KOSZT I

STRUKTURA
KAPITAU
2008

Kevin Campbell, University of Stirling, November 2005

Cost of Capital
Cost

of Capital - The return the firms

investors could expect to earn if they
invested in securities with comparable
degrees of risk

Capital

Structure - The firms mix of long

term financing and equity financing

Kevin Campbell, University of Stirling, November 2005

Cost of Capital
The cost of capital represents the overall cost
of financing to the firm
The cost of capital is normally the relevant
discount rate to use in analyzing an investment
The overall cost of capital is a weighted
average of the various sources:
WACC = Weighted Average Cost of Capital
WACC = After-tax cost x weights

Kevin Campbell, University of Stirling, November 2005

Cost of Debt
The cost of debt to the firm is the effective yield to
maturity (or interest rate) paid to its bondholders
Since interest is tax deductible to the firm, the
actual cost of debt is less than the yield to
maturity:
After-tax cost of debt = yield x (1 - tax rate)
The cost of debt should also be adjusted for
flotation costs (associated with issuing new
bonds)

Kevin Campbell, University of Stirling, November 2005

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 shareholders
Kevin Campbell, University of Stirling, November 2005

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
Kevin Campbell, University of Stirling, November 2005

Cost of Debt
After-tax cost
of Debt

33,000

Before-tax cost
of Debt

50,000

50,000 ( 1 - .34)

Tax
Savings

17,000

OR

33,000

Or, if we want to look at percentage costs:

Kevin Campbell, University of Stirling, November 2005

Cost of Debt
After-tax
% cost of
Debt

Kd
.066

Before-tax
% cost of
Debt

Marginal
tax
rate

kd (1 - T)
=

.10 (1 - .34)

Kevin Campbell, University of Stirling, November 2005

EXAMPLE: Cost of Debt

Prescott

Corporation issues a $1,000 par,

20 year bond paying the market rate of
10%. Coupons are annual. 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?
Kevin Campbell, University of Stirling, November 2005

EXAMPLE: Cost of Debt

Pre-tax

cost of debt:

950 = 100(PVIFA 20, Kd) + 1000(PVIF 20, Kd)

using a financial calculator:
So a 10% bond
Kd = 10.61%
After-tax

cost of debt:

Kd

Kd (1 - T)

Kd

.1061 (1 - .34)

Kd

.07

costs the firm

only 7%
(with flotation costs)
because interest
is tax deductible

7%

Kevin Campbell, University of Stirling, November 2005

10

Cost of New Preferred

Stock
Preferred stock:
has a fixed dividend (similar to debt)
has no maturity date
dividends are not tax deductible and are
expected to be perpetual or infinite
Cost of preferred stock = dividend
price - flotation cost

Kevin Campbell, University of Stirling, November 2005

11

Cost of Preferred stock:

Example
Baker Corporation has preferred stock that sells for $100 per share and pays an annual
dividend of $10.50. If the flotation costs are $4 per share, what is the cost of new
preferred stock?
KP

$10.50
.1094 10.94%
$100 - 4

Kevin Campbell, University of Stirling, November 2005

12

Cost of Equity:

Retained
Earnings
Why is there a cost
for retained earnings?
Earnings

can be reinvested or paid out as

dividends
Investors could buy other securities, and
earn a return.
Thus, there is an opportunity cost if
earnings are retained

Kevin Campbell, University of Stirling, November 2005

13

Cost of Equity:

Retained
Earnings
Common stock equity
is available through

retained earnings (R/E) or by issuing new

common stock:
Common equity = R/E + New common stock

Kevin Campbell, University of Stirling, November 2005

14

Cost of Equity:
New Common Stock

The

cost of new common stock is higher

than the cost of retained earnings
because of flotation costs
selling and distribution costs (such as
sales commissions) for the new
securities

Kevin Campbell, University of Stirling, November 2005

15

Cost of Equity
There

are a number of methods used to

determine the cost of equity
We will focus on two
Dividend

growth Model

CAPM

Kevin Campbell, University of Stirling, November 2005

16

The Dividend Growth Model

Approach

Estimating the cost of equity: the dividend growth model

approach
According to the constant growth (Gordon) model,
D1
P0 =
RE - g
Rearranging

D1
RE =

+g
P0

Kevin Campbell, University of Stirling, November 2005

17

Example: Estimating the

Dividend Growth Rate
Percentage
Year
Dividend

Dollar Change

Change

1990

$4.00

--

1991

4.40

$0.40

10.00%

1992

4.75

0.35

7.95

1993

5.25

0.50

10.53

1994

5.65

0.40

7.62

Average Growth Rate

(10.00 + 7.95 + 10.53 + 7.62)/4 = 9.025%

Kevin Campbell, University of Stirling, November 2005

18

Dividend Growth Model

This model has drawbacks:

Some firms concentrate on growth and do not

pay dividends at all, or only irregularly
Growth rates may also be hard to estimate
Also this model doesnt adjust for market risk
Therefore many financial managers prefer the
capital asset pricing model (CAPM) - or security
market line (SML) - approach for estimating the
cost of equity
Kevin Campbell, University of Stirling, November 2005

19

Capital Asset Pricing Model (CAPM)

kj Rf ( Rm Rf )
Cost of
capital

Risk-free
return

Co-variance
of returns against
the portfolio
(departure from the average)

Average rate of return

on common stocks
(WIG)

B < 1, security is safer than WIG average

B > 1, security is riskier than WIG average

Kevin Campbell, University of Stirling, November 2005

20

The Security Market Line (SML)

Required rate
of return
Percent
20.0

SML = Rf + (Km Rf)

18.0
16.0
14.0
12.0
10.0
Rf

Market risk premium

8.0
5.5
0.5

1.0

1.5

Kevin Campbell, University of Stirling, November 2005

2.0

Beta (risk)
21

Finding the Required Return on

Common Stock using the Capital
Asset Pricing Model
The Capital Asset Pricing Model (CAPM) can be used to estimate the
required return on individual stocks. The formula:
K j R f j K m R f
where
Kj

Required return on stock j

Rf
j

=
=

Risk-free rate of return (usually current rate on Treasury Bill).

Beta coefficient for stock j represents risk of the stock

Km

Return in market as measured by some proxy portfolio (index)

Suppose that Baker has the following values:

=
5.5%
Rf
j
=
1.0
Km

12%
.

Kevin Campbell, University of Stirling, November 2005

22

Finding the Required Return on

Common Stock using the Capital
Asset Pricing Model
Then, using the CAPM we would get a required return of
K j 5.5 1.0 12 - 5.5 12%

Kevin Campbell, University of Stirling, November 2005

23

CAPM/SML approach
Advantage:

Evaluates risk, applicable

to firms that dont pay dividends

Disadvantage:

Need to estimate

Beta
the risk premium (usually based on past data,

not future projections)

use an appropriate risk free rate of interest

Kevin Campbell, University of Stirling, November 2005

24

Estimation of Beta: Measuring

Market Risk
Market

Portfolio - Portfolio of all assets in

the economy
In practice a broad stock market index,
such as the WIG, is used to represent the
market
Beta - sensitivity of a stocks return to the
return on the market portfolio

Kevin Campbell, University of Stirling, November 2005

25

Estimation of Beta

Theoretically, the calculation of beta is

straightforward:
Cov ( Ri , RM ) iM

2
Problems
Var ( RM )
M

1. Betas may vary over time.

2. The sample size may be inadequate.
3. Betas are influenced by changing financial leverage and business risk.

Solutions

Problems 1 and 2 (above) can be moderated by more sophisticated statistical

techniques.
Problem 3 can be lessened by adjusting for changes in business and financial
risk.
Look at average beta estimates of comparable firms in the industry.

Kevin Campbell, University of Stirling, November 2005

26

Stability of Beta
Most

analysts argue that betas are generally

stable for firms remaining in the same industry
Thats not to say that a firms beta cant change

Changes in product line

Changes in technology
Deregulation
Changes in financial leverage

Kevin Campbell, University of Stirling, November 2005

27

What is the appropriate riskfree rate?

Use the yield on a long-term bond if you are

analyzing cash flows from a long-term investment

For short-term investments, it is entirely

appropriate to use the yield on short-term
government securities

Use the nominal risk-free rate if you discount

nominal cash flows and real risk-free rate if you
discount real cash flows

Kevin Campbell, University of Stirling, November 2005

28

Survey evidence: What do you

use for the risk-free rate?
Corporations

Financial Advisors

90-day T-bill (4%)

90-day T-bill (10%)

3-7 year Treasuries (7%)

5-10 year Treasuries (10%)

10-year Treasuries (33%)

10-30 year Treasuries (30%)

20-year Treasuries (4%)

30-year Treasuries (40%)

10-30 year Treasuries (33%)

N/A (10%)

10-years or 90-day; depends

(4%)
N/A (15%)

Source: Bruner et. al. (1998)

Kevin Campbell, University of Stirling, November 2005

29

Weighted Average Cost of Capital

(WACC)

WACC weights the cost of equity and the cost

of debt by the percentage of each used in a
firms capital structure
WACC=(E/ V) x RE + (D/ V) x RD x (1-TC)

(E/V)= Equity % of total value

(D/V)=Debt % of total value
(1-Tc)=After-tax % or reciprocal of corp tax rate Tc.
The after-tax rate must be considered because
interest on corporate debt is deductible

Kevin Campbell, University of Stirling, November 2005

30

WACC Illustration
ABC Corp has 1.4 million shares common valued at $20 per
share =$28 million. Debt has face value of $5 million and trades
at 93% of face ($4.65 million) in the market. Total market value
of both equity + debt thus =$32.65 million. Equity % = .8576
and Debt % = .1424
Risk free rate is 4%, risk premium=7% and ABCs =.74
Return on equity per SML : RE = 4% + (7% x .74)=9.18%
Tax rate is 40%
Current yield on market debt is 11%
Kevin Campbell, University of Stirling, November 2005

31

WACC Illustration
WACC = (E/V) x RE + (D/V) x RD x (1-Tc)
= .8576 x .0918 + (.1424 x .11 x .60)
= .088126 or 8.81%

Kevin Campbell, University of Stirling, November 2005

32

Final notes on WACC

WACC should be based on market rates and

valuation, not on book values of debt or equity
Book values may not reflect the current
marketplace
WACC will reflect what a firm needs to earn on
a new investment. But the new investment
should also reflect a risk level similar to the
firms Beta used to calculate the firms RE.

In the case of ABC Co., the relatively low WACC of

8.81% reflects ABCs =.74. A riskier investment
should reflect a higher interest rate.
Kevin Campbell, University of Stirling, November 2005

33

Final notes on WACC

The

WACC is not constant

It changes in accordance with the risk of
the company and with the floatation
costs of new capital

Kevin Campbell, University of Stirling, November 2005

34

Marginal cost of capital and

Percent
investment
projects
16.0 A
12.0 10.0 8.0 14.0

10.77%

11.23%
Kmc

10.41%
D

E
F

4.0 2.0 0.0 -

Marginal
cost of
capital

G
H

6.0

10 15 19

39
50
70
Amount of capital ($ millions)
Kevin Campbell, University of Stirling, November 2005

85

95
35

The End .

KAPITA - bogactwo zebrane uprzednio w celu podjcia dalszej produkcji

(F. Quesnay, XVIII)
wszelki wynik procesu produkcyjnego, ktry przeznaczony jest do pniejszego
wykorzystania w procesie produkcyjnym (MCKenzzie, Nardelli,1991)
caoksztat zaangaowanych w przedsibiorstwie wewntrznych i
zewntrznych, wasnych i obcych, terminowych i nieterminowych zasobw
(bilans)
STRUKTURA KAPITAU
proporcja udziau kapitau wasnego i obcego w finansowaniu dziaalnoci
przedsibiorstwa
relacja wartoci zaduenia dugoterminowego do kapitaw wasnych
przedsibiorstwa
struktura finansowania struktura kapitau = zobowizania biece
ramy statycznego kompromisu, w ktrym przedsibiorstwo ustala docelow
wielko wskanika zaduenia i stopniowo zblia si do jego osignicia.

Kevin Campbell, University of Stirling, November 2005

36