Ch. 12

Cost of Capital

2002, Prentice Hall, Inc.

• Basic Skills: (Time value of money, Financial Statements)

• Investments: (Stocks, Bonds, Risk and Return)

• Corporate Finance: (The Investment Decision - Capital Budgeting)

Where we’ve been...

Assets Liabilities & Equity

Current assets Current Liabilities

Fixed assets Long-term debt

Preferred Stock

Common Equity

Assets Liabilities & Equity

Current assets Current Liabilities

Fixed assets Long-term debt

Preferred Stock

Common Equity

The investment decision

• Corporate Finance: (The Financing Decision)

Cost of capital

Leverage

Capital Structure

Dividends

Where we’re going...

Assets Liabilities & Equity

Current assets Current Liabilities

Fixed assets Long-term debt

Preferred Stock

Common Equity

Assets Liabilities & Equity

Current assets Current Liabilities

Fixed assets Long-term debt

Preferred Stock

Common Equity

The financing decision

Assets Liabilities & Equity

Current assets Current Liabilities

Long-term debt

Preferred Stock

Common Equity

Assets Liabilities & Equity

Current assets Current Liabilities

Long-term debt

Preferred Stock

Common Equity

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Capital Structure

Ch. 12 - Cost of Capital

• For Investors, the rate of return on a security is a benefit of investing.

• For Financial Managers, that same rate of return is a cost of raising funds that are needed to operate the firm.

• In other words, the cost of raising funds is the firm’s cost of capital.

How can the firm raise capital?

• Bonds

• Preferred Stock

• Common Stock

• Each of these offers a rate of return to investors.

• This return is a cost to the firm.

• “Cost of capital” actually refers to the weighted cost of capital - a weighted average cost of financing sources.

Cost of Debt

Cost of Debt

For the issuing firm, the cost of debt is:

• the rate of return required by investors,

• adjusted for flotation costs (any costs associated with issuing new bonds), and

• adjusted for taxes.

Example: Tax effects of financing with debt

with stock with debt

EBIT 400,000 400,000

- interest expense 0 (50,000)

EBT 400,000 350,000

- taxes (34%) (136,000) (119,000)

EAT 264,000 231,000

Example: Tax effects of financing with debt

with stock with debt

EBIT 400,000 400,000

- interest expense 0 (50,000)

EBT 400,000 350,000

- taxes (34%) (136,000) (119,000)

EAT 264,000 231,000

• Now, suppose the firm pays $50,000 in dividends to the stockholders.

Example: Tax effects of financing with debt

with stock with debt

EBIT 400,000 400,000

- interest expense 0 (50,000)

EBT 400,000 350,000

- taxes (34%) (136,000) (119,000)

EAT 264,000 231,000

- dividends (50,000) 0

Retained earnings 214,000 231,000

After-tax Before-tax Marginal % cost of % cost of x tax Debt Debt rate

-= 1

After-tax Before-tax Marginal % cost of % cost of x tax Debt Debt rate

Kd = kd (1 - T)

-= 11

After-tax Before-tax Marginal % cost of % cost of x tax Debt Debt rate

Kd = kd (1 - T)

.066 = .10 (1 - .34)

-= 11

Example: Cost of Debt

• Prescott Corporation issues a $1,000 par, 20 year bond paying the market rate of 10%. Coupons are semiannual. The bond will sell for par since it pays the market rate, but flotation costs amount to $50 per bond.

• What is the pre-tax and after-tax cost of debt for Prescott Corporation?

• Pre-tax cost of debt: (using TVM)

P/Y = 2 N = 40

PMT = -50

FV = -1000

PV = 950

solve: I = 10.61% = kd

• After-tax cost of debt:

Kd = kd (1 - T)

Kd = .1061 (1 - .34)

Kd = .07 = 7%

• Pre-tax cost of debt: (using TVM)

P/Y = 2 N = 40

PMT = -50

FV = -1000 So, a 10% bond

PV = 950 costs the firm

solve: I = 10.61% = kd only 7% (with

• After-tax cost of debt: flotation costs)

Kd = kd (1 - T) since the interest

Kd = .1061 (1 - .34) is tax deductible.

Kd = .07 = 7%

Cost of Preferred Stock

• Finding the cost of preferred stock is similar to finding the rate of return, (from Chapter 8) except that we have to consider the flotation costs associated with issuing preferred stock.

Cost of Preferred Stock

• Recall:

Cost of Preferred Stock

• Recall:

kp = =

DPo

Dividend Price

Cost of Preferred Stock

• Recall:

kp = =

• From the firm’s point of view:

DPo

Dividend Price

Cost of Preferred Stock

• Recall:

kp = =

• From the firm’s point of view:

kp = =

DPo

Dividend Price

DividendNet Price

DNPo

Cost of Preferred Stock

• Recall:

kp = =

• From the firm’s point of view:

kp = =

NPo = price - flotation costs!

DPo

Dividend Price

DividendNet Price

DNPo

Example: Cost of Preferred

• If Prescott Corporation issues preferred stock, it will pay a dividend of $8 per year and should be valued at $75 per share. If flotation costs amount to $1 per share, what is the cost of preferred stock for Prescott?

Cost of Preferred Stock

Cost of Preferred Stock

kp = DividendNet Price

DNPo =

Cost of Preferred Stock

kp = =

= =

DividendNet Price

DNPo

8.0074.00

Cost of Preferred Stock

kp = =

= = 10.81%

DividendNet Price

DNPo

8.0074.00

Cost of Common Stock

• There are 2 sources of Common Equity:

1) Internal common equity (retained earnings), and

2) External common equity (new common stock issue)

Do these 2 sources have the same cost?

Cost of Internal Equity

• Since the stockholders own the firm’s retained earnings, the cost is simply the stockholders’ required rate of return.

• Why?

• If managers are investing stockholders’ funds, stockholders will expect to earn an acceptable rate of return.

Cost of Internal Equity

Cost of Internal Equity

1) Dividend Growth Model

Cost of Internal Equity

1) Dividend Growth Model

kc = + gD1

Po

Cost of Internal Equity

1) Dividend Growth Model

kc = + g

2) Capital Asset Pricing Model (CAPM)

D1

Po

Cost of Internal Equity

1) Dividend Growth Model

kc = + g

2) Capital Asset Pricing Model (CAPM)

kj = krf + j (km - krf )

D1

Po

Cost of External Equity

Dividend Growth Model

Cost of External Equity

Dividend Growth Model

knc = + g

Cost of External Equity

D1

NPo

Dividend Growth Model

knc = + g

Cost of External Equity

D1

NPo

Net proceeds to the firmafter flotation costs!

Weighted Cost of Capital

• The weighted cost of capital is just the weighted average cost of all of the financing sources.

Weighted Cost of Capital

Capital

Source Cost Structure

debt 6% 20%

preferred 10% 10%

common 16% 70%

• Weighted cost of capital =

.20 (6%) + .10 (10%) + .70 (16%)

= 13.4%

Weighted Cost of Capital(20% debt, 10% preferred, 70% common)