The Cost of Capital

1. The Cost of Capital Chapter 9 Oct 17, 2012

2. Learning Goals • Determining the value of K, the required rate of return for an investor • Sources of capital funding (Debt, Equity) • Cost of each type of funding • Calculation of the weighted average cost of capital funding (WACC) = K • Construction and use of the marginal cost of capital schedule (MCC) for decision making

3. Cost of Capital • Capital is the term used by firms for funds needed for investment purposes, i.e., capital equipment (not for day to day operating needs) • This capital carries a cost because each source of capital funding costs money to raise (i.e., issuing stock costs a lot of money)

4. Cost of Capital • To properly evaluate investment decisions, the firm must know how much it will cost them to raise capital funds from all sources • WACC = K = hurdle rate • If it costs more to raise the capital (K) than you make on your investment, then you don’t make the investment!

5. Sources of Capital • Borrowing: issue Bonds, bank loans, • Issuing Preferred stock • Issuing Common stock • Net Income (earnings) • Each of these sources carries a different cost based on the required rate of return of each provider (source) of these funds

6. Optimal Capital Structure • The capital structure of a firm is how the firm has elected to finance its assets • It is the level or percentage of total assets financed by debt, preferred stock and common equity (common stock and retained earnings) • Each firm has an optimal level of debt and equity at which it can operate most efficiently and profitability (Draw curve)

7. Weighted Cost of Capital Model • Compute the cost of each source of capital, i.e., debt, preferred stock, common stock, retained earnings • Determine percentage (weights) of each source of capital in the firm’s optimal capital structure • Calculate Weighted Average Cost of Capital (WACC)

8. 1. Compute Cost of Debt • Required rate of return for creditors • e.g. Suppose that a company issues bonds with a before tax cost of 10%. • Since interest payments are tax deductible, the true cost of the debt is the After Tax cost (ATkd = Int Rate (1 – T), where T is tax rate) • If the company’s tax rate (state and federal combined) is 40%, the after tax cost of debt AT kd = 10%(1-.4) = 6% (show example)

9. Flotation Costs – cost of issuing securities to the general public • Accounting • Legal • Prospectus – (pass out examples) • Underwriting (investment banker) • Filing Fees (SEC)

10. Dividend (Dp) Market Price (PP) - F Required rate kp = 2. Compute Cost Preferred Stock • Cost to raise a dollar of preferred stock. • Dp = preferred stock dividend • Pp = Market price per share • F = flotation costs per share • Flotation costs reduce the amount of money you get when you sell preferred stock

11. $5.00 = $42.00 kp = Cost of Preferred Stock • Example: You can issue preferred stock with a market price of $45, and flotation costs of $3 per share, for a net price of $42 and if the preferred stock pays a $5 dividend, • The cost of preferred stock: 11.9% (vs 11.1%)

12. 3. Compute Cost of Common Equity • Two Types of Common Equity Financing • Retained Earnings (internal common equity) • Issuing new shares of common stock (external common equity)

13. 3. Compute Cost of Common Equity • Cost of Common Equity (Retained Earnings) • Management should retain earnings only if they earn as much as stockholder’s next best investment opportunity of the same risk. • Cost of Common Equity = opportunity cost of common stockholders’ funds. • Two methods to determine • Dividend Growth Model • Capital Asset Pricing Model

14. D1 P0 kS = + g 3. Compute Cost of Common Equity • Cost of Common Equity (Retained Earnings) • Dividend Growth Model Ks = cost of internal common equity D1 = the next dividend to be paid Po = the current market price of the stock g = the projected rate of growth of the company

15. D1 P0 kS = + g 3. Compute Cost of Common Equity • Cost of Internal Common Equity • Dividend Growth Model • Example: • The market price (Po) of a share of common stock is $60. The prior dividend paid (D0) was $3, and the expected growth rate (g) is 10%. If you are given D0, you must calculate D1 D1 = D0 (1 + g) D1 = 3.00 (1.10) = 3.30

16. D1 P0 kS = + g 3.30 60 kS = + .10 3. Compute Cost of Common Equity • Cost of Internal Common Equity • Dividend Growth Model • Example: • The market price of a share of common stock is $60. The prior dividend (D0) is $3, and the expected growth rate is 10%. (D1 = 3.00 x 1.10 = 3.30) =.055 + .10 = 15.5%

17. D1 P0 - F kn = +g 3. Compute Cost of Common Equity • Cost of New Common Stock • Must adjust the Dividend Growth Model equation for flotation (F) costs of the new common shares. Kn = cost of sale of new common stock D1 is the next dividend to be paid Po is the current market price of shares outstanding F is the flotation cost G is the rate of growth

18. 3.30 52.80 kn = + .10 3. Compute Cost of Common Equity • Example: • If additional shares are issued, floatation costs will be 12% of price per share. D0 = $3.00 and estimated growth is 10%, Price is $60 as before. Flotation cost = $60 x .12 = $7.20. • (Po – F = $60.00 – 7.20 = $52.80) (D1 = 3.00 x 1.10 = 3.30) = .0625 + .10 = 16.25%

19. Source of Capital Cost Bonds (after tax) kd = 6.0% Preferred Stock kp = 11.9% Common Stock Retained Earnings ks = 15.5% New Shares kn = 16.25% Weighted Average Cost of Capital Gallagher Corporation estimates the following costs for each component in its capital structure: Gallagher’s tax rate is 40%

20. WACC = (WTd x AT kd ) + (WTp x kp ) + (WTs x ks) Weighted Average Cost of Capital • If using retained earnings (Internal Equity) to finance the equity portion: WACC = weighted average cost of capital WT = the weight, or percentage of each element of capital (% of debt, preferred and common stock to total assets) ATkd = after tax cost of debt Kp = Cost of preferred stock Ks = Cost of equity (Internal – retained earnings)

21. WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks) Weighted Average Cost of Capital • If using retained earnings (internal equity) to finance the common equity portion : • Assume that Gallagher’s desired capital structure is 40% debt, 10% preferred and 50% common equity.

22. WACC = (WTd x AT kd ) + (WTp x kp ) + (WTs x ks) Weighted Average Cost of Capital • If using retained earnings (Internal Equity) to finance the equity portion: • Assume that Gallagher’s desired capital structure is 40% debt, 10% preferred and 50% common equity. WACC = Cost of Debt .40 x 6.0% = 2.40% + Cost of Preferred .10 x 11.9% = 1.19% + Cost of Int. Equity .50 x 15.5% =7.75% 1.00 = 11.34%

23. WACC = (WTd x AT kd ) + (WTp x kp ) + (WTs x ks) Weighted Average Cost of Capital • If using new common stock (External Equity) to finance the common stock portion: Then we must use the cost of stock adjusted for the Flotation costs WACC = Cost of Debt .40 x 6.0% = 2.40% + Cost of Pref .10 x 11.9% = 1.19% + Cost of Ext. Eq. .50 x 16.25% = 8.13% =11.72%

24. Marginal Cost of Capital • Gallagher’s weighted average cost will change if one component cost of capital changes. • This may occur when a firm raises a particularly large amount of capital such that investors think that the firm is riskier. • The WACC of the next dollar of capital raised is called the marginal cost of capital.

25. Spending Capital Money • The assumption is that the capital money is spent in direct proportion to the optimal capital structure. • So, if we spend $100,000, it would be in the following proportions: Capital StructureSpend Debt 40% 40,000 Preferred 10% 10,000 Common 50% 50,000 (Buckets) Total 100,000

26. Available Retained Earnings Breakpoint = Equity Percentage of Total Calculating the Breakpoint • Assume now that Gallagher Corporation has $100,000 in retained earnings with which to finance its capital budget. • We can calculate the point at which they will need to issue new equity since we know that Gallagher’s desired capital structure calls for 50% common equity.

27. Calculating the Breakpoint Breakpoint = ($100,000)/.5 = $200,000 • What this means is that once we spend $200,000 in total on capital projects, we will have used up our retained earnings of $100,000 (internal equity). • Therefore, if we spend over $200,000, we will need additional financing from the issue of new shares of stock since 50% of our spending must come from Equity. • The cost of issuing new shares is greater than internal equity due to flotation costs

28. Marginal weighted cost of capital curve: 11.72% 13% 11.34% 12% Weighted Cost of Capital 11% 10% 400,000 0 100,000 200,000 300,000 TotalFinancing Making Decisions Using MCC Usingnew common equity Using internal common equity

29. Marginal weighted cost of capital curve: 12% 11% Project 1 IRR = 12.4% Project 2 IRR = 12.1% Project 3 IRR =11.5% Weighted Cost of Capital 10% 9% 400,000 0 100,000 200,000 300,000 TotalFinancing Making Decisions Using MCC • Graph IRRs of potential projects

30. Marginal weighted cost of capital curve: 11.72% 12% 11.34% 11% Project 1 IRR = 12.4% Project 2 IRR = 12.1% Project 3 IRR =11.5% Weighted Cost of Capital 10% 9% 400,000 0 100,000 200,000 300,000 TotalFinancing Making Decisions Using MCC • Graph IRRs of potential projects Graph MCC Curve

31. Marginal weighted cost of capital curve: 11.72% 12% 11.34% 11% Project 1 IRR = 12.4% Project 2 IRR = 12.1% Project 3 IRR =11.5% Weighted Cost of Capital 10% 9% 400,000 0 100,000 200,000 300,000 TotalFinancing Making Decisions Using MCC • Graph IRRs of potential projects • Graph MCC Curve • Choose projects whose IRR is above the weighted marginal cost of capital Accept Projects #1 & #2

32. MCC and Capital Budgeting Decisons • See pages 250 – 256 • Calculate the breakpoints Calculate the new MCC’s Plot MCC’s and Investment Projects • See Figures 9-5 and 9-6 for results • Do all the Self-test problems before doing the homework