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The Cost of Capital

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The Cost of Capital

Corporate Finance

Dr. A. DeMaskey

- Questions to be answered:
- What is the cost of capital?
- What are the component costs?
- What is the target capital structure?
- How is each of the component costs and weights estimated?
- How is the weighted average cost of capital used?

- Minimum Acceptable Rate of Return
- Discount Rate (NPV)
- Hurdle Rate (IRR, MIRR)
- Marginal Cost of Capital (MCC)
- Weighted Average Cost of Capital (WACC)

- Equal Risk
- Target Capital Structure
- Reflects Average Risk

- What types of long-term capital do firms use?
- Long-term debt
- Preferred stock
- Common equity

- Should we focus on before-tax or after-tax capital costs?
- 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 after-tax costs.
- Only cost of debt is affected.

- Should we focus on historical (embedded) costs or new (marginal) costs?
- The cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we should focus on marginal costs.

- Determine the proportion of each capital component.
- Determine the marginal cost of each source of capital.
- Calculate the weighted average cost of capital.

WACC= wdkd(1 - T) + wpskps + wsks

where: wi = proportion of source of capital used in the

capital structure; ki = marginal cost of source of capital;

T = corporate tax rate.

- Capital structure of the firm.
- Future capital structure of the firm.
- Optimal capital structure.

- Find either YTM or YTC as estimate of kd.
- Interest is tax deductible, so
kd,AT= kd,BT(1 - T).

- Use nominal rate.
- Flotation costs are small, so ignore.

- Solve for kps in the following formula:
- Note:
- Flotation costs for preferred are significant, so are reflected. Use net price.
- Preferred dividends are not deductible, so no tax adjustment. Just kps.
- Nominal kps is used.

- Companies can issue new shares of common stock.
- Companies can reinvest earnings.

Three ways to determine the cost of equity, ks:

1.CAPM: ks= kRF + (kM - kRF)b

= kRF + (RPM)b.

2.DCF: ks = D1/P0 + g.

3.Bond-Yield-Plus-Risk Premium:

ks = kd + RP.

- Investors are risk averse.
- Investors hold diversified portfolios.
- Drawbacks of the CAPM
- Requires historical returns to determine beta.
- Assumes beta will be the same in the future as it has been in the past.
- Requires estimation of a riskfree rate of return.

- The greater is the current dividend yield, the greater is the cost of equity.
- The greater is the growth in dividends, the greater is the cost of equity.
- Drawbacks of the DVM
- Assumes constant growth in dividends.
- Requires dividends in the near future.
- Requires a market value for a share of stock.

- Suppose the company has been earning 15% on equity (ROE = 15%) and retaining 35% (dividend payout = 65%), and this situation is expected to continue.
- What is the expected future g?
- Retention growth rate:g = b(ROE) = 0.35(15%) = 5.25%.Here b = Fraction retained.
- This is close to g = 5% given earlier.

- When a company issues new common stock they also have to pay flotation costs to the underwriter.
- Issuing new common stock may send a negative signal to the capital markets, which may depress stock price.
- Thus, the cost of internal equity from reinvested earnings is cheaper than the cost of issuing new common stock.

- 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.

- Market conditions
- Level of interest rates
- Market risk premium
- Tax rates

- The firm’s capital structure and dividend policy.
- The firm’s investment policy. Firms with riskier projects generally have a higher WACC.