Chapter 9: The Cost of Capital

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Chapter 9The Cost of Capital
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The Cost of Capital
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Chapter Outline

• The Purpose of the Cost of Capital
• Capital Components
• Calculating Component Costs of Capital
• Calculating the WACC
• Factors that affect the cost of capital
• Problem areas in cost of capital

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The Purpose of the Cost of Capital

• The cost of capitalthe average rate paid for the
  use of capital.
• Primarily used in capital budgeting
• Used as the hurdle rate, or benchmark for
  projects
• Compare IRR to this rate
• Discount cash flows at this rate to find NPV
• If a project cannot earn above this return, it is
  not worthwhile

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The Purpose of the Cost of Capital

• It is important to estimate the cost of capital
  as accurately as possible in order to effectively
  manage the firm
• Firms cost of capital can be viewed as its
  required rate of return on projects of average
  risk

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Required Rate of Return(Opportunity Cost Rate)

• The return that must be raised on invested funds
  to cover the cost of financing such investments

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Capital Components

• Components of firms capital are
• Debt
• Borrowed money, either loans or bonds
• Common equity
• From sale of common shares or from retained
  earnings
• Preferred shares
• Cross between debt and common equity

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Capital Components

• Capital structure is mix of three capital
  components
• Target Capital Structure
• Mix of capital components that management
  considers optimal and strives to maintain

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Basic Definitions

• Capital Component
• Types of capital used by firms to raise money
• kd before tax interest cost
• kdT kd(1-T) after tax cost of debt
• kps cost of preferred stock
• ke cost of retained earnings
• ks cost of issuing new stocks

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Basic Definitions

• WACC Weighted Average Cost of Capital
• Capital StructureA combination of different
  types of capital(debt and equity) used by a firm

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After-Tax Cost of Debt

• The relevant cost of new debt
• Taking into account the tax deductibility of
  interest
• Used to calculate the WACCkdT bondholders
  required rate of return minus tax savingskdT
  kd(1-T).

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Cost of Debt

• Interest is tax deductible, so
• kdT kd (1-T)
• 10 (1 - 0.40) 6
• Use nominal rate.
• Flotation costs are small, so ignore them.

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Cost of Preferred Stock

• Rate of return investors require on the firms
  preferred stock
• The preferred dividend divided by the net issuing
  price

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Cost of Preferred Stock

• The cost of preferred stock can be solved by
  using this formula
• kp Dp / Pp
• 10 / 111.10
• 9

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Cost of Retained Earnings

• Rate of return investors require on the firms
  common stock

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Why there is a cost for retained earnings?

• Earnings can be reinvested or paid out as
  dividends.
• Investors could buy other securities, earn a
  return.
• If earnings are retained, there is an opportunity
  cost (the return that stockholders could earn on
  alternative investments of equal risk).
• Investors could buy similar stocks and earn ks.
• Firm could repurchase its own stock and earn ks.
• Therefore, ks is the cost of retained earnings.

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Three ways to determine the cost of common equity

• The CAPM Approach.
• The Discounted Cash Flow Approach.
• The Bond-Yield-Plus-Premium Approach.

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The CAPM Approach
ks kRF (kM kRF) ß 7.0 (6.0)1.2
14.2
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The Discounted Cash Flow Approach

• Price and expected rate of return on a share of
  common stock depend on the dividends expected on
  the stock.

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The Discounted Cash Flow Approach
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The Discounted Cash Flow Approach

• ks D1 / P0 g
• 4.3995 / 50 0.05
• 13.8

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The Bond-Yield-Plus-Premium Approach

• Estimating a risk premium above the bond interest
  rate
• Judgmental estimate for premium
• Ballpark figure only

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The Bond-Yield-Plus-Premium Approach

• ks kd RP
• ks 10.0 4.0 14.0

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Cost of Newly Issued Common Stock

• External equity, ke
• Based on the cost of retained earnings
• Adjusted for flotation costs (the expenses of
  selling new issues)

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Flotation costs

• Flotation costs depend on the risk of the firm
  and the type of capital being raised.
• The flotation costs are highest for common
  equity. However, since most firms issue equity
  infrequently, the per-project cost is fairly
  small.
• We will frequently ignore flotation costs when
  calculating the WACC.

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The Weighted Average Cost of CapitalThe WACC

• A firms WACC is the average of the costs of the
  separate sources weighted by the proportion of
  each source used

To compute a WACC, we need two things the mix of
the capital components in use and the cost of
each component
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Weighted Average Cost of Capital, WACC

• A weighted average of the component costs of
  debt, preferred stock, and common equity

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Example 15.1 Computing the WACC
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