3 Chapter Outline: The Purpose of the Cost of Capital Capital Components Calculating Component Costs of CapitalCalculating the WACCFactors that affect the cost of capitalProblem areas in cost of capital
4 The Purpose of the Cost of Capital: The cost of capital—the average rate paid for the use of capital.Primarily used in capital budgetingUsed as the ‘hurdle rate,’ or benchmark for projectsCompare IRR to this rateDiscount cash flows at this rate to find NPVIf a project cannot earn above this return, it is not worthwhile
5 The Purpose of the Cost of Capital: It is important to estimate the cost of capital as accurately as possible in order to effectively manage the firmFirm’s cost of capital can be viewed as its required rate of return on projects of average risk
6 Required Rate of Return (Opportunity Cost Rate): The return that must be raised on invested funds to cover the cost of financing such investments
7 Capital Components: Components of firm’s capital are: Debt: Borrowed money, either loans or bondsCommon equity:From sale of common shares or from retained earningsPreferred shares:Cross between debt and common equity
8 Capital Components:Capital structure is mix of three capital componentsTarget Capital StructureMix of capital components that management considers optimal and strives to maintain
9 Basic Definitions: Capital Component: Types of capital used by firms to raise moneykd = before tax interest costkdT = kd(1-T) = after tax cost of debtkps = cost of preferred stockke = cost of retained earningsks = cost of issuing new stocks
10 Basic Definitions: WACC: Weighted Average Cost of Capital Capital Structure: A combination of different types of capital(debt and equity) used by a firm
11 After-Tax Cost of Debt: The relevant cost of new debtTaking into account the tax deductibility of interestUsed to calculate the WACC kdT = bondholders’ required rate of return minus tax savings kdT = kd(1-T).
12 Cost of Debt: Interest is tax deductible, so kdT = kd (1-T) = 10% ( ) = 6%Use nominal rate.Flotation costs are small, so ignore them.
13 Cost of Preferred Stock: Rate of return investors require on the firm’s preferred stockThe preferred dividend divided by the net issuing price
14 Cost of Preferred Stock: The cost of preferred stock can be solved by using this formula:kp = Dp / Pp= $10 / $111.10= 9%
15 Cost of Retained Earnings: Rate of return investors require on the firm’s common stock
16 Why there is a cost for retained earnings? Earnings can be reinvested or paid out as dividends.Investors could buy other securities, earn a return.If earnings are retained, there is an opportunity cost (the return that stockholders could earn on alternative investments of equal risk).Investors could buy similar stocks and earn ks.Firm could repurchase its own stock and earn ks.Therefore, ks is the cost of retained earnings.
17 Three ways to determine the cost of common equity: The CAPM Approach.The Discounted Cash Flow Approach.The Bond-Yield-Plus-Premium Approach.
18 ( ) b k - + = The CAPM Approach: ks = kRF + (kM – kRF) β = 7.0% + (6.0%)1.2 = 14.2%
19 The Discounted Cash Flow Approach: Price and expected rate of return on a share of common stock depend on the dividends expected on the stock.
24 Cost of Newly Issued Common Stock: External equity, keBased on the cost of retained earningsAdjusted for flotation costs (the expenses of selling new issues)
25 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.
26 The Weighted Average Cost of Capital—The WACC: A firm’s WACC is the average of the costs of the separate sources weighted by the proportion of each source usedTo compute a WACC, we need two things: the mix of the capital components in use and the cost of each component
27 Weighted Average Cost of Capital, WACC: A weighted average of the component costs of debt, preferred stock, and common equity
28 Example 15.1: Computing the WACC: Q: Calculate the WACC given the following capital structure.A: First calculate the capital structure weights. For debt this weight is $60,000 $200,000 = 30%. Next, multiply each component’s cost by its weight.$200,0001090,000Common shares450,000Preferred shares6%$60,000DebtCostValueCapital ComponentWACC =100%45%25%30%Weight7.3%4.5%1.0%1.8%
29 Factors influence a company’s composite WACC: The Level of Interest Rates.Tax Rate.The firm’s capital structure policy.Dividend policy.The firm’s investment policy.
30 Problem areas in cost of capital: Depreciation-generated fundsPrivately owned firmsMeasurement problemsAdjusting costs of capital for different riskCapital structure weights