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Learning OutcomesChapter 11

Compute the component cost of capital for (a) debt, (b) preferred stock, (c) retained earnings, and (d) new common equity.

Describe the weighted average cost of capital (WACC) and discuss the logic of using WACC to make informed financial decisions.

Describe how the marginal cost of capital (MCC) is used to make capital budgeting decisions.

Discuss the relationship between the firm’s weighted average cost of capital (WACC) and investor’s’ required rates of return.

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Cost of Capital

Firm’s average cost of funds, which is the average return required by firm’s investors

What must be paid to attract funds

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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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Basic Definitions

Capital ComponentTypes of capital used by firms to raise money

• rd = before tax interest cost

• rdT = rd(1-T) = after tax cost of debt

• rps = cost of preferred stock

• rs = cost of retained earnings

• re = cost of external equity (new stock)

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WACC Weighted Average Cost of Capital

Capital StructureA combination of different types of capital(debt and equity) used by a firm

Basic Definitions

After-Tax Cost of Debt

The relevant cost of new debt

Taking into account the tax deductibility of interest

Used to calculate the WACC

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Cost of Preferred StockRate of return investors require on the firm’s preferred stock

The preferred dividend divided by the net issuing price

F = percentage flotation costs as a decimalNP0 = per share net proceeds firm receives from the issue

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Cost of Retained EarningsRate of return investors require on the firm’s common stock

rs = required rate of return RPs = risk premium for Stock S

= expected rate of return g = constant growth raterRF = risk-free rate of return P0 = current stock price

= next period’s expected dividend

sr

1D

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The CAPM Approach

rs = cost of retained earningsrRF = risk-free rate of returnrM = risk-free rate of returnRPs = risk premium for Stock Sβs = beta coefficient for Stock S

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The Discounted Cash Flow Approach(Expected Rate of Return)

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

rs = cost of retained earnings P0 = current stock price

= expected rate of return g = constant growth rate

= next period’s expected dividend

sr

1D

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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

Cost of Newly Issued Common StockExternal equity, re

Based on the cost of retained earnings

Adjusted for flotation costs (the expenses of selling new issues)

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re = cost of new equity

g = constant growth rate

= next period’s expected dividend

F = percentage flotation cost stated as a decimal

P0 = current stock price

1D

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Target Capital Structure

Optimal Capital StructurePercentage of debt, preferred stock, and common

equity in the capital structure that will maximize the price of the firm’s stock

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Weighted Average Cost of Capital, WACC

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

wd = proportion of debt in firm’s capital structure

wps = proportion of preferred stock in firm’s capital structure

ws = proportion of common stock in firm’s capital structure

Taxes and the WACC

We are concerned with after-tax cash flows, so the effect of taxes on the various costs of capital has to be consideredInterest expense reduces tax liabilityReduction in taxes reduces cost of debtAfter-tax cost of debt = RD(1-TC)

Dividends are not tax deductible, so there is no tax impact on the cost of equity

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Taxes and the Value of the Firm

The value of the firm increases by the present value of the annual interest tax shieldValue of a levered firm = value of an unlevered firm

+ PV of interest tax shield

Value of equity = Value of the firm – Value of debt

RU - unlevered cost of capital; D –face value of debt

VU = EBIT(1-T) / RU

VL = VU + DTC

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Taxes and the Value of the Firm-Use of Leverage

EBIT = $25 million; Tax rate = 35%; Debt = $75 million; Cost of debt = 9%; Unlevered cost of capital = 12%

The WACC decreases as D/E increases because of the government subsidy on interest paymentsWACC↓ Value ↑

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WACC (1)

Equity Information50 million shares

$80 per share

Beta = 1.15

Market risk premium = 9%

Risk-free rate = 5%

Debt Information$1 billion in

outstanding debt (face value)

Current quote = 110

Coupon rate = 9%, semiannual coupons

15 years to maturity

Tax rate = 40%

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WACC (2)

1. What is the cost of equity?

2. What is the cost of debt?

3. What is the after-tax cost of debt?

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WACC (3)

What are the capital structure weights?

What is the WACC?

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The Logic of the Weighted Average Cost of Capital

The use of debt impacts the ability to use equity, and vice versa, so the weighted average cost must be used to evaluate projects, regardless of the specific financing used to fund a particular project.

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Marginal Cost of Capital

Marginal Cost of Capital ScheduleA graph that relates the firm’s weighted

average of each dollar of capital to the total amount of new capital raised

Reflects changing costs, depending on amounts of capital raised

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MCC Schedule for Unilate Textiles

Break Point (BP)

The dollar value of new capital that can be raised before an increase in the firm’s weighted average cost of capital occurs

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MCC Schedule Using Retained Earnings, New Common Stock and Higher-Cost Debt

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Combining the MCC and Investment Opportunity Schedules

Use the MCC schedule to find the cost of capital for determining projects’ net present values.

Investment Opportunity Schedule (IOS)Graph of the firm’s investment opportunities ranked

in order of the projects’ internal rate of return

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Combining the MCC and Investment Opportunity Schedules