Fm10e ch12
-
Upload
institute-of-cost-and-management-accountant-pakistan -
Category
Business
-
view
846 -
download
0
description
Transcript of Fm10e ch12
![Page 1: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/1.jpg)
Chapter 12 -Chapter 12 - Cost of Capital Cost of Capital
2005, Pearson Prentice Hall
![Page 2: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/2.jpg)
Basic Skills:Basic Skills: (Time value of money, (Time value of money, Financial Statements)Financial Statements)
Investments:Investments: (Stocks, Bonds, Risk and (Stocks, Bonds, Risk and Return)Return)
Corporate Finance:Corporate Finance: (The Investment (The Investment Decision - Capital Budgeting)Decision - Capital Budgeting)
Where we’ve been...Where we’ve been...
![Page 3: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/3.jpg)
Assets Liabilities & EquityAssets Liabilities & EquityCurrent Assets Current LiabilitiesCurrent Assets Current Liabilities
Fixed Assets Long-term DebtFixed Assets Long-term Debt Preferred StockPreferred Stock Common EquityCommon Equity
![Page 4: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/4.jpg)
Assets Liabilities & EquityAssets Liabilities & EquityCurrent Assets Current LiabilitiesCurrent Assets Current Liabilities
Fixed Assets Long-term DebtFixed Assets Long-term Debt Preferred StockPreferred Stock Common EquityCommon Equity
The investment decision
![Page 5: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/5.jpg)
Corporate Finance:Corporate Finance: (The (The FinancingFinancing Decision)Decision)
Cost of capitalCost of capital LeverageLeverage Capital StructureCapital Structure DividendsDividends
Where we’re going...Where we’re going...
![Page 6: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/6.jpg)
Assets Liabilities & EquityAssets Liabilities & EquityCurrent Assets Current LiabilitiesCurrent Assets Current Liabilities
Fixed Assets Long-term DebtFixed Assets Long-term Debt Preferred StockPreferred Stock Common EquityCommon Equity
![Page 7: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/7.jpg)
Assets Liabilities & EquityAssets Liabilities & EquityCurrent Assets Current LiabilitiesCurrent Assets Current Liabilities
Fixed Assets Long-term DebtFixed Assets Long-term Debt Preferred StockPreferred Stock Common EquityCommon Equity
The financing decision
![Page 8: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/8.jpg)
Assets Liabilities & EquityAssets Liabilities & EquityCurrent Assets Current LiabilitiesCurrent Assets Current Liabilities
Long-term DebtLong-term Debt Preferred StockPreferred Stock Common EquityCommon Equity
![Page 9: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/9.jpg)
Assets Liabilities & EquityAssets Liabilities & EquityCurrent assets Current LiabilitiesCurrent assets Current Liabilities
Long-term DebtLong-term Debt Preferred StockPreferred Stock Common EquityCommon Equity
}
Capital Structure
![Page 10: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/10.jpg)
Ch. 12 - Cost of CapitalCh. 12 - Cost of Capital
For InvestorsFor Investors, the rate of return on a , the rate of return on a security is a security is a benefitbenefit of investing. of investing.
For Financial ManagersFor Financial Managers, that same , that same rate of return is a rate of return is a costcost of raising funds of raising funds that are needed to operate the firm.that are needed to operate the firm.
In other words, the cost of raising In other words, the cost of raising funds is the firm’s funds is the firm’s cost of capitalcost of capital..
![Page 11: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/11.jpg)
How can the firm raise capital?How can the firm raise capital?
BondsBonds Preferred StockPreferred Stock Common StockCommon Stock Each of these offers a Each of these offers a rate of returnrate of return to to
investors.investors. This return is a This return is a costcost to the firm. to the firm. ““Cost of capitalCost of capital”” actually refers to the actually refers to the
weighted cost of capitalweighted cost of capital - a weighted - a weighted average cost of financing sources. average cost of financing sources.
![Page 12: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/12.jpg)
Cost of Cost of DebtDebt
![Page 13: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/13.jpg)
Cost of DebtCost of Debt
For the issuing firm, the For the issuing firm, the cost of cost of debtdebt is: is:
the the rate of returnrate of return required by required by investors,investors,
adjusted for adjusted for flotation costsflotation costs (any costs associated with (any costs associated with issuing new bonds), and issuing new bonds), and
adjusted for adjusted for taxes.taxes.
![Page 14: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/14.jpg)
Example: Tax effects Example: Tax effects of financing with debtof financing with debt
with stockwith stock with debtwith debtEBITEBIT 400,000 400,000 400,000 400,000- interest expense- interest expense 0 0 (50,000)(50,000)EBTEBT 400,000 400,000 350,000 350,000- taxes (34%)- taxes (34%) (136,000)(136,000) (119,000)(119,000)EATEAT 264,000 264,000 231,000 231,000
![Page 15: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/15.jpg)
Example: Tax effects Example: Tax effects of financing with debtof financing with debt
with stockwith stock with debtwith debtEBITEBIT 400,000 400,000 400,000 400,000- interest expense- interest expense 0 0 (50,000)(50,000)EBTEBT 400,000 400,000 350,000 350,000- taxes (34%)- taxes (34%) (136,000)(136,000) (119,000)(119,000)EATEAT 264,000 264,000 231,000 231,000
Now, suppose the firm pays $50,000 in Now, suppose the firm pays $50,000 in dividends to the stockholders.dividends to the stockholders.
![Page 16: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/16.jpg)
Example: Tax effects Example: Tax effects of financing with debtof financing with debt
with stockwith stock with debtwith debtEBITEBIT 400,000 400,000 400,000 400,000- interest expense- interest expense 0 0 (50,000)(50,000)EBTEBT 400,000 400,000 350,000 350,000- taxes (34%)- taxes (34%) (136,000)(136,000) (119,000)(119,000)EATEAT 264,000 264,000 231,000 231,000- dividends- dividends (50,000) (50,000) 0 0Retained earnings Retained earnings 214,000 214,000 231,000 231,000
![Page 17: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/17.jpg)
After-tax Before-tax MarginalAfter-tax Before-tax Marginal % cost of % cost of x tax% cost of % cost of x tax Debt Debt rateDebt Debt rate
-= 11
![Page 18: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/18.jpg)
After-tax Before-tax MarginalAfter-tax Before-tax Marginal % cost of % cost of x tax% cost of % cost of x tax Debt Debt rateDebt Debt rate
KKdd = k = kd d (1 - T) (1 - T)
-= 11
![Page 19: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/19.jpg)
After-tax Before-tax MarginalAfter-tax Before-tax Marginal % cost of % cost of x tax% cost of % cost of x tax Debt Debt rateDebt Debt rate
KKdd = k = kd d (1 - T) (1 - T)
.066 = .10 (1 - .34).066 = .10 (1 - .34)
-= 11
![Page 20: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/20.jpg)
Example: Cost of DebtExample: Cost of Debt Prescott Corporation issues a Prescott Corporation issues a $1,000$1,000
par, par, 20 year20 year bond paying the market bond paying the market rate of rate of 10%.10%. Coupons are Coupons are semiannual. The bond will sell for par semiannual. The bond will sell for par since it pays the market rate, but since it pays the market rate, but flotation costs amount to flotation costs amount to $50$50 per per bond.bond.
What is the pre-tax and after-tax What is the pre-tax and after-tax cost cost of debtof debt for Prescott Corporation? for Prescott Corporation?
![Page 21: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/21.jpg)
Pre-tax cost of debtPre-tax cost of debt: (using TVM): (using TVM)P/Y = 2P/Y = 2 N = 40N = 40PMT = -50PMT = -50FV = -1000FV = -1000PV = 950PV = 950solve: I = solve: I = 10.61%10.61% = kd = kd
After-tax cost of debtAfter-tax cost of debt::Kd = kd (1 - T)Kd = kd (1 - T)Kd = .1061 (1 - .34)Kd = .1061 (1 - .34)Kd = .07 = Kd = .07 = 7%7%
![Page 22: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/22.jpg)
Pre-tax cost of debtPre-tax cost of debt: (using TVM): (using TVM)P/Y = 2P/Y = 2 N = 40N = 40PMT = -50PMT = -50FV = -1000FV = -1000 So, a 10% bondSo, a 10% bondPV = 950PV = 950 costs the firmcosts the firmsolve: I = solve: I = 10.61%10.61% = kd = kd only only 7%7% (with (with
After-tax cost of debtAfter-tax cost of debt:: flotation costs)flotation costs)Kd = kd (1 - T) Kd = kd (1 - T) since the interestsince the interestKd = .1061 (1 - .34) Kd = .1061 (1 - .34) is tax deductible.is tax deductible.Kd = .07 = Kd = .07 = 7%7%
![Page 23: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/23.jpg)
Cost of Preferred StockCost of Preferred Stock
Finding the Finding the costcost of preferred stock of preferred stock is similar to finding the is similar to finding the rate of rate of return return (from Chapter 8), except (from Chapter 8), except that we have to consider the that we have to consider the flotation costsflotation costs associated with associated with issuing preferred stock.issuing preferred stock.
![Page 24: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/24.jpg)
Cost of Preferred StockCost of Preferred Stock Recall:Recall:
![Page 25: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/25.jpg)
Cost of Preferred StockCost of Preferred Stock Recall:Recall:
kkpp = = = =
DPo
Dividend Price
![Page 26: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/26.jpg)
Cost of Preferred StockCost of Preferred Stock Recall:Recall:
kkpp = = = =
From the From the firm’sfirm’s point of view: point of view:
DPo
Dividend Price
![Page 27: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/27.jpg)
Cost of Preferred StockCost of Preferred Stock Recall:Recall:
kkpp = = = =
From the From the firm’sfirm’s point of view: point of view:
kkpp = = = =
DPo
Dividend Price
DividendNet Price
DNPo
![Page 28: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/28.jpg)
Cost of Preferred StockCost of Preferred Stock Recall:Recall:
kkpp = = = =
From the From the firm’sfirm’s point of view: point of view:
kkpp = = = =
NPo = price - flotation costs!NPo = price - flotation costs!
DPo
Dividend Price
DividendNet Price
DNPo
![Page 29: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/29.jpg)
Example: Cost of PreferredExample: Cost of Preferred
If Prescott Corporation issues If Prescott Corporation issues preferred stock, it will pay a preferred stock, it will pay a dividend of dividend of $8$8 per year and per year and should be valued at should be valued at $75$75 per share. per share. If flotation costs amount to If flotation costs amount to $1$1 per share, what is the cost of per share, what is the cost of preferred stock for Prescott?preferred stock for Prescott?
![Page 30: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/30.jpg)
Cost of Preferred StockCost of Preferred Stock
![Page 31: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/31.jpg)
Cost of Preferred StockCost of Preferred Stock
kpkp = = DividendNet Price
DNPo =
![Page 32: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/32.jpg)
Cost of Preferred StockCost of Preferred Stock
kpkp = = = =
= == =
DividendNet Price
DNPo
8.0074.00
![Page 33: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/33.jpg)
Cost of Preferred StockCost of Preferred Stock
kpkp = = = =
= = 10.81% = = 10.81%
DividendNet Price
DNPo
8.0074.00
![Page 34: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/34.jpg)
Cost of Common StockCost of Common Stock
There are two sources of Common Equity:There are two sources of Common Equity:
1) 1) Internal common equityInternal common equity (retained (retained earnings).earnings).
2) 2) External common equityExternal common equity (new common (new common stock issue).stock issue).
Do these two sources have the same cost?Do these two sources have the same cost?
![Page 35: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/35.jpg)
Cost of Internal EquityCost of Internal Equity
Since the stockholders own the firm’s Since the stockholders own the firm’s retained earnings, the cost is simply retained earnings, the cost is simply the stockholders’ required rate of the stockholders’ required rate of return.return.
Why?Why? If managers are investing If managers are investing
stockholders’ funds, stockholders will stockholders’ funds, stockholders will expect to earn an acceptable rate of expect to earn an acceptable rate of return.return.
![Page 36: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/36.jpg)
Cost of Internal EquityCost of Internal Equity
![Page 37: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/37.jpg)
Cost of Internal EquityCost of Internal Equity
1) 1) Dividend Growth ModelDividend Growth Model
![Page 38: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/38.jpg)
Cost of Internal EquityCost of Internal Equity
1) 1) Dividend Growth ModelDividend Growth Model
kkcc = + g = + gD1Po
![Page 39: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/39.jpg)
Cost of Internal EquityCost of Internal Equity
1) 1) Dividend Growth ModelDividend Growth Model
kkcc = + g = + g
2) 2) Capital Asset Pricing Model (CAPM)Capital Asset Pricing Model (CAPM)
D1Po
![Page 40: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/40.jpg)
Cost of Internal EquityCost of Internal Equity
1) 1) Dividend Growth ModelDividend Growth Model
kkcc = + g = + g
2) 2) Capital Asset Pricing Model (CAPM)Capital Asset Pricing Model (CAPM)
kkjj = k = krfrf + + jj (k (kmm - k - krf rf ))
D1Po
![Page 41: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/41.jpg)
Cost of External EquityCost of External Equity
![Page 42: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/42.jpg)
Dividend Growth ModelDividend Growth Model
Cost of External EquityCost of External Equity
![Page 43: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/43.jpg)
Dividend Growth ModelDividend Growth Model
kkncnc = + g = + g
Cost of External EquityCost of External Equity
D1NPo
![Page 44: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/44.jpg)
Dividend Growth ModelDividend Growth Model
kkncnc = + g = + g
Cost of External EquityCost of External Equity
D1NPo
Net proceeds to the firmafter flotation costs!
![Page 45: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/45.jpg)
Weighted Cost of CapitalWeighted Cost of Capital
The weighted cost of capital is just the The weighted cost of capital is just the weighted average cost of all of the weighted average cost of all of the financing sources.financing sources.
![Page 46: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/46.jpg)
Weighted Cost of CapitalWeighted Cost of Capital
CapitalCapital Source Cost StructureSource Cost Structure debt 6% 20%debt 6% 20%preferred 10% 10%preferred 10% 10%common 16% 70%common 16% 70%
![Page 47: Fm10e ch12](https://reader033.fdocuments.us/reader033/viewer/2022061111/545459f6af795964498b57fb/html5/thumbnails/47.jpg)
Weighted cost of capital =Weighted cost of capital = .20 (6%) + .10 (10%) + .70 (16%).20 (6%) + .10 (10%) + .70 (16%)= = 13.4%13.4%
Weighted Cost of CapitalWeighted Cost of Capital(20% debt, 10% preferred, 70% common)(20% debt, 10% preferred, 70% common)