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Understanding the Cost of CapitalPowerPoint Presentation

Understanding the Cost of Capital

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Understanding the Cost of Capital

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Understanding the Cost of Capital

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- Financial managers must know the cost of capital in order to
- Make capital budgeting decisions,
- Help establish the optimal capital structure and
- Make decisions concerning leasing, bond refunding and working capital management.

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- The cost of capital is computed as a weighted average of the various capital components, items on the right hand side of the balance sheet such as debt, preferred stock, common stock and retained earnings.

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- Each element of capital has a component cost that is identified by the following:
- ki = before tax cost of debt
- kd = ki (1-t) = after tax cost of debt, where t = tax rate
- kp = cost of preferred stock

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- ks = cost of retained earnings (or internal equity)
- ke = cost of external equity, or cost of issuing new common stock
- ko = company’s overall cost of capital , or a weighted average cost of capital
- The after tax weighted average cost of capital (WACC) is given by the following formula:
- WACC = ka = ke = (S/V) + kd (1-t) (D/V)

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- Suppose this firm faces a corporate tax rate of 40%, has variable expenses equal to 30% of sales, and has fixed costs of $158.
- Working back from these requirements we can forecast the level of sales the firm must earn in order to achieve these operating results…thereby setting a sales performance target for management.

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- Working backwards, we get:
- SalesX
- Variable Costs0.3X
- Fixed Costs158
- EBIT
- Interest42
- Taxes (40%)
- Net Income:300

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- If sales = X, then VC = .3X and X - .3X – 158 = EBIT
- (EBIT – I)(1-T) = NI so (EBIT – 42)(1-.4) = 300 => EBIT = 542 which => X = 1000, and so VC = 300 and also Taxes = (542-42)(.4) = 200, so:

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- Sales1000
- Variable costs300
- Fixed costs158
- EBIT542
- Interest42
- Taxes (40%)200
- Net Income:300

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- This working backwards process is the approach taken by regulators to set pricing for rate of return regulated industries, like utilities. So cost of capital drives utility rate increases!
- Assuming earnings are a perpetuity, we have

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- P = EPS/Ke = ROE* BVPS/Ke
- Firm ABC has:
- Debt D of 8% annual coupon bonds with 10 years to maturity and book value of $1 m.
- Preferred shares P with 10% annual dividend and book value of $1 m.
- 100,000 Common shares originally issued at $15/share for a value of $1.5 m.
- Retained earnings of $0.5
- Total of $4 m.

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- Market values:
- The present market rate of similar risk 10 year bonds is 6% so the market value of the bonds is given by 80,000PVIFA(10 years, 6%) = [80000/.06](1-1/1.06^10) + 1,000,000/1.06^10 = $1,147,202.

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- Similar risk preferred shares are providing yields of 8%, so the market value of the preferred shares is 100,000/.08 = $1,250,000.
- The market value of the common shares is currently $25/share, so the total market value of the shares is $2,500,000.

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- The market value of the firm’s balance sheet V = D + P + SE = $1,147,202 + $1,250,000 + $2,500,000 = $4,897,202 and D/V = .234, P/V = .255 and SE/V = .511.

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