The Cost of Capital

1. The Cost of Capital Chapter 12

2. Cost of Capital • The firm’s average cost of funds, which is the average return required by the firm’s investors • What must be paid to attract funds

3. The Logic of the Weighted Average Cost of Capital • The use of debt impacts a fim’s ability to use equity, and vice versa, so the weighted average cost must be used to evaluate projects, regardless of the specific financing used to fund a particular project

4. Basic Definitions • Capital component • types of capital used by firms to raise money • kd = before tax interest cost • kdT = kd(1-T) = after tax cost of debt • kps = cost of preferred stock • ks = cost of retained earnings • ke = cost of external equity (new stock)

5. Basic Definitions • WACC = weighted average cost of capital • Capital structure • combination of different types of capital used by a firm

6. After-Tax Cost of Debt • The relevant cost of new debt—its yield to maturity (YTM) • Taking into account the tax deductibility of interest • Used to calculate the WACC • kdT = bondholders’ required rate of return minus tax savings • kdT = kd - (kd T) = kd(1-T)

7. Cost of Preferred Stock • Rate of return investors require on the firm’s preferred stock • the preferred dividend divided by the net issuing price

8. Cost of Retained Earnings • Rate of return investors require on the firm’s common stock Three solutions: 1. CAPM 2. Bond yield plus risk premium 3. Discounted cash flow (DCF)

9. The CAPM Approach

10. The Bond-Yield-Plus-Premium Approach • Estimate a risk premium above the bond interest rate • Judgmental estimate for premium • “Ballpark” figure only

11. The Discounted Cash Flow (DCF) Approach • Price and expected rate of return on a share of common stock depend on the dividends expected on the stock

12. DCF Approach • Internal equity, ks • based on the fact that investors demand the firm use funds that are retained to earn an appropriate rate of return

13. Cost of Newly Issued Common Stock • External equity, ke • based on the cost of retained earnings • adjusted for flotation costs (the expenses of selling new issues)

14. Target Capital Structure • Optimal capital structure • percentage of debt, preferred stock, and common equity that will maximize the price of the firm’s stock

15. Weighted Average Cost of Capital, WACC • A weighted average of the component costs of debt, preferred stock, and common equity

16. Marginal Cost of Capital • MCC • the cost of obtaining another dollar of new capital • the weighted average cost of the last dollar of new capital raised

17. MCC Schedule • Marginal cost of capital schedule • a graph that relates the firm’s weighted average of each dollar of capital to the total amount of new capital raised • reflects changing costs depending on amounts of capital raised

18. MCC Schedule • Weighted Average Cost of Capital (WACC) (%) WACC3=11.5% 11.5 - 11.0 - 10.5 - WACC2=11.0% WACC1=10.5% New Capital Raised (millions of dollars) 100 150

19. Break Point • BP • the dollar value of new capital that can be raised before an increase in the firm’s weighted average cost of capital occurs

20. BPRE BPDebt MCC Schedule WACC3=11.5% • Weighted Average Cost of Capital (WACC) (%) 11.5 - 11.0 - 10.5 - WACC2=11.0% WACC1=10.5% New Capital Raised (millions of dollars) 100 150

21. MCC Schedule • Schedule and break points depend on capital structure used

22. MCC Schedule Smooth, or Continuous, Marginal Cost of Capital Schedule • Weighted Average Cost of Capital (WACC) (%) WACC 0 - Dollars of New Capital Raised

23. Combining the MCC and Investment Opportunity Schedules • Use the MCC schedule to find the cost of capital for determining whether a project should be purchased • Investment Opportunity Schedule (IOS) • graph of the firm’s investment opportunities ranked in order of the projects’ rates of return

24. ReturnC = 12.0% ReturnB = 11.6% WACC3=11.5% ReturnD = 11.5% ReturnE = 11.3% WACC2=11.0% MCC IRRA = 10.8% WACC1=10.5% Optimal Capital Budget - $139 IOS Combining the MCC and Investment Opportunity Schedules Percent 12.0 - 11.5 - 11.0 - 10.5 - 20 40 60 80 100 120 140 160 180 New Capital Raised and invested (millions of dollars)

25. End of Chapter 12 The Cost of Capital