Chap 11 - The Cost of Capital

8/16/2019 Chap 11 - The Cost of Capital

1/27

10-1

CHAPTER 10

The Cost of Capital

Sources of capital

Component costs WACC


2/27

10-2

What sources of long-

term capital do rms use?

Long-Term Capital

Long-Term Capital

Long-Term Debt

Long-Term Debt Preferred Stock

Preferred Stock Common Stock

Common Stock

etained !arnings

etained !arnings "e# Common Stock

"e# Common Stock


3/27

10-3

Calculating the #eighted

a$erage cost of capitalWACC % #drd&'-T( ) #prp ) #crs

The #*s refer to the rm*s capitalstructure #eights+

The r*s refer to the cost of eachcomponent+


4/27

10-4

Should our anal,sis focus onbefore-ta or after-ta capital

costs? Stockholders focus on A-T C.s+ Therefore/ #e should focus on A-T

capital costs/ i+e+ use A-T costs ofcapital in WACC+ 0nl, rd needs

ad1ustment/ because interest is tadeductible+

Pro1ect return is based on A-T C.s andC. in stock $aluation is based on A-TC.s


5/27

10-5

Should our anal,sis focus onhistorical &embedded( costs or

ne# &marginal( costs? The cost of capital is used

primaril, to make decisions that

in$ol$e raising ne# capital+ So/focus on toda,*s marginal costs&for WACC(+


6/27

10-6

Component cost of debt WACC % #drd&'-T( ) #prp ) #crs

rd is the marginal cost of debt

capital+

The ,ield to maturit, on outstanding

L-T debt is often used as a measureof rd+

Wh, ta-ad1ust/ i+e+ #h, rd&'-T(?


7/27

10-7

A '2-,ear/ '34 semiannualcoupon bond sells for

5'/'26+73+ What is the cost ofdebt &rd(? emember/ the bond pa,s asemiannual coupon/ so rd % 2+84

3 % '84+

INPUTS

OUTPUT

N I/YR PMTPV FV

30

5

60 1000-1153.72


8/27

10-8

Component cost of debt 9nterest is ta deductible/ so

A-T rd % :-T rd &'-T(

% '84 &' - 8+;8( %


9/27

10-9

Component cost of preferred

stock WACC % #drd&'-T( ) #prp ) #crs

rp is the marginal cost of preferredstock/ #hich is the return in$estorsre>uire on a rm*s preferred stock+

Preferred di$idends are not ta-

deductible/ so no ta ad1ustmentsnecessar,+ ust use nominal rp+ 0ur calculation ignores possible

@otation costs+


10/27

10-10

What is the cost of preferred

stock? The cost of preferred stock can be

sol$ed b, using this formula

rp % Dp B Pp

% 5'8 B 5'''+'8

% 4


11/27

10-11

9s preferred stock more orless risk, to in$estors thandebt? ore risk,E compan, not re>uired to pa,

preferred di$idend+

Fo#e$er/ rms tr, to pa, preferreddi$idend+ 0ther#ise/ &'( cannot pa,common di$idend/ &3( diGcult to raiseadditional funds/ &6( preferredstockholders ma, gain control of rm+


12/27

10-12

Wh, is the ,ield onpreferred stock lo#er thandebt? Preferred stock #ill often ha$e a lo#er :-

T ,ield than the :-T ,ield on debt+

Corporations o#n most preferred stock/because 784 of preferred di$idends areecluded from corporate taation+

The A-T ,ield to an in$estor/ and the A-T

cost to the issuer/ are higher on preferredstock than on debt+ Consistent #ithhigher risk of preferred stock+


13/27

10-13

Component cost of e>uit, WACC % #drd&'-T( ) #prp ) #crs

rs is the marginal cost of common

e>uit, using retained earnings+

The rate of return in$estorsre>uire on the rm*s common

e>uit, using ne# e>uit, is re+


14/27

10-14

Wh, is there a cost for

retained earnings? !arnings can be rein$ested or paid out as

di$idends+ 9n$estors could bu, other securities/ earn a

return+ 9f earnings are retained/ there is an

opportunit, cost &the return thatstockholders could earn on alternati$e

in$estments of e>ual risk(+ 9n$estors could bu, similar stocks and earn rs+ .irm could repurchase its o#n stock and earn rs+


15/27

10-15

Three #a,s to determinethe cost of commone>uit,/ rs CAP rs % r. ) &rD H r.( b

DC. rs % &D' B P8( ) g

0#n-:ond-Iield-Plus-isk-Premiumrs % rd ) P


16/27

10-16

9f the r. % 74/ P %


17/27

10-17

9f D8 % 5;+'/ P8 % 528/ and g % 24/

#hat*s the cost of common e>uit,

based upon the DC. approach?

D' % D8 &' ) g(

D' % 5;+' &' ) +82(

D' % 5;+62

rs % &D' B P8( ) g% &5;+62 B 528( ) 8+82

% '6+J4


18/27

10-18

What is the epectedfuture gro#th rate?

The rm has been earning '24 on e>uit,&0! % '24( and retaining 624 of itsearnings &di$idend pa,out %


19/27

10-19

Can DC. methodolog, beapplied if gro#th is not

constant? Ies/ nonconstant gro#th stocks are

epected to attain constant gro#th

at some point/ generall, in 2 to '8,ears+

a, be complicated to compute+


20/27

10-20

9f rd % '84 and P % ;4/ #hat is rs

using the o#n-bond-,ield-plus-risk-

premium method? This P is not the same as the

CAP P+

This method produces a ballparkestimate of rs/ and can ser$e as auseful check+

rs % rd ) P

rs % '8+84 ) ;+84 % ';+84


21/27


22/27

10-22

Wh, is the cost of retained earningscheaper than the cost of issuing ne#

common stock? When a compan, issues ne# common

stock the, also ha$e to pa, @otationcosts to the under#riter+

9ssuing ne# common stock ma, send anegati$e signal to the capital markets/#hich ma, depress the stock price+

T#o approaches to ad1ust @otation cost&'(add @otation cost &5( directl, to apro1ect*s cost &3( ad1ust the percentageof WACC


23/27

10-23

9f issuing ne# common stock incursa @otation cost of '24 of the

proceeds/ #hat is re?

'2+;4

2+845;3+285;+62

2+848+'2(-528&'

(5;+'&'+82

g.(-&'P

g(&'D r

8

8e

=

+=

+=

++

=


24/27

10-24

.lotation costs

.lotation costs depend on the rm*srisk and the t,pe of capital being

raised+ .lotation costs are highest for

common e>uit,+ Fo#e$er/ sincemost rms issue e>uit, infre>uentl,/

the per-pro1ect cost is fairl, small+ We #ill fre>uentl, ignore @otation

costs #hen calculating the WACC+


25/27

10-25

9gnoring @otation costs/#hat is the rm*s WACC?

WACC % #drd&'-T( ) #prp ) #crs

% 8+6&'84(&8+


26/27

10-26

What factors in@uence acompan,*s compositeWACC? Capital arket conditions+

The rm*s capital structure and

di$idend polic,+ The rm*s in$estment polic,+

.irms #ith riskier pro1ects

generall, ha$e a higher WACC+


27/27

10-27

Should the compan, use thecomposite WACC as the hurdle

rate for each of its pro1ects? "0 The composite WACC re@ects

the risk of an a$erage pro1ect

undertaken b, the rm+ Therefore/the WACC onl, represents theMhurdle rateN for a t,pical pro1ect#ith a$erage risk+

DiOerent pro1ects ha$e diOerentrisks+ The pro1ect*s WACC should bead1usted to re@ect the pro1ect*s risk+

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Chap 11 - The Cost of Capital

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