COST OF CAPITAL Cost of Debt Suppose a firm issued $1,000 par value bonds at face value that paid

an 8% coupon rate of interest. At that time, the before-tax cost of debt was 8% for those bonds. If the company has a 40% tax rate, then the after-tax cost of debt would have been 4.8% since the interest payments are tax-deductible. Before-tax Kd * (1-t) = After-tax Kd 8% * (1-.4) = 4.8% Suppose interest rates have risen since the bonds were issued, however, to a current 10% market rate of interest. The price of the bond will have fallen to, say, $950 in the market. This means that the cost of debt would have risen to 10% before-tax or 6% after-tax. Why is the cost of debt not still 8%? Because the opportunity cost of debt funds is based upon the market rate of interest. What is one alternative use of any money that the company has? It could go out into the marketplace and buy back its bonds for $950 and thus earn a rate of return of 10%. By not doing so, it is foregoing the opportunity cost of earning 10%. Notice also that the amount of debt is only $950 and not the $1,000 that is on the balance sheet. This is because the accounting for the debt is based upon historical costs and not the economic value. When debt is set at a fixed rate of interest, who wins when interest rates go up? Think of a mortgage on your home. If you lock in a 30-year mortgage at 7% and interest rates go up to 8%, you are a winner because your debt is at a below-market rate of interest. Of course, the lender is the loser since for every winner there is a loser in the markets. So how do you determine the market value cost of debt? Consider the following bonds current price and contractual payments: 0 $950 1 ---------------------(80) - - - - - - - - - - - - - - - - - - - - N-1 (80) N (1,080)

If these are before-tax cash flows, what is the before-tax cost of debt? Turn the question around. If you were to buy this bond for $950 today and receive interest payments of $80 per year for N years and $1,000 at the end of N years, what rate of return would you be earning? The answer is whatever the Internal Rate of Return is on the bond. Thus, the cost of the debt is the IRR between the amount of money you get and the amounts of money that you must pay back. While the after-tax cost of debt should really be the IRR on the after-tax cash flows, simply multiplying the before-tax cost by (1-t) is a very close approximation.

Cost of Preferred Stock We previously determined that the price of a share of preferred stock was

PP / S

Div KP

Rearranging to solve for the preferred stockholders required rate of return we get

KP

Div PP / S

Thus, if a share of preferred stock pays a $10 annual dividend and is selling for $100 per share in the market, the cost of the preferred stock is 10%. Again, this is an opportunity cost based upon market prices. If the company intends to sell new preferred stock using a broker, the flotation costs result in an increase in the effective cost of preferred stock. For example, suppose the same company wanted to sell more preferred stock paying a $10 dividend. The price that it would be offered in the market would be $100 in order to avoid diluting the market price. Lets assume that the broker would charge a 10% commission for selling the stocks. Then the company would only net $90 per share and the cost of the new preferred stock would be 11.1% as follows:
new KP

Div PP / S *(1 F )

$10 $10 11.1% $100(1.1) $90

While the purchasers of the preferred stock are still willing to buy it for only a 10% yield, or $10 on the $100 they pay for the stock, the company must earn 11.1% on the $90 that it receives in order to be able to pay the $10 dividend each year.

Cost of Retained Earnings From the stockholders viewpoint, what is the difference between $1 invested in the purchase of stock from the company, which ends up in the Common Stock account, and $1 of earnings that the company retains and ends up listed in the Retained Earnings account? Both represent a $1 investment in the company, the only difference is how the accountant records the source of the

$1. Thus, we can essentially ascribe a cost to the retained earnings of the company as being equal to the stockholders required rate of return.

K R / E KS

D1 g P0

Just as in the case of Preferred Stock, however, if new common stock is sold we must take into account the flotation costs incurred from its issuance. Thus,

KNew C/S

D1 g P0 (1 F )

In some instances, primarily those where a company pays no dividends, the cost of equity will have to be estimated using a Risk-Adjusted Discount Rate model, such as the Capital Asset Pricing Model (see the Discount Rates handout for another approach).

KS RF ( RM RF )
As before, the cost of equity is always based upon current market rates and prices.

The Average Cost of Capital In order to calculate the average cost of capital, we need only to take a weighted average of the costs of the different components of capital.
K Avg K d (1 t ) Debt P/S C/S KP KS Debt + P/S + C/S Debt + P/S + C/S Debt + P/S + C/S

The values in calculating the weights are all based upon the market values of the Debt, Preferred Equity (P/S) and Common Equity (C/S) and not based upon the book values. We saw how the weighted average cost of capital was used in valuing individual projects when we looked at Net Present Value. Now lets look at how the average cost of capital is calculated.

Suppose a firm has the following balance sheet: Debt (8%) Preferred Stock (7%) Common Stock ($1 par) Retained Earnings Total Assets 1,000,000 Total Liabs. & Equity 200,000 100,000 100,000 600,000 1,000,000

Assume that the debt is selling at $936 per bond ($1,000 par) and matures in ten years. The preferred stock is selling at $87.50 for each per share (each share has a par value of $100) and the common stock has a current market price of $11.25 per share. The last dividend paid (D0) was $0.75 per share and stockholders have come to expect a 5% annual rate of growth in dividends. The tax rate of the company is 40%. First, the yield to maturity on the debt needs to be determined. From an investors viewpoint, buying one of the bonds at the market price of $936 and receiving $80 per year for ten years plus the face value of the bond at the end of the tenth year would result in a yield to maturity of 9%.

0 $(936)

1 ------------------------

10 1,080

80 - - - - - - - - - - - - - - - - - - - - - - - - 80 IRR = 8.997% or roughly 9%

On an after-tax basis, the cost of the debt is Kd = 9.0% * (1 0.4) = 5.4% Again, this represents the opportunity cost of the firm not buying back its own debt at the market price of $936 per bond. If the firm could buy all of its bonds back at $936 apiece, it would cost a total of 200 bonds * $936/bond = $187,200 The market price of the outstanding preferred stock indicates that the current required rate of return on the firms preferred equity is 8%

KP

Div 7.00 .08 PP / S 87.50

or 8%

With 1,000 shares of preferred stock outstanding, the total market value of the preferred equity is $87,500. The stockholders required rate of return can be estimated by using the Gordon model and is found to be 12%

KS

D1 0.75* (1.05) 0.7875 g .05 .05 P0 11.25 11.25

.07 .05 .12 or 12%

Again, the market price of $11.25 per share times 100,000 shares yields a total market value of $1,125,000 for the common equity. Combining all of the costs of the different capital components and weighting them using market values, we arrive at a weighted average cost of capital for the firm as:
K Avg K d (1 t ) Debt P/S C/S KP KS Debt + P/S + C/S Debt + P/S + C/S Debt + P/S + C/S

9% * (1 - .4) *

187,200 87,500 8% * 187,200 87,500 1,125,000 187,200 87,500 1,125,000 12% * 1,125,000 187,200 87,500 1,125,000

5.4% * 0.133743 8% * 0.062513 12% * 0.803744 10.87%

This is the appropriate discount rate to use for the evaluation of average risk projects which can be financed with cash on hand. Calculation of the weighted average marginal cost of capital proceeds in a similar fashion, the difference being that the marginal cost of each capital component is employed (for example, the cost of new equity if additional common stock must be issued) along with the use of target weights for the capital structure as opposed to actual weights.