Chapter 11-Chapter 11- Cost of Capital Cost of Capital

2005, Pearson Prentice Hall

Basic Skills:Basic Skills: (Time value of money, (Time value of money, Financial markets , Risk and returns)Financial markets , Risk and returns)

Investments:Investments: (Stocks, Bonds) (Stocks, Bonds) Corporate Finance:Corporate Finance: (The Investment (The Investment

Decision - Capital Budgeting)Decision - Capital Budgeting)

Where we’ve been...Where we’ve been...

Assets Liabilities & EquityAssets Liabilities & Equity

Current Assets Current LiabilitiesCurrent Assets Current Liabilities

Fixed Assets Long-term DebtFixed Assets Long-term Debt

Preferred StockPreferred Stock

Common EquityCommon Equity

The investment decision

Corporate Finance:Corporate Finance: (The (The FinancingFinancing Decision)Decision)

Cost of capitalCost of capital LeverageLeverage Capital StructureCapital Structure DividendsDividends

Where we’re going...Where we’re going...

Assets Liabilities & EquityAssets Liabilities & Equity

Current Assets Current LiabilitiesCurrent Assets Current Liabilities

Fixed Assets Long-term DebtFixed Assets Long-term Debt

Preferred StockPreferred Stock

Common EquityCommon Equity

The financing decision

Assets Liabilities & EquityAssets Liabilities & Equity

Current assets Current LiabilitiesCurrent assets Current Liabilities

Long-term DebtLong-term Debt

Preferred StockPreferred Stock

Common EquityCommon Equity

}

Capital Structure

Ch. 12 - Cost of CapitalCh. 12 - Cost of Capital

For InvestorsFor Investors, the rate of return on a , the rate of return on a security is a security is a benefitbenefit of investing. of investing.

For Financial ManagersFor Financial Managers, that same , that same rate of return is a rate of return is a costcost of raising funds of raising funds that are needed to operate the firm.that are needed to operate the firm.

In other words, the cost of raising In other words, the cost of raising funds is the firm’s funds is the firm’s cost of capitalcost of capital..

How can the firm raise capital?How can the firm raise capital?

BondsBonds Preferred StockPreferred Stock Common StockCommon Stock Each of these offers a Each of these offers a rate of returnrate of return to to

investors.investors. This return is a This return is a costcost to the firm. to the firm. ““Cost of capitalCost of capital”” actually refers to the actually refers to the

weighted cost of capitalweighted cost of capital - a weighted - a weighted average cost of financing sources. average cost of financing sources.

Cost of DebtCost of Debt

For the issuing firm, the For the issuing firm, the cost of cost of debtdebt is: is:

the the rate of returnrate of return required by required by investors,investors,

adjusted for adjusted for flotation costsflotation costs (any costs associated with (any costs associated with issuing new bonds), and issuing new bonds), and

adjusted for adjusted for taxes.taxes.

Example: Tax effects Example: Tax effects of financing with debtof financing with debt

with stockwith stock with debtwith debt

EBITEBIT 400,000 400,000 400,000 400,000

- interest expense- interest expense 0 0 (50,000)(50,000)

EBTEBT 400,000 400,000 350,000 350,000

- taxes (34%)- taxes (34%) (136,000)(136,000) (119,000)(119,000)

EATEAT 264,000 264,000 231,000 231,000

Example: Tax effects Example: Tax effects of financing with debtof financing with debt

with stockwith stock with debtwith debt

EBITEBIT 400,000 400,000 400,000 400,000

- interest expense- interest expense 0 0 (50,000)(50,000)

EBTEBT 400,000 400,000 350,000 350,000

- taxes (34%)- taxes (34%) (136,000)(136,000) (119,000)(119,000)

EATEAT 264,000 264,000 231,000 231,000

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

Example: Tax effects Example: Tax effects of financing with debtof financing with debt

with stockwith stock with debtwith debt

EBITEBIT 400,000 400,000 400,000 400,000

- interest expense- interest expense 0 0 (50,000)(50,000)

EBTEBT 400,000 400,000 350,000 350,000

- taxes (34%)- taxes (34%) (136,000)(136,000) (119,000)(119,000)

EATEAT 264,000 264,000 231,000 231,000

- dividends- dividends (50,000) (50,000) 0 0

Retained earnings Retained earnings 214,000 214,000 231,000 231,000

After-tax Before-tax MarginalAfter-tax Before-tax Marginal % cost of % cost of x tax% cost of % cost of x tax Debt Debt rateDebt Debt rate

KKdd = k = kd d (1 - T) (1 - T)

.066 = .10 (1 - .34).066 = .10 (1 - .34)

-= 11

Example: Cost of DebtExample: Cost of Debt Prescott Corporation issues a Prescott Corporation issues a $1,000$1,000

par, par, 20 year20 year bond paying the market bond paying the market rate of rate of 10%.10%. Coupons are Coupons are semiannual. The bond will sell for par semiannual. The bond will sell for par since it pays the market rate, but since it pays the market rate, but flotation costs amount to flotation costs amount to $50$50 per per bond.bond.

What is the pre-tax and after-tax What is the pre-tax and after-tax cost cost of debtof debt for Prescott Corporation? for Prescott Corporation?

Pre-tax cost of debtPre-tax cost of debt: (using TVM): (using TVM)

P/Y = 2P/Y = 2 N = 40N = 40

PMT = -50PMT = -50

FV = -1000FV = -1000 So, a 10% bondSo, a 10% bond

PV = 950PV = 950 costs the firmcosts the firm

solve: I = solve: I = 10.61%10.61% = kd = kd only only 7%7% (with (with After-tax cost of debtAfter-tax cost of debt:: flotation costs)flotation costs)

Kd = kd (1 - T) Kd = kd (1 - T) since the interestsince the interest

Kd = .1061 (1 - .34) Kd = .1061 (1 - .34) is tax deductible.is tax deductible.

Kd = .07 = Kd = .07 = 7%7%

Cost of Preferred StockCost of Preferred Stock

Finding the Finding the costcost of preferred stock of preferred stock is similar to finding the is similar to finding the rate of rate of return return (from Chapter 8), except (from Chapter 8), except that we have to consider the that we have to consider the flotation costsflotation costs associated with associated with issuing preferred stock.issuing preferred stock.

Cost of Preferred StockCost of Preferred Stock

Recall:Recall:

kkpp = = = =

From the From the firm’sfirm’s point of view: point of view:

kkpp = = = =

NPo = price - flotation costs!NPo = price - flotation costs!

DPo

Dividend Price

DividendNet Price

DNPo

Example: Cost of PreferredExample: Cost of Preferred

If Prescott Corporation issues If Prescott Corporation issues preferred stock, it will pay a preferred stock, it will pay a dividend of dividend of $8$8 per year and per year and should be valued at should be valued at $75$75 per share. per share. If flotation costs amount to If flotation costs amount to $1$1 per share, what is the cost of per share, what is the cost of preferred stock for Prescott?preferred stock for Prescott?

Cost of Preferred StockCost of Preferred Stock

kpkp = = = =

= = 10.81% = = 10.81%

DividendNet Price

DNPo

8.0074.00

Cost of Common StockCost of Common Stock

There are two sources of Common Equity:There are two sources of Common Equity:

1) 1) Internal common equityInternal common equity (retained (retained earnings).earnings).

2) 2) External common equityExternal common equity (new common (new common stock issue).stock issue).

Do these two sources have the same cost?Do these two sources have the same cost?

Cost of Internal EquityCost of Internal Equity

Since the stockholders own the firm’s Since the stockholders own the firm’s retained earnings, the cost is simply retained earnings, the cost is simply the stockholders’ required rate of the stockholders’ required rate of return.return.

Why?Why? If managers are investing If managers are investing

stockholders’ funds, stockholders will stockholders’ funds, stockholders will expect to earn an acceptable rate of expect to earn an acceptable rate of return.return.

Cost of Internal EquityCost of Internal Equity

1) 1) Dividend Growth ModelDividend Growth Model

kkcc = + g = + g

2) 2) Capital Asset Pricing Model (CAPM)Capital Asset Pricing Model (CAPM)

kkjj = k = krfrf + + jj (k (kmm - k - krf rf ))

D1

Po

Dividend Growth ModelDividend Growth Model

kkncnc = + g = + g

Cost of External EquityCost of External Equity

D1

NPo

Net proceeds to the firmafter flotation costs!

Weighted Cost of CapitalWeighted Cost of Capital

The weighted cost of capital is just the The weighted cost of capital is just the weighted average cost of all of the weighted average cost of all of the financing sources.financing sources.

WACC = wWACC = wEERREE + w + wDDRRDD(1-T(1-TCC))

Weighted Cost of CapitalWeighted Cost of Capital

CapitalCapital

Source Cost StructureSource Cost Structure

debt 6% 20%debt 6% 20%

preferred 10% 10%preferred 10% 10%

common 16% 70%common 16% 70%

Weighted cost of capital =Weighted cost of capital =

.20 (6%) + .10 (10%) + .70 (16%).20 (6%) + .10 (10%) + .70 (16%)

= = 13.4%13.4%

Weighted Cost of CapitalWeighted Cost of Capital(20% debt, 10% preferred, 70% common)(20% debt, 10% preferred, 70% common)