5/8/20151 HFT 4464 Chapter 8 Cost of Capital. 8-2 Chapter 8 Introduction A firm’s long-term...
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5/8/20151 HFT 4464 Chapter 8 Cost of Capital. 8-2 Chapter 8 Introduction A firm’s long-term success depends upon the firm’s investments earning a sufficient
8-2 Chapter 8 Introduction A firms long-term success depends
upon the firms investments earning a sufficient rate of return.
This sufficient or minimum rate of return necessary for a firm to
succeed is called the cost of capital. The cost of capital can also
be viewed as the minimum rate of return required to keep investors
satisfied.
Slide 3
8-3 Organization of Chapter 8 Measure the cost of capital on a
marginal, after-tax basis. Estimating the cost of capital
components Debt Preferred stock Common equity Internal new retained
earnings Externalnew issues of common stock
Slide 4
8-4 Organization of Chapter 8 Estimating the weighted average
cost of capital Separating the finance decision from the investment
decision
Slide 5
8-5 The Weighted Average Cost of Capital The weighted average
cost of capital is: The firms minimum required rate of return on
investments Measured as a percentage rate (%) An average cost of
the various sources of capital employed by a firm Debt Preferred
stock Retained earnings Common stock
Slide 6
8-6 The Weighted Average Cost of Capital Also, the weighted
average cost of capital is: The cost of long-term sources of funds;
long- term sources of funds are relevant because these are the
funds used to make long-term investments. Measured on an after-tax
basis. Measured as a marginal cost of capital. We want to measure
the cost of new capital used to finance new investments.
Slide 7
8-7 The Weighted Average Cost of Capital The weights used are
determined by a firms target capital structure. A target capital
structure is the % of various capital components a firm plans to
use to fund investments. An example is a firm may plan to raise 70%
of capital from long-term debt and 30% from equity. Another firm
may plan to raise 40% of capital from long-term debt, 10% from
preferred stock, and 50% from equity.
Slide 8
8-8 The Weighted Average Cost of Capital The basic weighted
average cost of capital (k a ) equation is: k a = ( w d * k d ) + (
w p * k p ) + ( w e * k e ) Cost of Capital = (%Debt * Cost of
Debt) + (% P.S. * Cost of P.S.) + (%C.S. * Cost of C.S.) Where the
ws represent the firms target capital structure and must add up to
100%. And the ks represent the cost of each capital componentdebt,
preferred stock, and common equity.
Slide 9
8-9 Estimating the Cost of Capital Components Components of a
firms capital structure may include: Long-term debt Preferred stock
New retained earnings Common stock
Slide 10
8-10 Estimating the Cost of Capital Components A components
cost of capital is a reflection of the investor-required rate of
return. A business loan at a 10% interest rate provides a 10%
return to the investor (lender) and a 10% cost to the business plus
any transaction costs the company may pay to process the loan.
Slide 11
8-11 Estimating the Cost of Capital Components A components
cost of capital is just the investor-required return plus an
adjustment for transaction costs. These transaction costs are
called issuance or flotation costs and consist of fees paid to
investment bankers and lawyers for assisting a firm in the issuance
of securities.
Slide 12
8-12 Seniority Risk and the Cost of Capital Debt securities
have the least seniority risk and common stock the most seniority
risk of the 3 basic security types a corporation may issue.
Therefore investors demand the lowest returns on debt securities
and the highest returns on common stock.
Slide 13
8-13 Seniority Risk and the Cost of Capital There is a clear
ranking of cost for a firms funds raised by different security
types. The cost of debt securities is lowest due to their
relatively low risk. The cost of common stocks is the highest due
to its relatively high risk to investors. The cost of preferred
stocks falls between the above two.
Slide 14
8-14 The Cost of Debt The interest cost of debt is a
tax-deductible cost. We take this into account by multiplying a
firms before-tax cost of debt by one minus the firms marginal tax
rate: k d = k dbt x (1 t) With a 10% before-tax cost and a 40%
marginal tax rate the relevant after-tax cost of debt is: k d = 10%
x (1 40%) = 6%
Slide 15
8-15 The Cost of Debt The before-tax interest cost on bonds can
be computed with the same method used to compute the yield to
maturity on bonds in Chapter 6. Net Proceeds = (Coupon * PVA) +
(Face Value * PVLS) Where V net is the net proceeds from the bond
issuance after issuance costs are paid.
Slide 16
8-16 The Cost of Debt Suppose a firm is considering the
issuance of a 20-year bond at a $1,000 price with a 9% coupon rate
and issuance costs of $10 for each bond. K dbt = 9.11% and the
after-tax cost of debt assuming a 40% tax rate is: k d = 9.11% x (1
- 40%) = 5.47%
Slide 17
8-17 The Cost of Preferred Stock Preferred stock is sometimes
considered a perpetuity, but many issues have a call feature or a
sinking fund as described in Chapter 6. We will show how to compute
the cost of funds raised with preferred stock assuming the
preferred stock is a perpetuity and also assuming there is a stated
ending date for the preferred stock.
Slide 18
8-18 The Cost of Preferred Stock Computing the cost of funds
raised with preferred stock is similar to computing the investors
rate of return as in Chapter 6. If the preferred stock is
perpetual: Cost of P.S. = P.S. Dividend / P.S. Net Proceeds Where V
net is the net proceeds from the preferred stock issuance after
issuance costs are paid.
Slide 19
8-19 The Cost of Preferred Stock Suppose a firm is considering
the issuance of preferred stock at $100 market price, with a 10%
dividend rate and issuance costs of $3 per share. The par value is
also $100 per share. What is the cost of raising funds with
preferred stock in this case?
Slide 20
8-20 The Cost of Preferred Stock Lets consider the same example
with one change. What will be the cost of raising funds with
preferred stock if all the preferred stock will be called at a $100
par value in 10 years? The computation is similar to the bond
computation but without the tax impact! K p = 10.50%
Slide 21
8-21 Common Equity Funds provided from a firms common equity
have 2 possible sources: Funds provided by reinvestment of a firms
profits are called new retained earnings. We call this internal
equity because these funds come from the firm itself. Funds
provided by the sale of new common stock we call external
equity.
Slide 22
8-22 The Cost of Internal Equity The source of internal equity
are profits not paid out as dividends. Profits belong to the common
stockholders. The stockholders could have used this money to make
further investments of their own. Thus profits should only be
reinvested if the firm can earn as much as stockholders could earn
on their own. How much is this? We will estimate this by the rate
of return stockholders can expect when they buy the firms common
stock at its current price. We will use this rate as the cost of
funds raised from internal equity!
Slide 23
8-23 The Cost of Internal Equity How do we measure the rate of
return investors expect when they buy a firms common stock? We will
present 3 different methods for estimating this rate of return and
thus the cost of using funds from internal equity: The dividend
valuation model The capital asset pricing model The bond yield plus
risk premium method
Slide 24
8-24 The Cost of Internal Equity The constant growth dividend
valuation model was presented in chapter 7: We need to
algebraically rearrange the terms to solve for investor rate of
return:
Slide 25
8-25 The Cost of Internal Equity Suppose a firms common stock
is selling for $40 per share, pays a current dividend of $3.50 per
share and earnings and dividends are expected to grow at a 4% rate
into the foreseeable future. The cost of internal equity estimate
is:
Slide 26
8-26 The Cost of Internal Equity The capital asset pricing
model (CAPM) was presented in Chapter 4. The CAPM estimates
investor-required rate of return on common stock as a function of
the firms systematic risk as measured by beta. investor-required
rate of return = Risk Free Rate + { ( Market Rate Risk Free Rate) *
beta }
Slide 27
8-27 The Cost of Internal Equity Suppose a firms beta is
estimated at 1.20, the expected risk-free rate of return is 5%, and
the expected market return is 12%. The CAPM can be used to estimate
the firms internal cost of equity:
Slide 28
8-28 The Cost of Internal Equity The bond yield plus risk
premium method of estimating the cost of internal equity: Begins
with an estimate of the firms before-tax bond yield. A risk premium
is added to the bond yield to estimate the cost of internal equity.
The difficulty is in estimating the appropriate risk premium. This
risk premium may vary over time and across different firms.
Slide 29
8-29 The Cost of Internal Equity Suppose a firm has bonds
trading at an 8.5% yield. The typical risk premium over bond yield
for an average company is 4%. But we believe our firm to have
above-average risk so we think 5% is a better estimate of its risk
premium over bond yield. The cost of internal equity using the bond
yield plus risk premium is: k e = 8.5% + 5% = 13.5% Cost of
Internal Equity = Bond Yield + Risk Premium
Slide 30
8-30 The Cost of External Equity If retained earnings growth is
not sufficient to meet a firms need for equity funding, then new
shares of common stock may be sold to raise capital. We call this
external equity since the funds come from outside the firm. The
cost of external equity should be the same as the cost of internal
equity plus additional issuance costs. Of course issuance costs are
not relevant to internal equity.
Slide 31
8-31 The Cost of External Equity The same general approach to
handling issuance costs with bonds and preferred stock is used to
in the cost estimation for external equity. The market price of the
security is reduced by the amount of the issuance costs. The
dividend valuation model uses market price to estimate the cost of
equity:
Slide 32
8-32 The Cost of External Equity Lets use the same example as
before. A firms common stock is selling for $40 per share, expects
to pay a dividend of $3.64 in 1 year, and growth rate is 4%. If the
issuance costs are $6 per share, the cost is: Remember, the cost of
internal equity for this firm was 13.10% using the dividend
valuation model.
Slide 33
8-33 The Cost of External Equity We just have this 1 model for
estimating the cost of external equity, but we have 3 models for
estimating the cost of internal equity! We should just estimate the
cost adjustment for external equity (14.71%13.10%) of 1.61% and add
this to whatever estimate we use for internal equity. For example,
if you use the 13.4% estimate of cost of internal equity from the
CAPM, then add 1.61% to this to estimate a cost of external equity
of 15.01%!
Slide 34
8-34 The Weighted Average Cost of Capital Now that we know how
to compute the components cost of capital we are ready to complete
the weighted average cost of capital estimation. Previously we
presented the equation for this computation: k a = w d x k d + w p
x k p + w e x k e We also need to know a firms target capital
structure so we can estimate the w i s.
Slide 35
8-35 The Weighted Average Cost of Capital Suppose our firm has
a target capital structure of 40% long-term debt (w d ), 10%
preferred stock (w p ), and 50% common equity (w e ). Assume the
firm has sufficient retained earnings growth to need no funds from
a new common stock issuance. Lets use our previously computed 5.44%
cost of long-term debt and 10.31% cost of funds from preferred
stock.
Slide 36
8-36 The Weighted Average Cost of Capital For the cost of
internal equity lets use an average of our 3 estimates:
Slide 37
8-37 The Weighted Average Cost of Capital Now we have all the
inputs we need to estimate the weighted average cost of capital: k
a = 0.4 x 5.47% + 0.1 x 10.31% + 0.5 x 13.33% k a = 9.88%
Therefore, this firm should use 9.88% as the minimum required rate
of return when evaluating investments. An average return of 9.88%
is required to pay off the firms contractual obligations on bonds
and preferred stock and still have enough left over to satisfy
common shareholders with a sufficient return!
Slide 38
8-38 The Weighted Average Cost of Capital Lets now consider how
this computation will change if external equity becomes part of the
equation. Suppose the firm is considering investing up to $100
million in new projects. According to the target capital structure
the following funds will be needed: Long-term debt funding = 0.4 x
$100 million = $40 million Preferred stock funding = 0.1 x $100
million = $10 million Common equity funding = 0.5 x $100 million =
$50 million
Slide 39
8-39 The Weighted Average Cost of Capital What if the firm
expects to have only $20 million of new retained earnings to help
finance this growth when up to $50 million of equity funding may be
required? The other $30 million of equity funding could be provided
by a new issue of common stockexternal common equity! The cost
adjustment for external equity we obtained was 1.61%. When added to
our cost of internal equity, we obtain: K e = 13.33% + 1.61% =
14.94%
Slide 40
8-40 The Weighted Average Cost of Capital The new estimate for
the weighted average cost of capital is: k a =.4x5.47% + 0.1x10.31%
+ 0.2x13.33% +.3x14.94% = 10.37% We have broken up the weight for
equity into 2 components: 20% for internal equity ($20/$50) 30% for
external equity ($30/$50) Therefore, this firm should use 10.37% as
the minimum required rate of return when evaluating
investments.
Slide 41
8-41 Using The Weighted Average Cost of Capital A weighted
average cost of capital should always be used to evaluate an
investment project even if all the capital components are not used
to finance the project. Thus, even if a project is financed with
only debt, the project should still return at a minimum the
weighted average cost of capital computed using the firms marginal
cost of capital and its target capital structure.
Slide 42
8-42 Summary of Chapter 8 Topics Cost of capital measured as an
average, marginal, after-tax cost of long-term sources of funds The
weights used to compute a firms weighted average cost of capital
reflect the firms target capital structure.
Slide 43
8-43 Summary of Chapter 8 Topics The components cost of
capitals are reflections of investor-required rates of return. Show
how to compute the cost of funds from: Debt Preferred stock Common
equity Internalnew retained earnings Externalnew issues of common
stock
Slide 44
8-44 Summary of Chapter 8 Topics Estimate the weighted average
cost of capital. The finance decision should be separate from the
investing decision.