The Cost of Capital Chapter 12. Cost of Capital uThe firm’s average cost of funds, which is the...
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Transcript of The Cost of Capital Chapter 12. Cost of Capital uThe firm’s average cost of funds, which is the...
Cost of CapitalCost 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
The use of debt impacts a fim’s 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
The Logic of the Weighted The Logic of the Weighted Average Cost of CapitalAverage Cost of Capital
Basic DefinitionsBasic Definitions
Capital component types of capital used by firms to raise
money
kd = 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)
Basic DefinitionsBasic Definitions
WACC = weighted average cost of capital
Capital structure combination of different types of capital
used by a firm
After-Tax Cost of DebtAfter-Tax Cost of Debt
The relevant cost of new debt—its yield to maturity (YTM)
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 T) = kd(1-T)
Cost of Preferred StockCost 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-P
D
NP
Dk
0
pspsps ==
s0
1RFs k̂
P
D̂RPkk =+=+= g
Cost of Retained EarningsCost of Retained Earnings
Rate of return investors require on the firm’s common stock
Three solutions:1. CAPM2. Bond yield plus risk premium3. Discounted cash flow (DCF)
The Bond-Yield-Plus-The Bond-Yield-Plus-Premium ApproachPremium Approach
Estimate a risk premium above the bond interest rate
Judgmental estimate for premium “Ballpark” figure only
14% 4% 10%
premium Risk yield Bond k s
=+=+=
The Discounted Cash Flow The Discounted Cash Flow (DCF) Approach(DCF) Approach
Price and expected rate of return on a share of common stock depend on the dividends expected on the stock
( ) ( ) ( )
( )∑∞
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sss
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DCF ApproachDCF Approach
Internal equity, ks
based on the fact that investors demand the firm use funds that are retained to earn an appropriate rate of return
gP
D̂k
0
1s +=
Cost of Newly Issued Cost of Newly Issued Common StockCommon Stock
External equity, ke
based on the cost of retained earnings adjusted for flotation costs (the expenses of
selling new issues)
( ) gFP
D̂g
NP
D̂k
0
11e +
−=+=
1
Optimal capital structure percentage of debt, preferred stock, and
common equity that will maximize the price of the firm’s stock
Target Capital StructureTarget Capital Structure
Weighted Average Cost of Weighted Average Cost of Capital, WACCCapital, WACC
A weighted average of the component costs of debt, preferred stock, and common equity
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W
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sspspsdTd ×+×+×=
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Marginal Cost of CapitalMarginal Cost of Capital
MCC the cost of obtaining another dollar of new
capital the weighted average cost of the last dollar
of new capital raised
MCC ScheduleMCC Schedule
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
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%
MCC ScheduleMCC Schedule
Break PointBreak 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
Point structure capital the in capital of type this of Proportion
type given a of capitalcost lower ofamount TotalBreak=
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 ScheduleMCC Schedule
Weighted Average Cost of Capital (WACC) (%)
Dollars of New Capital Raised0 -
WACC
Smooth, or Continuous, Marginal Cost of Capital Schedule
MCC ScheduleMCC Schedule
Combining the MCC and Combining the MCC and Investment Opportunity SchedulesInvestment Opportunity Schedules
Use the MCC schedule to find the cost of capital for determining whether a project should be purchased
Investment Opportunity Schedule (IOS) graph of the firm’s investment
opportunities ranked in order of the projects’ rates of return
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%
WACC2=11.0%
WACC3=11.5%
ReturnC = 12.0%
ReturnB = 11.6%ReturnD = 11.5%
ReturnE = 11.3%
IRRA = 10.8%
Optimal Capital Budget - $139
Combining the MCC and Combining the MCC and Investment Opportunity SchedulesInvestment Opportunity Schedules