Assignment 98_ Lesson 1_ Cost of Capital

8/19/2019 Assignment 98_ Lesson 1_ Cost of Capital

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Lesson 1: Cost of Ca pital

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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(

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Cost of Ca pital

Study Guide


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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


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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 )&ample 4(4$:

WCC ! "wd #"r d #"1 $ t# %"w p #"r p # % "we #"r e #

where:

wd ;


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new

f und

s rd

;

=efor

e>ta&

mar

inal

cost

ofdebt

t ; Compan%*s marinal ta& rate

wp ;


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of

euit%

that

the

comp

an%

uses

when

it

raises

new

f unds

re ;

.arin

al cost

of

e6uit%

)&ample 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 #


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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(


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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

)&amples 4(G and )&ample 4(3(

)&ample 4(G

Calculatin Capital Structure "eihts


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=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?

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#lwa%s chec0 that the

weihts add up to 4: wd% we % w p

! &'2 % &'&( % &')- ! 1

)&ample 4(

3)stimatin


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"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

! &'*)+


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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


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# 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&ample, 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$(


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Jiure 4

(4 Optimal

/nvestment Decis

i


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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


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Debt ; 8@?


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t

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5uestion 2

#n anal%st athered the followin information about acompan%:

Ca pi

t

al Str

u4tur e 6


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6

at

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6 et

ur n

G@? debt 4G

3@? preferred stoc0 48

8? common stoc0 4


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#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


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Assignment 98_ Lesson 1_ Cost of Capital