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# Understanding the Cost of Capital - PowerPoint PPT Presentation

The Cost of Capital is defined as the rate of return that a company must offer on its securities in order to maintain its market value.

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### Understanding the Cost of Capital

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• The Cost of Capital is defined as the rate of return that a company must offer on its securities in order to maintain its market value.

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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:

• Sales X

• Variable Costs 0.3X

• Fixed Costs 158

• EBIT

• Interest 42

• 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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• Sales 1000

• Variable costs 300

• Fixed costs 158

• EBIT 542

• Interest 42

• 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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