The document provides an overview of the cost of capital concept. It defines the cost of capital as the rate of return a firm must earn on its investments to maintain its stock price. It also discusses how the cost of capital links a firm's investment decisions to shareholder wealth. The document then covers various sources of capital like debt, preferred stock, and common equity. It explains how to calculate the costs of these different sources. It also discusses the weighted average cost of capital and how firms can use WACC to evaluate investment opportunities.
The document provides an overview of the cost of capital concept. It defines the cost of capital as the rate of return a firm must earn on its investments to maintain its stock price. It also discusses how the cost of capital links a firm's investment decisions to shareholder wealth. The document then covers various sources of capital like debt, preferred stock, and common equity. It explains how to calculate the costs of these different sources. It also discusses the weighted average cost of capital and how firms can use WACC to evaluate investment opportunities.
The document provides an overview of the cost of capital concept. It defines the cost of capital as the rate of return a firm must earn on its investments to maintain its stock price. It also discusses how the cost of capital links a firm's investment decisions to shareholder wealth. The document then covers various sources of capital like debt, preferred stock, and common equity. It explains how to calculate the costs of these different sources. It also discusses the weighted average cost of capital and how firms can use WACC to evaluate investment opportunities.
The document provides an overview of the cost of capital concept. It defines the cost of capital as the rate of return a firm must earn on its investments to maintain its stock price. It also discusses how the cost of capital links a firm's investment decisions to shareholder wealth. The document then covers various sources of capital like debt, preferred stock, and common equity. It explains how to calculate the costs of these different sources. It also discusses the weighted average cost of capital and how firms can use WACC to evaluate investment opportunities.
The cost of capital acts as a link between the firms long-term investment decisions and the wealth of the owners as determined by investors in the marketplace. It is the magic number that is used to decide whether a proposed investment will increase or decrease the firms stock price. Formally, the cost of capital is the rate of return that a firm must earn on the projects in which it invests to maintain the market value of its stock.
11-2
The Firms Capital Structure
Some Key Assumptions
Business Riskthe risk to the firm of being
unable to cover operating costsis assumed to be unchanged. This means that the acceptance of a given project does not affect the firms ability to meet operating costs.
Financial Riskthe risk to the firm of being
unable to cover required financial obligationsis assumed to be unchanged. This means that the projects are financed in such a way that the firms ability to meet financing costs is unchanged.
After-tax costs are considered relevantthe cost
of capital is measured on an after-tax basis.
The Basic Concept
Why do we need to determine a companys overall
weighted average cost of capital?
Assume the ABC company has the following investment opportunity:
- Initial Investment = $100,000 - Useful Life = 20 years - IRR = 7% - Least cost source of financing, Debt = 6% Given the above information, a firms financial manger would be inclined to accept and undertake the investment.
The Basic Concept (cont.)
Why do we need to determine a companys overall
weighted average cost of capital?
Imagine now that only one week later, the firm has another available investment opportunity - Initial Investment = $100,000 - Useful Life = 20 years - IRR = 12% - Least cost source of financing, Equity = 14% Given the above information, the firm would reject this second, yet clearly more desirable investment opportunity.
The Basic Concept (cont.)
Why do we need to determine a companys overall
weighted average cost of capital?
As the above simple example clearly illustrates, using
this piecemeal approach to evaluate investment opportunities is clearly not in the best interest of the firms shareholders.
Over the long haul, the firm must undertake
investments that maximize firm value.
This can only be achieved if it undertakes projects that
provide returns in excess of the firms overall weighted average cost of financing (or WACC).
Should we focus on before
before--tax or after--tax capital costs? after 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 aftertax costs. Only cost of debt is affected.
Specific Sources of Capital:
The Cost of LongLong - Term Debt
The pretax cost of debt is equal to the yield-to-maturity on the
firms debt adjusted for flotation costs.
Recall that a bonds yield-to-maturity depends upon a number
of factors including the bonds coupon rate, maturity date, par value, current market conditions, and selling price.
After obtaining the bonds yield, a simple adjustment must be
made to account for the fact that interest is a tax-deductible expense.
This will have the effect of reducing the cost of debt.
Specific Sources of Capital:
The Cost of LongLong -Term Debt (cont.) P9-17 Dillon Labs has asked its financial manager to measure the cost of each specific type of capital as well as the weighted average cost of capital. The weighted average cost of capital to be measured by using the following weights: 40% Long Term Debt, 50% Common Stock Equity (Retained Earnings, New Common Stock or Both). The Firm Tax Rate is 40% Debt: The firm can sell for $980 a 10 year, $1,000 par value bond paying annual interest at a 10% coupon rate. A flotation cost of 3% of the par value is required in addition to the discount of $20 per bond
Specific Sources of Capital:
The Cost of LongLong -Term Debt (cont.)
Before-Tax Cost of Debt
Using Cost Quotations
When the net proceeds from the sale of a bond equal its par value, the before-tax cost equals the coupon interest rate.
A second quotation that is sometimes used is the yield-tomaturity (YTM) on a similar risk bond.
Specific Sources of Capital:
The Cost of LongLong -Term Debt (cont.)
Before-Tax Cost of Debt
Calculating the Cost
This approach finds the before-tax cost of debt by
calculating the internal rate of return (IRR).
As discussed in earlier in the text, YTM can be calculated
using: (a) trial and error, (b) a financial calculator, or (c) a spreadsheet.
Specific Sources of Capital:
The Cost of LongLong -Term Debt (cont.)
Before-Tax Cost of Debt
Approximating the Cost
Specific Sources of Capital:
The Cost of LongLong -Term Debt (cont.)
Find the after-tax cost of debt for Dillon Lab
assuming it has a 40% tax rate: ri = 9.4% (1-.40) = 5.6%
This suggests that the after-tax cost of raising debt
capital for Dillon Lab is 6.50%
Specific Sources of Capital:
The Cost of Preferred Stock
Dillon Lab is contemplating the issuance of a 8% (annual
dividend) preferred stock having a par value $100 that is expected to sell for its $65-per share value. An additional fee of $2 per share must be paid to underwriters rP = DP/Np = $8/$63 12.70%
Specific Sources of Capital:
The Cost of Common Stock
There are two forms of common stock financing: retained
earnings and new issues of common stock.
In addition, there are two different ways to estimate the cost
of common equity: any form of the dividend valuation model, and the capital asset pricing model (CAPM).
The dividend valuation models are based on the premise that
the value of a share of stock is based on the present value of all future dividends.
Why is there a cost for reinvested earnings?
Earnings can be reinvested or paid out as dividends.
Investors could buy other securities, earn a return.
Thus, there is an opportunity cost if earnings are
reinvested.
Opportunity cost: The return stockholders could earn
on alternative investments of equal risk.
They could buy similar stocks and earn ks, or company
could repurchase its own stock and earn ks. So, ks, is the cost of reinvested earnings and it is the cost of equity.
Specific Sources of Capital:
The Cost of Common Stock (cont.) Using the constant growth model, we rS = (D1/P0) + g
We can also estimate the cost of common equity
using the CAPM: rE = rF + b(rM - rF).
Specific Sources of Capital:
The Cost of Common Stock (cont.)
The CAPM differs from dividend valuation models in that it
explicitly considers the firms risk as reflected in beta.
On the other hand, the dividend valuation model does not
explicitly consider risk.
Dividend valuation models use the market price (P0) as a
reflection of the expected risk-return preference of investors in the marketplace.
Specific Sources of Capital:
The Cost of Common Stock (cont.)
Although both are theoretically equivalent, dividend
valuation models are often preferred because the data required are more readily available.
The two methods also differ in that the dividend
valuation models (unlike the CAPM) can easily be adjusted for flotation costs when estimating the cost of new equity.
This will be demonstrated in the examples that follow.
Specific Sources of Capital:
Cost of Retained Earnings (r ( rE)
Constant Dividend Growth Model
rs = D1/P0 + g
The firms common stock is currently selling for $50/ share. The dividend expected to be paid at the end of the coming year (2013) is $4. Its dividend payments, which have been approximately 60% of earnings per share in each of the past 5 years, were as shown in the following table Year
Dividend
2012
$3.75
2011
$3.50
2010
$3.30
2009
$3.15
2008
$2.85
rS = ($4/$50.00) + 7.10%15.10%.
Specific Sources of Capital:
The Cost of Common Stock (cont.)
Cost of Retained Earnings (rE)
Security Market Line Approach
rs = rF + b(rM - rF). For example, if the 3-month T-bill rate is currently 5.0%, the market risk premium is 9%, and the firms beta is 1.20, the firms cost of retained earnings will be: rs = 5.0% + 1.2 (9.0%) = 15.8%.
Specific Sources of Capital:
The Cost of Common Stock (cont.)
Cost of Retained Earnings (rE)
The previous example indicates that our estimate of the cost
of retained earnings is somewhere between 15.5% and 15.8%. At this point, we could either choose one or the other estimate or average the two. Using some managerial judgment and preferring to err on the high side, we will use 15.10% as our final estimate of the cost of retained earnings.
Specific Sources of Capital:
The Cost of Common Stock (cont.)
Cost of New Equity (rn)
Constant Dividend Growth Model
rn = D1/Nn + g Continuing with the previous example, it is expected that to attract buyers new common stock must be underpriced $5 per share, an the firm also paid $3 per share in flotation cost. Dividend payments are expected to continue at 60% of earnings rn = [$4/($45.00 - $3.00)] + 7.10% 16.62
The Weighted Average Cost of Capital
WACC = ra = wiri + wprp + wsrr or n
Capital Structure Weights
The weights in the above equation are intended to represent a
specific financing mix (where wi = % of debt, wp = % of preferred, and ws= % of common). Specifically, these weights are the target percentages of debt and equity that will minimize the firms overall cost of raising funds.
The Weighted Average Cost of Capital
WACC = ra = wiri + wprp + wsrr or n
Capital Structure Weights
One method uses book values from the firms balance sheet. For example, to estimate the weight for debt, simply divide the book value of the firms long-term debt by the book value of its total assets. To estimate the weight for equity, simply divide the total book value of equity by the book value of total assets.
The Weighted Average Cost of Capital
WACC = ra = wiri + wprp + wsrr or n
Capital Structure Weights
A second method uses the market values of the firms debt and equity. To find the market value proportion of debt, simply multiply the price of the firms bonds by the number outstanding. This is equal to the total market value of the firms debt. Next, perform the same computation for the firms equity by multiplying the price per share by the total number of shares outstanding.
The Weighted Average Cost of Capital
WACC = ra = wiri + wprp + wsrr or n
Capital Structure Weights
Using the costs previously calculated along with the market value weights, we may calculate the weighted average cost of capital as follows: WACC = .40(10.77%) + .10(12.70%) + .50(15.10%) 11.35% This assumes the firm has sufficient retained earnings to fund any anticipated investment projects. Or 12.11% if the firm issuing new stock
The Marginal Cost
& Investment Decisions (cont.) WMCC
11.76% 11.75% 11.66% 11.50%
11.25% 11.13%
$2.5
$4.0
Total Financing (millions)
The Marginal Cost
& Investment Decisions (cont.)
Investment Opportunities Schedule (IOS)
Now assume the firm has the following investment
opportunities available: Initial
Cumulative
Ivestment
Investment
Project
IRR
13.0%
1,000,000
1,000,000
12.0%
1,000,000
2,000,000
11.5%
1,000,000
3,000,000
11.0%
1,000,000
4,000,000
10.0%
1,000,000
5,000,000
The Marginal Cost
& Investment Decisions (cont.) 13.0%
12.0%
WACC B
11.66% This indicates that the firm can accept only Projects A & B.
