View
220
Download
0
Category
Preview:
Citation preview
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
1/35
Contact Us Live C
Lesson 1: Cost of Ca pital
Views q v
f g t s p
Over viewUpon completion of this lesson, candidatesshould be able to:
LOS 36a: Calculate and interpret theweihted averae cost of capital !"#CC$ of acompan%
LOS 36b: Describe how ta&es a'ect the costof capital from di'erent capital sources(
LOS 36c: Describe the use of taret capital
structure in estimatin "#CC and how taret
capital structure weihts ma% be
determined(
LOS 36d: )&plain how the marinal cost of
capital and the investment opportunit%
schedule are used to determine the optimal
capital budet(
LOS 36e: )&plain the marinal cost of
capital*s role in determinin the net
present value of a pro+ect(
his lesson includes printable lecture slides(Download
Current-rade
imeSpent
Lesson.aster%
C
o
r
r
e
c
t
/
n
c
o
r
r
e
c
t
S
0
i
p
p
e
d
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
2/35
12#
3:33:45 b3
f 3
e
3
Get Mentor ing on this Lesson h
Video
Cost of Ca pital
Study Guide
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
3/35
1 Cost of Ca pital
Cost of capital refers to the rate of return that the suppliers or
providers of capital reuire to contribute their capital to the 7rm( "e
can also thin0 of the cost of capital as the opportunit% cost of funds
for the providers of capital( Unless the return o'ered b% a compan%
meets or e&ceeds the rate that could be earned elsewhere from an
investment of similar ris0, a potential supplier of capital will not
provide capital to the compan%(
LOS 36a: Calculate and interpret the weihted averae cost of capital!"#CC$ of a compan%( Vol 8, pp 3693
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
4/35
o raise capital, a compan% can either issue euit% or debt
!some instruments ma% have features of both debt and
euit%$( #n instrument that is used to obtain 7nancin is
called a component, and each component has a di'erent
reuired rate of return, which is 0nown as the component costof capital( he weihted averae of the costs of the various
components used b% the compan% to 7nance its operations is
0nown as the weihted averae cost of capital !"#CC$ or the
marinal cost of capital !.CC$( he "#CC is the e&pected rate
of return that investors demand f or 7nancin an averae ris0
investment of the compan%( # compan%*s "#CC is calculated
usin the followin formula !See )&le 4(4$:
WCC ! "wd #"r d #"1 $ t# %"w p #"r p # % "we #"r e #
where:
wd ;
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
5/35
new
f und
s rd
;
=efor
e>ta&
mar
inal
cost
ofdebt
t ; Compan%*s marinal ta& rate
wp ;
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
6/35
of
euit%
that
the
comp
an%
uses
when
it
raises
new
f unds
re ;
.arin
al cost
of
e6uit%
)&le 4(4
Calculatin "#CC
#&en Compan%*s capital structure is composed of 8?
debt, @? preferred stoc0, and @@? common euit%(
#&en*s before>ta& cost of debt is ?, cost of preferred
euit% is A?, and cost of common euit% is 4?( hecompan%*s marinal ta& rate is 3?( Calculate #&en*s
"#CC(
Solution
WCC ! "wd #"r d #"1 $ t# %"w p #"r p # % "we #"r e #
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
7/35
WCC ! "&'(# "&'&)# "1 $ &'*# % "&'&+#"&'&,# % "&'++# "&'1 ! )',-.
LOS 36b: Describe how ta&es a'ect the cost of capital fromdi'erent capital sources( Vol 8, pp 393A
Let*s assume that a compan% pa%s B@, in interest for a
iven %ear( he B@, is an e&pense that the compan% is
allowed to reconie for ta& purposes to reduce ta&able
income( /nterest e&pense reduces the compan%*s pro7ts
before ta& b% B@,, and assumin a 3? ta& rate, reducespro7ts after ta& b% onl% B3@,( his is because interest
e&pense provides a ta& shield of B4@,( his ta& shield is
calculated as interest e&pense multiplied b% the ta& rate
!B@, 3? ; 4@,$(
#d+ustin for the interest ta& shield, the real after>ta& cost of
debt for the compan% is not reall% B@,, but onl%
B3@,( a& savins are onl% realied on pa%ments to
holders of debt instruments(
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
8/35
and will raise capital in line with its taret structure, we should
use the taret capital structure in calculatin "#CC(
he taret capital structure is the capital structure that the
compan% aims to maintain( he weihts used in the
calculation of the "#CC are the proportions of debt, preferredstoc0, and euit% that the 7rm hopes to achieve and
maintain in its capital structure over time( # simple wa% to
transform a debt>to>e6uit% ratio !D2)$ into a weiht is to
simpl% divide the ratio b% !4 E D2)$:
/0
1 % /0
wd % we
/!
/ % ! wd
! 1
/f information about the taret capital structure is not easil%
available, we can use the weihts in the compan%*s current
capital structure( he weihts of the various components
should be based on mar0et values(
#nother option is to e&amine trends in the compan%*s capital
structure over time or statements b% manaement reardin
the compan%*s capital structure polic% to estimate the taret
capital structure(
#n anal%st ma% also use the averae weihts of comparablecompaniesF capital structures as the taret capital structurefor the compan%( See
)&les 4(G and )&le 4(3(
)&le 4(G
Calculatin Capital Structure "eihts
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
9/35
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
10/35
e
r
r
e
d
s
t
o
c
0
B
G
m
i
l
l
i
o
n
C
o
m
m
o
n
s
t
o
c
0
B
3
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
11/35
A
m
i
l
l
i
o
n
o
t
al
c
a
p
i
t
a
l
B
@
m
i
l
l
i
o
n
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
12/35
=ased on the f irm*s e&istin capital
structure, what weihts should be
used to determine the compan%*s
"#CCH Solution
"eiht of debt ; wd ; B4 million2B@ million ; G?
"
e
i
h
t
o
f
p
r
e
f
e
r
r
e
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
13/35
d
s
t
o
c
0
;
w
p
;
B
G
m
i
l
l
i
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
14/35
o
n
2
B
@
m
i
l
l
i
o
n
;
8
?
"
e
i
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
15/35
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
16/35
e
;
B
3
A
m
i
l
l
i
o
n
2
B
@
m
i
l
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
17/35
l
i
o
n
;
6
?
#lwa%s chec0 that the
weihts add up to 4: wd% we % w p
! &'2 % &'&( % &')- ! 1
)&le 4(
3)stimatin
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
18/35
"eiht of euit% ; we ; B3@ million 2 !BG@ million E B3@
million$ ; (@A3G( he weiht of debt in the taret capital structure iscalculated b% dividin the taret D2) ratio b% !4 E D2)$:
wd ! //%
!/0
1 % /0
wd
!
&'
-
0 "
1 %
&'
-
#
w
d
! &'*)+
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
19/35
we
!
1 $ wd
w
e
!
1 $ &'*)+ ! &'-2+
LOS 36d: )&plain how the marinal cost of capital and
the investment opportunit% schedule are used to
determine the optimal capital budet( Vol 8, pp 898G
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
20/35
# compan%*s marinal cost of capital !.CC$ increases as it
raises additional capital( his is because most 7rms must
pa% a hiher cost to obtain increasin amounts of capital(
Jor e&le, the more a compan% borrows, the reater the
ris0 that it will be unable to repa% its lenders, and therefore,the hiher the return reuired b% investors(
he pro7tabilit% of a compan%*s investment opportunities
decreases as the compan% ma0es additional investments(
he compan% priorities investments in pro+ects with the
hihest /KKs( #s more resources are invested in the most
rewardin pro+ects, remainin opportunities o'er lower and
lower /KKs( his fact is represented b% an investment
opportunit% schedule !/OS$ that is downward>slopin(
he optimal capital budet occurs at the point where themarinal cost of capital intersects the investment opportunit%schedule !see Jiure 4(4$(
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
21/35
Jiure 4
(4 Optimal
/nvestment Decis
i
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
22/35
on
he compan% should raise capital !at the iven .CC$ and
underta0e all pro+ects !to earn the iven /KK$ to the left
of the intersection point because these pro+ects
enhance shareholder wealth iven the cost of 7nancin
them(
o raise capital in e&cess of the optimal capital budet
!to the riht of the intersection point$ the 7rm will be
reuired to incur a cost of capital that is reater than
the return on available investments( Underta0in
these pro+ects, iven the .CC, will erode the f irm*s
value(
LOS 36e: )&plain the marinal cost of capital*s role indeterminin the net present value of a pro+ect( Vol 8, p 84
he "#CC is the discount rate that reIects the averae ris0 of
the compan%( "hen we choose "#CC as the discount rate to
evaluate a particular pro+ect, we assume that:
he pro+ect under consideration is an averae ris0 pro+ect(
he pro+ect will have a constant capital structure !whiche6uals the compan%*s taret capital structure$ throuhoutits lif e(
he cost of capital for a particular pro+ect should reIect the
ris0 inherent in that particular pro+ect, which will not
necessaril% be the same as the ris0 of the compan%*s averae
pro+ect( /f the ris0 of the pro+ect under consideration is above
or below the averae ris0 of the compan%*s current portfolio
of pro+ects, an ad+ustment is made to the "#CC( Specif icall%:
/f a pro+ect has
reater ris0 than
the f irm*s e&istin
pro+ects, the "#CC
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
23/35
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
24/35
o
n
s
h
a
s
t
h
e
f
o
l
l
o
w
i
n
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
25/35
c
a
p
i
t
a
l
s
t
r
u
c
t
u
r
e
:
)
6
u
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
26/35
i
t
%
;
@
?
Debt ; 8@?
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
27/35
;
!
(
@
(
4
6
$
E
!
(
8
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
28/35
@
(
4
8
$
E
!
(
@
C
o
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
29/35
s
t
o
f
p
r
e
f
e
r
r
e
d
e
6
u
i
t
%
$
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
30/35
C
o
s
t
o
f
p
r
e
f
e
r
r
e
d
e
u
i
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
31/35
t
%
;
!
(
4
8
@
9
(
4
8
3
$
2
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
32/35
(
@
;
8
?
5uestion 2
#n anal%st athered the followin information about acompan%:
Ca pi
t
al Str
u4tur e 6
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
33/35
e
q
u
i
r
ed
6
at
e o
f
6 et
ur n
G@? debt 4G
3@? preferred stoc0 48
8? common stoc0 4
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
34/35
#ssumin a ta& rate of 3?, the compan%Fs cost of capital isclosest to:
48(?
43(A?
4G(6?
b "#CC ; !(G@$ !(4G$ !4 9 (3$ E !(3@$!(48$ E !(8$!(4$; 43(A?
7otes
Mou havenFt made an% notes %et(
What to done8t9
Nave %ou masteredthis lessonH Jind outor +ump to the ne&tone(
a;e an ssess
8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital
35/35
G4@, Pohn "ile% Q Sons, /nc( Contact Us R Version /nf o
Recommended