1. Ch 9. The Cost of Capital

2. Goals: To understand cost of capitals or hurdle rate To understand how to estimate cost components To understand how to estimate risk-adjust cost of capitals

3. 1. Cost of Capitals: Required rate of return to maintain company’s optimal capital structure Hurdle rate to screen the projects Decided by the Capital component (types of capital used by firms to raise money)

4. Ex) 2. Cost of Debts Costs of new debt

5. After tax component cost of debt Due to tax shield After tax cost of debts with flotation costs Seasonal debt financing for working capital needs fluctuates during the year. It is not considered as a permanent financing source for US corporations.

6. 3. Cost of preferred stock The rate of return investors require on the firm ‘s preferred stock. K p =D p /P p After flotation costs K p =D p /P p (1-F)

7. 4. Cost of Retained Earnings (Common Equities) The rate of return required by stockholders on a firm’s common stock. New common equity is raised by two ways: retained earnings (internal equity) and issuing new common stocks. (1) CAPM K s =K RF +(K M -K RF )B i Consider systematic risk directly Difficult to obtain correct estimates of input Difficult to adjust for flotation costs for newly issued common stock.

8. (2) Bond Yield plus Risk Premium Approach Ks=Bond Yield + Risk Premium (Here, Risk premium is ranged from 3 to 5 %) (3) Discounted Cash Flow (DCF) Approach. As shown in Ch.9, in equilibrium, expected return should be the same as required rate of return. K S =D 1 /P 0 +g

9. Costs after flotation costs

10. g (growth rate)= (retention rate)*ROE = (1-payout rate)*ROE Retained Earnings Breakpoint = Addition to retained earnings/Equity Fraction 5. Weighted average of cost of capital (WACC) Target (optimal) capital structure: The percentages of debt, preferred stock and common equity that will maximize the firm’ s stock price

11. Assuming that firms will raise capital in a manner designed to keep the actual target capital structure. WACC=W d k d (1-t)+W p k p +W c K s A weighted average of the component costs of debt, preferred stock and common equity Weights should be based on the market values. WACC represents Marginal cost of capital (MCC) which is the cost of obtaining another dollar of new capital

12. 6. Factors that affect the composite cost of capital 1) Factors the firm can’t control Level of interest rates – increase cost of debt, preferred and common equities. Tax rates 2) Factors the firm can control Capital structure policy Dividend policy – retained earnings Investment policy – assumption that new capital will be invested in assets of the same type and with the same degree of risk as is embedded in the existing assets

13. 7. Adjusting the cost of capital for risk What happen if the risk of project differs from the company’s risk? Do we have to use WACC as a hurdle rate? The hurdle rate for a project should reflect the risk of project itself not the risks (WACC) associated with the firm’s