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Understanding the Cost of Capital

The Cost of Capital is defined as the rate of return that a company must offer on its securities in order to maintain its market value.

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Understanding the Cost of Capital

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  1. Understanding the Cost of Capital www.HelpWithAssignment.com

  2. Cost of Capital • The Cost of Capital is defined as the rate of return that a company must offer on its securities in order to maintain its market value. www.HelpWithAssignment.com

  3. Cost of Capital • Financial managers must know the cost of capital in order to • Make capital budgeting decisions, • Help establish the optimal capital structure and • Make decisions concerning leasing, bond refunding and working capital management. www.HelpWithAssignment.com

  4. Cost of Capital • The cost of capital is computed as a weighted average of the various capital components, items on the right hand side of the balance sheet such as debt, preferred stock, common stock and retained earnings. www.HelpWithAssignment.com

  5. Weighted Average Cost of Capital • Each element of capital has a component cost that is identified by the following: • ki = before tax cost of debt • k­d = ki (1-t) = after tax cost of debt, where t = tax rate • kp = cost of preferred stock www.HelpWithAssignment.com

  6. Weighted Average Cost of Capital • ks = cost of retained earnings (or internal equity) • ke = cost of external equity, or cost of issuing new common stock • ko = company’s overall cost of capital , or a weighted average cost of capital • The after tax weighted average cost of capital (WACC) is given by the following formula: • WACC = ka = ke = (S/V) + kd (1-t) (D/V) www.HelpWithAssignment.com

  7. An Example of Cost of Capital www.HelpWithAssignment.com

  8. Formula for Cost of Capital www.HelpWithAssignment.com

  9. An Example of Cost of Capital • Suppose this firm faces a corporate tax rate of 40%, has variable expenses equal to 30% of sales, and has fixed costs of $158. • Working back from these requirements we can forecast the level of sales the firm must earn in order to achieve these operating results…thereby setting a sales performance target for management. www.HelpWithAssignment.com

  10. An Example of Cost of Capital • Working backwards, we get: • Sales X • Variable Costs 0.3X • Fixed Costs 158 • EBIT • Interest 42 • Taxes (40%) • Net Income: 300 www.HelpWithAssignment.com

  11. An Example of Cost of Capital • If sales = X, then VC = .3X and X - .3X – 158 = EBIT • (EBIT – I)(1-T) = NI so (EBIT – 42)(1-.4) = 300 => EBIT = 542 which => X = 1000, and so VC = 300 and also Taxes = (542-42)(.4) = 200, so: www.HelpWithAssignment.com

  12. An Example of Cost of Capital • Sales 1000 • Variable costs 300 • Fixed costs 158 • EBIT 542 • Interest 42 • Taxes (40%) 200 • Net Income: 300 www.HelpWithAssignment.com

  13. An Example of Cost of Capital • This working backwards process is the approach taken by regulators to set pricing for rate of return regulated industries, like utilities. So cost of capital drives utility rate increases! • Assuming earnings are a perpetuity, we have www.HelpWithAssignment.com

  14. An Example of Cost of Capital • P = EPS/Ke = ROE* BVPS/Ke • Firm ABC has: • Debt D of 8% annual coupon bonds with 10 years to maturity and book value of $1 m. • Preferred shares P with 10% annual dividend and book value of $1 m. • 100,000 Common shares originally issued at $15/share for a value of $1.5 m. • Retained earnings of $0.5 • Total of $4 m. www.HelpWithAssignment.com

  15. An Example of Cost of Capital • Market values: • The present market rate of similar risk 10 year bonds is 6% so the market value of the bonds is given by 80,000PVIFA(10 years, 6%) = [80000/.06](1-1/1.06^10) + 1,000,000/1.06^10 = $1,147,202. www.HelpWithAssignment.com

  16. An Example of Cost of Capital • Similar risk preferred shares are providing yields of 8%, so the market value of the preferred shares is 100,000/.08 = $1,250,000. • The market value of the common shares is currently $25/share, so the total market value of the shares is $2,500,000. www.HelpWithAssignment.com

  17. An Example of Cost of Capital • The market value of the firm’s balance sheet V = D + P + SE = $1,147,202 + $1,250,000 + $2,500,000 = $4,897,202 and D/V = .234, P/V = .255 and SE/V = .511. www.HelpWithAssignment.com

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