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CONTEMPORARY FINANCIAL MANAGEMENT
Chapter 8:
The Cost of Capital
INTRODUCTION This chapter discusses:
The cost of capital What is it How is it measured What is the Weighted Average Cost of Capital (WACC)
Risk vs. required return trade-off
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COST OF CAPITAL The return required by investors to hold a company’s
securities
Determined in the capital markets
Depends on the risk associated with the firm’s activities
Determines what the firm must pay to acquire new capital (sell new securities)
Firms must earn more than their cost of capital or they destroy shareholder wealth
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CONCEPT OF CAPITAL STRUCTURE A firm’s capital structure consists of the mix of debt and
equity securities that have been issued to finance the firm’s activities.
Forms of financing include: Common stock Preferred stock Bonds (secured debt) Debentures (Unsecured debt)
Each different type of security has different risk characteristics and therefore will earn a different return in the market.
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WEIGHTED AVE. COST OF CAPITAL (WACC)
Discount rate used when computing the net present value of a project of average risk.
Calculated by weighting the cost of each form of security issued (Common stock, preferred stock, bonds, debentures).
Weights equal to the proportion of each of the components in the capital structure.
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WEIGHTED AVERAGE COST OF CAPITAL
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( ) ( ) ( ) ( ) = + − + ÷ ÷ ÷+ + + + + +
fa e d p
f f f
E D Pk k k 1 T k
E D P E D P E D P
ka = Weighted Average Cost of CapitalD = Market value of the firm’s DebtPf = Market value of the firm’s Preferred SharesE = Market value of the firm’s Common Equityke = Marginal Cost of Common Share Capitalkd = Marginal Pre-Tax Cost of Debtkp = Marginal Cost of Preferred Share CapitalT = Corporate Tax Rate
WEIGHTED AVERAGE COST OF CAPITAL Example: A firm’s capital structure includes $3 Million in
bonds, $6 Million in equity, and $1 Million in preferred stock (market values). The firm’s cost of equity is 15%, the cost of debt is 8% and the cost of preferreds is 10%. If the firm’s marginal tax rate is 50%, what is its WACC?
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( ) ( ) ( ) ( )
( ) ( ) ( ) ( )
= + − + ÷ ÷ ÷+ + + + + +
= + − + ÷ ÷ ÷+ + + + + + =
fa e d p
f f f
E D Pk k k 1 T k
E D P E D P E D P
6 3 1.15 .08 1 0.50 .10
6 3 1 6 3 1 6 3 1
11.2%
REQUIRED RATE OF RETURN
Risk-free Rate of Return + Risk Premium
Risk-free Rate of Return: real rate of return (compensation for deferring consumption)
plus compensation for expected inflation
Risk Premium: additional reward required for bearing the risk of an investment Composed of business risk, financial risk, marketability risk,
interest rate risk and seniority risk.
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RISK-RETURN TRADE-OFFS
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RequiredRate ofReturn
Risk-FreeRate ofReturn
Risk
X Short-term Government Debt
X Long-term Government Debt
X High Quality Corporate Debt
X High Quality Preferred Shares
Low Quality Corporate XDebt
Common Shares X
COST OF DEBT
The firm’s after-tax cost of debt (ki) is found by multiplying the firm’s pre-tax cost of debt (kd) by 1 minus the firm’s marginal tax rate (T).
Debt is the firm’s lowest cost source of funds, since interest is a tax-deductible expense.
As the amount of debt issued increases, the risk of default rises and so does the cost.
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i dk = k (1 - T)
COST OF PREFERREDS
The firm’s after-tax cost of preferreds (kp) is equal to the pre-tax cost (Dp/Pnet), since dividends are not tax deductible (dividends are paid out of after-tax cash flow).
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pp
net
Dk =
P
COST OF INTERNAL EQUITY CAPITAL
The firm’s cost of internal equity is the return demanded by the existing shareholder.
The CAPM defines this return as:
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1e
0
Dk = + g
P
e f j m fk = r + b (r - r )
COST OF EXTERNAL EQUITY CAPITAL
The cost of external equity is greater than the cost of internal equity due to the existence of Issue costs New issue discounts from market price
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1e
net
Dk = + g
P
ISSUE COSTS & DISCOUNTS
Issue (flotation) costs are the costs associated with making a new issue of equity to the public.
To sell a new issue of shares, the sale price may have to be set below the current market price.
Current market price represents an equilibrium between supply & demand
Without new demand being created, the new supply will push down the market price
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GROWTH RATE INFORMATION
Institutional Brokers Estimate System www.firstcall.com/
Zacks Earnings Estimates www.zacks.com/
Thomson Financial First Call Service www.firstcall.com/index.html
Dividend growth model www.finplan.com/invest/divgrowmod.htm 15
CAPM
Check out this Web site to see how the CAPM is used to calculate a firm’s cost of equity:http://www.ibbotson.com/
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DIVISIONAL COSTS OF CAPITAL
Some divisions of a company have higher or lower systematic risk.
Discount rates for divisions are higher or lower than the discount rate for the firm as a whole.
Each division could have its own beta and discount rate.
Should reflect both the differential risks and the differential normal debt ratios for each division.
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DEPRECIATION A major source of funds
Equal to the firm’s weighted cost of capital based on retained earnings and the lowest cost of debt
Availability of funds from depreciation shifts the marginal cost of capital (MCC) to the right by the amount of depreciation
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COST OF CAPITAL: CASE STUDY Major Foods Corporation is developing its cost of capital.
The firm’s current & target capital structure is: 40% debt 10% preferred shares 50% common equity
The firm can raise the following funds Debt – up to $5 Million at 9% Debt – over $5 Million at 10% Preferred shares – 10%
The firm’s marginal tax rate is 40%
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COST OF CAPITAL: CASE STUDY (CONT’D)
Equity and internally generated funds The firm will generate $10 Million of retained earnings this year Current dividend is $2 per share Current share price is $25 New common shares can be sold at $24
Earnings and dividends growing at 7% per year
Payout ratio expected to remain constant
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COST OF CAPITAL: CASE STUDY SOLUTION Step #1: Calculate the cost of capital for each component of financing
Cost of debt (up to $5 Million of new debt)
Cost of debt (over $5 Million of new debt)
( ) ( )= − = − =i dk k 1 T 9.0 1 0.4 5.4%
( ) ( )= − = − =i dk k 1 T 10.0 1 0.4 6.0%
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COST OF CAPITAL: CASE STUDY SOLUTION
Step #1: Calculate the cost of capital for each component of
financing
Cost of Preferreds
Cost of Equity (internal)
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( )= =1p
Net
Dk 10% Givenfor this problem
P
( ) ( )+= + = + =0
e0
D 1 g 2.00 1.07k g 0.07 15.6%
P 25
COST OF CAPITAL: CASE STUDY SOLUTION
Step #1: Calculate the cost of capital for each component of
financing
Cost of Equity (external)
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( ) ( )+= + = + =0
e0
D 1 g 2.00 1.07k g 0.07 15.9%
P 24
COST OF CAPITAL: CASE STUDY SOLUTION
Step #2: Compute the weighted average cost of capital for each
increment of capital raised.
The firm wants to retain its target capital structure
The firm should always raise its cheapest source of funds first. These are: Retained earnings (internal equity) Preferred shares Debt up to $5 Million
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COST OF CAPITAL: CASE STUDY SOLUTION Increment #1: Calculate total financing that can be acquired
using 9% debt while retaining the target capital structure with 40% debt.
Amount of low-cost debt availableX =
Proportion debt comprises of target capital structure$5 Million
= = $12.5 Million0.40
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The firm can raise a total of $12.5 Million of new financing (including $5 Million of 9% debt) before it has to begin issuing new debt at 10%.
COST OF CAPITAL: CASE STUDY SOLUTION
The WACC for increment #1 is:
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( ) ( ) ( )
( ) ( ) ( )
( )
= + + ÷ ÷ ÷+ + + + + +
= + − + ÷ ÷+ + + +
÷+ +
=
fa e e e
f f f
E D Pk k k k
E D P E D P E D P
6.25 5.00.156 .09 1 0.40
6.25 5.0 1.25 6.25 5.0 1.25
1.25.10
6.25 5.0 1.25
10.96%
COST OF CAPITAL: CASE STUDY SOLUTION
Increment #2: Calculate total financing that can be acquired using internally generated equity (retained earnings) while retaining the target capital structure with 50% equity.
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=
Amount of retained earnings availableX =
Proportion R/E comprises of target capital structure$10 Million
= $20 Million0.50
The firm can raise a total of $20 Million of new financing before it needs to issue new common stock.
COST OF CAPITAL: CASE STUDY SOLUTION
The WACC for increment #2 (total new funding between $12.5 Million & $20 Million is:
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( ) ( ) ( )
( ) ( ) ( )
( )
= + + ÷ ÷ ÷+ + + + + +
= + − + ÷ ÷+ + + +
÷+ +
=
fa e e e
f f f
E D Pk k k k
E D P E D P E D P
3.75 3.0.156 .10 1 0.40
3.75 3.0 0.75 3.75 3.0 0.75
0.75.10
3.75 3.0 0.75
11.20%
COST OF CAPITAL: CASE STUDY SOLUTION
Increment #3: Financing in excess of $20 Million will require both high-cost debt and issuing new common stock. The WACC for Increment #3 is:
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( ) ( ) ( )
( ) ( ) ( ) ( )
= + + ÷ ÷ ÷+ + + + + +
= + − +
=
fa e e e
f f f
E D Pk k k k
E D P E D P E D P
0.50 .159 0.40 .10 1 0.40 0.10 .10
11.35%
COST OF CAPITAL: CASE STUDY SOLUTION
30Funds Raised
Incremental WACC
$12.5 M $20 M
10.96%11.20%11.35%
SMALL FIRMS
Have a difficult time attracting capital
Issuance costs are high (> 20% of issue)
Often issue two classes of stock One class sold to outsiders paying a higher dividend Second class held by founders with greater voting power
Limited sources of debt
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MAJOR POINTS
The Weighted Average Cost of Capital (WACC) is a weighted average cost of funding.
Equity is the most expensive form of funding; debt is the cheapest.
Debt has a tax advantage due to the tax-deductibility of interest
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