8/6/2019 Cost of Cost

1/18

The Cost of Capital

8/6/2019 Cost of Cost

2/18

The Cost of Capital The Cost of Capital is the rate of return that a

firm must earn on its investment projects to

increase the market value of its commonshares.

Only those investment projects whose expected

returns are greater than or equal to the cost offunds used to acquire the projects would be

recommended.

8/6/2019 Cost of Cost

3/18

Basic Assumptions

The cost of capital is dynamically affected by

many economic and firm specific factors.

Business Risk Financial Risk

The cost of capital is measured on an after-tax basis.

8/6/2019 Cost of Cost

4/18

TheB

asic Concept Firms typically raise money in lumps, the cost of

capital should reflect the interrelatedness of

financing activities.

Most firms maintain a deliberate mix of debt and

equity financing to minimize the cost of capital,

called the Optimal Capital Structure.

The Optimal Capital Structure looks at the overallcost of capital, not just the cost of specific funds.

8/6/2019 Cost of Cost

5/18

Cost of Specific Sources

of Capital

To determine which fixed asset investments

should be selected, the cost of capital must

be known.

Three basic sources of long-term funds are:

Long-term debt,

Preferred equity, and

Common equity.

8/6/2019 Cost of Cost

6/18

Before-Tax Cost of Debt

When net proceeds from a bond equal its parvalue, the before-tax cost will equal the

coupon rate. The Yield to Maturity on a similar-risk bond isalso used.

The before-tax cost of debt can be found by

calculating the Internal Rate of Return (IRR)on the bond cash flows, and is called the costof maturity.

8/6/2019 Cost of Cost

7/18

After-Tax Cost of Debt Because interest on debt is tax deductible, it

reduces the firms taxable income.

Simply state the After-Tax Cost of Debt is:

kdt=k

dv (1-T)

8/6/2019 Cost of Cost

8/18

Cost of Preferred Equity The Cost of Preferred Equity, kp, is the ratio

of the preferred share annual dividend to the

net proceeds from the sale of the preferredshares.

p

p

p

N

Dk !

8/6/2019 Cost of Cost

9/18

Cost of Common Equity There are two forms of common equity

financing:

reinvested profits; and new issues of common shares.

The Cost of Common Equity, ks, is theexpected return investors require to hold the

common shares of the company.

8/6/2019 Cost of Cost

10/18

Finding the Cost with DVM

The constant-growth dividend valuationmodel (DVM) or Gordon Model equation

can be arranged to solve forks.

Since dividends are paid from after-taxincome, no tax adjustment is required.

gP

ks 0

1

8/6/2019 Cost of Cost

11/18

Cost of Reinvested Profits By retaining earnings, the company is using

common shareholders funds.

The Cost of Reinvested Profits, kr, is equalto the cost of common equity, ks, as follows:

kr=ks

It is not necessary to adjust the cost ofreinvested profits for flotation costs,because these costs are not incurred.

8/6/2019 Cost of Cost

12/18

Cost of New Shares Issues The Cost of New Shares Issues, kn, is

determined by calculating the cost of common

shares, net of discounts and associated flotationcosts.

Normally new issues will be discounted to a

price below the current market price 0.

8/6/2019 Cost of Cost

13/18

Weighted Average Cost of

Capital (WACC) The Weighted Average Cost of Capital (WACC), ka,

reflects the expected average future cost of funds.

ka = (wdv kd) + (wp v kp) + (ws v kr or n)where

wd = proportion of log-term debt in capital structure

wp=

proportion of preferred equity in capital structurews = proportion of common equity in capital structure

wd+ wp + ws = 1.0

8/6/2019 Cost of Cost

14/18

Weighting Schemes

Weights can be calculated based on either

Book Value, or

Market Value for costs.

And may use either

Historic, or

Target proportions for weighting.

The preferred weighting scheme is marketvalue with target proportions.

8/6/2019 Cost of Cost

15/18

Marginal Cost and Investment

Decisions

As the volume of financing increases, the

costs of various types of financing will

increase, raising the firms weighted average

cost of capital.

The Marginal Cost of Capital (MCC) is the

firms average cost of capital associated withits next dollar of total new financing.

8/6/2019 Cost of Cost

16/18

Investment Opportunities

Schedule (IOS)

The Investment Opportunities Schedule

(IOS) is a ranking of investment

possibilities from best (highest return) to

worst (lowest return).

8/6/2019 Cost of Cost

17/18

Using MCC and IOS in Decision-Making

When a projects expected return (internal

rate of return) is equal to or greater than the

marginal cost of new financing, the project

should be accepted.

Firms should accept projects up to the point at

which the marginal return on its investmentequals its marginal cost of capital.

8/6/2019 Cost of Cost

18/18

MCC-IOS Schedules