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Contemporary Financial Management. Chapter 8: The Cost of Capital. Introduction. This chapter discusses: The cost of capital What is it How is it measured What is the Weighted Average Cost of Capital (WACC) Risk vs. required return trade-off. Cost of Capital.

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contemporary financial management

Contemporary Financial Management

Chapter 8:

The Cost of Capital

introduction
Introduction
  • This chapter discusses:
    • The cost of capital
      • What is it
      • How is it measured
      • What is the Weighted Average Cost of Capital (WACC)
    • Risk vs. required return trade-off
cost of capital
Cost of Capital
  • The return required by investors to hold a company’s securities
  • Determined in the capital markets
  • Depends on the risk associated with the firm’s activities
  • Determines what the firm must pay to acquire new capital (sell new securities)
  • Firms must earn more than their cost of capital or they destroy shareholder wealth
concept of capital structure
Concept of Capital Structure
  • A firm’s capital structure consists of the mix of debt and equity securities that have been issued to finance the firm’s activities.
  • Forms of financing include:
    • Common stock
    • Preferred stock
    • Bonds (secured debt)
    • Debentures (Unsecured debt)
  • Each different type of security has different risk characteristics and therefore will earn a different return in the market.
weighted ave cost of capital wacc
Weighted Ave. Cost of Capital (WACC)
  • Discount rate used when computing the net present value of a project of average risk.
  • Calculated by weighting the cost of each form of security issued (Common stock, preferred stock, bonds, debentures).
  • Weights equal to the proportion of each of the components in the capital structure.
weighted average cost of capital
Weighted Average Cost of Capital

ka = Weighted Average Cost of Capital

D = Market value of the firm’s Debt

Pf = Market value of the firm’s Preferred Shares

E = Market value of the firm’s Common Equity

ke = Marginal Cost of Common Share Capital

kd = Marginal Pre-Tax Cost of Debt

kp = Marginal Cost of Preferred Share Capital

T = Corporate Tax Rate

weighted average cost of capital1
Weighted Average Cost of Capital

Example: A firm’s capital structure includes $3 Million in bonds, $6 Million in equity, and $1 Million in preferred stock (market values). The firm’s cost of equity is 15%, the cost of debt is 8% and the cost of preferreds is 10%. If the firm’s marginal tax rate is 50%, what is its WACC?

required rate of return
Required Rate of Return
  • Risk-free Rate of Return + Risk Premium
  • Risk-free Rate of Return:
    • real rate of return (compensation for deferring consumption) plus compensation for expected inflation
  • Risk Premium: additional reward required for bearing the risk of an investment
    • Composed of business risk, financial risk, marketability risk, interest rate risk and seniority risk.
risk return trade offs
Risk-Return Trade-Offs

Required

Rate of

Return

Common Shares X

Low QualityCorporate X

Debt

XHigh QualityPreferred Shares

XHigh QualityCorporate Debt

XLong-term Government Debt

Risk-Free

Rate of

Return

XShort-term Government Debt

Risk

cost of debt
Cost of Debt
  • The firm’s after-tax cost of debt (ki) is found by multiplying the firm’s pre-tax cost of debt (kd) by 1 minus the firm’s marginal tax rate (T).
  • Debt is the firm’s lowest cost source of funds, since interest is a tax-deductible expense.
  • As the amount of debt issued increases, the risk of default rises and so does the cost.
cost of preferreds
Cost of Preferreds
  • The firm’s after-tax cost of preferreds (kp) is equal to the pre-tax cost (Dp/Pnet), since dividends are not tax deductible (dividends are paid out of after-tax cash flow).
cost of internal equity capital
Cost of Internal Equity Capital
  • The firm’s cost of internal equity is the return demanded by the existing shareholder.
  • The CAPM defines this return as:
cost of external equity capital
Cost of External Equity Capital
  • The cost of external equity is greater than the cost of internal equity due to the existence of
    • Issue costs
    • New issue discounts from market price
issue costs discounts
Issue Costs & Discounts
  • Issue (flotation) costs are the costs associated with making a new issue of equity to the public.
  • To sell a new issue of shares, the sale price may have to be set below the current market price.
    • Current market price represents an equilibrium between supply & demand
    • Without new demand being created, the new supply will push down the market price
growth rate information
Growth Rate Information
  • Institutional Brokers Estimate System
    • www.firstcall.com/
  • Zacks Earnings Estimates
    • www.zacks.com/
  • Thomson Financial First Call Service
    • www.firstcall.com/index.html
  • Dividend growth model
    • www.finplan.com/invest/divgrowmod.htm
slide16
CAPM
  • Check out this Web site to see how the CAPM is used to calculate a firm’s cost of equity:

http://www.ibbotson.com/

divisional costs of capital
Divisional Costs of Capital
  • Some divisions of a company have higher or lower systematic risk.
  • Discount rates for divisions are higher or lower than the discount rate for the firm as a whole.
  • Each division could have its own beta and discount rate.
  • Should reflect both the differential risks and the differential normal debt ratios for each division.
depreciation
Depreciation
  • A major source of funds
  • Equal to the firm’s weighted cost of capital based on retained earnings and the lowest cost of debt
  • Availability of funds from depreciation shifts the marginal cost of capital (MCC) to the right by the amount of depreciation
cost of capital case study
Cost of Capital: Case Study
  • Major Foods Corporation is developing its cost of capital. The firm’s current & target capital structure is:
    • 40% debt
    • 10% preferred shares
    • 50% common equity
  • The firm can raise the following funds
    • Debt – up to $5 Million at 9%
    • Debt – over $5 Million at 10%
    • Preferred shares – 10%
  • The firm’s marginal tax rate is 40%
cost of capital case study cont d
Cost of Capital: Case Study (Cont’d)
  • Equity and internally generated funds
    • The firm will generate $10 Million of retained earnings this year
    • Current dividend is $2 per share
    • Current share price is $25
    • New common shares can be sold at $24
  • Earnings and dividends growing at 7% per year
  • Payout ratio expected to remain constant
cost of capital case study solution
Cost of Capital: Case Study Solution
  • Step #1:
  • Calculate the cost of capital for each component of financing
  • Cost of debt (up to $5 Million of new debt)
  • Cost of debt (over $5 Million of new debt)
cost of capital case study solution1
Cost of Capital: Case Study Solution
  • Step #1:
  • Calculate the cost of capital for each component of financing
  • Cost of Preferreds
  • Cost of Equity (internal)
cost of capital case study solution2
Cost of Capital: Case Study Solution
  • Step #1:
  • Calculate the cost of capital for each component of financing
  • Cost of Equity (external)
cost of capital case study solution3
Cost of Capital: Case Study Solution
  • Step #2:
  • Compute the weighted average cost of capital for each increment of capital raised.
    • The firm wants to retain its target capital structure
    • The firm should always raise its cheapest source of funds first. These are:
      • Retained earnings (internal equity)
      • Preferred shares
      • Debt up to $5 Million
cost of capital case study solution4
Cost of Capital: Case Study Solution
  • Increment #1: Calculate total financing that can be acquired using 9% debt while retaining the target capital structure with 40% debt.

The firm can raise a total of $12.5 Million of new financing (including $5 Million of 9% debt) before it has to begin issuing new debt at 10%.

cost of capital case study solution5
Cost of Capital: Case Study Solution
  • The WACC for increment #1 is:
cost of capital case study solution6
Cost of Capital: Case Study Solution
  • Increment #2: Calculate total financing that can be acquired using internally generated equity (retained earnings) while retaining the target capital structure with 50% equity.

The firm can raise a total of $20 Million of new financing before it needs to issue new common stock.

cost of capital case study solution7
Cost of Capital: Case Study Solution
  • The WACC for increment #2 (total new funding between $12.5 Million & $20 Million is:
cost of capital case study solution8
Cost of Capital: Case Study Solution
  • Increment #3: Financing in excess of $20 Million will require both high-cost debt and issuing new common stock. The WACC for Increment #3 is:
cost of capital case study solution9
Cost of Capital: Case Study Solution

Incremental WACC

11.35%

11.20%

10.96%

$12.5 M

$20 M

Funds Raised

small firms
Small Firms
  • Have a difficult time attracting capital
  • Issuance costs are high (> 20% of issue)
  • Often issue two classes of stock
    • One class sold to outsiders paying a higher dividend
    • Second class held by founders with greater voting power
  • Limited sources of debt
major points
Major Points
  • The Weighted Average Cost of Capital (WACC) is a weighted average cost of funding.
  • Equity is the most expensive form of funding; debt is the cheapest.
  • Debt has a tax advantage due to the tax-deductibility of interest