Cost Os Capital

8/2/2019 Cost Os Capital

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Chapter

McGraw-Hill/IrwinCopyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Cost of Capital

11


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Chapter Outline

Cost of capital and its importance

Discount rates used to analyze investments

Valuation and application to bonds, preferredstock, and common stock

Minimum cost of capital

Increase in cost of capital with increase inutilization of finances


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Cost of Capital

In corporate finance, an investment made isfor an anticipated return in future

Knowing the appropriate discount rate is vital

Return on investments must, in the least,garner a return equaling the costs incurredto acquire it the minimum acceptable

return


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The Overall Concept

An investment:

Should not be judged against the specific meansof financing used to implement it

This would make investment selection decisionsinconsistent

With a low-cost debt, must be chosen carefully

May result in increase of the overall risk May make all eventual forms of financing more

expensive


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Cost of CapitalBaker Corporation


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Cost of Debt

Measured by interest rate, or yield, paid tobondholders Example: $1,000 bond paying $100 annual

interest 10% yield Calculation is complex discount rate or premium

from par value bonds

To determine the cost of a new debt in themarketplace: The firm will compute the yield on its currently

outstanding debt


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Approximate Yield to Maturity (Y')

Annual interest payment +

Number of years to maturity

0.6 (Price of the bond) + 0.4 (Principal payment)

Assuming:

Y'= $101. 50 +20

.6 ($940) + .4 ($1,000)

= $101.50 +

20

$564 + $400

Y = $101.50 + 3 = $104.50 = 10.84%

$964 $964

Principal payment

Price of the bond

$1,000 - $940

60


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Adjusting Yield

for Tax Considerations

Yield to maturity indicates how much the firmhas to pay on a before-tax basis

Interest payment on a debt is a tax-deductible expense

Due to this, the true cost is less than the statedcost


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Adjusting Yield

for Tax Considerations (contd)

The after-tax cost of debt is calculated as shownbelow:

Assuming:


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Cost of Preferred Stock

A constant annual payment with no maturitydate for the principal payment

Computed by dividing dividend payment by net

price or proceeds received Represents the rate of return to preferred

stockholders and annual cost to corporation for issue

Preferred stock dividend is not a tax-deductibleexpense, with no downward tax adjustment

The proceeds to the firm equals selling pricein the market minus flotation cost


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Cost of Preferred Stock (contd)

The cost of preferred stock is as follows:

Where,

= Cost of preferred stock; = Annual dividend onpreferred stock; = Price of preferred stock; F =Floatation, or selling cost

Assuming annual dividend as $10.50, preferred stock is

$100, and flotation, or selling cost is $4. Effective cost is:

= $10.50 = $10.50 = 10.94%$100 - $4 $96


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Cost of Common Equity

Valuation Approach In determining the cost of common stock, the firm must be sensitive to

pricing and performance demands of current and future stockholders

Dividend valuation model:

Where,

= Price of the stock today; = Dividend at the end of the year (orperiod); = Required rate of return; g = Constant growth rate individends

Assuming = $2; = $40 and g = 7%, equals 12 percent

= $2 + 7% = 5% + 7% = 12%

$40


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Alternate Calculation of the

Required Return on Common Stock Capital asset pricing model (CAPM)

Where:

= Required return on common stock; = Risk-free rate of return,usually the current rate on Treasury bill securities; = Beta coefficient(measures the historical volatility of an individual stocks return relative

to a stock market index; = return in the market as measured by anapproximate index

Assuming = 5.5%, = 12%, = 1.0, would be:

= 5.5% + 1.0 (12% - 5.5%) = 5.5% + 1.0 (6.5%)

= 5.5% + 6.5% = 12%


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Cost of Retained Earnings

Sources of capital for common stock equity:

Purchaser of the new shares external source

Retained earnings internal source

Represent the present and past earnings of the firmminus previously distributed dividends

Belong to the current stockholders may be paid inthe form of dividends or reinvested in the firm

Reinvestments represent a source of equity capitalsupplied by the current stockholders

An opportunity cost is involved


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Cost of Retained Earnings (contd)

The cost of retained earnings is equivalent to the rate of return on thefirms common cost representing the opportunity cost

represents both the required rate of return on common stock, andthe cost of equity in the form of retained earnings

For ease of reference,

= Cost of common equity in the form of retained earnings

= Dividend at the end of the first year, $2

= Price of stock today, $40

g = Constant growth rate in dividends, 7%

= $2 + 7% = 5% + 7% = 12%

$40


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Cost of New Common Stock

A slightly higher return than , representingthe required rate of return of presentstockholders, is expected

Needed to cover the distribution costs of thenew securities

Common stock

New common stock


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Cost of New Common Stock

(contd) Assuming = $2, = $40, F (Flotation or selling costs) =

$4 and g = 7%;

= $2 + 7%$40 - $4

= $2 + 7%

$36

= 5.6% + 7% = 12.6%


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Overview of Common Stock Costs


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Optimal Capital Structure

Weighting Costs

The desire to achieve a minimum overallcapital cost of capital

Calculated decisions are required on the

appropriate weights for: Debt

Preferred stock

Common stock financing Capital mix is determined by:

Considering the present capital structure

Ascertaining if the current position is optimal


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Weighting Costs (contd)

Assessment of different plans (next slide): Firm is able to initially reduce weighted average

cost of capital with debt financing Beyond Plan B, continued use of debt becomes

unattractive and greatly increases costs ofsources of financing


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Weighting Costs (contd)

Cost (After-tax) Weights Weighted Cost

Financial Plan A:

Debt 6.5% 20% 1.3%

Equity. 12.0 80 9.610.9%

Financial Plan B:

Debt 7.0% 40% 2.8%

Equity. 12.5 60 7.5

10.3%Financial Plan C:

Debt 9.0% 60% 5.4%

Equity. 15.0 40 6.0

11.4%


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Cost of Capital Curve


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Debt as a Percentage of Total Assets

(2006)


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Capital Acquisition and

Investment Decision Making

Financial capital consists of bonds, preferredstock, and common equity

Money raised by sales of these securities and

retained earnings is invested in: The real capital of the firm, the long-term productive

assets of plant and equipment

To minimize cost of equity, a firm may sellcommon stock when prices are relatively high

A balance between debt and equity is requiredto achieve minimum cost of capital


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Cost of Capital Over Time


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Cost of Capital in the

Capital Budgeting Decision

Current cost of capital for each source offunds is important for capital budgetingdecision

The required rate of return will be the weightedaverage cost of capital

The common stock value of the firm will be

maintained or increase, as long as the firmearns its cost of capital


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Investment Projects Available

to the Baker Corporation


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Cost of Capital and Investment

Projects for the Baker Corporation


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The Marginal Cost of Capital

The market may demand a higher cost ofcapital for each amount of fund required if alarge amount of financing is required

Equity (ownership) capital is represented byretained earnings

Retained earnings cannot grow indefinitely as thefirms capital needs to expand

Retained earnings is limited to the amount of pastand present earnings that can be redeployed intoinvestments


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The Marginal Cost of Capital

(contd) Assumptions:

60% is the amount of equity capital a firm must maintain to keep abalance between fixed income securities and ownership interest

Baker Corporation has $23.40 million of retained earning availablefor investment

There is adequate retained earning to support the capital structure asshown below:

Assuming: X = Retained earnings ;Percent of retained earnings in the capital structure

Where X represents the size of the capital structure that retainedearnings will support

X = $23.40 million = $39 million.60


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Costs of Capital for

Different Amounts of Financing


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Increasing Marginal Cost of Capital

Both and represent the cost of capital

The mcsubscript after K indicates the increasein cost of capital

Increase is because common equity is nowin the form of new common stock rather thanretained earnings

The aftertax cost of the new common stockis more expensive than retained earningsbecause of flotation costs


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Increasing Marginal Cost of Capital

(contd) Equation for the cost of new common stock:

= $2 + 7% = $2 + 7% = 5.6% + 7% = 12.6%

$40 - $4 $36

The $50 million figure can be derived thus:

Z = Amount of lower-cost debt ;

Percent of debt in the capital structure

Z = $15 million = $50 million

.30

Where Z represents the size of the capital structure in which lower-costdebt can be used


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Cost of Capital for

Increasing Amounts of Financing


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Changes in the

Marginal Costs of Capital


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Marginal Cost of Capital

and Baker Corporation Projects

C f C


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Cost of Components

in the Capital Structure


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Performance of PAI and the Market


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Linear Regression of Returns

Between PAI and the Market


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The Security Market Line (SML)


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The Security Market Line

and Changing Interest Rates

Th S i M k Li d


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The Security Market Line and

Changing Investor Expectations

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Cost Os Capital