Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of...
-
Upload
olivia-banks -
Category
Documents
-
view
223 -
download
0
description
Transcript of Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of...
![Page 1: Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of capital…](https://reader035.fdocuments.us/reader035/viewer/2022062911/5a4d1be17f8b9ab0599df757/html5/thumbnails/1.jpg)
Chapter 11The Cost of Capital
1
![Page 2: Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of capital…](https://reader035.fdocuments.us/reader035/viewer/2022062911/5a4d1be17f8b9ab0599df757/html5/thumbnails/2.jpg)
2
Learning OutcomesChapter 11
Compute the component cost of capital for (a) debt, (b) preferred stock, (c) retained earnings, and (d) new common equity.
Describe the weighted average cost of capital (WACC) and discuss the logic of using WACC to make informed financial decisions.
Describe how the marginal cost of capital (MCC) is used to make capital budgeting decisions.
Discuss the relationship between the firm’s weighted average cost of capital (WACC) and investor’s’ required rates of return.
![Page 3: Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of capital…](https://reader035.fdocuments.us/reader035/viewer/2022062911/5a4d1be17f8b9ab0599df757/html5/thumbnails/3.jpg)
3
Cost of Capital Firm’s average cost of funds, which is
the average return required by firm’s investors
What must be paid to attract funds
![Page 4: Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of capital…](https://reader035.fdocuments.us/reader035/viewer/2022062911/5a4d1be17f8b9ab0599df757/html5/thumbnails/4.jpg)
4
Required Rate of Return(Opportunity Cost Rate)
The return that must be raised on invested funds to cover the cost of financing such investments
![Page 5: Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of capital…](https://reader035.fdocuments.us/reader035/viewer/2022062911/5a4d1be17f8b9ab0599df757/html5/thumbnails/5.jpg)
5
Basic Definitions Capital Component
Types of capital used by firms to raise money• rd = before tax interest cost• rdT = rd(1-T) = after tax cost of debt• rps = cost of preferred stock• rs = cost of retained earnings• re = cost of external equity (new
stock)
![Page 6: Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of capital…](https://reader035.fdocuments.us/reader035/viewer/2022062911/5a4d1be17f8b9ab0599df757/html5/thumbnails/6.jpg)
6
Basic Definitions WACC
Weighted Average Cost of Capital
Capital StructureA combination of different types of capital(debt and equity) used by a firm
![Page 7: Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of capital…](https://reader035.fdocuments.us/reader035/viewer/2022062911/5a4d1be17f8b9ab0599df757/html5/thumbnails/7.jpg)
7
After-Tax Cost of Debt The relevant cost of new debt Taking into account the tax deductibility
of interest Used to calculate the WACC
![Page 8: Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of capital…](https://reader035.fdocuments.us/reader035/viewer/2022062911/5a4d1be17f8b9ab0599df757/html5/thumbnails/8.jpg)
8
Cost of Preferred Stock Rate of return investors require on the
firm’s preferred stock The preferred dividend divided by the
net issuing price
F = percentage flotation costs as a decimalNP0 = per share net proceeds firm receives from the issue
![Page 9: Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of capital…](https://reader035.fdocuments.us/reader035/viewer/2022062911/5a4d1be17f8b9ab0599df757/html5/thumbnails/9.jpg)
9
Cost of Retained Earnings Rate of return investors require on the
firm’s common stock
rs = required rate of return RPs = risk premium for Stock S= expected rate of return g = constant growth rate
rRF = risk-free rate of return P0 = current stock price= next period’s expected dividend
sr
1D
![Page 10: Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of capital…](https://reader035.fdocuments.us/reader035/viewer/2022062911/5a4d1be17f8b9ab0599df757/html5/thumbnails/10.jpg)
10
The CAPM Approach
rs = cost of retained earningsrRF = risk-free rate of returnrM = risk-free rate of returnRPs = risk premium for Stock Sβs = beta coefficient for Stock S
![Page 11: Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of capital…](https://reader035.fdocuments.us/reader035/viewer/2022062911/5a4d1be17f8b9ab0599df757/html5/thumbnails/11.jpg)
11
The Discounted Cash Flow Approach(Expected Rate of Return)
Price and expected rate of return on a share of common stock depends on the dividends expected on the stock.
rs = cost of retained earnings P0 = current stock price= expected rate of return g = constant growth rate= next period’s expected dividend
sr
1D
![Page 12: Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of capital…](https://reader035.fdocuments.us/reader035/viewer/2022062911/5a4d1be17f8b9ab0599df757/html5/thumbnails/12.jpg)
12
The Bond-Yield-Plus-Premium Approach
Estimating a risk premium above the bond interest rate
Judgmental estimate for premium “Ballpark” figure only
![Page 13: Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of capital…](https://reader035.fdocuments.us/reader035/viewer/2022062911/5a4d1be17f8b9ab0599df757/html5/thumbnails/13.jpg)
13
Cost of Newly Issued Common Stock External equity, re
Based on the cost of retained earningsAdjusted for flotation costs (the expenses of selling
new issues)
re = cost of new equityg = constant growth rate
= next period’s expected dividend F = percentage flotation cost stated as a decimalP0 = current stock price
1D
![Page 14: Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of capital…](https://reader035.fdocuments.us/reader035/viewer/2022062911/5a4d1be17f8b9ab0599df757/html5/thumbnails/14.jpg)
14
Target Capital Structure Optimal Capital Structure
Percentage of debt, preferred stock, and common equity in the capital structure that will maximize the price of the firm’s stock
![Page 15: Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of capital…](https://reader035.fdocuments.us/reader035/viewer/2022062911/5a4d1be17f8b9ab0599df757/html5/thumbnails/15.jpg)
15
Weighted Average Cost of Capital, WACC
A weighted average of the component costs of debt, preferred stock, and common equity
wd = proportion of debt in firm’s capital structurewps = proportion of preferred stock in firm’s capital structurews = proportion of common stock in firm’s capital structure
![Page 16: Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of capital…](https://reader035.fdocuments.us/reader035/viewer/2022062911/5a4d1be17f8b9ab0599df757/html5/thumbnails/16.jpg)
16
The Logic of the Weighted Average Cost of Capital
The use of debt impacts 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.
![Page 17: Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of capital…](https://reader035.fdocuments.us/reader035/viewer/2022062911/5a4d1be17f8b9ab0599df757/html5/thumbnails/17.jpg)
17
Marginal Cost of Capital Marginal 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
![Page 18: Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of capital…](https://reader035.fdocuments.us/reader035/viewer/2022062911/5a4d1be17f8b9ab0599df757/html5/thumbnails/18.jpg)
18
MCC Schedule for Unilate Textiles
![Page 19: Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of capital…](https://reader035.fdocuments.us/reader035/viewer/2022062911/5a4d1be17f8b9ab0599df757/html5/thumbnails/19.jpg)
19
Break Point (BP) The dollar value of new capital that can
be raised before an increase in the firm’s weighted average cost of capital occurs
![Page 20: Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of capital…](https://reader035.fdocuments.us/reader035/viewer/2022062911/5a4d1be17f8b9ab0599df757/html5/thumbnails/20.jpg)
20
MCC Schedule Using Retained Earnings, New Common Stock and Higher-Cost Debt
![Page 21: Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of capital…](https://reader035.fdocuments.us/reader035/viewer/2022062911/5a4d1be17f8b9ab0599df757/html5/thumbnails/21.jpg)
21
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
![Page 22: Chapter 11 The Cost of Capital 1. Learning Outcomes Chapter 11 Compute the component cost of capital…](https://reader035.fdocuments.us/reader035/viewer/2022062911/5a4d1be17f8b9ab0599df757/html5/thumbnails/22.jpg)
22
Combining the MCC and Investment Opportunity Schedules