Gitman& Zutter (2012:358)

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1 The Cost of Capital Management need to understand the cost of capital to select long-term investments after assessing their acceptability and relative rangkings.

2 Gitman& Zutter (2012:358) The cost of capital represents the firm s cost of financing and is the minimum rate of return that a project must earn to increase firm value.

3 The cost of capital acts as a link between the firm s long-term investment decisions and the wealth of the owners as determined by investors in the marketplace. It is the magic number that is used to decide whether a proposed investment will increase or decrease the firm s stock price.

4 Brealey, Myers & Marcus (2004:324) 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.

5 The Basic Concept The cost of capital is estimated at a given point in time. It reflects the expected average future cost of funds over the long run.

6 A firm is currently faced with an investment opportunity. - Best project available today: Cost $100,000 Life 20 years IRR = 7% Cost of least-cost financing source available, Debt = 6% The firm undertakes the opportunity

7 Best project available 1 week later: Cost $100,000 Life 20 years IRR = 7% Cost of least-cost financing source available: Equity =14% The firm rejects the opportunity

8 Assuming that a mix of debt and equity is targeted, the weighted average cost here would be 10%: (50% x 6%) + (50% x 14%)

9 Specific Sources of Capital: Long-term sources of funds the permanent financing: 1.long-term debt 2.Preferred stock 3.Common stock equity: Common stock and Retained earnings.

10 The Firm s Capital Structure

11 Brealey, Myers & Marcus (2004:322) The company cost of capital is a weighted average of the returns demanded by debt and equity investors. The weighted average is the expected rate of return investors would demand on a portfolio of all the firm s outstanding securities.

12 The Cost of Long-Term Debt Duchess Corporation is contemplating selling $ 10 million worth of 20-year, 9% coupon bonds with a par value of $ 1,000. The firm sell the bonds at $ 980. Flotation costs are 2% or $ 20. The net proceeds to the firm for each bond is therefore $ 960 ($ $ 20).

13 Calculating the cost of debt before tax:

14 Approximating the cost of debt before tax:

16 Find the after-tax cost of debt for Duchess assuming it has a 40% tax rate: rd = 9.4% (1-40%) = 5.6% This suggests that the after-tax cost of This suggests that the after-tax cost of raising debt capital for Duchess is 5.6%.

17 The Cost of Preferred Stock Duchess Corporation is contemplating issuance of a 10% preferred stock that is expected to sell for its $87 per share par value. The cost of issuing and selling the stock expected to be $5 per share. r p = D P /N p = $8.70/$82 = 10.6%

18 The Cost of Common Stock The cost of common stock equity is the rate at which investors discount the expected dividends of the firm to determine its share value. Finding the cost of common equity: (1)the constant-growth valuation model, (2)capital asset pricing model (CAPM).

19 Using the constant-growth valuation (Gordon) model : r s = D 1 /Po + g Estimate the cost of common equity using the CAPM: r s = R F + b(r m - R F )

20 The constant-growth valuation (Gordon) model Duchess Corporation wishes to determine its cost of common stock equity. The market price of its common stock is $ 50 per share. The firm expects to pay dividend of $ 4 at the end of the coming year. The dividend paid out the outstanding stock over the past 6 years were as follows:

21 Year Dividend 2012 $ $ $ $ $ $ 2.97

22 g = 5% P0 = $ 50 D1 = $ 4 Cost of common stock equity = 13%

23 Using CAPM r s = r F + b(r M - r F ). The firm s investment advisors and its own analysts indicate that the risk-free rate equals 7%, the firm s beta equals 1.5 and the market return equals 11%. 7% + {1.5(11%-7%)} = 13% The 13% cost of common equity represents the required return of investors in Duchess Corp common stock.

24 CAPM memperhitungkan risiko perusahaan yaitu beta, sedangkan The constant-growth valuation (Gordon) model tidak memperhitungkan risiko. The constant-growth valuation (Gordon) model menggunakan harga pasar (P 0 ) sebagai tingkat risk-return yang diharapkan.

25 Cost of Retained Earnings The same as the cost of an equivalent fully subscribed issue of additionalcommonstock, which is equal to the cost of common stock equity.

26 Cost of New Issues of Common Stock r n = = D 1 /N n + g Continuing with the previous example, how much would it cost the firm to raise new equity if new share can be sold for $ 47 and flotation costs amount to $ 2.50 per share? r n = $ 4/$ % = 14%

27 Weighted Average Cost of Capital WACC = ka = wix ki+ wpx kp+ wsx kn The weights in the above equation are intended to represent a specific financing mix (where wi = % of debt, wp= % of preferred, and ws= % of common).

28 Capital Structure Weights For example, assume 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.

29 WACC Cost of debt = 5,6% Cost of preferred stock = 10,6% Cost of retained earnings = 13% Cost of new common stock = 14% Source of capital: - Long term debt 40% - Preferred stock 10% - Common stock equity 50%

30 Capital Structure Weights: One method uses book values from the firm s balance sheet. For example, to estimate the weight for debt, simply divide the book value of the firm s longterm debt by the book value of its total assets. To estimate the weight for equity, simply divide the total book value of equity by the book value of total assets.

31 A second method uses the market values of the firm s debt and equity. To find the market value proportion of debt, simply multiply the price of the firm s bonds by the number outstanding. This is equal to the total market value of the firm s debt. Next, perform the same computation for the firm s equity by multiplying the price per share by the total number of shares outstanding.

32 Finally, add together the total market value of the firm s equity to the total market value of the firm s debt. This yields the total market value of the firm s assets. To estimate the market value weights, simply dividend the market value of either debt or equity by the market value of the firm s assets.

Long-Term Financial Decisions

Part 4 Long-Term Financial Decisions Chapter 10 The Cost of Capital Chapter 11 Leverage and Capital Structure Chapter 12 Dividend Policy LG1 LG2 LG3 LG4 LG5 LG6 Chapter 10 The Cost of Capital LEARNING