The Cost of Capital

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2e created Summer 11

• The Cost of Capital
• What is Capital?
• In the finance world, capital refers to the
  sources of financing available to a firm
• This is usually debt, stock (equity) and other
  types of securities
• When investors (individuals other corporations)
  provide a corporation with funds, they expect the
  company to generate a return on these funds..
• to at least compensate them for opportunity cost
  and inflation
• to compensate them for various risks (i.e.
  default, interest rate and reinvestment risks,
  etc.)
• to justify their investment in this specific
  firm versus investing in other firms or other
  types of investments (i.e. Opportunity Costs)
• Point These are the cost firms pay to use
  capital these are the costs of financing
• Firms generate returns for their investors by
  using funds to expand and improve operations/NI
• stock returns are generated through dividends
  and increased stock value (opportunity for
  capital gains)
• bond returns in the form interest (Note any
  capital gain resulting from falling rd is not the
  result of any specific firm)
• lowered risk derived from a firms increased
  ability to cover debt (thru increased NI)
• Point This is how firms meet the cost of
  financing
• What we want is a single number that expresses
  the overall cost of financing the firm. This is
  the Weighted Average Cost of Capital (WACC)

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• Bonds and stocks(common and preferred) are
  referred to as capital components
• The required ROR of each component from the
  investors perspective are referred to as a
  component cost from the firms point of view
• Capital Structure the proportions of debt and
  equity(common preferred) used to finance a firm
• Example Diamond Jims Inc.s assets are financed
  60 by debt, 35 by common stock and 5 by
  preferred stock. The capital structure is
• A D SE (Share Holders Equity)
• Capital Structure 60 35 CS 5 PS
• Capital Component Costs
• Cost of Debt(rdT or rEFF)
• Recall from Ch 5 that the cost of debt to a firm
  (or an individual) is the interest paid on any
  borrowed funds
• The firms cost of debt is the interest rate the
  firm would have to pay to refinance its existing
  debt
• Thus a firms cost of debt is the current market
  interest rate / YTM
• rd is the before tax cost of debt
• Interest payments are usually federal
  tax-deductible
• The tax deduction lowers the total cost of debt
• it lowers the actual cash costs of debt by the
  amount deducted
• it effectively lowers the interest rate (from
  the borrowers perspective)

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Capital Component Costs (continued) Cost of
Debt (continued) Consider a firm that has 150m
in debt and has an average cost of debt of 8.
Its annual sales are 600m and annual COGS is
475m. The firm is subject to a 35 marginal tax
rate Find the firms NI under the following two
cases Case 1 The fed allows interest payments
to be deducted prior to computing taxes
( x 1m)
Sales 600.00
COGS 475.00
EBIT 125.00
Interest 12.00
EBT 113.00
Taxes 39.55
NI 73.45
150m x 0.08
113m x 0.35
Case 2 The fed doesnt allow interest payment
deductions
( x 1m)
Sales 600.00
COGS 475.00
EBIT 125.00
Taxes 43.75
EAT 81.25
Interest 12.00
NI 69.25
125m x 0.35
150m x 0.08
Case 2a The fed doesnt allow interest payment
deductions but you compute interest using rEFF
rEFF rd(1-TC) 8(1-0.35) 5.2
( x 1m)
Sales 600.00
COGS 475.00
EBIT 125.00
Taxes 43.75
EAT 81.25
Interest 7.80
NI 73.45
125m x 0.35
150m x 0.052
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• Capital Component Costs (continued)
• Cost of Debt (continued)
• What to do if the firm has debt costing several
  different interest rates? (i.e. several different
  bond issues)
• Answer compute a weighted average interest rate
• Example 40 of a firms debt costs 6, 30 costs
  6.5 and 30 costs 6.7. The firms marginal tax
  rate is 40. What is the firms after-tax cost
  of debt?
• 1) Find weighted average rd 0.40(6) 0.30(6.5)
  0.30(6.7)
• 6.36
• 2) Find rdT rd(1 - TC) 6.36(1 - 0.40) 3.81
• Cost of Preferred Stock (rps)
• Recall that preferred stock usually pays a fixed
  dividend on a specified schedule (its kind of
  like a perpetuity)
• rps Dps / (P0 - Flotation Costs)
• Flotation Costs the cost (per share) to issue
  the stock
• Example A share of a firms preferred stock cost
  100 and it will pay a 10 dividend annually. It
  cost the firm 3 per share to issue this stock.
  What is the cost of the firms preferred stock?

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Capital Component Costs (continued)

• The Cost of Common Stock (rs)
• rs is the required ROR from an investors
  perspective and thus its a cost from the firms
  perspective
• rdT is easy to determine and accurately reflects
  cost of debt based on the contractual nature of
  borrowing/lending
• rs is harder to determine since its based on
  overall expectations rather than contractual
  obligations
• Three methods to estimate rs
• CAPM (Ch 10) rs rRF (rM - rRF)bs
• Discounted Cash Flow (DCF) (Ch 7) rs rs
  D1/P0 g
• Bond-Yield-plus-Risk Premium approach
• they produce different estimates for rs
• these methods are not mutually exclusive
• one can average them or..
• make an educated guess based on confidence of the
  data used to choose one method over the others
• The CAPM method is most commonly used
• Provides a rs that reflects a correspondingly
  appropriate amount of risk
• b measures a stocks price volatility relative
  to that of the market portfolio
• b is a measure of a securitys sensitivity to
  changes in the market
• Betas may not totally reflect true risk
  characteristics but they are at least widely and
  consistently used

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• Weighted Average Cost of Capital (WACC)
• What we want is a single number that expresses
  the overall cost of financing the firm. This is
  the Weighted Average Cost of Capital (WACC)
• Definition the weighted average of the component
  costs of capital
• It is the overall cost of financing the firm
• WACC wdrdT wpsrps wsrs
• Component Costs
• Recall Capital Structure A D SE
  These are the weights
• CS PS
• Example A firms common stock cost 23.50 per
  share and it has a b of 1.3. The firms
  preferred stock costs 75 per share, pays an
  annual dividend of 7 and cost 0.50 per share to
  issue. The firms average cost of debt is 7.
  The firms marginal tax rate is 35. Its capital
  structure is 60 debt, 35 common stock and 5
  preferred stock. The firms common stock trades
  on the NASDAQ which is currently has had an
  average return of 7 for the last 24 months. A
  30-day T bill has returned an average of 2.7 for
  the last 24 months. What is the firms WACC?
• Capital Structure 60D 35 CS 5 PS
• a) Find rdT rdT rd(1 - TC) 0.07(1 - 0.35)
  4.5000
• b) Find rs rs rRF (rM - rRF)b 2.7 (7
  - 2.7)1.3 8.2900

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• Weighted Average Cost of Capital (WACC)
  (continued)
• Factors that Affect WACC
• Factors that the firm cannot control
• debt market interest rates (rd)
• stock market risk premium
• tax rates
• Factors that the firm can control
• capital structure policy (i.e. the proportion of
  debt and equity)
• dividend policy (affects firms ability to meet
  investors rs)
• its own risk position
• affects bond rating
• affects rs (firm specific risk component)
• measured by financial ratios, and other metrics
• Some Problem Areas in determining WACC
• rs of privately owned firms since stocks from
  these firms are not publicly traded, the concept
  of investor expectation as a cost of stock is
  meaningless
• most small businesses are privately owned
• Accuracy of b and g (as previously discussed)
• Why should we care about WACC?