Chapter 16 – Cost of Capital

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# Chapter 16 – Cost of Capital - PowerPoint PPT Presentation

Chapter 16 – Cost of Capital Capital definition : Mix of long-term financing sources, primarily debt and equity, used by the company Opportunity Cost Concept Cost of capital is an opportunity cost

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Chapter 16 – Cost of Capital
• Capital definition:Mix of long-term financing sources, primarily debt and equity, used by the company
Opportunity Cost Concept
• Cost of capital is an opportunity cost
• The opportunity cost is the return investors could have expected by investing somewhere else at equal risk
Weighted Average Concept
• The cost of capital is an average of the opportunity costs of stockholders and creditors
• The average is weighted by the proportion of funds provided by each source
Marginal Cost Concept
• The marginal cost of capital is the rate of return that must be earned on new capital to satisfy investors
• The marginal cost of capital is the weighted average cost of capital that must be earned on new investments
• The marginal cost of capital is the change in the amount needed to satisfy investors, divided by the amount of new capital raised
Cost of Debt
• Cost of debt is the interest rate the company would be required to pay on new debt, adjusted upward for flotation costs
• Yield to maturity on bonds frequently measures the marginal cost of debt
• To sell new bonds, you must pay at least the yield to maturity for new bonds
• To justify reinvesting existing funds, your internal investments must be better than the return earned by buying back your existing debt in the marketplace
After-tax Cost of Debt
• Payment of interest results in a tax savings
• After-tax cost of debt:Kd = before-tax cost of debt X (1 – Tax rate)
Cost of Preferred Stock
• Most preferred stock is perpetual; it has no maturity date
• Cost of preferred stock:Kp = Dividend per share  Market price per share
• The cost of new preferred stock requires the use of a net price, the amount that the company will net after paying flotation costs
Cost of Common Stock
• No direct way to observe the return required by common stockholders; must estimate
• Use
• Dividend growth model
• Earnings yield
• CAPM
Dividend Growth Model
• Ke = (D1/P) + gWhereD1 = Expected dividend at the end of the next year P = Current price of the stock g = Anticipated growth rate of dividends
• Applies when dividend growth is stable
Earnings Yield Model
• Ke = Earnings per share  Price
• Sometimes used, but
• Ignores growth
• Not based on cash flow
Mean-variance CAPM
• Ke = Rf + s,m[E(Rm) - Rf]

Where

Rf = Risk-free rate

s,m = Beta of the company’s stock with regard to the market portfolio

E(Rm) = Expected return on the market portfolio

• Widely used
• E(Rm) is still widely debated
• Can use similar company betas for a stock that is not publicly traded
Cost of Existing Equity
• Also called the cost of retained earnings
• Some authors argue that the cost of retained earnings is Ke(1 – stockholders’ tax rate on dividends)
• Much stock is held by pension funds and charitable endowments that do not pay taxes on dividends
Cost of new Equity
• No dividend growth anticipated:Kne = Ke/(1 – f)where f is flotation cost as a percent of market price
• With dividend growth anticipated:Kne = D1/[P/(1 – f)] + g
Weight for Weighted Average Cost
• Market value weights are recommended
• Target capital structure is typically used if the the company is moving toward that target
• Deferred taxes: typically not considered a source of funds because deferred tax reconciles difference between accounting records and cash flows
• Accounts payable and accrued expenses: typically not considered a source of funds because they reconcile the difference between accounting and cash flow
• Short-term debt is included if it is used as permanent capital