Date post: | 06-May-2015 |
Category: |
Documents |
Upload: | winnerbdit |
View: | 1,032 times |
Download: | 0 times |
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 21
Chapter Chapter 88
The Cost of Capital
Pub
lish
ed b
y w
ww
.lect
ures
heet
.com
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 2 of 21
The Cost of Capital
• The cost of capital acts as a link between the firm’s
long-term investment decisions and the wealth of the
owners as determined by investors in the marketplace.
• It is used to decide whether a proposed investment
will increase or decrease the firm’s stock price.
• Formally, the cost of capital is the rate of return that a
firm must earn on the projects in which it invests to
maintain the market value of its stock.
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 3 of 21
The Firm’s Capital StructureThe Firm’s Capital StructureThe Firm’s Capital Structure
Current Assets
Fixed Assets
Current Liabilities
Long-TermDebt
Equity
The Firm’s
Capital Structure
& Cost of Capital
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 4 of 21
The Weighted AverageThe Weighted AverageCost of CapitalCost of Capital
• Capital—refers to the long-term funds used by a firm to finance its assets.
• Capital components—the types of capital used by a firm—long-term debt and equity
• WACC—the average percentage cost, based on the proportion of each type of capital, of all the funds used by the firm to finance its assets.
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 5 of 21
• The pretax cost of debt is equal to the the yield-to-maturity on the firm’s debt adjusted for flotation costs.
• Recall that a bond’s yield-to-maturity depends upon a number of factors including the bond’s coupon rate, maturity date, par value, current market conditions, and selling price.
• After obtaining the bond’s yield, a simple adjustment must be made to account for the fact that interest is a tax-deductible expense.
• This will have the effect of reducing the cost of debt.
The Cost of Debt
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 6 of 21
Par Value -1000
Flotation Costs (% of Par) 2%
Flotation Costs (€) -20
Issue Price 980
Net Proceeds Price 960
Coupon Interest (%) 9%
Coupon Interest (€) -90
Time to maturity 20
Tax 40%
Before-tax cost of debt 9,45%
After-tax cost of debt 5,67%
Finding the Cost of Debt
The Cost of Debt - Example
Suppose a company could issue 9% coupon, 20 year debt face value of €1,000 for €980. Suppose that flotation costs
will amount to 2% of par value. Find the after-tax cost of debt assuming the company is in the 40% tax bracket.
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 7 of 21
The Cost of EquiThe Cost of Equityty The cost of equity is based on the rate of return
required by the firm’s stockholders. Cost of preferred stock - dividends received by preferred
stockholders represent an annuity Cost of retained earnings (internal equity)—return that
common stockholders require the firm to earn on the funds that have been retained, thus reinvested in the firm, rather than paid out as dividends
Cost of new (external) equity—rate of return required by common stockholders after considering the cost associated with issuing new stock (flotation costs)
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 8 of 21
The Cost of Preferred Stock (kThe Cost of Preferred Stock (kpp))
KP = DP/(PP - F) = DP/(NP)
In the above equation, “F” represents flotation costs
(in €). As was the case for debt, the cost of raising
new preferred stock will be more than the yield on the
firm’s existing preferred stock since the firm must pay
investment bankers to sell (or float) the issue.
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 9 of 21
A company can issue preferred stock that pays a €5
annual dividend, sell it for €55 per share, and have
to pay €3 per share to sell it. Then, the cost of
preferred stock would be:
kP = €5/(€55 - €3) = 9.62%
There is no tax adjustment, because dividends are
not a tax-deductible expense.
KP = DP/(PP - F)
The Cost of Preferred Stock (kThe Cost of Preferred Stock (kpp) - ) -
ExampleExample
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 10 of 21
The Cost of Retained Earnings
• The firm must earn a return on reinvested earnings that is sufficient to satisfy existing common stockholders’ investment demands.
• If the firm does not earn a sufficient return using retained earnings, then the earnings should be paid out as dividends so that stockholders can invest the funds outside the firm to earn an appropriate rate.
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 11 of 21
Discounted Cash Flow (DCF) approach
kS = (D1/P0) + g.
For example, assume a firm has just paid a dividend of €2.50 per share, expects dividends to grow at
10% indefinitely, and is currently selling for €50 per share.
First, D1 = 2.50(1+.10) = 2.75, and
kS = (2.75/50) + .10 = 15.5%.
The Cost of Retained Earnings (kThe Cost of Retained Earnings (kss))
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 12 of 21
Security Market Line Approach
kE = rF + b(kM - RF).
For example, if the 3-month government bond rate is currently 5.0%, the market risk premium is 9%, and
the firm’s beta is 1.20, the firm’s cost of retained earnings will be:
kE = 5.0 + 1.2(9) = 15.8%.
The Cost of Retained Earnings (kThe Cost of Retained Earnings (kEE))
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 13 of 21
The Cost of Retained Earnings, ks—Bond-Yield-Plus-Risk-Premium Approach
• Studies have shown that the return on equity for a particular firm is approximately 3 to 5 percentage points higher than the return on its debt.
• As a general rule of thumb, firms often compute the YTM, or kd, for their bonds and then add 3 to 5 percent.
• In the current example, kd = 6.0%. As a rough estimate, then, we might say the cost of retained earnings is
ks kd + 4% = 6% + 4% = 10.0%
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 14 of 21
The Cost of New Equity
• Rate of return required by common stockholders after considering the costs associated with issuing new stock, which are called flotation costs.
• Because the firm has to provide the same gross return to new stockholders as existing stockholders, when the flotation costs associated with a common stock issue are considered, the cost of new common stock always must be greater than the cost of existing stock—that is, the cost of retained earnings.
• Modify the DCF approach for computing the cost of retained earnings to include flotation costs
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 15 of 21
Discounted Cash Flow (DCF) approach
Kn = [D1/(P0 - F)] + g = D1/Nn + g
Αssume a firm has just paid a dividend of €2.50 per share, expects dividends to grow at 10%
indefinitely, and is currently selling for €50 per share.Ηow much would it cost the firm to raise new equity if flotation costs amount to €4.00 per share?
Kn = [2.75/(50 - 4)] + .10 = 15.97% or 16%.
The Cost of New Equity (kThe Cost of New Equity (knn))
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 16 of 21
The Weighted Average Cost of Capital
Capital Structure Weights
WACC = ka = wiki + wpkp + wskr or n
The weights in the above equation are intended to represent a specific financing mix (where wi = % of
debt, wp = % of preferred, and ws= % of common).
Specifically, these weights are the target percentages of debt and equity that will minimize the firm’s overall cost of raising funds.
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 17 of 21
One method uses book values from the firm’s balance sheet. For example, to estimate the weight for debt, simply divide the book value of the firm’s long-term debt by the book value of its total assets.
To estimate the weight for equity, simply divide the total book value of equity by the book value of total assets.
The Weighted Average Cost of Capital
Capital Structure Weights
WACC = ka = wiki + wpkp + wskr or n
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 18 of 21
A second method uses the market values of the firm’s debt and equity. To find the market value proportion of debt, simply multiply the price of the firm’s bonds by the number outstanding. This is equal to the total market value of the firm’s debt.
Next, perform the same computation for the firm’s equity by multiplying the price per share by the total number of shares outstanding.
The Weighted Average Cost of Capital
Capital Structure Weights
WACC = ka = wiki + wpkp + wskr or n
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 19 of 21
Finally, add together the total market value of the firm’s equity to the total market value of the firm’s debt. This yields the total market value of the firm’s assets.
To estimate the market value weights, simply divide the market value of either debt or equity by the market value of the firm’s assets .
The Weighted Average Cost of Capital
Capital Structure Weights
WACC = ka = wiki + wpkp + wskr or n
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 20 of 21
For example, assume the market value of the firm’s debt is €40 million, the market value of the firm’s preferred stock is €10 million, and the market value of the firm’s equity is €50 million.
Dividing each component by the total of €100 million gives us market value weights of 40% debt, 10% preferred, and 50% common.
The Weighted Average Cost of Capital
Capital Structure Weights
WACC = ka = wiki + wpkp + wskr or n
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 21 of 21
Using the costs previously calculated along with the market value weights, we may calculate the weighted average cost of capital as follows:
WACC = .4(5.67%) + .1(9.62%) + .5 (15.8%)
= 11.13%
This assumes the firm has sufficient retained earnings to fund any anticipated investment projects.
The Weighted Average Cost of Capital
Capital Structure Weights
WACC = ka = wiki + wpkp + wskr or n