ch 10 learning goals

Copyright © 2003 Pearson Education, Inc. Slide 10-1

Ch 10 Learning Goals1. Concept of cost of capital

2. Determine the annual percentage cost of

individual sources of capital.

3. Calculate the weighted average cost of capital

(WACC).


• The cost of capital is the annual % cost of financing

projects in the capital budget.

• It is the required rate of return that must be earned on

investment projects of _______________________.

• If the project under consideration has high or low risk,

the cost of capital must be adjusted to determine the

risk adjusted discount rate ____________________.

Overview of the Cost of Capital


Firm’s Capital Structure

Current Assets

Fixed Assets

Current Liabilities

Long-TermDebt

Equity

The Firm’s

Capital


Key Considerations

• The relevant cost of capital is the annual percentage cost of __________ financing on a ___________________ basis.


After-Tax Cost of Debt (ki)

• The pretax cost of debt (kd) is the interest rate

the firm must pay on new debt financing.

• The before tax interest rate must be adjusted for the fact that interest expense is __________________________________. This ___________________ the cost of debt.

Cost of Specific Sources of Capital


ki = kd (1-t)

For example, if the interest rate on new debt is 9% and the firm is in the 40% tax bracket:

ki = 9% (1-.40) = 5.4%

The annual percentage cost (after-tax) of debt financing is 5.4%.

After-Tax Cost of Debt (ki)



Cost of Preferred Stock (kp)

KP = DP/(NP)

In the above equation, DP is the annual dividend per

share of preferred stock and NP is the per share net

proceeds from the sale of preferred.



For example, if a company can sell preferred stock

with a $5 annual dividend for $58 per share, and

has flotation costs of $3 per share to sell it, the

annual percentage cost of preferred stock is:

kP = $5/($58 - $3) = 9.1%

Cost of Preferred Stock (kp)

KP = DP/NP



Cost of Common Equity


• There are two sources of common stock

financing: ____________________________

and new issues of ______________________.

• In addition, there are two ways to estimate the

cost of common equity: the dividend valuation

model, and the capital asset pricing model

(CAPM).


Constant Dividend Growth Model

ks = (D1/P0) + g.

For example, the firm has just paid a dividend of $2.50 per share, expects dividends to grow at 8%,

and the stock is selling for $50 per share.

First, D1 = 2.50(1+.08) = 2.70, and

kS = (2.70/50) + .08 = 13.4%.

Cost of Retained Earnings (kr)



CAPM Approach

Cost of Retained Earnings (kr = ks)

ks = rF + b(kM - RF).

For example, if the T-bill rate is currently 3.0%, the market risk premium is 9%, and the firm’s beta is 1.2,

the firm’s cost of retained earnings will be:

ks = 3.0 + 1.2(9) = 13.8%.



The previous example indicates that our estimate of the cost of retained earnings is somewhere

between 13.4% and 13.8%. At this point, we could choose one or average the two (13.6%).

Cost of Common Equity

Cost of Retained Earnings (ks)



Cost of New Common Stock (kn)

Cost of new common stock financing (kn)

kn = (D1 / Nn)+ g

Where:

D1 is the dividend expected in the coming year.

Nn = net proceeds from the sale of new common stock


Cost of New Common Stock (kn)

Example:

D1 = 2.70

Nn = $40

g = 8%

kn = (D1 / Nn)+ g

kn = (2.70 / 40) + .08 = .1475 = 14.8%


Capital Structure Weights

WACC = ka = wiki + wpkp + ws(kS or kn)

The weights in the above equation represent a specific financing mix (where wi = % of financing from

debt, wp = % of financing from preferred, and ws= %

of financing from common).

The Weighted Average Cost of Capital




The weights can be determined by: Firm’s policy (target weights)Market values of firm’s debt and equityBook values of firm’s debt and equity



For example, the market value of the firm’s debt is $40 million, the market value of the firm’s preferred stock is $10 million, and the market value of the firm’s equity is $50 million.

Dividing each component by the total of $100 million gives us market value weights of 40% debt, 10% preferred, and 50% common.





Using the costs previously calculated along with the market value weights, if retained earnings is the source of common equity the weighted average cost of capital as follows:

WACC = .4(5.4%) + .1(9.1%) + .5 (13.6%)

= 9.9%


WACC = ka = wiki + wpkp + WACC = ka = wiki + wpkp + ws(kS or kn)


Retained Earnings Breakpoint

The retained earnings breakpoint is the maximum amount of _______________ that can be raised without selling new common stock. To finance additional projects, new common stock must be sold.


Retained Earnings Breakpoint

REBP = ($ of retained earnings) / ws

Example: firm expects to add $1 mil to retained earnings this year.

ws = .50REBP = $1 mil / .5 = $2 mil

The firm can finance a capital budget of $2 mil without selling new common stock.


Using the costs previously calculated along with the market value weights, if new common stock is the source of common equity the weighted average cost of capital as follows:

WACC = .4(5.4%) + .1(9.1%) + .5 (14.8%)

= 10.5%


WACC = ka = wiki + wpkp + WACC = ka = wiki + wpkp + ws(kS or kn)

ch 10 learning goals

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