Cost of Capital

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• understand the basic concepts underlying the cost
  of capital
• understand the key factors influencing a
  companys cost of capital
• appreciate the assumptions generally required in
  measuring and using a firms overall or company
  wide cost of capital
• be able to calculate a companys overall cost of
  capital

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• Financial Performance
• Time value of money
• Share and Bond Valuation
• Risk and Return
• 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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• The financing decision
• Cost of capital
• Leverage
• Capital Structure
• The Dividend Decision
• Working Capital

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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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• 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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• The rate that must be earned in order to satisfy
  the required rate of return of the firms
  investors.
• It is based on the opportunity cost of funds as
  determined in capital markets

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• Affect
• Affect Affect

Financing Decisions
Cost of Capital
Investment Decisions
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• Bonds
• Preferred Shares
• Ordinary Shares
• 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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• Step 1. Compute the cost of capital for each and
  every source of financing used by the firm
• Step 2. Determine the percentage of each source
  of finance to be used in financing future
  investments
• Step 3. Using the individual costs and the
  capital structure percentages calculate the
  weighted average cost using the percentage of
  finance as the weights

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• Recall the discussions in chapter 2 concerning
  the taxation categories of corporations.
• Taxation Category 1 (Limited Liability
  Corporations) Tax is paid on company profits at
  the corporate rate, and dividends are taxed in
  the hands of shareholders at the marginal
  personal rate. (Classical taxation system)
• Capital budgeting projects are evaluated on an
  after-tax basis, THUS an after-tax cost of
  capital is required.

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• Taxation category 2 (non company firms )
• Capital budgeting projects are evaluated on an
  after tax cash flow basis THUS an after tax cost
  of capital is required

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• Step 1 Cost of Capital Sources
• To calculate the firms weighted cost of capital,
  we must first calculate the costs of the
  individual financing sources
• Cost of Debt
• Cost of Preferred Shares
• Cost of Ordinary Shares

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• For the issuing firm, the cost of debt is
• the rate of return required by investors (given
  the market price of the bond the cost is found by
  trial and error),
• adjusted for taxes (the use of a before tax or
  after tax cost depends on the taxation category
  of the firm)
• corporations and other firms ? after tax

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After Tax Cost of Debt kd ki(1-t)
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• Objective to find the rate of return that must
  be earned on the preference shareholders
  investment to satisfy their required rate of
  return.

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• Recall that for an irredeemable preference share
• kp
• From the firms point of view
• kpAT
• NPo price - flotation costs!

Dividend Price
D Po
Dividend Net Price
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• If Company issues preference shares, 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 the preference
  shares?

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Dividend Net Price

• kpAT
• 
  10.81

8.00 74.00
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• There are 2 sources of Ordinary Equity
• 1) Internal ordinary equity (retained earnings),
  and
• 2) External ordinary equity (new ordinary share
  issue)
• Do these 2 sources have the same cost?

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• Since the shareholders own the firms retained
  earnings, the cost is simply the shareholders
  required rate of return.
• Why?
• If managers are investing shareholders funds,
  shareholders will expect to earn an acceptable
  rate of return.
• For internal equity, the required rates of return
  are equivalent to the cost as no adjustments are
  required for issue costs.

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• 1) Dividend Growth Model
• ReAT keAT g

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• 2) Capital Asset Pricing Model (CAPM)
• ReAT KeAT Rf B ( Rm - Rf )

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• The weighted cost of capital is just the weighted
  average cost of all of the financing sources.
• What is the appropriate weighting system?

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• Step 2 - The weighting system
• The weights should reflect the companys
  financing mix
• ASSUMPTION
• the company s financial mix is relatively
  stable so the firms target capital structure
  provides the appropriate weights to be used.

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• Example Assume a firms target capital structure
  is 20 debt, 10 preference shares, and 70
  ordinary shares. The respective costs of capital
  are 6, 10 and 16.
• Weighted cost of capital
• .20 (6) .10 (10) .70 (16)
• 13.4

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• General economic conditions
• Marketability conditions
• Firms operating and financing decisions
• business risk and financial risk
• Amount of financing

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• Constant business risk - the weighted average
  cost of capital is an appropriate investment
  criterion only for an investment having a
  business risk level similar to that of existing
  assets
• Constant financial risk - data used in the
  computation are appropriate only if the same
  financial mix is maintained.

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• Constant dividend policy -assume that a firms
  dividend are increasing at a constant annual
  growth rate
• A firms cost of capital cannot be measured
  precisely due to the limiting assumptions and
  limitations of the models employed to estimate
  costs. Hence sensitivity analysis is desirable.

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• The cost of capital should only be used as an
  estimate of the cost of capital for a new project
  if
• the risk of the new project is equivalent to the
  risk of existing projects (business risk will not
  alter)
• the new project will not cause the companys
  optimal or target capital structure to change
  (financial risk will not alter)

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• If an individual projects risk is different to
  that of the companys, the cost of capital will
  not be appropriate for project evaluation.
• Why? - because the discount rate will not reflect
  the risk of that particular project and hence
  incorrect investment decisions could be made.

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• Cost of capital is relevant for capital budgeting
  decisions. Depending on the type of firm a before
  or after rate may be required.
• It is the rate of return that must be achieved on
  the companys projects to satisfy the investors
  required rate of return
• It is the rate of return that will leave the
  companys value unchanged
• Cost of capital is affected by various factors
• Calculation involves costing individual sources
  of capital, and using a target capital structure
  as a weighting system to find the weighted cost.
• Calculation entails limiting assumptions