COST OF CAPITAL

What we know
Basic Skills: (Time value of money, Financial Statements) Investments: (Stocks, Bonds, Risk and Return) Corporate Finance: (The Investment Decision - Capital Budgeting)

Assets Current assets Fixed assets

Liabilities & Equity Current Liabilities Long-term debt Preferred Stock Common Equity

The investment decision

Assets Current assets Fixed assets

Liabilities & Equity Current Liabilities Long-term debt Preferred Stock Common Equity

Where were going...

Corporate Finance: (The Financing Decision) Cost of capital Leverage Capital Structure Dividends

Assets Current assets Fixed assets

Liabilities & Equity Current Liabilities Long-term debt Preferred Stock Common Equity

The financing decision

Assets Current assets Fixed assets

Liabilities & Equity Current Liabilities Long-term debt Preferred Stock Common Equity

Assets Current assets

Liabilities & Equity Current Liabilities Long-term debt Preferred Stock Common Equity

Assets Current assets

Liabilities & Equity Current Liabilities Long-term debt Preferred Stock Common Equity

Capital Structure

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 firms 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.

Some concept usage

Systematic Risk: Risk factors that affect the overall market, such as changes in nations economy, tax reforms, or a change in the world energy situation. These are risks that affect securities overall where an investor who holds a well-diversified portfolio will be exposed to this type of risk. Flotation Costs: The costs associated with issuing securities, such as underwriting, legal, listing, and printing fees.

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

EBIT - interest expense EBT - taxes (34%) EAT

with stock 400,000 0 400,000 (136,000) 264,000

with debt 400,000 (50,000) 350,000 (119,000) 231,000

Example: Tax effects of financing with debt

EBIT - interest expense EBT - taxes (34%) EAT

with stock 400,000 0 400,000 (136,000) 264,000

with debt 400,000 (50,000) 350,000 (119,000) 231,000

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

Example: Tax effects of financing with debt

with stock EBIT 400,000 - interest expense 0 EBT 400,000 - taxes (34%) (136,000) EAT 264,000 - dividends (50,000) Retained earnings 214,000 with debt 400,000 (50,000) 350,000 (119,000) 231,000 0 231,000

After-tax % cost of Debt

Before-tax % cost of Debt

Marginal - tax rate

After-tax % cost of Debt

Before-tax % cost of Debt

Marginal - tax rate

Ki

k d (1 - t)

After-tax % cost of Debt

Before-tax % cost of Debt

Marginal - tax rate

Ki .066

= =

k d (1 - t) .10 (1 - .34)

Example: Cost of Debt Prescott Corporation issues a $1,000 par, 8 %, 20 year bond whose net proceeds are $940. The tax rate is 40%.
What is the pre-tax and after-tax cost of debt for Prescott Corporation?

 Pre-tax cost of debt: Use approximate method of YTM on a Bond. I + (M V) / n

kd =

(M + V) / 2

80 + (1000 940) / 20 (1000 + 940) / 2

Where, I = annual interest M = par value per bond V = value or net proceeds form sale of a bond n = bond years

83 = 8.56% = 970

 After-tax cost of debt Ki = k d (1 -t) = 8.56% (1 - 0.4) = 8.56% (0.6) Ki = 5.136%

On an almost 9% before-tax cost, the aftertax cost of debt is 5.14%.

Cost of Preferred Stock

Most corporations that issue preferred stock fully intend to pay the stated dividend. The required rate of return for this stock, or simply the yield on preferred stock, serves as the estimate of the cost of preferred stock. Because such stocks have no maturity date.

Cost of Preferred Stock

It is represented as:
kp = Dp Po =

Dividend Price

Where, D p is the stated annual dividend and Po is the current market price of the preferred stock. It also means net proceeds from the sale of the stock.

Example: Cost of Preferred

Suppose that the Carter Company has preferred stock that pays a $13 dividend per share and sells for $100 per share in the market. The flotation (or underwriting) cost is 3%, or $3 per share. What is the cost of preferred stock?

Cost of Preferred Stock

kp = D1 NPo = Dividend Net Price

= =

$13
$100 - $3

$13 $97

13.4%

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 firms 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 ke = D1 Po +g

Cost of Internal Equity

1) Dividend Growth Model ke = D1 Po +g

2) Capital Asset Pricing Model (CAPM)

Cost of Internal Equity

1) Dividend Growth Model ke = D1 +g Po

2) Capital Asset Pricing Model (CAPM) Rj

Rf

+ b j(Rm - Rf )

Cost of Internal Equity

Where, Rj = required rate of return Rf = risk-free rate Rm = expected r.o.r. for market portfolio bj = beta coefficient for stock j
From markets aversion to systematic risk, greater the Beta of a stock, the greater its required return. The risk-return relationship in the form of an equation is also known as the security market line. It implies that in market equilibrium, security prices will be such that there is a linear trade-off between required r.o.r. and Systematic risk, as measured by Beta.

The Capital-Asset Pricing Model Approach

An alternative approach to measuring the cost of common stock. The steps are: Estimate the risk-free rate, Rf. Estimate the stocks beta coefficient, b, which is an index of systematic (or non diversifiable market) risk. Estimate the r.o.r. on the market portfolio, Rm, such as the Standard & Poors 500 Stock Composite Index. Use the CAPM equation to find required r.o.r.

Example: Dividend Growth Model

Assume that the market price of a companys stock is $40. Dividend to be paid at end of the coming year is $4 per share and is expected to grow at a constant annual rate of 6%. What is cost of common stock?

ke =

D1

Po

+ g

$4 = + 6% = 16% $40

Example: CAPM approach

Assume that risk-free rate is 7%, beta is 1.5, and market portfolio r.o.r. is 13%. Then what is cost of common stock?

Rj

Rf

+ b j(Rm - Rf )

= 7% + 1.5(13% - 7%) = 16%

This 16% cost can be viewed as consisting of a 7% riskfree rate plus a 9% risk premium, reflecting firms stock price as 1.5 times more volatile than market portfolio to factors affecting systematic risk.

Cost of External Equity

Dividend Growth Model

Cost of External Equity

Dividend Growth Model

D1 k e = NP + g o

Cost of External Equity

Dividend Growth Model

D1 k e = NP + g o
Net proceeds to the firm after flotation costs!

Example: Cost of External Equity

Assume that the market price of a companys stock is $40. Dividend to be paid at end of the coming year is $4 per share and is expected to grow at a constant annual rate of 6%. The company is trying to sell new issues and its flotation cost is 10%. What is cost of common stock?

ke

D1

= + g NPo

$4 + 6% $36

= 11.11% + 6% = 17.11%

Weighted Cost of Capital

The weighted cost of capital is just the weighted average cost of all of the financing sources. K = wi k i + wp k p+ we k e
Where, Wi = % of total capital supplied by debt Wp= % of total capital supplied by preferred stock We = % of total capital supplied by equity

Weighted Cost of Capital

Capital Structure 20% 10% 70%

Source debt preferred common

Cost 6% 10% 16%

Weighted Cost of Capital

(20% debt, 10% preferred, 70% common)

Weighted cost of capital =

0.20 (6%) + 0.10 (10%) + 0.70 (16%) = 13.4%

Exercise: Weighted Average Cost of Capital

Assume the following capital structure of a Company:

Mortgage ($1,000 par) $20,000,000 Preferred Stock ($100 par) 5,000,000 Common Stock ($40 par) 20,000,000 Retained Earnings 5,000,000 TOTAL $50,000,000

Calculate book value weights and the Overall cost of capital.

Source Debt PS CS RE

Book Value 20,000,000 5,000,000 20,000,000 5,000,000

Weights (%) 40 10 40 10

Cost (%) 5.14 13.14 17.11 16.00

WC (%) 2.06 1.34 6.84 1.60

Totals

50,000,000

100

11.84

Overall Cost of Capital = 11.84%