Cost of Capital

1
Cost of Capital

• Chapter 11

2
Where weve been...

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

3
The investment decision

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

4
Where were going...

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

5
The financing decision

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

6

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

Capital Structure
7
Ch. 11 - 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.

8
Cost of Capital

• Link between financing decisions and investment
  decisions
• Hurdle rate that must be achieved by an
  investment before it will increase shareholder
  wealth
• Basis for evaluating division or firm performance

9
Cost of Capital

• Also called
• Hurdle rate for new investment
• Discount rate
• Opportunity cost of funds
• Required rate of return

10
Discount Rate

• Investors required rate of return
• or
• Minimum rate of return necessary to attract an
  investor to purchase or hold a security
• Considers opportunity cost

11
Required Rate of Return vs. Cost of Capital

• Cost of capital incorporates
• Taxes or Tax Savings
• Flotation Costs any transaction costs incurred
  when a firm raises funds by issuing a particular
  type of security

12
How can the firm raise capital?

• Debt (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.

13
Cost of Debt

• For the issuing firm, the cost of debt is
• the rate of return required by investors,
• adjusted for flotation costs (any costs
  associated with issuing new bonds), and
• adjusted for taxes.

14
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.

15
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

-
17
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?

18

• Pre-tax cost of debt (using TVM)
• P/Y 1 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.

20
Cost of Preferred Stock

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

Dividend Price
D Po
Dividend Net Price
21
Cost of Preferred vs. Investors Required Rate

• If a firm sells new stock for 30.00 a share and
  incurs 5 in flotation costs, and the investors
  have a required rate of return of 12, what is
  the cost of capital?
• .12 x30 3.60
• 3.60 / (30-5) 14.40

22
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?

23
Cost of Preferred Stock
Dividend Net Price

• kp
• 
  10.81

8.00 74.00
24
Cost of Common Stock

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

25
Cost of Internal Equity

• Since the stockholders own the firms retained
  earnings, the cost is simply the stockholders
  required rate of return.
• Why?
• If managers are investing stockholders funds,
  stockholders will expect to earn an acceptable
  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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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 Structure
• debt 6 20
• preferred 10 10
• common 16 70

30
Weighted Cost of Capital(20 debt, 10
preferred, 70 common)

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

31
Economic Profit

• Accounting profit less a charge for use of
  capital
• Calculated by
• Net operating profit after tax (NOPAT) invested
  capital X cost of capital

32
Kmart Example

• Economic Profit NOPAT Invested capital X cost
  of capital
• (568.979M) 950M (19,727M X .0770)
• Note return is 4.82 and cost of capital is
  7.70
• - as long as Kmart continues to earn a return on
  invested capital that is lower than its cost of
  capital, shareholder value declines
• Note Kmart declared bankruptcy in Jan 2002

33
Economic Value

• Created by earning a return greater than
  investors required return
• Destroyed by earning a return less than they
  require

34
EVA Measurement

• Encourages management to make business decisions
  that create economic value through improved
  operating efficiency, better asset utilization,
  and growth that generates returns which exceed
  the cost of capital

35
EVA

• Emphasis on EVA will more closely align the
  interests of employees and shareholders

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Market Value AddedMVA

• Difference in the current market value of the
  firm and the sum of all the funds that have been
  invested in the firm over its entire operating
  life
• MVA
• Total value of the firm Invested capital
• market value of debt preferred stock common
  stock

37
Capital

• Capital represents the funds used to finance a
  firm's assets and operations. Capital constitutes
  all items on the right hand side of a balance
  sheet i.e. liabilities and common equity.
• Main sources Debt, Preferred stock, Retained
  earnings and Common Stock

38
Cost of Capital

• Cost of capital is the return/interest the
  investors/lenders require on their capital (for
  example, a corporation has to pay interest on
  bonds).
• Cost of capital can also be regarded as the
  hurdle rate that must be achieved by an
  investment before it will increase shareholder
  wealth.
• Cost of capital provides the basis for evaluating
  division or firm performance.

39
Cost of Capital

• Cost of Capital is also called
• Hurdle rate for new investment
• Discount rate
• Opportunity cost of funds
• Required rate of return

40
Investors Required Rate of Return

• Investors Required Rate of Return the minimum
  rate of return necessary to attract an investor
  to purchase or hold a security.
• Investors required rate of return is not the
  same as cost of capital due to taxes and
  transaction costs.
• For example, a firm may pay 8 interest on debt
  but due to tax benefit on interest expense, the
  net cost to the firm will be lower than 8.

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Weighted Average Cost of Capital (WACC)

• Combined costs of all the sources of financing
  used by the firm. The weighted average of the
  after-tax costs of each of the sources of capital
  used by a firm to finance a project where the
  weights reflect the proportion of total financing
  from each source.

42
Cost estimation techniques

• Two commonly used methods for estimating common
  stockholders required rate of return are
• Dividend Growth Model
• Capital Asset Pricing Model

43
Dividend Growth Model

• Investors required rate of return (For Retained
  Earnings)
• Kcs D1/Pcs g
• D1 Dividends expected one year hence
• Pcs Price of common stock
• g growth rate

44
Dividend Growth Model

• Investors required rate of return (For new
  issues)
• Kpcs D1/NPcs g
• D1 Dividends expected one year hence
• Pcs Net proceeds per share
• g growth rate

45
Dividend Growth Model

• Example A company expects dividends this year
  to be 2.20, based upon the fact that 2 were
  paid last year. The firm expects dividends to
  grow 10 next year and into the foreseeable
  future. Stock is trading at 50 a share.
• Cost of retained earnings
• Kcs D1/Pcs g
• 2.20/50 .10 .144 or 14.4
• Cost of new stock
• Kncs D1/NPcs g
• 2.20/(50-7.50) .10 .1518 or 15.18

46
Dividend Growth Model

• Dividend growth model is simple to use but
  suffers from the following drawbacks
• It assumes a constant growth rate.
• The growth rate is then not easy to forecast.

47
Capital Asset Pricing Model

• kc krf ?(km krf)
• Krf Risk Free rate
• ? Beta
• km krf Market Risk Premium or Expected rate
  of return for average security minus the risk
  free rate, km krf

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Capital Asset Pricing Model

• Example If beta is 1.4, risk-free rate is 3.75
  and expected market rate is 12
• kc krf B(km krf)
• .0375 1.4(.12 - .0375)
• 15.3

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Capital Asset Pricing Model Variable estimates

• CAPM is easy to apply. Also, the estimates for
  model variables are generally available from
  public sources.
• Risk Free Rate Wide range of US government
  securities on which to base risk-free rate.
• Beta Estimates of beta available from a wide
  range of services, or can be estimated using
  regression analysis of historical data.
• Market risk premium It can be estimated by
  looking at history of stock returns and premium
  earned over risk-free rate.

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Shareholder Value-Based Management
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How much value has a firm created for its owners?

• Compute the Market Value added (MVA). MVA
  measures the wealth created by a firm at a
  particular point in time.
• MVA Total market value of the firm Invested
  capital
• Market value of the Firm Market value of the
  firms outstanding debt market value of
  preferred stock market value of the firms
  common stock

52
How to evaluate performance over a period of
time?

• Compute Economic Profit (EP)
• Accounting profit less a charge for use of
  capital
• Net operating profit after tax (NOPAT)
  invested capital X cost of capital

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Kmart Example

• EP NOPAT (Invested capital X cost of capital)
• (568.979M) 950M (19,727M X .0770)
• Note NOPAT represents a return of 4.82 while
  cost of capital is 7.70 leading to negative
  economic profit.
• As long as Kmart continues to earn a return on
  invested capital that is lower than its cost of
  capital, shareholder value declines.
• Kmart declared bankruptcy in Jan 2002

54
How to increase Economic Profit?

• Economic profits will increase if
• (a) NOPAT increases without a corresponding
  increase in the cost of capital.
• (b) Firm invests in projects that earn more than
  the firms cost of capital.
• (c) Firms capital charge (cost of capital
  invested capital) is reduced.

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Economic Profit

• Domtar Corp. increased NOPAT and economic profit
  by identifying the following operating
  efficiencies
• Cutting down on waste and damaged products.
• Operating machinery and equipment more
  efficiently.
• Improving product mix, devising methods to save
  on the purchase of raw materials.
• Improving health and safety performance,
  attracting and retaining new customers.
• Making better use of time in the office and the
  plant, implementing or improving preventative
  maintenance programs.
• Developing links with suppliers.

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How to link Pay for Performance and Wealth
Creation?

• Base managers incentive compensation on economic
  profit

57

• Example Base pay 100K/yr. 30 incentive
  compensation, with a target economic profit 1M
  and an earned profit of 1.25M

Incentive Compensation 37,500 Total
compensation 100,000 37,500 137,500