CHAPTER 9 The Cost of Capital

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# CHAPTER 9 The Cost of Capital - PowerPoint PPT Presentation

CHAPTER 9 The Cost of Capital. Cost of Capital Components Debt Preferred Common Equity WACC MCC IOS. © 1998 The Dryden Press. What types of long-term capital do firms use?. Long-term debt Preferred stock Common equity: Retained earnings New common stock. © 1998 The Dryden Press.

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CHAPTER 9The Cost of Capital
• Cost of Capital Components
• Debt
• Preferred
• Common Equity
• WACC
• MCC
• IOS

What types of long-term capital do firms use?

Long-term debt

Preferred stock

Common equity:

Retained earnings

New common stock

Should we focus on before-tax or after-tax capital costs?

Stockholders focus on A-T CFs.

Thus, focus on A-T capital costs,

i.e., use A-T costs in WACC. Only

Should we focus on historical (embedded) costs or new (marginal) costs?

The cost of capital is used primarily to make decisions which involve raising new capital. So, focus on today’s marginal costs (for WACC).

N

I/YR

PV

FV

0

1

2

30

i = ?

...

60

60

60 + 1,000

-1,153.72

INPUTS

30 -1153.72 60 1000

5.0% x 2 = kd = 10%

PMT

OUTPUT

Component Cost of Debt
• Interest is tax deductible, so

kd AT = kd BT(1 - T)

= 10%(1 - 0.40) = 6%.

• Use nominal rate.
• Flotation costs small.

Ignore.

What’s the cost of preferred stock? PP = \$113.10; 10%Q; Par = \$100; F = \$2.

Use this formula:

Picture of Preferred

Ï

0

1

2

kps = ?

...

-111.1

2.50

2.50

2.50

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.

• More risky; company not required to pay preferred dividend.
• However, firms try to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, (3) preferred stockholders may gain control of firm.

Why is yield on preferred lower than kd?
• Corporations own most preferred stock, because 70% of preferred dividend are nontaxable to corporations.
• Therefore, preferred often has a lower B-T yield than the B-T yield on debt.
• The A-T yield to an investor, and the A-T cost to the issuer, are higher on preferred than on debt. Consistent with higher risk of preferred.

Example:

kps = 8.84% kd = 10% T = 40%

kps, AT = kps - kps (1 - 0.7)(T)

= 8.84% - 8.84%(0.3)(0.4) = 7.78%

kd, AT = 10% - 10%(0.4) = 6.00%

A-T Risk Premium on Preferred = 1.78%

Why is there a cost for retained 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 retained.

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 retained earnings.

Three ways to determine cost of retained earnings, ks:

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

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

ks = kd + RP.

What’s the cost of retained earnings based on the CAPM?kRF = 7%, MRP = 6%, b = 1.2.

ks = kRF + (kM - kRF )b.

= 7.0% + (6.0%)1.2 = 14.2%.

What’s the DCF cost of retained earnings, ks? Given: D0 = \$4.19;P0 = \$50; g = 5%.

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’s the expected future g?

Retention growth rate:g = b(ROE) = 0.35(15%) = 5.25%.Here b = Fraction retained.Close to g = 5% given earlier. Think of bank account paying 10% with b = 0, b = 1.0, and b = 0.5. What’s g?

Could DCF methodology be applied if g is not constant?
• YES, nonconstant g stocks are expected to have constant g at some point, generally in 5 to 10 years.
• But calculations get complicated.

Find ks using the own-bond-yield-plus-risk-premium method. (kd = 10%, RP = 4%.)
• This RP = CAPM RP.
• Produces ballpark estimate of ks. Useful check.

ks = kd + RP

= 10.0% + 4.0% = 14.0%

How do we find the cost of new common stock, ke?

Use DCF formula, but

End up with ke > ks.

New common, F = 15%:

ke - ks = 15.4% - 13.8% = 1.6%.

average ks = 14% to find average ke :

ke = ks + Floatation adjustment

= 14% + 1.6% = 15.6%.

Why is ke > ks?

1. Investors expect to earn ks.

2. Company gets money as retained earnings; earns ks; everything’s O.K.

3. But investors put up money to buy new stock; F pulled out; so net money must earn > ks to provide ks on money investors put up.

Example

1. ks = D1/P0 + g = 10%; F = 20%.

2. Investors put up \$100, expect EPS = DPS = 0.1(\$100) = \$10.

3. But company nets only \$80.

4. If earn ks = 10% on \$80, EPS = DPS = 0.10(\$80) = \$8. Too low. Price falls.

5. Need to earn ke = 10% /0.8 = 12.5%.

6. Then EPS = 0.125(\$80) = \$10.

Conclusion: ke = 12.5% > ks = 10.0%.

What’s WACC using only retained earnings for equity component of WACC1?

WACC1 = wdkd(1 - T) + wpskps + wceks

= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)

= 1.8% + 0.9% + 8.4% = 11.1%.

= Cost per \$1 until retained earnings used up.

WACC with New CS

F = 15%

WACC2 = wdkd(1 - T) + wpskps + wceke

= 0.3(10%)(0.6) + 0.1(9%) + 0.6(15.6%)

= 1.8% + 0.9% + 9.4% = 12.1%.

Summary to this Point

WACC rises because equity cost is rising.

MCC Schedule Definition
• MCC shows cost of each dollar raised.
• Each dollar consists of \$0.30 of debt, \$0.10 of Preferred and \$0.60 of equity (retained earnings or new common stock).
• First dollars cost WACC1 = 11.1%, then WACC2 = 12.1%.

How large will capital budget be before must issue new CS?

Capital Budget = Capital Raised

Debt = 0.3 Capital Raised

Preferred = 0.1 Capital Raised

Equity = 0.6 Capital Raised

= 1.0 Total Capital

Equity = RE = 0.6 Capital Raised, so

Capital Raised = RE/0.6.

Find Retained Earnings Break Point

Dollars of RE

Fraction of equity

BPRE =

\$300,000

0.60

= = \$500,000.

\$500,000 total can be financed with retained earnings, debt, and preferred.

WACC (%)

WACC1 = 11.1%

15

WACC2 = 12.1%

10

\$500 \$2,000

Dollars of New Capital

(in thousands)

Investment Opportunities(Capital Budgeting Projects)

Which to accept?

%

A = 17

B = 15

MCC

12.1

C = 11.5

11.1

IOS

Optimal Capital Budget

500

1,200

2,000 \$