Chapter 11Chapter 11

Cost of CapitalCost of Capital

Chapter ObjectivesChapter Objectives

Cost of Capital After-tax cost of debt, preferred stock and

common stock Weighted average cost of capital PepsiCo’s cost of capital Cost of capital and new investments Economic profit Equivalent interest rates for different countries

Economic ValueEconomic Value

Created by earning a return greater than investors’ required return

Destroyed by earning a return less than they require

EVA MeasurementEVA Measurement

Encourages management to make business decisions that create economic value through improved operating efficiency, better asset utilization, and growth that generates returns which exceed the cost of capital

Shareholder Value-Based Shareholder Value-Based ManagementManagement

Rewards the firm’s employees in ways that continually encourage them to seek out new ways to create shareholder value

EVAEVA

Emphasis on EVA will more closely align the interests of employees and shareholders

Cost of CapitalCost of Capital

Link between financing decisions and investment decisions

Hurdle rate that must be achieved by an investment before it will increase shareholder wealth

Basis for evaluating division or firm performance

Cost of CapitalCost of Capital

Also called:Hurdle rate for new investmentDiscount rateOpportunity cost of fundsRequired rate of return

Discount RateDiscount Rate

Investors’ required rate of return

orMinimum rate of return necessary to attract

an investor to purchase or hold a securityConsiders opportunity cost

Required Rate of Return and Required Rate of Return and Cost of CapitalCost of Capital

Cost of capital incorporates– Taxes or Tax Savings– Flotation Costs

Cost of CapitalCost of Capital

If a firm sells new stock for $30.00 a share and incurs $5 in flotation costs, and the investors have a required rate of return of 12%, what is the cost of capital?

.12 x30 = $3.603.60 / (30-5) = 14.40%

Financial PolicyFinancial Policy

Policies regarding the sources of finances a firm plans to use and the particular mix in which they will be used

Governs the use of debt and equity financing.

The particular mixture of debt and equity a firm utilizes impacts the firm’s cost of capital.

Weighted Average Cost of Weighted Average Cost of CapitalCapital

Combined costs of all the sources of financing used by the firm. The weighted average of the after-tax costs of each of the sources of capital used by a firm to finance a project where the weights reflect the proportion of total financing from each source.

Financing InstrumentsFinancing Instruments

DebtPreferred StockCommon Stock

Cost of DebtCost of Debt

After tax cost of debt = kd(1-Tc)

Before tax cost of capital less the effect of tax savings

ExampleDebt at 9.75% and tax rate of 34%After-tax cost of debt = .0975(1-.34) =

6.435%

Cost of Preferred StockCost of Preferred Stock

Cost of preferred stock = Preferred Stock dividend/ Net proceeds per share

Example: Annual dividend $5, Stock price $65 and flotation costs of $1.50

Cost = 5/(65 - 1.50) = 5/(63.50) = .07874

or Cost of preferred stock = 7.874%

Common EquityCommon Equity

Sources:– Retained Earnings– Sales of new shares

No Flotation costs on retained earnings

Cost of Equity CapitalCost of Equity Capital

First estimate common stockholders’ required rate of return:

Dividend Growth ModelCapital Asset Pricing Model

Dividend Growth ModelDividend Growth Model

Investors’ required rate of return:Kcs = D1/Pcs + gDividends divided by price of stock; plus

growth rateIssue new common stockKncs = D1/NPcs + gDividends divided by net proceeds; plus

growth

Dividend Growth ModelDividend Growth Model Example: A company expects dividends this year to be

$2.20, based upon the fact that $2 were paid last year. The firm expects dividends to grow 10% next year and into the foreseeable future. Stock is trading at $50 a share.

Cost of retained earnings: Kcs = D1/Pcs+ g

2.20/50 + .10 = 14.4% Cost of new stock: Kncs = D1/NPcs + g

2.20/(50-7.50) + .10 = 15.18%

Issues with the Dividend Issues with the Dividend Growth ModelGrowth Model

SimplicityAssume constant growth rateEstimating rate of growth

Capital Asset Pricing Model Capital Asset Pricing Model

Combines:Risk Free rate krf

Systematic risk or Beta (B)Market Risk Premium or Expected rate of

return for market or average security less the risk free rate km – krf

kc = krf + B(km – krf)

Capital Asset Pricing ModelCapital Asset Pricing Model

Example:Beta is 1.4; Risk-free rate is 3.75%;

Expected market rate is 12%.0375 + 1.4(.12 - .0375) = 15.3%

Issues with the Capital Asset Issues with the Capital Asset Pricing ModelPricing Model

Simple/Easy to understandVariables available from public sourcesNo reliance upon dividends or growth rate

assumptions

Weighted Average Cost of Weighted Average Cost of CapitalCapital

Need cost of each of the sources of capital used and capital structure mix

Capital Structure Mix –proportions of each source of financing used by the firm

WACoC = (After tax cost of debt X proportion of debt financing) + (Cost of equity X proportion of equity financing)

Weighted Average Cost of Weighted Average Cost of CapitalCapital

Example:A firm borrows money at 6% after taxes

and pays 10% for equity. The company raises capital in equal proportions – 50/50

WACoC = (.06 X .5) + (.1 X .5) = .08 or 8%

PepsiCoPepsiCo

Calculated divisional cost of capitalDifferent target ratios for debt/equity mix

per divisionDifferent pretax cost of debt for each

division

PepsiCoPepsiCo

Division Cost of Cost of WA

Equity X Debt X COC

ratio ratio

Restaurant (12.20 X .7) (5.54 X .3) 10.2

Snack Foods (11.56 X .8) (5.23 X .2) 10.29

Beverages (11.77 X .74) (5.28 X .26) 10.08

Cost of Capital and New Cost of Capital and New InvestmentInvestment

Cost of Capital can serve as the discount rate in evaluating new investment when the projects offer the same risk as the firm as a whole.

If risk differs, may calculate a different cost of capital for each division.

Generally, calculate the cost of capital per division, not per project.

Market Value AddedMarket Value AddedMVAMVA

Difference in the current market value of the firm and the sum of all the funds that have been invested in the firm over its entire operating life

MVA =

Total value of the firm – Invested capital

Economic ProfitEconomic Profit

Accounting profit less a charge for use of capital

Calculated by:Net operating profit after tax (NOPAT) –

invested capital X cost of capital

Kmart ExampleKmart Example

Economic Profit = NOPAT – Invested capital X cost of capital

568.979 = 950M – (19,727M X .0770)

Note: return is 4.82% and cost of capital is 7.70%.

Note: Kmart declared bankruptcy in Jan 2002

Economic ProfitEconomic Profit

Increase economic profit by:Identifying and eliminating operating

deficienciesInvesting in projects that earn returns in

excess of cost of capitalReduce capital charge

Incentive Based Incentive Based CompensationCompensation

Way to align shareholder and manager interests

Incentive= Base Pay X Percentage X actual Eco pro

compensation incentive Target Eco prof

compensation

Multinational Firms and Multinational Firms and Interest RatesInterest Rates

In an international setting, there can be different rates of inflation among different countries.

The Fisher Model indicates that the nominal interest rate in the home or domestic country is a function of real interest rates and anticipated rate of inflation

Fisher Model and Domestic Fisher Model and Domestic Interest RatesInterest Rates

rn,h = (1 + r r,h)(1 + ih) – 1or

Nominal rate of interest = (1 plus real interest rate) (1 plus inflation rate)

Example:Real interest rate is 5% and inflation rate is

10%(1.05)(1.10) – 1 = 15.5%

International or Foreign Rates International or Foreign Rates and Fisher Effectand Fisher Effect

rn,h - rn,f = ih – if

Differences in observed nominal rates of interest between two countries should equal the difference in expected rates of inflation between the two countries

Interest Rates and Currency Interest Rates and Currency Exchange Rates Exchange Rates

Interest Rate Parity Theorem 1 + r n,h = E1

1 + rn,f E0

rn,h Domestic one period rate of interest

rn,f Corresponding rate in foreign country

Ej Exchange rates corresponding to current period I.e. spot rate E0 and one-period forward

-- Nominal interest rates are tied to exchange rates

-- Differences in nominal interest rates are tied to expected rates of inflation

Interest Rates and Currency Interest Rates and Currency Exchange RatesExchange Rates

Example:Domestic interest rate is 15.5% and the

Japanese interest rate is 5%1 + .155 / 1 + .05 = 1.10