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LECTURE 6 The Cost of Capital

Cost of Capital Components

Debt

Preferred

Ordinary Shares

WACC

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What types of long-term capital do firms use?

Long-term debt

Preferred shares

Ordinary equity

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Capital components are sources of funding that come from investors.

Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the cost of capital.

We do adjust for these items when calculating the cash flows of a project, but not when calculating the cost of capital.

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Should we focus on before-tax or after-tax capital costs?

Tax effects associated with financing can be incorporated either in capital budgeting cash flows or in cost of capital.

Most firms incorporate tax effects in the cost of capital. Therefore, focus on after-tax costs.

Only cost of debt is affected.

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Should we focus on historical (embedded) costs or new (marginal)

costs?

The cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we should focus on marginal costs.

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Cost of Debt

Method 1: Ask an investment banker what the coupon rate would be on new debt.

Method 2: Find the bond rating for the company and use the yield on other bonds with a similar rating.

Method 3: Find the yield on the company’s debt, if it has any.

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A 15-year, 12% semiannual bond sells for RM1,153.72. What’s rd?

60 60 + 1,00060

0 1 2 30i = ?

30 -1153.72 60 1000

5.0% x 2 = rd = 10%

N I/YR PV FVPMT

-1,153.72

...

INPUTS

OUTPUT

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Component Cost of Debt

Interest is tax deductible, so the after tax (AT) cost of debt is:

rd AT = rd BT(1 - T)

= 10%(1 - 0.40) = 6%.

Use nominal rate.

Flotation costs small, so ignore.

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What’s the cost of preferred share? PP = RM113.10; 10%Q; Par = RM100; F = RM2.

%.0.9090.010.111$

10$

00.2$10.113$

100$ 1.0

n

psps P

Dr

Use this formula:

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Picture of Preferred

2.50 2.50

0 1 2rps = ?

-111.1

...

2.50

.50.2$

10.111$PerPer

Q

rr

D

%.9)4%(25.2 %;25.210.111$

50.2$)( NompsPer rr

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Note:

Flotation costs for preferred are significant, so are reflected. Use net price.

Preferred dividends are not deductible, so no tax adjustment. Just rps.

Nominal rps is used.

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Is preferred share more or less risky to investors than debt?

More risky; company not required to pay preferred dividend.

However, firms want to pay preferred dividend. Otherwise, (1) cannot pay ordinary dividend, (2) difficult to raise additional funds, and (3) preferred shareholders may gain control of firm.

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Example:

rps = 9% rd = 10% T = 23%

rps, AT = rps - rps (1 - 0.7)(T)

= 9% - 9%(0.3)(0.23) = 8.38%

rd, AT = 10% - 10%(0.23) = 7.70%

A-T Risk Premium on Preferred = 0.68%

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Directly, by issuing new shares of ordinary share.

Indirectly, by reinvesting earnings that are not paid out as dividends (i.e., retaining earnings).

What are the two ways that companies can raise ordinary equity?

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Earnings can be reinvested or paid out as dividends.

Investors could buy other securities, earn a return.

Thus, there is an opportunity cost if earnings are reinvested.

Why is there a cost for reinvested earnings?

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Opportunity cost: The return shareholders could earn on alternative investments of equal risk.

They could buy similar shares and earn rs, or company could repurchase its own share and earn rs. So, rs, is the cost of reinvested earnings and it is the cost of equity.

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Three ways to determine the cost of equity, rs:

1. CAPM: rs = rRF + (rM - rRF)b

= rRF + (RPM)b.

2. DCF: rs = D1/P0 + g.

3. Own-Bond-Yield-Plus-Risk Premium:

rs = rd + Bond RP.

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What’s the cost of equity based on the CAPM?

rRF = 7%, RPM = 6%, b = 1.2.

rs = rRF + (rM - rRF )b.

= 7.0% + (6.0%)1.2 = 14.2%.

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What’s the DCF cost of equity, rs?Given: D0 = RM4.19;P0 = RM50; g = 5%.

g

P

gDg

P

Drs

0

0

0

1 1

$4. .

$50.

. .

.

19 1050 05

0 088 0 05

13 8%.

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Estimating the Growth Rate

Suppose the company has been earning 15% on equity (ROE = 15%) and retaining 35% (dividend payout = 65%), and this situation is expected to continue.

What’s the expected future g?

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Retention growth rate:

g = ROE(Retention rate)

g = 0.35(15%) = 5.25%.

This is close to g = 5% given earlier. Think of bank account paying 15% with retention ratio = 0. What is g of account balance? If retention ratio is 100%, what is g?

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Determining the Weights for the Weighted Average Cost of Capital (WACC)

The weights are the percentages of the firm that will be financed by each component.

If possible, always use the target weights for the percentages of the firm that will be financed with the various types of capital.

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Estimating Weights for the Capital Structure

If you don’t know the targets, it is better to estimate the weights using current market values than current book values.

If you don’t know the market value of debt, then it is usually reasonable to use the book values of debt, especially if the debt is short-term.

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Estimating Weights (Continued)

Suppose the share price is RM50, there are 3 million shares of share, the firm has RM25 million of preferred share, and RM75 million of debt.

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Vos = RM50 (3 million) = RM150 million.

Vps = RM25 million.

Vd = RM75 million.

Total value = RM150 + RM25 + RM75 = RM250 million.

wos = RM150/RM250 = 0.6

wps = RM25/RM250 = 0.1

wd = RM75/RM250 = 0.3

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Where, V os = Value of ordinary share V ps = Value of preferred shareV d = Value of debtWos = weight of ordinary shareW ps = weight of preferred shareW d = weight of debt

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What’s the WACC?

WACC = wdrd(1 - T) + wpsrps + wcers

= 0.3(10%)(0.77) + 0.1(9%) + 0.6(14%)

= 2.3% + 0.9% + 8.4% = 11.6%.