10-1 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Chapter 10: The Cost of Capital...

10-1

Copyright (C) 2000 by Harcourt, Inc. All rights reserved.

Chapter 10:The Cost of Capital

Copyright © 2000 by Harcourt, Inc.

All rights reserved. Requests for permission to make copies of any part of the work should be mailed to the following address: Permissions Department, Harcourt, Inc., 6277 Sea Harbor Drive, Orlando, Florida 32887-6777.

10-2


Cost of Capital

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

What must be paid to attract funds

10-3


The Logic of the Weighted Average Cost of Capital

The use of debt impacts on 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.

10-4


Basic Definitions

Capital ComponentCapital Component

Types of capital used by firms to raise moneykd = before tax interest cost

kdT = kd(1-T) = after tax cost of debt

kps = cost of preferred stock

ks = cost of retained earnings

ke = cost of external equity (new stock)

10-5


WACCWACC = weighted average cost of capital

Capital StructureCapital StructureA combination of different types of capital used by a firm

Basic Definitions

10-6


After-Tax Cost of Debt

The relevant cost of new debt Taking into account the tax deductibility

of interest Used to calculate the WACC

kdT = bondholders’ required rate of return minus tax savings

kdT = kd - (kd x T) = kd(1-T)

10-7


Cost of Preferred Stock

Rate of return investors require on the firm’s preferred stock

The preferred dividend divided by the net issuing price

costs Flotation-0

P

psD

NP

psD

psk

10-8


Cost of Retained Earnings

Rate of return investors require on the firm’s common stock

sk̂ g

0P

1D̂

RP RF

ks

k

10-9


The CAPM Approach

sβ

RFk -

Mk

RFk

sk

10-10


The Bond-Yield-Plus-Premium Approach

14% 4% 10%

premium Risk yield Bond s

k

Estimating a risk premium above the bond interest rate

Judgmental estimate for premium “Ballpark” figure only

10-11


The Discounted Cash Flow (DCF) Approach

1t ts

k1

tD̂

sk1

D̂...

2s

k1

2D̂

1s

k1

1D̂

0P

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

10-12


constant is g if g

sk

1D̂

1t ts

k1

tD̂

sk1

D̂...

2s

k1

2D̂

1s

k1

1D̂

0P

g

0P

1D̂

sk̂

sk

The Discounted Cash Flow (DCF) Approach

10-13


Cost of Newly Issued Common Stock

External equity, ke

based on the cost of retained earnings adjusted for flotation costs (the expenses

of selling new issues)

gF

0P

1D̂

gNP

1D̂

sk

1

10-14


Target Capital Structure

Optimal Capital StructureOptimal Capital Structure

Percentage of debt, preferred stock, and common equity in the capital structure that will maximize the price of the firm’s stock

10-15


Weighted Average Cost of Capital, WACC

sk

s W

psk

psW

dTk

d W

equity

common

of Cost

equity

common of

Proportion

stock

preferred

of Cost

stock

preferred of

Proportion

debt

of cost

tax-After

debt

of

Proportion

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

10-16


Marginal Cost of Capital

MCCMCC The cost of obtaining another dollar

of new capital The weighted average cost of the

last dollar of new capital raised

10-17


Marginal Cost of Capital ScheduleMarginal Cost of Capital Schedule A 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

Marginal Cost of Capital

10-18


MCC Schedule

Weighted Average Cost of Capital (WACC) (%)

New Capital Raised (millions of dollars)100 150

11.5 -

11.0 -

10.5 -WACC1=10.5%

WACC2=11.0%

WACC3=11.5%

10-19


Break Point

BPBP The dollar value of new capital that

can be raised before an increase in the firm’s weighted average cost of capital occurs

Point structure capital in the capital of type thisof Proportion

given type a of capitalcost lower ofamount TotalBreak

10-20



New Capital Raised (millions of dollars)100 150

11.5 -

11.0 -

10.5 -WACC1=10.5%

WACC2=11.0%

WACC3=11.5%

BPRE BPDebt

MCC Schedule

10-21


Schedule and break points depend on capital structure used

MCC Schedule

10-22



Dollars of New Capital Raised0 -

WACC

Smooth, or Continuous, Marginal Cost of Capital Schedule

MCC Schedule

10-23


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

10-24


Combining the MCC and Investment Opportunity Schedules

IRRC = 12.0%

IRRB = 11.6%IRRD = 11.5%

IRRE = 11.3%

IRRA = 10.8%

Percent

New Capital Raised and invested (millions of dollars)

20 40 60 80 100 120 140 160 180

12.0 -

11.5 -

11.0 -

10.5 -

MCC

IOS

WACC1=10.5%

WACC3=11.5%

Optimal Capital Budget - $139

WACC2=11.0%

10-25


End of Chapter 10

The Cost of Capital

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