Chapter 10. The Cost of Capital

Transcription

1 Chapter 10 The Cost of Capital

2 The Cost of Capital Introductory concepts the nature of a cost of capital The process of calculating a cost of capital Determining required rates of return Calculating the cost of a capital source The cost of various capital sources Calculating the overall cost of capital Producing the marginal cost of capital schedule 10-2

3 The Cost of Capital Introductory concepts the nature of a cost of capital The process of calculating a cost of capital Determining required rates of return Calculating the cost of a capital source The cost of various capital sources Calculating the overall cost of capital Producing the marginal cost of capital schedule 10-3

4 The Nature of a Cost of Capital An incremental cost The opportunity cost of investing money Always calculated using the rates of return investors would require today to provide new funds to the firm Effect on the organization Defines acceptable rates of return on investments Can lead to undesirable gaming by business units 10-4

5 The Cost of Capital Introductory concepts the nature of a cost of capital The process of calculating a cost of capital Determining required rates of return Calculating the cost of a capital source The cost of various capital sources Calculating the overall cost of capital Producing the marginal cost of capital schedule 10-5

6 The Process of Calculating a Cost of Capital Identify the firm s capital sources Determine the required rate of return for each source Convert each required rate of return to the cost of that source of funds Integrate the various capital costs into an overall cost of capital Extrapolate the cost of capital into a cost of capital schedule 10-6

7 The Process of Calculating a Cost of Capital 10-7

8 The Cost of Capital Introductory concepts the nature of a cost of capital The process of calculating a cost of capital Determining required rates of return Calculating the cost of a capital source The cost of various capital sources Calculating the overall cost of capital Producing the marginal cost of capital schedule 10-8

9 Determining Required Rates of Return Ask for quotations from professional investors Infer investors required rate of return from securities prices Investors use their required rate of return to determine a security s value Do the calculation in reverse, using the market price to solve for the rate of return 10-9

10 Determining Required Rates of Return Use the Capital Asset Pricing Model to calculate a required rate directly rate = r f + (market priceof portfolio risk) Requires as inputs: the risk-free rate (typically the rate on long-term U.S. Treasury bonds) an estimate of the market price of risk the security s beta 10-10

11 The Cost of Capital Introductory concepts the nature of a cost of capital The process of calculating a cost of capital Determining required rates of return Calculating the cost of a capital source The cost of various capital sources Calculating the overall cost of capital Producing the marginal cost of capital schedule 10-11

12 Calculating the Cost of a Capital Source Modify the required rate of return by incorporating two additional cash flows Flotation costs the costs of issuing securities Increases the cost of the capital source by reducing the money received from the issue Income tax reductions from deducting interest expense and amortizing flotation cost (affect debt only) Reduces the cost of the capital source by lowering taxes which offset annual interest costs 10-12

13 Summary of Additional Cash Flows Flotation Reduced corporate Financing source cost income tax Long-term debt Private placement X (bonds) Public issue X X Preferred stock Private placement Public issue X Retained earnings Common equity Private placement Public issue X 10-13

14 The Cost of Capital Introductory concepts the nature of a cost of capital The process of calculating a cost of capital Determining required rates of return Calculating the cost of a capital source The cost of various capital sources Calculating the overall cost of capital Producing the marginal cost of capital schedule 10-14

15 The Cost of Various Capital Sources Solve for the interest rate in the cash flows the firm would experience if it issued new securities to give investors their required rate of return Illustrations in the textbook: Cost of bonds Cost of preferred stock Cost of common equity retained earnings (no flotation costs), new stock issue (flotation costs), capital asset pricing model, bond-yield-plus model 10-15

16 The Cost of Capital Introductory concepts the nature of a cost of capital The process of calculating a cost of capital Determining required rates of return Calculating the cost of a capital source The cost of various capital sources Calculating the overall cost of capital Producing the marginal cost of capital schedule 10-16

17 Calculating the Overall Cost of Capital A weighted average of the cost of each capital source Weights come from: Management s target capital structure how the firm plans to raise funds Existing capital structure if target is not known (market value weights better than book values) Referred to as: The weighted-average cost of capital (WACC) reflecting its construction The marginal cost of capital (MCC) reflecting that it is the cost of the next dollar of financing 10-17

18 The Cost of Capital Introductory concepts the nature of a cost of capital The process of calculating a cost of capital Determining required rates of return Calculating the cost of a capital source The cost of various capital sources Calculating the overall cost of capital Producing the marginal cost of capital schedule 10-18

19 The Marginal Cost of Capital Schedule A graph of the cost of capital as a function of the amount of money raised at any one time 10-19

20 Producing the Marginal Cost of Capital Schedule Estimate break points Points on the MCC schedule where the cost of capital increases Calculated as: total new amount financing = its from this source proportion Recalculate the cost of capital in each interval between break points 10-20