .10 x 11.9% + .50 x 15% = %

Computing WACC If use newly issued common stock, use knc rather than kcs for the cost of the equity portion. WACC= k0 = %Bonds x Cost of Bonds x (1-T) + %Preferred x Cost of Preferred + %Common x Cost of Common Stock knc

Computing WACC-using New Common Shares
Balance Sheet Assets Liabilities Current Assets \$5,000 Current Liabilities \$2,000 Plant & Equipment 7,000 Bonds (10%) 4,000 Total Assets \$12,000 Preferred Stock (11.9%) 1,000 Common Stock(16.25%) 5,000 Tax Rate = 40% Total Liabilities and Owners Equity \$12,000 WACC= k0 = %Bonds x Cost of Bonds x (1-T) + %Preferred x Cost of Preferred + %Common x Cost of Common Stock WACC = x 10% (1-.4) + .10 x 11.9% + .50 x 16.25% = %

Weighted Marginal Cost of Capital
A firm’s cost of capital will changes as it is raising more and more capital Retained earnings will be used up at some level The cost of other sources may rise beyond a certain amount of money raised Calculate the point at which the cost of capital increases Break in cost of capital curve = Retained earnings available for reinvesting Percentage of common financing

Weighted Marginal Cost of Capital
Retained earnings available for reinvesting Percentage of common financing Break in cost of capital curve = If Green Apple Company has \$100,000 of internally generated common: Break in cost of capital curve \$100,000 .50 = = \$200,000 Once \$200,000 is raised from all sources, the cost of capital will rise because all the lower cost retained earnings will be used up.

Weighted Marginal Cost of Capital
Marginal weighted cost of capital curve: 9% 10% 11% 12% 100,000 200,000 300,000 400,000 11.09% Weighted Cost of Capital Cost of Capital using internal common stock Total Financing

Weighted Marginal Cost of Capital
Marginal weighted cost of capital curve: 9% 10% 11% 12% 100,000 200,000 300,000 400,000 11.09% Weighted Cost of Capital Break-Point for common equity Total Financing

Weighted Marginal Cost of Capital
Marginal weighted cost of capital curve: Cost of Capital using new common equity 9% 10% 11% 12% 100,000 200,000 300,000 400,000 11.72% 11.09% Weighted Cost of Capital Cost of Capital using internal common stock Total Financing

Weighted Marginal Cost of Capital
Marginal weighted cost of capital curve: 9% 10% 11% 12% 100,000 200,000 300,000 400,000 11.72% 11.09% Weighted Cost of Capital Total Financing

Making Decisions Choosing Projects Using Weighted Marginal Cost of Capital Graph IRR’s of potential projects Marginal weighted cost of capital curve: 12% 11% Project 1 IRR = 12.4% Project 2 IRR = 12.1% Weighted Cost of Capital 10% Project 3 IRR = 11.5% 9% 100,000 200,000 300,000 400,000 Total Financing

Making Decisions Choosing Projects Using Weighted Marginal Cost of Capital Graph IRR’s of potential projects Graph Weighted Marginal Cost of Capital Weighted Cost of Capital Total Financing 9% 10% 11% 12% 100,000 200,000 300,000 400,000 Marginal weighted cost of capital curve: Project 1 IRR = 12.4% Project 2 IRR = 12.1% Project 3 IRR = 11.5%

Making Decisions Choosing Projects Using Weighted Marginal Cost of Capital Graph IRR’s of potential projects Graph Weighted Marginal Cost of Capital Choose projects whose IRR is above the weighted marginal cost of capital Weighted Cost of Capital Total Financing 9% 10% 11% 12% 100,000 200,000 300,000 400,000 Marginal weighted cost of capital curve: Project 1 IRR = 12.4% Project 2 IRR = 12.1% Project 3 IRR = 11.5% Accept Projects #1 & #2

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