1 / 19

Cost of Capital

Cost of Capital. Rate of return required by firm’s investors Cost of capital is required rate of return for projects with same level of risk as overall firm Required rate of return must be adjusted to reflect anticipated risk of project. The Big Picture…. Cost of Capital.

Télécharger la présentation

Cost of Capital

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript


  1. Cost of Capital • Rate of return required by firm’s investors • Cost of capital is required rate of return for projects with same level of risk as overall firm • Required rate of return must be adjusted to reflect anticipated risk of project Cost of Capital

  2. The Big Picture…. Cost of Capital • Cost of Capital = Average cost of debt and equity • For now, assume ratio of debt to equity constant • As debt increases, required will start to increase at some point Cost of Capital

  3. Cost of debt • After-tax YTM on debt • Includes flotation costs Cost of Capital

  4. Cost of Debt • Rate of return required by firm’s investors • YTM (required return) on IBM’s bonds is 10% • (Ms. Investor demands a 10% rate of return) • However, IBM’s after-tax cost of debt is 7% Assuming IBM has a 30% tax rate • $100 Interest (10%) • - 30 Tax Savings • = 70 After-Tax Interest Cost (7%) Cost of Capital

  5. Cost of Debt • Rate of return required by firm’s investors • Coupon rate on debt is not relevant • 12% coupon bond, trading at $1,117 has a 9% YTM • Would issue additional debt at 9% (before tax) • This would be 6.3% after-tax (assume 30% tax rate) Cost of Capital

  6. Calculating Required Rate of Return (Yield to Maturity) • Bond has 6.5% coupon rate, 7 years to maturity and has net price of $870. What is yield to maturity? • Required rate of return (YTM) = 9.09% • After-tax rate required rate of return = 9.09% - (38% x 9.09%) = 5.64% Cost of Capital

  7. Cost of Preferred Stock • Cost of preferred stock = annual dividend / net price of preferred stock • Net price is after flotation costs Cost of Capital

  8. Cost of Equity • Must be estimated. No stated rate like YTM on bonds or loans. • Calculate cost for both: • Retained earnings • Issuing new equity Cost of Capital

  9. Cost of Equity • Dividend Growth Model • NP = D1 / (RR – G) • RR = (D1/NP) + G • Calculate cost of retained earnings • Price (P) , Dividend (D) are known. • Can estimate growth rate (G). • Then solve for required return (RR) • Use Net Price after flotation costs for P Cost of Capital

  10. Cost of Equity • Dividend Growth Model • NP = D1 / (RR – G) • RR = (D1/NP) + G • P = $32, D = $2.20, G = 4%, NP = $32.00, D1 = $2.29 • RR = ($2.29/$32.00)+4% • RR = 11.15% Cost of Capital

  11. Cost of Equity • Dividend Growth Model • Advantage: • Simple • Issues: • Must estimate growth rate • Some companies don’t pay dividends • Take into account risk? Cost of Capital

  12. Cost of Equity • Capital Asset Pricing Model (CAPM) • RR = RF + (RM – RF) X Beta • Risk-free rate of return (RF) is known • Beta is generally known • Required Return for Market (RM) must be estimated Cost of Capital

  13. Cost of Equity • Capital Asset Pricing Model (CAPM) • RR = RF + (RM – RF) X Beta • Advantages • Adjusts for risk • Can be used for companies with no dividends Cost of Capital

  14. Cost of Equity • Capital Asset Pricing Model (CAPM) • RR = RF + (RM – RF) X Beta • Issues: • Calculating Market Risk Premium (RM – RF) • One study: 9.2% for large cap stocks • Another study: 9.5% for large cap stocks • Another study: 4-6% for large cap stocks Cost of Capital

  15. Cost of Equity • Bond-yield plus equity risk • RR = YTM + (RM – RF) • Advantage • Uses YTM for company’s bonds as starting point • Can be used to compare with other two methods Cost of Capital

  16. WACC • Market Value Company = Equity Value + Debt Value • Equity Value = Market cap • Number of shares x Price of stock • Debt Value • Number of bonds x Value of Bonds Cost of Capital

  17. WACC • WACC = • (Debt Value x Cost of Debt) + • (Equity Value x Cost of Equity) • Due to risk premium for equity, generally equity will have a larger cost than debt • But required return on debt will increase if very little equity Cost of Capital

  18. WACC: cost of capital • Debt: usually cheapest after-tax cost • Deduct interest • Barclays 2006 study: • Investment grade: 4.0%; high-yield: 5.6% • Preferred stock • Less risk than common stock • Internal equity (retained earnings) • No flotation costs • External equity (issue new stock) • Usually most expensive • Barclays 2006 study: 9% Cost of Capital

  19. WACC • Value of firm maximized when WACC is minimized • Should reduce Required Return • This would increase NPV of projects • WACC is not Required Return for all projects • Adjust Required Return based on risk of project • If use WACC for all projects, will accept risky projects and decline safe projects • Since safe projects will generally have low IRR Cost of Capital

More Related