1 / 15

The Cost of Capital

Chapter 10. The Cost of Capital. What sources of capital do firms use?. What is the “Cost” of Capital?. When we talk about the “cost” of capital, we are talking about the required rate of return on invested funds

marthalynch
Télécharger la présentation

The 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. Chapter 10 The Cost of Capital

  2. What sources of capital do firms use?

  3. What is the “Cost” of Capital? • When we talk about the “cost” of capital, we are talking about the required rate of return on invested funds • It is also referred to as a “hurdle” rate because this is the minimum acceptable rate of return • Any investment which does not cover the firm’s cost of funds will reduce shareholder wealth (just as if you borrowed money at 10% to make an investment which earned 7% would reduce your wealth)

  4. Calculating the Weighted Average Cost of Capital WACC = wdrd(1 – T) + wprp + wcrs Where: WACC= weighted average cost of capital rd = cost of debt rp= cost of preferred stock rs= cost of equity (common stock and retained earnings) wd= weight of debt wp= weight of preferred stock we = weight of equity T= tax rate • The cost of capital is calculated as a weighted average, or composite, of the various types of funds used over time, regardless of the specific financing used in a given year.

  5. Other facts about WACC - Should our analysis focus on before-tax or after-tax capital costs? Stockholders focus on A-T CFs. Therefore, we should focus on A-T capital costs, i.e. use A-T costs of capital in WACC. Only rd needs adjustment, because interest is tax deductible.

  6. Finding the Weights WACC = wdrd(1 – T) + wprp + wcrs • The weights that we use to calculate the WACC will obviously affect the result

  7. Component Cost of Debt WACC = wdrd(1 – T) + wprp + wcrs • rd is the marginal cost of debt capital. • The yield to maturity on outstanding L-T debt is often used as a measure of rd. • Why tax-adjust; i.e., why rd(1 – T)?

  8. A 15-year, 12% annual coupon bond sells for $1,153.72. What is the cost of debt (kd)? • Annual coupon Payment: $1000 X 12% = $120 • kd = $120/$1153.72 = 10.40%. • HOWEVER, during problem solving (most of the time), we will use YTM as cost of debt • Interest is tax deductible, If the tax rate is 40%, then A-T kd = B-T kd (1-T) = 10.40% (1 - 0.40) = 6.24%

  9. Component Cost of Preferred Stock WACC= wdrd(1 – T) + wprp+ wcrs • rp is the marginal cost of preferred stock, which is the return investors require on a firm’s preferred stock. • Preferred dividends are not tax-deductible, so no tax adjustments necessary. Just use nominal rp. • Our calculation ignores possible flotation costs. • The cost of preferred stock can be solved by using this formula: rp = Dp/Pp = $10/$111.10 = 9%

  10. Component Cost of Equity WACC = wdrd(1 – T) + wprp + wcrs • rs is the marginal cost of common equity using retained earnings. • The rate of return investors require on the firm’s common equity using new equity is re. • 2 - Ways to Determine the Cost of Common Equity, rs • 1. CAPM: rs = rRF + (rM – rRF)b • 2. Dividend model: rs = (D1/P0) + g

  11. If the rRF = 7%, RPM = 6%, and the firm’s beta is 1.2, what’s the cost of common equity based upon the CAPM?rs = rRF + (rM – rRF) β = 7.0% + (6.0%)1.2 = 14.2%If D0 = $4.19, P0 = $50, and g = 5%, what’s the cost of common equity based upon the DCF approach? D1 = D0 (1+g) D1 = $4.19 (1 + .05) D1 = $4.3995rs = D1 / P0 + g = $4.3995 / $50 + 0.05 = 13.8% Range = 13.8%-14.2%, might use midpoint of range, 14%. Component Cost of Equity

  12. Flotation costs • Flotation costs depend on the risk of the firm and the type of capital being raised. • The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small. • We will frequently ignore flotation costs when calculating the WACC. • If new common stock issue incurs a flotation cost of 15% of the proceeds, what is re?

  13. Ignoring flotation costs, what is the firm’s WACC? WACC = wdrd(1 – T) + wprp + wcrs = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1%

  14. What is the expected future growth rate? • The firm has been earning 15% on equity (ROE = 15%) and retaining 35% of its earnings (dividend payout = 65%). This situation is expected to continue. g = ( 1 – Dividend Payout ratio ) (ROE) = Retention ratio * ROE = (0.35) (15%) = 5.25%

  15. What factors influence a company’s composite WACC? • Market conditions. • The firm’s capital structure and dividend policy. • The firm’s investment policy. Firms with riskier projects generally have a higher WACC.

More Related