1

The Cost of Capital

The Cost of Capital is the capital budgeting project’s required return. It is the opportunity cost of investing those funds in the

project. It is the rate of return at which investors are willing to

provide financing for the project today. It is based on current market conditions.

It reflects the risk of the project.The Cost of Capital is NOT the historical cost of funds.

2

Corporate Valuation

The market value of the firm (or simply, firm value) can be viewed in two ways:• Firm value equals the sum of the market values of the

claims on the firm’s assets.• Firm value equals the sum of the market values of its

assets.These two views are simply the balance-sheet accounting identity, but in current market values:

Assets = Liabs + O.E.

3

The Market Line for Capital Budgeting ProjectsThe Capital Asset Pricing Model (CAPM) can be used to obtain the cost of capital for a capital budgeting project. rj = rf + j(rm – rf)where rj = cost of capital for project j,rf = riskless returnrm = required return on the market portfolioj = beta of project j

4

Using the Project Market Line

A capital budgeting project costs $2,300, and expects to return $410 per year in perpetuity. If rf = 7%, rm = 14%, and j = 1.3, what is the project’s NPV?

rj = rf + j(rm - rf) = 7 + 1.3(14 – 7) = 16.1%

NPV = 410/0.161 – 2,300 = $246.58

5

Leverage

According to the CAPM, the required return depends only on the non-diversifiable risk.The non-diversifiable risk borne by shareholders can be split into two parts: Operating (business) Risk Financial Risk

Operating risk results in operating leverage.Financial risk results in financial leverage. Financial leverage is moving along the CML—

lending or borrowing.

6

Operating Leverage

Operating leverage arises from the mix of fixed versus variable costs of production.High fixed costs (and correspondingly lower variable costs per unit) results in high operating leverage. The firm’s profits are more sensitive to changes in

sales.Conversely, low fixed costs (and correspondingly higher variable costs per unit) result in low operating leverage.

7

Operating Leverage

Jewel Plastics, Inc., plans to make plastic jewel cases for CD-ROM disks. Each packet of 10 cases can be sold for $5.00. Two alternative manufacturing technologies are available.

Ignoring taxes, compute the profits under each plan.

Plan A Plan BAnnual Fixed Costs

Variable Cost (per unit)

60,000

$2.00

$100,000

$1.00

8

Operating Leverage

Profit = Sales – Costs(Unit Sales) (Selling Price – Variable Costs) – Fixed Costs

At a sales level of 50,000 units, the profits under plan A are:50,000 ($5.00 – $2.00) – $60,000 = $90,000.

Under Plan B, profits at a sales level of 50,000 units are $100,000.

9

Financial Leverage

The presence of fixed costs associated with debt financing results in financial leverage.As financial leverage increases, the variability of shareholder returns increases. This increases shareholder’s risk.

We’ve seen financial leverage before, Borrowing to move up the CML.

10

The Weighted Average Cost of Capital

The Weighted Average Cost of Capital, WACC, is the weighted average rate of return required by the suppliers of capital for the firm’s investment project.The suppliers of capital will demand a rate of return that compensates them for the proportional risk they bear by investing in the project.

11

Components of a Financing PackageConsider the case where a project will be financed with 40% debt and 60% equity.Suppose the project requires an initial investment of $8,000 and has a NPV of $2,000. The TOTAL value of the project is thus $10,000.

How much debt should the firm use? (0.40) 10,000 = $4,000.

12

Components of a Financing Package

Since the project requires an initial investment of $8,000, the firm will raise the remaining $4,000 by selling stock.Since the total value of the project is $10,000, the stock will be worth $6,000. In perfect markets, ALL of the benefits from a

project (the project’s NPV) goes to the shareholders.

13

WACC Calculation

Let L = the ratio of debt financing to total financing,

re = required return for equity,

rd = required return on debt, and

T = marginal corporate tax rate on income from the project.

Then,de rTLrL )1()1(WACC

14

WACC Calculation

Compute the WACC for the Nikko Co. given the following information:Nikko has 9 million common shares outstanding priced at $13.00 each. Next year’s dividend on these shares is expected to be $1.33, and will grow at 5% per year forever. Nikko has 60,000 bonds outstanding, each with a coupon rate of 11% and are priced at $1,050 each to yield 10% to bondholders. Nikko’s marginal corporate income tax rate is 34%.

15

WACC Calculation

Market value of Nikko’s equity = 9 million × $13.00 per share = $117 million.

Market value of Nikko’s debt = 60,000 × $1,050 per bond = $63 million.

Total market value of Nikko = $117 million + $63 million = $180 million.

Proportion of debt financing used by Nikko = L = $63 M / $180 L = 35%

16

WACC Calculation

To compute the rate of return required by Nikko’s stockholders, we use the constant growth model of stock valuation.

r DP

ge = + = + =1

0

3300

0 05 15 25%$1.$13.

. .

17

WACC Calculation

Because we are interested in measuring the firm’s current cost of capital, we use the bond yield currently demanded by the bondholders.Thus, rd = 10%.

Also, the tax rate, T, is 34%.

18

WACC Calculation

de rTLrL )1()1(WACC

%)10)(34.01(35.0%)25.15)(65.0(WACC

%22.12WACC

19

Perfect Market View of Capital Structure

Unleveraged Firm Leveraged FirmVU = $2,000 VL = $2,000

$1,000

Equity

$1,000

Debt$2,000 Equity

20

Shareholder’s Required Return in Perfect Markets

At 10%, MFI’s annual interest expense is $100.The annual expected cash flow to its shareholders is $300 – $100 or $200.Since the equity is worth $1,000, the rate of return required by the shareholders is 20%:

$1,000 = $200/0.20With leverage, equity is riskier and the shareholder’s required rate of return increases.

21

Leverage Ratio

The leverage ratio, (L) is:

= =$1,$2,

.000000

0 50 50%or

valuefirm totaldebt of ueMarket valL

22

WACC and Capital Structure in Perfect MarketsThe weighted average cost of capital is 15%:

WACC = (1 – L)re + L rd

= (1 – 0.5)×(0.20) + 0.5×0.10

=15%

23

Dividend Policy in Practice

Preference for paying common dividends Smaller and younger firms Mature firms

Stability of Dividends Dividends are more stable from year to year

than are earnings. They follow the trend in cash flow more

closely.

24

Dividend Policy in Practice

Regular decisions Review dividend policy at least annually, and

at about the same time each year.

Regular payments Quarterly payments most common. Annual, semi-annual, and monthly payments

are less common.

25

Dividend Policy in Practice

Reluctance to cut dividends Dividend cut is interpreted as a negative

signal.

Extra or special dividends Paid during periods of temporarily high

earnings. Generally occur at the end of the fiscal year.

26

Industry Differences in Dividend Policy

Investment opportunities are comparable within an industry, but vary across industries.

Firm-specific information must be taken into account.

27

Dividend Payment Mechanics

Dividends are declared by the board of directors: amount of dividend record date payment date

The ex-dividend date is two business days prior to the record date.

28

Dividend Payment Mechanics

On Tuesday, October 15, 2002, General Supply Co. announced a dividend of $0.36 per share payable to shareholders of record as of Thursday, November 7, 2002. The dividend would be paid on Monday, December 9, 2002.What is the ex-dividend day?What happens to the stock price on this day?

29

Dividend Payment Mechanics

The ex-dividend day is 2 business days prior to the ex-dividend day. Tuesday, November 5, 2002.

Suppose General Supply’s stock closed at $20 on Monday, November 4, 2002.The stock would open ex-dividend on Tuesday, November 5, 2002 at about $19.64 = $20 – $0.36

30

Dividend Payment Mechanics

Declaration Date

Ex-Dividend Date

Record Date

Payment Date

December 9, 2002November 5, 2002October 15, 2002 November 7, 2002

… …

31

Dividend Policy Guidelines

Project future residual funds. Earnings and cash flow projections for the next few

years. Include depreciation generated funds. Deduct capital expenditures.

Determine an appropriate target payout ratio. Range of payout ratios.

Set the quarterly dividend. Evaluate alternative dividend policies.

32

Stock Dividends

A stock dividend proportionately increases the number of shares each shareholder owns.A 10% stock dividend: Increases total number of shares outstanding by

10%. Increases each shareholders holdings by 10%.

If a shareholder own 50 shares before the dividend, she owns 55 shares after the stock dividend is paid.

33

Stock Splits

A stock split alters the par value of the shares but there is no transfer of balances between the equity accounts.The total number of shares outstanding increases. In a 3-for-2 stock split, 3 new shares are issued for

every 2 pre-split shares outstanding. Thus, there is a 50% increase in the number of

shares outstanding.