Cost of Capital Reviewer for Financial Management I

8/9/2019 Cost of Capital Reviewer for Financial Management I

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COST OF CAPITAL

2012 Pearson Education 9-1


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Learning Goals

LG1 Understand the basic concept and sources of

capital associated with the cost of capital.

LG2 Explain what is meant by the marginal cost ofcapital.

LG3 Determine the cost of longterm debt! and

explain why the aftertax cost of debt is the

rele"ant cost of debt.


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Learning Goals (cont.)

LG# Determine the cost of preferred stoc$.

LG% &alculate the cost of common stoc$ e'uity! and

con"ert it into the cost of retained earnings andthe cost of new issues of common stoc$.

LG( &alculate the weighted a"erage cost of capital

)*+&&, and discuss alternati"e weighting

schemes.


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Oerie! o" t#e Cost o" Ca$ital

- he cost of capitalrepresents the firms cost of financing! and is

the minimum rate of return that a pro/ect must earn to increase firm

"alue.

0inancial managers are ethically bound to only in"est in pro/ects that they

expect to exceed the cost of capital.

he cost of capital reflects the entirety of the firms financing acti"ities.

- ost firms attempt to maintain an optimal mix of debt and e'uity

financing.

o capture all of the rele"ant financing costs! assuming some desired mix of

financing! we need to loo$ at the o"erall cost of capital rather than /ust the

cost of any single source of financing.


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2012 Pearson Education 9-%


(cont.)

+ firm is currently faced with an in"estment opportunity.+ssume the following

est pro/ect a"ailable today

&ost 4 5166!666 Life 4 26 years

Expected 7eturn 4 89

Least costly financing source a"ailable

Debt 4 (9

ecause it can earn 89 on the in"estment of funds costing only(9! the firm underta$es the opportunity.


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2012 Pearson Education 9-&


(cont.)

:magine that 1 wee$ later a new in"estment opportunity isa"ailable

est pro/ect a"ailable 1 wee$ later

&ost 4 5166!666 Life 4 26 years

Expected 7eturn 4 129

Least costly financing source a"ailable

E'uity 4 1#9

:n this instance! the firm re/ects the opportunity! because the1#9 financing cost is greater than the 129 expected return.


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(cont.)

*hat if instead the firm used a combined cost of financing;

+ssuming that a %6%6 mix of debt and e'uity is targeted! the

weighted a"erage cost here would be

)6.%6 (9 debt, < )6.%6 1#9 e'uity, 4 169

*ith this a"erage cost of financing! the first opportunity would

ha"e been re/ected )89 expected return = 169 weighted

a"erage cost,! and the second would ha"e been accepted

)129 expected return > 169 weighted a"erage cost,.


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Focs on *t#ics

he Ethics of ?rofit

:ntroduced in 1@@@! Aioxx was an immediate success! 'uic$lyreaching 52.% billion in annual sales.

Bowe"er! a erc$ study launched in 1@@@ e"entually found thatpatients who too$ Aioxx suffered from an increased ris$ of heartattac$s and stro$es.

Despite the ris$s! erc$ continued to mar$et and sell Aioxx.

he 266# Aioxx withdrawal hit erc$s reputation! profits! and

stoc$ price hard. he Aioxx recall increased erc$s cost of capital. *hat effect

would an increased cost of capital ha"e on a firms futurein"estments;


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Oerie! o" t#e Cost o" Ca$ital+

Sorces o" Long-Ter, Ca$ital



Cost o" Long-Ter, e/t

- he pretax cost of debt is the financing cost associated with new

funds through longterm borrowing.

ypically! the funds are raised through the sale of corporate bonds.

- Net proceedsare the funds actually recei"ed by the firm from thesale of a security.

- Flotation costsare the total costs of issuing and selling a security.

hey include two components

1. Underwriting costscompensation earned by in"estment ban$ers forselling the security.

2. +dministrati"e costsissuer expenses such as legal! accounting! and

printing.


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Cost o" Long-Ter, e/t (cont.)

- he beforetax cost of debt! rd! is simply the rate of returnthe firm must pay on new borrowing.

- he beforetax cost of debt can be calculated in any one

of three ways1. Using mar$et 'uotations obser"e the yield to maturity ),

on the firms existing bonds or bonds of similar ris$ issued byother companies

2. &alculating the cost find the beforetax cost of debt bycalculating the generated by the bond cash flows

3. +pproximating the cost


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+pproximating the cost

where

I4 annual interest in dollars

Nd 4 net proceeds from the sale of debt )bond,

n 4 number of years to the bonds maturity


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+pproximating the cost


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2012 Pearson Education 9-1'

Cost o" Long-Ter, e/t+

A"ter-Ta0 Cost o" e/t

- he interest payments paid to bondholders are tax

deductable for the firm! so the interest expense on debt

reduces the firms taxable income and! therefore! the

firms tax liability.

- he aftertax cost of debt! ri! can be found by multiplying

the beforetax cost! rd! by 1 minus the tax rate! T! as stated

in the following e'uation

ri4 rd)1T,


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Cost o" Long-Ter, e/t+

A"ter-Ta0 Cost o" e/t (cont.)

Duchess &orporation has a #69 tax rate. Using the @.#%29

beforetax debt cost calculated abo"e! we find an aftertax

cost of debt of %.(9 @.#9 )16.#6,F.

ypically! the cost of longterm debt for a gi"en firm is lessthan the cost of preferred or common stoc$! partly because

of the tax deductibility of interest.


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Personal Finance *0a,$le

ait and asim Hulli"an! a married couple in the 2C9 federal incometax brac$et! wish to borrow 5(6!666 for a new car.

hey can either borrow the 5(6!666 through the auto dealer at an annualinterest rate of (.69! or they can ta$e a 5(6!666 second mortgage on their

home at an annual interest rate of 8.29. :f they borrow from the auto dealer! the interest on this consumer loanwill

not be deductible for federal tax purposes. Bowe"er! the interest on thesecond mortgage would be taxdeductible because the tax law allowsindi"iduals to deduct interest paid on a home mortgage.

ecause interest on the auto loan is nottaxdeductible! its aftertax coste'uals its stated cost of (.69.

ecause interest on the auto loan is taxdeductible! its aftertax cost e'uals itsstated cost of 8.29 )16.2C, 4 %.29.


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Cost o" Pre"erre Stoc

- ?referred stoc$ gi"es preferred stoc$holders the right to recei"e

their stated di"idends before the firm can distribute any earnings to

common stoc$holders.

ost preferred stoc$ di"idends are stated as a dollar amount.

Hometimes preferred stoc$ di"idends are stated as an annual percentage rate!

which represents the percentage of the stoc$s par! or face! "alue that e'uals

the annual di"idend.

- he cost of preferred stock, rp, is the ratio of the preferred stoc$

di"idend to the firms net proceeds from the sale of preferred stoc$.


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Cost o" Co,,on Stoc

- he cost of common stoc$ is the return re'uired on the

stoc$ by in"estors in the mar$etplace.

- here are two forms of common stoc$ financing

1. retained earnings

2. new issues of common stoc$

- he cost of common stock equity, rs, is the rate at which

in"estors discount the expected di"idends of the firm todetermine its share "alue.


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Cost o" Co,,on Stoc (cont.)

he constant-growth valuation (Gordon) model assumes that the

"alue of a share of stoc$ e'uals the present "alue of all future

di"idends )assumed to grow at a constant rate, that it is expected to

pro"ide o"er an infinite time horiKon.

where

P6 4 "alue of common stoc$D1 4 pershare di"idend expectedat the end of year 1

rs 4 re'uired return on common stoc$

g4 constant rate of growth in di"idends


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Hol"ing for rsresults in the following expression for the costof common stoc$ e'uity

he e'uation indicates that the cost of common stoc$ e'uity

can be found by di"iding the di"idend expected at the end ofyear 1 by the current mar$et price of the stoc$ )thedi"idend yield, and adding the expected growth rate )thecapital gains yield,.


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Duchess &orporation wishes to determine its cost of common stoc$

e'uity! rs. he mar$et price!P6! of its common stoc$ is 5%6 per share.

he firm expects to pay a di"idend!D1! of 5# at the end of the coming

year! 2613. he di"idends paid on the outstanding stoc$ o"er the past

( years )26682612, were as follows


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*e can calculate the annual rate at which di"idends ha"e

grown!g, from 2668 to 2612. :t turns out to be

approximately %9 )more precisely! it is %.6%9,.

HubstitutingD14 5#!P64 5%6! andg4 %9 into the pre"iouse'uation yields the cost of common stoc$ e'uity

rs4 )5#J5%6, < 6.6% 4 6.6C < 6.6% 4 6.136! or 13.69


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he capital asset pricing model (!"#)describes the

relationship between the re'uired return! rs! and the

nondi"ersifiable ris$ of the firm as measured by the beta

coefficient! b.rs4RF< b)rmRF,F

where

RF4 ris$free rate of return

rm 4 mar$et return return on the mar$et portfolio of assets


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Duchess &orporation now wishes to calculate its cost of

common stoc$ e'uity! rs! by using the capital asset pricing

model. he firms in"estment ad"isors and its own analysts

indicate that the ris$free rate!RF! e'uals 89 the firms beta!

b,e'uals 1.% and the mar$et return! rm! e'uals 119.

Hubstituting these "alues into the &+?! the company

estimates the cost of common stoc$ e'uity! rs! to be

rs4 8.69 < 1.% )11.698.69,F 4 8.69 < (.69 4 13.69


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- he &+? techni'ue differs from the constantgrowth"aluation model in that it directly considers the firmsris$! as reflected by beta! in determining the requiredreturn or cost of common stoc$ e'uity.

- he constantgrowth model does not loo$ at ris$ it usesthe mar$et price!P6! as a reflection of the expectedris$return preference of in"estors in the mar$etplace.

- he constantgrowth "aluation and &+? techni'ues forfinding rsare theoretically e'ui"alent! though in practiceestimates from the two methods do not always agree.


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- +nother difference is that when the constantgrowth

"aluation model is used to find the cost of common stoc$

e'uity! it can easily be ad/usted for flotation costs to find

the cost of new common stoc$ the &+? does notpro"ide a simple ad/ustment mechanism.

- he difficulty in ad/usting the cost of common stoc$

e'uity calculated by using &+? occurs because in its

common form the model does not include the mar$etprice!P6! a "ariable needed to ma$e such an ad/ustment.


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Cost o" Co,,on Stoc+

Cost o" etaine *arnings

he cost of retained earnings, rr,is the same as the cost of

an e'ui"alent fully subscribed issue of additional common

stoc$! which is e'ual to the cost of common stoc$ e'uity! rs.

rr4 rs

he cost of retained earnings for Duchess &orporation was

actually calculated in the preceding examples :t is e'ual tothe cost of common stoc$ e'uity. hus rre'uals 13.69.


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atter o" Fact

7etained Earnings "s. 7ein"esting Earnings

echnically! if a stoc$holder recei"ed di"idends and wished to

in"est them in additional shares of the firms stoc$! he or she

would first ha"e to pay personal taxes on the di"idends and then

pay bro$erage fees before ac'uiring additional shares.

y usingptas the a"erage stoc$holders personal tax rate

and bfas the a"erage bro$erage fees stated as a percentage!

we can specify the cost of retained earnings! rr! asrr4 rs)1pt, )1bf,.


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Cost o" Co,,on Stoc+ Cost o"

5e! Isses o" Co,,on Stoc

- he cost of a new issue of common stock, rn,is the cost

of common stoc$! net of underpricing and associated

flotation costs.

- Iew shares are underpricedif the stoc$ is sold at a pricebelow its current mar$et price!P6.


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Cost o" Co,,on Stoc+ Cost o" 5e!

Isses o" Co,,on Stoc (cont.)

*e can use the constantgrowth "aluation model expression

for the cost of existing common stoc$! rs! as a starting point.

:f we letNnrepresent the net proceeds from the sale of new

common stoc$ after subtracting underpricing and flotationcosts! the cost of the new issue! rn! can be expressed as

follows


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- he net proceeds from sale of new common stoc$!Nn!

will be less than the current mar$et price!P6.

- herefore! the cost of new issues! rn! will always be

greater than the cost of existing issues! rs! which is e'ualto the cost of retained earnings! rr.

- he cost of new common stoc$ is normally greater than

any other longterm financing cost.


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o determine its cost of newcommon stoc$! rn! Duchess&orporation has estimated that on a"erage! new shares can

be sold for 5#8. he 53pershare underpricing is due to thecompetiti"e nature of the mar$et. + second cost associated

with a new issue is flotation costs of 52.%6 per share thatwould be paid to issue and sell the new shares. he totalunderpricing and flotation costs per share are therefore5%.%6.

rn4 )5#.66J5##.%6, < 6.6% 4 6.6@ < 6.6% 4 6.1#6! or 1#.69

C "


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6eig#te Aerage Cost o"

Ca$ital

he weighted average cost of capital ($!), ra,reflects

the expected a"erage future cost of capital o"er the long run

found by weighting the cost of each specific type of capital

by its proportion in the firms capital structure.

ra4 )wiri, < )wprp, < )wsrror n,

wherewi 4 proportion of longterm debt in capital structure

wp 4 proportion of preferred stoc$ in capital structurews 4 proportion of common stoc$ e'uity in capital

structure

wi< wp< ws 4 1.6

6 i #t A C t "


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Ca$ital (cont.)

hree important points should be noted in the e'uation for ra

1. 0or computational con"enience! it is best to con"ert the weights into decimal

form and lea"e the indi"idual costs in percentage terms.

2. he weights must be nonnegati"e and sum to 1.6. Himply stated! *+&&

must account for all financing costs within the firms capital structure.

3. he firms common stoc$ e'uity weight! ws! is multiplied by either the cost

of retained earnings! rr! or the cost of new common stoc$! rn. *hich cost is

used depends on whether the firms common stoc$ e'uity will be financed

using retained earnings! rr! or new common stoc$! rn.

6 i #t A C t "


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Ca$ital (cont.)

:n earlier examples! we found the costs of the "arious types of capitalfor Duchess &orporation to be as follows

&ost of debt! ri4 %.(9

&ost of preferred stoc$! rp4 16.(9

&ost of retained earnings! rr4 13.69

&ost of new common stoc$! rn4 1#.69

he company uses the following weights in calculating its weighteda"erage cost of capital

Longterm debt 4 #69

?referred stoc$ 4 169

&ommon stoc$ e'uity 4 %69


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Ta/le 9.1 Calclation o" t#e 6eig#te Aerage

Cost o" Ca$ital "or c#ess Cor$oration


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Focs on Practice

Uncertain imes a$e for an Uncertain *eighted +"erage &ost of&apital

+s U.H. financial mar$ets experienced and reco"ered from the 266C financial

crisis and 266@ great recession!firms struggled to $eep trac$ of their

weighted a"erage cost of capital since the indi"idual component costs weremo"ing rapidly in response to the financial mar$et turmoil.

he financial crisis pushed credit costs to a point where longterm debt was

largely inaccessible! and the great recession saw reasury bond yields fall to

historic lows ma$ing cost of e'uity pro/ections appear unreasonably low.

*hy dont firms generally use both a short and longrun weighted a"erage

cost of capital;

6 i #t A C t "


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Ca$ital+ 6eig#ting Sc#e,es

- oo$ Aalue "ersus ar$et Aalue %ook value weightsare weights that use accounting "alues to measure the

proportion of each type of capital in the firms financial structure.

#arket value weights are weights that use mar$et "alues to measure theproportion of each type of capital in the firms financial structure.

- Bistorical "ersus arget

&istorical weightsare either boo$ or mar$et "alue weights based on actualcapital structure proportions.

'arget weightsare either boo$ or mar$et "alue weights based on desired

capital structure proportions.

- 0rom a strictly theoretical point of "iew! the preferred weightingscheme is target mar$et "alue proportions.


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P l Fi * l


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(cont.)

&huc$ found a lender who would loan him 5C6!666 for (years at an annual interest rate @.29 on the condition that

the loan proceeds be used to fully repay the three

outstanding loans! which combined ha"e an outstanding

balance of 5C6!666 )52(!666 < 5@!666 < 5#%!666,.

&huc$ wishes to choose the least costly alternati"e )1, do

nothing or )2, borrow the 5C6!666 and pay off all three

loans.

P l Fi * l


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(cont.)

&huc$ calculates the weighted a"erage cost of his currentdebt by weighting each debts annual interest cost by the

proportion of the 5C6!666 total it represents and then

summing the three weighted "alues as follows

*eighted a"erage cost of current debt

4 )52(!666J5C6!666, @.(9F < )5@!666J5C6!666, 16.(9F

< )5#%!666J5C6!666, 8.#9F4 ).32%6 @.(9, < ).112% 16.(9, < ).%(2% 8.#9,4 3.129 < 1.1@9 < #.1(9 4 C.#89 M C.%9


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eie! o" Learning Goals

LG1 Understand the basic concept and sources of capitalassociated with the cost of capital.

he cost of capital is the minimum rate of return that a firm

must earn on its in"estments to grow firm "alue. +weighted a"erage cost of capital should be used to find the

expected a"erage future cost of funds o"er the long run.

he indi"idual costs of the basic sources of capital )long

term debt! preferred stoc$! retained earnings! and common

stoc$, can be calculated separately.


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(cont.)

LG3 Determine the cost of longterm debt! and explainwhy the aftertax cost of debt is the rele"ant cost of

debt.

he beforetax cost of longterm debt can be found byusing cost 'uotations! calculations! or an approximation.

he aftertax cost of debt is calculated by multiplying the

beforetax cost of debt by 1 minus the tax rate. he after

tax cost of debt is the rele"ant cost of debt because it is the

lowest possible cost of debt for the firm due to the

deductibility of interest expenses.


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(cont.)

LG% &alculate the cost of common stoc$ e'uity! andcon"ert it into the cost of retained earnings and the

cost of new issues of common stoc$.

he cost of common stoc$ e'uity can be calculated byusing the constantgrowth "aluation )Gordon, model or the

&+?. he cost of retained earnings is e'ual to the cost of

common stoc$ e'uity. +n ad/ustment in the cost of common

stoc$ e'uity to reflect underpricing and flotation costs is

necessary to find the cost of new issues of common stoc$.



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(cont.)

LG( &alculate the weighted a"erage cost of capital)*+&&, and discuss alternati"e weighting schemes.

he firms *+&& reflects the expected a"erage future cost

of funds o"er the long run. :t combines the costs of specifictypes of capital after weighting each of them by its

proportion. he theoretically preferred approach uses target

weights based on mar$et "alues.

C#a$ter esorces on


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C#a$ter esorces on

7FinanceLa/

- &hapter &ases

- Group Exercises

- &ritical hin$ing ?roblems

Integratie Case+ *co Plastics


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Co,$an7

he target capital structure for E&N is gi"en by the weightsin the following table



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Co,$an7

- Eco can raise debt by selling 26year bonds with a 51!666par "alue and a 16.%9 annual coupon interest rate.

- Ecos corporate tax rate is #69 and its bonds generally

re'uire an a"erage discount of 5#% per bond and flotationcosts of 532 per bond when being sold.

- Ecos outstanding preferred stoc$ pays a @9 di"idend and

has a 5@%pershare par "alue. he cost of issuing and

selling additional preferred stoc$ is expected to be 58 per

share.



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2012 Pearson Education 9-%%


Co,$an7

- :n order to trac$ the cost of common stoc$ the &0N uses the capitalasset pricing model )&+?,. he &0N and the firms in"estment

ad"isors belie"e that the appropriate ris$free rate is #9 and that

the mar$ets expected return e'uals 139. Using data from 266@

through 2612! Ecos &0N estimates the firms beta to be 1.3.- +lthough Ecos current target capital structure includes 269

preferred stoc$! the company is considering using debt financing to

retire the outstanding preferred stoc$! thus shifting their target

capital structure to %69 longterm debt and %69 common stoc$.- :f Eco shifts its capital mix from preferred stoc$ to debt! its

financial ad"isors expect its beta to increase to 1.%.



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Co,$an7 (cont.)

o Do

a. &alculate Ecos current aftertax cost of longterm debt.

b. &alculate Ecos current cost of preferred stoc$.

c. &alculate Ecos current cost of common stoc$.

d. &alculate Ecos current weighted a"erage cost capital.

e. +ssuming that the debt financing costs do not change! what effect would a

shift to a more highly le"eraged capital structureconsisting of %69 long

term debt! 69 preferred stoc$! and %69 common stoc$ ha"e on the ris$

premium for Ecos common stoc$; *hat would be Ecos new cost of

common e'uity; *hat would be Ecos new weighted a"erage cost of

capital; *hich capital structurethe original one or this oneseems

better; *hy;

Documents

Cost of Capital Reviewer for Financial Management I