Chapter 12 - Cost of Capital

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Chapter 12 - Cost of Capital
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Where weve been...

• Basic Skills (Time value of money, Financial
  Statements)
• Investments (Stocks, Bonds, Risk and Return)
• Corporate Finance (The Investment Decision -
  Capital Budgeting)

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The investment decision

• Assets Liabilities
  Equity
• Current Assets Current
  Liabilities
• Fixed Assets Long-term Debt
• 
  Preferred Stock
• Common
  Equity

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Where were going...

• Corporate Finance (The Financing Decision)
• Cost of capital
• Leverage
• Capital Structure
• Dividends

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The financing decision

• Assets Liabilities
  Equity
• Current Assets Current
  Liabilities
• Fixed Assets Long-term Debt
• 
  Preferred Stock
• Common
  Equity

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• Assets Liabilities
  Equity
• Current assets Current
  Liabilities
• Long-term Debt
• 
  Preferred Stock
• Common
  Equity

Capital Structure
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Ch. 12 - Cost of Capital

• For Investors, the rate of return on a security
  is a benefit of investing.
• For Financial Managers, that same rate of return
  is a cost of raising funds that are needed to
  operate the firm.
• In other words, the cost of raising funds is the
  firms cost of capital.

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How can the firm raise capital?

• Bonds
• Preferred Stock
• Common Stock
• Each of these offers a rate of return to
  investors.
• This return is a cost to the firm.
• Cost of capital actually refers to the weighted
  cost of capital - a weighted average cost of
  financing sources.

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Basic Definitions

• Flotation costs underwriters spread and issuing
  cost associated with issuance and marketing new
  securities
• Tax effect borrow at 9, tax rate 34, what is
  the after-tax cost of debt?
• 9 (1 34) 5.94
• Cost of capital needs to adjust both flotation
  cost and corporate tax

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Cost of Debt

• For the issuing firm, the cost of debt is
• the rate of return required by investors,
• adjusted for flotation costs and
• adjusted for taxes.

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Example Tax effects of financing with debt

• with stock with debt
• EBIT 400,000 400,000
• - interest expense 0
  (50,000)
• EBT 400,000 350,000
• - taxes (34) (136,000) (119,000)
• EAT 264,000 231,000
• Now, suppose the firm pays 50,000 in dividends
  to the stockholders.

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Example Tax effects of financing with debt

• with stock with debt
• EBIT 400,000 400,000
• - interest expense 0
  (50,000)
• EBT 400,000 350,000
• - taxes (34) (136,000) (119,000)
• EAT 264,000 231,000
• - dividends (50,000) 0
• Retained earnings 214,000
  231,000

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• After-tax Before-tax
  Marginal
• cost of cost of x
  tax
• Debt Debt
  rate
• Kd kd (1 -
  T)
• .066 .10 (1 - .34)

1
-

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Example Cost of Debt

• Prescott Corporation issues a 1,000 par, 20 year
  bond paying the market rate of 10. Coupons are
  annual. The bond will sell for par since it pays
  the market rate, but flotation costs amount to
  50 per bond.
• What is the pre-tax and after-tax cost of debt
  for Prescott Corporation?

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• Pre-tax cost of debt
• N 20
• PMT 100
• FV 1000 So, a 10 bond
• PV -950 costs the firm
• solve I 10.61 kd only 7 (with
• After-tax cost of debt flotation costs)
• Kd kd (1 - T) since the interest
• Kd .1061 (1 - .34) is tax deductible.
• Kd .07 7

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Cost of Preferred Stock

• Finding the cost of preferred stock is similar to
  finding the rate of return (from Chapter 8),
  except that we have to consider the flotation
  costs associated with issuing preferred stock.

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Cost of Preferred Stock

• Recall
• kp
• From the firms point of view
• kp
• NPo price - flotation costs!

Dividend Price
D Po
Dividend Net Price
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Example Cost of Preferred

• If Prescott Corporation issues preferred stock,
  it will pay a dividend of 8 per year and should
  be valued at 75 per share. If flotation costs
  amount to 1 per share, what is the cost of
  preferred stock for Prescott?

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Cost of Preferred Stock
Dividend Net Price

• kp
• 
  10.81

8.00 74.00
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Cost of Common Stock

• There are two sources of Common Equity
• 1) Internal common equity (retained earnings).
• 2) External common equity (new common stock
  issue).
• Do these two sources have the same cost?

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Cost of Internal Equity

• Since the stockholders own the firms retained
  earnings, the cost is simply the stockholders
  required rate of return.

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Cost of Internal Equity

• 1) Dividend Growth Model
• kc g
• 2) Capital Asset Pricing Model (CAPM)
• kj krf j (km - krf )

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Cost of External Equity

• Dividend Growth Model
• knc g

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Example of Common Stock

• Google stock closes at 368.56 at the end of
  2007. The company paid 5 dividend in 2007, and
  expects that dividend to grow at 13. If Google
  issue new common stock, the flotation cost will
  be 50 per share. What is the cost of retained
  earnings and cost of new common equity capital?

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Example of Common Stock

• For cost of internal equity
• K D1/ P g 5 (1.13) / 368.56 .13
  0.145
• For cost of external equity
• K D1/NP g 5 (1.13) /(368.56 50) .13
  .148

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Example of Common Stock

• Issues with dividend growth model
• -- it is easy
• -- constant growth is not applicable
• -- have to estimate the growth rate

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Example of Common Stock

• If Googles common stock has a beta of 1.43, and
  suppose the risk free rate is 5.69, and the
  expected rate of return on the market portfolio
  is 14. Using the CAPM, what is the cost of
  capital for Google?
• K 0.0569 1.43 (0.14 -0.0569) 0.17
• Note that this is the internal equity, since we
  do not consider transaction cost

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Example of Common Stock

• Issues with CAPM
• -- simple
• -- does not require dividend growth rate
• -- need to pick the risk free rate according
  to the life of the project
• -- need to estimate beta
• -- need to estimate the market risk premium

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Weighted Cost of Capital

• The weighted cost of capital is just the weighted
  average cost of all of the financing sources.

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Weighted Cost of Capital

• 
  Capital
• Source Cost Amount Structure
  
• debt 6 2M
  20
• preferred 10 1M 10
• common 16 7M 70
• 10 M

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Weighted Cost of Capital(20 debt, 10
preferred, 70 common)

• Weighted cost of capital
• .20 (6) .10 (10) .70 (16)
• 13.4

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Cost of New Project

• Cost of capital for individual projects should
  reflect the individual risk of the project
• PepsiCo restaurants, snack foods, and beverages
• Use WACC for discount rate for a project only
  when the project has similar risk to the firm
• Cannot use if get into a brand new business