group 11-assignment 2

Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL

TABLE OF CONTENTS

I. The cost of capital of a firm/ project and its major components..........................2

1. Definition of the Cost of Capital.............................................................................2

2. Major components of the Cost of Capital...............................................................2

II. Motivations and calculations of Cost of Debt, Cost of Equity and WACC........4

1. Cost of debt.............................................................................................................5

2. Cost of equity..........................................................................................................6

2.1. Cost of preferred stock (kps)..............................................................................6

2.2. Cost of common (stock) equity.........................................................................6

2.2.1. Cost of retained earnings (kr)......................................................................7

2.2.2. Cost of a newly issued common stock (kn).................................................7

3. Weighted average cost of capital (WACC).............................................................8

III. Usefulness and applications of WACC..............................................................11

1. Project evaluation..................................................................................................11

2. Choosing the most appropriate investment...........................................................13

3. EVA Determination..............................................................................................13

REFERENCE..............................................................................................................16

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I. The cost of capital of a firm/ project and its major components

1. Definition of the Cost of Capital

The cost of capital is a decisive factor in financial decision-making. The

concept of it, therefore, is a recent development and has relevance in almost every

financial matter. The progressive management always has to take notice of the cost of

capital while taking a financial decision.

Cost of capital is the rate of return a firm must earn on its projects or

investments to maintain the market value of its stock. It is a composite cost of the

individual sources of funds, including common stock, debt, preferred stock. The

overall cost of capital depends on the cost of each source and the proportion that

source represents of all capital used by the firm. The goal of an individual or business

is to limit investment to assets that provide a return that is higher than the cost of the

capital that was used to finance those assets, which is also called average cost of

capital.

A company's cost of capital is exactly as its name implies. When a company

raises capital from its lenders and owners, both types of investors require a return on

their investment. Lenders expect to be paid interest on their loans, while owners

expect a return, too.

A stable, predictable company will have a low cost of capital, while a risky

company with unpredictable cash flows will have a higher cost of capital. It means

that the riskier company's future cash flows are worth less in present value terms,

which is why stocks of stable companies often look more expensive on the surface.

2. Major components of the Cost of Capital

A firm can finance new projects by borrowing, issuing common stocks or

issuing preferred stocks. Financing new projects only by borrowing is normally not

recommended since, at some point, the firm will find it necessary to use one of the

other forms of financing to prevent the debt ratio from becoming too large.

Alternatively, financing new projects by issuing too many preferred stocks is not

desirable since it is riskier to guarantee a given dividend to many people. A firm

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should, therefore, be considered as an on going concern, about what is the most

reasonable way to raise their capital.

The following are major components of cost of capital:

2.1. Cost of debt

The cost of debt is the effective rate that a company pays on its current loans,

bonds and various other forms of debt. The measure provides an idea as to the overall

rate being paid by the company to use debt financing. The higher the cost of debt, the

riskier the company is.

2.2. Cost of equity

The cost of equity is the rate of return on required by the company's ordinary

shareholders. The return consists both of dividend and capital gains. The returns are

expected future returns, not historical returns. Returns on equity are often expressed as

the anticipated dividends on the shares every year in perpetuity. The cost of equity is

then the cost of capital, which will equate the current market price of the share with

the discounted value of all future dividends. The cost of equity reflects the effective

opportunity cost of investment for shareholders.

2.3. Cost of preferred stock

Preferred Stock has a higher return than bonds, but is less costly than common

stock. In case of default, preferred stockholders get paid before common stock

holders. However, in the case of bankruptcy, the holders of preferred stock get paid

only after short and long-term debt holder claims are satisfied.

Preferred stock holders receive a fixed dividend and usually cannot vote on the firm’s

affairs.

For investors, the cost of preferred stock, once it has been issued, will vary like

any other stock price. That means it will be subject to supply and demand in the

market. In theory at least, preferred stock may be seen as more valuable than common

stock as it has a greater likelihood of paying a dividend and offers a greater deal of

security if the company folds.

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http://www.wisegeek.com/what-is-a-theory.htm

http://www.wisegeek.com/what-is-supply-and-demand.htm

http://www.wisegeek.com/what-determines-a-stock-price.htm


II. Motivations and calculations of Cost of Debt, Cost of Equity and

WACC

The firm must always decide how to raise the capital to fund its business or

finance its growth. Most firms employ several types of capital, called capital

components, with common stock equity (retained earnings plus common stock) and

preferred stock, along with debt, being the three most frequently used types. Any

increase in a firm’s total assets will have to be financed through an increase in at least

one of these capital components. All capital components have one feature in common:

The investors who provided the funds expect to receive a return on their investment.

The cost of each of these components is called the component cost of capital and the

minimum overall cost of capital will maximize the value of the firm (share price).

If a firm’s only investors are common stockholders, then the cost of capital will

be the required rate of return equity. If the capital structure of company only consists

of debt, the cost of capital will be required rate of return debt. However, most firms

employ different types of capital, and due to differences in risk, these different

securities have different required rates of return. The required rate of return on each

capital component is called its component cost, and the cost of capital used to analyze

capital budgeting decisions should be a weighted average of the various components’

costs. We call this weighted average just that, the weighted average cost of capital, or

WACC (rhymes with “quack”).

Indeed, the company cost of capital is usually calculated as a weighted average

of the after-tax interest cost of debt financing and the “cost of equity,” that is, the

expected rate of return on the firm’s common stock. The weights are the fractions of

debt and equity in the firm’s capital structure. Managers need to use the weighted-

average cost of capital to evaluate average-risk capital investment projects. “Average

risk” means that the project’s risk matches the risk of the firm’s existing assets and

operations.

The following sections discuss each of the component costs in more detail, then

we show how the weighted average cost of capital is calculated in practice and when

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the weighted-average cost of capital is or is not the appropriate rate at which the cash

flows associated with a capital budgeting project is discounted.

1. Cost of debt

We assume that funds of the firm are raised through the issuance and sale of

bonds and the bonds pay annual interest. The first step in estimating the cost of long –

term debt (bonds) is to determine the rate of return debt holders require, or kd. So the

cost of debt is referred as to the market interest rate demanded by bondholders. In

other words, it is the rate that the company would pay on new debt issued to finance

its investment projects. The cost of debt can be measured as either before-tax or after-

tax returns.

The before – tax cost of debt kd is the rate at which the firm can issue new debt.

This is the yield to maturity (YTM) on existing debt. The before – tax cost of debt

can be obtained by using the IRR method. However, because the interest expense

is tax deductible, the after-tax cost is seen more often than the before – tax cost of

debt.

The after – tax cost of debt, kd (1-t), is the interest rate on debt, kd, less the tax

savings from the tax deductibility of interest, kd(t), which is the same as before-

tax cost of debt multiplied by (1 – t), where t is the firm’s marginal tax rate.

After – tax cost of debt = interest rate – tax savings = kd – kd(t) = kd(1 – t)

We use the after-tax cost of debt in calculating the WACC because we are

interested in maximizing the value of the firm’s stock, and the sotock price depends on

after-tax cash flows.

Example:

Dexter, Inc., is planning to issue new debt at an interest rate of 8%. Dexter has

a 40% marginal federal-plus-state tax rate. What is Dexter’s cost of debt capital?

Answer:

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kd(1 – t) = 8% (1 – 0.4) = 4.8%

2. Cost of equity

2.1. Cost of preferred stock (kps).

Preferred stock dividends are usually a stated dollar amount. Alternatively,

preferred stock dividends may be stated as an annual percentage rate, e.g., 7%.

Preferred stockholders often receive a stated dividend prior to the distribution of

earnings to common stockholders.

The cost of preferred (kps) is just the preferred dividend divided by the market

price of a preferred share, or the net issuing price (not “book value” of preferred

stock).

kps = Dps/P

where Dps = annual dollar dividend per share; P = market price of preferred stock.

Example :

Suppose Dexter has preferred stock that pays an $16 dividend per share and

sells for $100 per share. What is Dexter’s cost of preferred stock?

Answer :

kps = Dps/P = $16/ $100 = 0.16 = 16%

2.2. Cost of common (stock) equity

The cost of common equity kce is the rate at which investors discount expected

dividends to determine the share value of the firm. The cost of common equity can be

estimated by using the following capital asset pricing model approach (CAMP).

The capital asset pricing model approach (CAMP)

Step 1: Estimate the risk-free rate, RFR. The short-term treasury bill (T-bill) rate is

usually used, but some analyst feel the long-term Treasury rate should be used.

Step 2: Estimate the stock’s beta, β. This is the stock’s reisk measure.

Step 3: Estimate the expected rate of return on the market, E(Rm).

Step 4: use the capital asset pricing model (CAMP) equation to estimate the required

rate of return:

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kce = RFR + β[E(Rm) - RFR]

Example: Using CAMP to estimate cost of equity

Suppose RFR = 6%, Rm = 11%, and Dexter has a beta of 1.1. Estimate Dexter’s

cost of equity.

Answer :

The required rate of return for Dexter’s stock is:

kce = 6% + 1.1(11% - 6%) = 11.5%

There are two forms of common stock including retained earnings and new

issues of common stock. The rationale here is that the firm could avoid part of the cost

of common stock outstanding by using retained earnings to buy back shares of its own

stock.

2.2.1. Cost of retained earnings (kr)

The cost of retained earnings is the rate of return stockholders require on equity

capital the firm obtains by retained earnings, or that part of current earnings not paid

out in dividends and, hence available for reinvestment. The cost of retained earnings is

essentially the same as the cost of common stock equity. Retained earnings increase

the stockholders’ equity in the same way as a new issue of common stock.

Stockholders accept the firm’s retention of earnings as long as they expect those

earnings to return to them a rate equal to their required return on the reinvested funds.

Thus, the cost of retained earnings kr is equal to ks and CAMP can be used to

determine it.

2.2.2. Cost of a newly issued common stock (kn)

Cost of a new stock issue (kn) is the cost of expernal equity, and it is based on

the cost of retained earnings increased for flotation costs (cost of issuing common

stock). For a constant-growth company, this can be calculated as follows:

ks = D1/ P0(1-F) + g

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where:

Ds: dividend price per share

P0(1-F): the net price per share received by the company

F: the percentage flotation cost required to sell the new stock, or (current stock price –

funds going to company)/ current stock price

(Flotation costs are the total costs incurred by the firm in issuing and selling a

security).

g: Growth rate as projected by security analysts

(g = (retention rate) x (ROE) = (1.0 – payout rate) x (ROE))

Example:

Suppose Dextex’s stock is selling for $40, its expected ROE is 10%, next year’s

dividend is $2 and the company expects to pay out 30% of its earnings. Additionally,

assume the company has a flotation costs of 5%. What is Dextex’s cost of new equity?

Answer:

ks = 2/ 40(1-0.05) + 0.07 = 0.123, or 12.3%

3. Weighted average cost of capital (WACC)

The weighted average cost of capital (WACC) is the expected rate of

return on a portfolio of all the firm’s securities, adjusted for tax savings due to interest

payments. WACC is calculated using weights based on the market values of each

component of a firm's capital structure and is the correct discount rate to use discount

the cash flows of project with risk equal to the average risk of a firm’s project.

Calculating a Company's Weighted-Average Cost of Capital

The WACC is given by:

WACC = wdkd(1 - t) + wcekce

where:

wd = the percentage of debt in the capital structure (weight debt)

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wce =the percentage of common stock in the capital structure (weight common

equity)

kd(1 - t) the after – tax cost of debt.

kce The cost of common equity.

This WACC formula is usually written assuming the firm’s capital structure

includes just two classes of securities, debt and equity. If there is another class, say

preferred stock, the formula expands to include it :

WACC = wdkd(1 - t) + wpskps + wcekce,

Where: wps is the percentage of preferred stock in the capital structure(weight

preferred stock) and kps is the cost of preferred stock.

In other words, we would estimate kps, the rate of return demanded by preferred

stockholders, determine wps, the fraction of market value accounted for by preferred,

and add kps × wps to the equation. Of course the weights in the WACC formula always

add up to 1.0. In this case wd + wps + wce = 1.0

Example: Computing WACC

Suppose Dextex Company seeks a target capital structure of 45% long-term

debt, 5% preferred stock, and 50% common stock equity. Assuming that Dextex can

obtain long-term debt financing at the before-tax cost of 8% for debt, its cost of equity

is 12%, its cost of preferred stock is 8,4%, and its marginal tax rate is 40%. Calculate

Dexter's WACC.

Answer :

We have: wd = 0,45; wps = 0,05; wce = 0,50; kps = 0,84; kce = 0,12

After-tax cost of debt = kd (1-t) = 0,08 x (1-0,4) = 0,08 x 0,6 = 0,048

WACC = wdkd(1 - t) + wpskps + wcekce

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WACC = 0,45 x 0,048 + 0,05 x 0,084 + 0,50 x 0,12 = 0,0858 or 8,6%

How a company raises capital and how they budget or invest it are considered

independently. Most companies have separate departments for the two tasks. The

financing department is responsible for keeping costs low and using a balance of

funding sources: common equity, preferred stock, and debt. Generally, it is necessary

to raise each type of capital in large sums. The large sums may temporarily

overweight the most recently issued capital, but in the long run, the firm will adhere to

target weights. Because of these and other financing considerations, each investment

decision must be made assuming a WACC which includes each of the different

sources of capital and is based on the long-run target weights. A company creates

value by producing a return on assets that is higher than the required rate rerum on the

capital needed to fund those assets.

The WACC as we have described it is the cost of financing firm assets. We can

view this cost as an opportunity cost. Consider how a company could reduce its costs

if it found a way to produce its output using fewer assets, say less working capital. If

we need less working capital, we can use the funds freed up to buy back our debt and

equity securities in a mix that just matches our target capital structure. Our after-tax

savings would be the WACC based on our target capital structure, times the total

value of the securities that are no longer outstanding.

For these reasons, any time we are considering a project that requires

expenditures, comparing the return on those expenditures to the WACC is the

appropriate way to determine whether undertaking that project will increase the value

of the firm. This is the essence of the capital budgeting decision. Since a firm's

WACC reflects the average risk of the projects that make up the firm, it is not

appropriate for evaluating all new projects. It should be adjusted upward for projects

with greater-than-average risk and downward for projects with less-than-average risk.

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III. Usefulness and applications of WACC

1. Project evaluation

Business and organizations are established to make profits. Before investment

decisions that will yield profits are made, organizations are expected to fully analyze

such investments to ensure that they comply with expectations. The first significant

usefulness of WACC therefore, is to evaluate capital projects of the company.

Example:

ATL limited is having an expansion project which will generate a rate of return

at 8%. Should this project be run? Given the following information:

ATL has a long term bond with:1. A face value of $1,000

2. Time to maturity of 15 years3. An annual coupon rate of 8%

4. An annual current market yield of 6%

5. 500,000 bonds are currently issued

ATL has ordinary shares with:

1. A cost of equity of 10%

2. A long term sustainable growth of 3%

3. The next dividend will be $3

4. There are twenty million shares outstanding

The tax rate is 35%

Assume that this project would cost all ATL’s capital.

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A note here is that the cost of capital must be based on what investors are

actually willing to pay for the company’s outstanding securities—that is, based on

the securities’ market values.

Therefore, let’s start with evaluating the market values of bond and share.

PVbond = PVA + PV = CF0

= 80 = $1,194.24498

Value of debt = 1,194.24 x 5,000,000 = $597,122,489.9

Rd = 6% (given)

PVshare = = = $42.8571

Value of equity = 42.8571 x 20,000,000 = $857,142,857.1

Re = 10% (given)

WACC =

=

= 0.0749 7.5% (< 8%)

Conclusion: The expansion project is supposed to generate net value for ATL

and its stockholders and looks like a good idea

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2. Choosing the most appropriate investment

The second usefulness of WACC that worth-mentioning is its value in

budgeting purposes. It helps organizations seek out sources of cheaper finance

among potential investments. A similar example with the above one can be easily

taken. Now keep the equity unchanged. Let assume that the company has two

options: to issued bond as the above example or to borrow from bank. With the same

way of calculation, you can easily have two WACCs and then simply make a

comparison. The cheaper is usually the chosen one (of course its WACCs must be

lower than project’s rate of return).

3. EVA Determination

Another thing that draws our attention is that WACC plays an irreplaceable

role in calculating Economic Value Added (EVA). Let’s have a look at the below

chart for EVA’s formula

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An EVA ratio is greater than zero suggests that the after-tax economic cash-

generating ability of a company exceeds its cost of capital. The reverse holds true for a

negative value generation. If EVA is equal to zero, the project’s cash flows are just

sufficient to give debt-holders and shareholders the returns they require.

This is likely to resemble our first point but here we’d like to emphasize on the

importance of value added. Capital or other sources of funds have cost. The cost for a

project is the rate or return its owners are seeking, with special consideration on the

risks inherent in the project. Projects or investments need to earn returns greater than

its cost of capital and value added for the investors to be satisfied. Any investment

which weighted average cost of capital does not cover its cost reduces investors funds

as the funds may be better invested elsewhere, even if it produces profitability.

One of the methods for calculating this is the Weighted Average Cost of

Capital (WACC). Simply put, this is the calculation of a firm’s cost of capital in

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which each category of investment is proportionately weighted. This is because; there

are different sources of funds for investment available for a firm to choose from.

Common stocks, bonds, debentures, and others can be used, and each of them has to

be analyzed for its WACC to determine if it passes the firms expectations or

requirements.

The company's WACC is a very important number, both to the stock market for

stock valuation purposes and to the company's management for capital budgeting

purposes. In an analysis of a potential investment by the company, investment projects

that have an expected return that is greater than the company's WACC will generate

additional free cash flow and will create positive net present value for stock owners.

These corporate investments should result in an increase in stock prices. These

projects are good things! Investments that earn less than the firm's WACC will result

in a decrease in stockholder value and should be avoided by the company.

Weighted average cost of capital is used to assess a company’s financial health.

It provides insight into the cost of finance used by an organization. It is useful in

investment decisions. With it, company can seek out other sources of cheaper finance.

Capital or other sources of funds have cost. The cost for a project is the rate or

return its owners are seeking, with special consideration on the risks inherent in the

project. Projects or investments need to earn returns greater than its cost of capital and

value added for the investors to be satisfied. Any investment which weighted average

cost of capital does not cover its cost reduces investors funds as the funds may be

better invested elsewhere, even if it produces profitability.

----------------------------------***---------------------------------

This also brings us to the end of our assignment. We have tried our best to

deliver the meaning as well as the importance of “Cost of capital”. We do hope that

this document is a valuable report as it contains our strict researches.

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REFERENCE

1. Fundamentals of financial management, Eugene F. Brigham, Joel F. Houston.

2. Investment decision making in the private and public sectors, Henri L.

Beenhakke.

3. Level 1 Book 4: Corporate finance, portfolio management, and equity

investments, 2008 Kaplan Schweser.

4. http://lexicon.ft.com

5. http://news.morningstar.com

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http://books.google.com.vn/books?id=cDbYAAAAMAAJ&q=the+before-tax+cost+of+debt&dq=the+before-tax+cost+of+debt&hl=vi&ei=T6CYTJj-B4K6sQPf8fW4DA&sa=X&oi=book_result&ct=result&resnum=7&ved=0CEcQ6AEwBg

group 11-assignment 2

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