Post on 22-Dec-2015
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
Copyright (C) 2000 by Harcourt, Inc. All rights reserved.
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
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Copyright (C) 2000 by Harcourt, Inc. All rights reserved.
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
Copyright (C) 2000 by Harcourt, Inc. All rights reserved.
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)
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WACCWACC = weighted average cost of capital
Capital StructureCapital StructureA combination of different types of capital used by a firm
Basic Definitions
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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
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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
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Cost of Retained Earnings
Rate of return investors require on the firm’s common stock
sk̂ g
0P
1D̂
RP RF
ks
k
10-10
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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
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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
Copyright (C) 2000 by Harcourt, Inc. All rights reserved.
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
Copyright (C) 2000 by Harcourt, Inc. All rights reserved.
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
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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
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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
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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
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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
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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%
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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
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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%
BPRE BPDebt
MCC Schedule
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Schedule and break points depend on capital structure used
MCC Schedule
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Weighted Average Cost of Capital (WACC) (%)
Dollars of New Capital Raised0 -
WACC
Smooth, or Continuous, Marginal Cost of Capital Schedule
MCC Schedule
10-23
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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
10-24
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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%