The Cost of Capital 1

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1 The Cost of Capital 1

2 Learning Goals Sources of capital Cost of each type of funding Calculation of the weighted average cost of capital (WACC) Construction and use of the marginal cost of capital schedule (MCC) 2

3 Factors Affecting the Cost of Capital General Economic Conditions Affect interest rates Market Conditions Affect risk premiums Operating Decisions Affect business risk Financial Decisions Affect financial risk Amount of Financing Affect flotation costs and market price of security 3

source of capital in the optimal capital structure

4 Weighted Cost of Capital Model Compute the cost of each source of capital Determine percentage of each source of capital in the optimal capital structure Calculate Weighted Average Cost of Capital (WACC) 4

Since interest payments are tax deductible, the true cost of the debt is the after tax cost.

5 1. Compute Cost of Debt Required rate of return for creditors Same cost found in Chapter 12 as yield to maturity on bonds (k d ). e.g. Suppose that a company issues bonds with a before tax cost of 10%. Since interest payments are tax deductible, the true cost of the debt is the after tax cost. If the company s tax rate (state and federal combined) is 40%, the after tax cost of debt AT k d = 10%(1-.4) = 6%. 5

6 2. Compute Cost Preferred Stock Cost to raise a dollar of preferred stock. Required rate k p = The cost of preferred stock: Dividend (D p ) Market Price (P P ) - F Example: You can issue preferred stock for a net price of $42 and the preferred stock pays a $5 dividend. k p = = $5.00 $ % 6

7 3. Compute Cost of Common Equity Two Types of Common Equity Financing Retained Earnings (internal common equity) Issuing new shares of common stock (external common equity) 7

8 3. Compute Cost of Common Equity Cost of Internal Common Equity Management should retain earnings only if they earn as much as stockholder s next best investment opportunity of the same risk. Cost of Internal Equity = opportunity cost of common stockholders funds. Two methods to determine Dividend Growth Model Capital Asset Pricing Model 8

9 3. Compute Cost of Common Equity Cost of Internal Common Stock Equity Dividend Growth Model D k 1 S = + g P 0 9

10 3. Compute Cost of Common Equity Cost of Internal Common Stock Equity Dividend Growth Model D k 1 S = + g P 0 Example: The market price of a share of common stock is $60. The dividend just paid is $3, and the expected growth rate is 10%. 10

11 3. Compute Cost of Common Equity Cost of Internal Common Stock Equity Dividend Growth Model D k 1 S = + g P 0 Example: The market price of a share of common stock is $60. The dividend just paid is $3, and the expected growth rate is 10%. 3(1+0.10) 60 k S = +.10 =.155 = 15.5% 11

12 3. Compute Cost of Common Equity Cost of Internal Common Stock Equity Capital Asset Pricing Model (Chapter 7) k S = k RF + β(k M k RF ) 12

13 3. Compute Cost of Common Equity Cost of Internal Common Stock Equity Capital Asset Pricing Model (Chapter 7) k S = k RF + β(k M k RF ) Example: The estimated Beta of a stock is 1.2. The risk-free rate is 5% and the expected market return is 13%. 13

14 3. Compute Cost of Common Equity Cost of Internal Common Stock Equity Capital Asset Pricing Model (Chapter 7) k S = k RF + β(k M k RF ) Example: The estimated Beta of a stock is 1.2. The risk-free rate is 5% and the expected market return is 13%. k S = 5% + 1.2(13% 5%) 14.6% = 14

15 3. Compute Cost of Common Equity Cost of New Common Stock Must adjust the Dividend Growth Model equation for floatation costs of the new common shares. k n = D 1 P 0 -F + g Link to Daily Stocks 15

k n = + g P Example: 0 -F If additional shares are

16 3. Compute Cost of Common Equity Cost of New Common Stock Must adjust the Dividend Growth Model equation for floatation costs of the new common shares. k n = + g P Example: 0 -F If additional shares are issued floatation costs will be 12%. D 0 = $3.00 and estimated growth is 10%, Price is $60 as before. D 1 16

3. Compute Cost of Common Equity Cost of New Common Stock Must adjust the Dividend Growth Model equation for floatation costs of the new common shares.

17 3. Compute Cost of Common Equity Cost of New Common Stock Must adjust the Dividend Growth Model equation for floatation costs of the new common shares. D 1 P 0 -F k n = + g Example: If additional shares are issued floatation costs will be 12%. D 0 = $3.00 and estimated growth is 10%, Price is $60 as before. 3(1+0.10) k n = +.10 =.1625 = % 17

18 Weighted Average Cost of Capital Gallagher Corporation estimates the following costs for each component in its capital structure: Source of Capital Cost Bonds k d = 10% Preferred Stock k p = 11.9% Common Stock Retained Earnings k s = 15% New Shares k n = 16.25% Gallagher s tax rate is 40% 18

19 Weighted Average Cost of Capital If using retained earnings to finance the common stock portion the capital structure: WACC= k a = (WT d x AT k d ) + (WT p x k p ) + (WT s x k s ) 19

20 Weighted Average Cost of Capital If using retained earnings to finance the common stock portion the capital structure: WACC= k a = (WT d x AT k d ) + (WT p x k p ) + (WT s x k s ) Assume that Gallagher s desired capital structure is 40% debt, 10% preferred and 50% common equity. 20

21 Weighted Average Cost of Capital If using retained earnings to finance the common stock portion the capital structure: WACC= k a = (WT d x AT k d ) + (WT p x k p ) + (WT s x k s ) Assume that Gallagher s desired capital structure is 40% debt, 10% preferred and 50% common equity. WACC =.40 x 10% (1-.4) +.10 x 11.9% +.50 x 15% = 11.09% 21

22 Weighted Average Cost of Capital If using a new equity issue to finance the common stock portion the capital structure: WACC= k a = (WT d x AT k d ) + (WT p x k p ) + (WT s x k s ) 22

23 Weighted Average Cost of Capital If using a new equity issue to finance the common stock portion the capital structure: WACC= k a = (WT d x AT k d ) + (WT p x k p ) + (WT s x k s ) WACC =.40 x 10% (1-.4) +.10 x 11.9% +.50 x 16.25% = 11.72% 23

This may occur when a firm raises a particularly large amount of capital such that

24 Marginal Cost of Capital Gallagher s weighted average cost will change if one component cost of capital changes. This may occur when a firm raises a particularly large amount of capital such that investors think that the firm is riskier. The WACC of the next dollar of capital raised in called the marginal cost of capital (MCC). 24

25 Graphing the MCC curve Assume now that Gallagher Corporation has $100,000 in retained earnings with which to finance its capital budget. We can calculate the point at which they will need to issue new equity since we know that Gallagher s desired capital structure calls for 50% common equity. 25

We can calculate the point at which they will need to issue new equity since we know that

26 Graphing the MCC curve Assume now that Gallagher Corporation has $100,000 in retained earnings with which to finance its capital budget. We can calculate the point at which they will need to issue new equity since we know that Gallagher s desired capital structure calls for 50% common equity. Breakpoint = Available Retained Earnings Percentage of Total 26

27 Graphing the MCC curve Breakpoint = ($100,000)/.5 = $200,000 27

28 Making Decisions Using MCC Marginal weighted cost of capital curve: Weighted Cost of Capital 12% 11% 10% 9% 11.09% Using internal common equity 11.72% Using new common equity 0 100, , , ,000 Total Financing 28

29 Making Decisions Using MCC Graph IRRs of potential projects Marginal weighted cost of capital curve: Weighted Cost of Capital 12% 11% 10% 9% Project 1 IRR = 12.4% Project 2 IRR = 12.1% Project 3 IRR = 11.5% 0 100, , , , Total Financing

30 Making Decisions Using MCC Graph IRRs of potential projects Graph MCC Curve Marginal weighted cost of capital curve: Weighted Cost of Capital 12% 11% 10% 9% 11.09% Project 1 IRR = 12.4% Project 2 IRR = 12.1% 0 100, , , , Total Financing 11.72% Project 3 IRR = 11.5%

31 Making Decisions Using MCC Graph IRRs of potential projects Graph MCC Curve Choose projects whose IRR is above the weighted marginal cost of capital Marginal weighted cost of capital curve: Weighted Cost of Capital 12% 11% 10% 9% 11.09% Project 1 IRR = 12.4% Project 2 IRR = 12.1% Accept Projects #1 & # , , , , Total Financing 11.72% Project 3 IRR = 11.5%

Chapter 10. The Cost of Capital

Chapter 10. The Cost of Capital Chapter 10 The Cost of Capital 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