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Learning Goals
Determining the value of K, the required rate of return for an investor Sources of capital funding (Debt, Equity) Cost of each type of funding Calculation of the weighted average cost of capital funding (WACC) = K Construction and use of the marginal cost of capital schedule (MCC) for decision making
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Cost of Capital
Capital is the term used by firms for funds needed for investment purposes, i.e., capital equipment (not for day to day operating needs) This capital carries a cost because each source of capital funding costs money to raise (i.e., issuing stock costs a lot of money)
Cost of Capital
To properly evaluate investment decisions, the firm must know how much it will cost them to raise capital funds from all sources WACC = K = hurdle rate If it costs more to raise the capital (K) than you make on your investment, then you dont make the investment!
Sources of Capital
Borrowing, such as Bonds, bank loans, Issuing Preferred stock Issuing Common stock Net Income (earnings) Each of these sources carries a different cost based on the required rate of return of each provider (source) of these funds
The capital structure of a firm is how the firm has elected to finance its assets It is the level or percentage of total assets financed by debt, preferred stock and common equity (common stock and retained earnings) Each firm has an optimal level of debt and equity at which it can operate most efficiently and profitability (Draw curve)
Compute the cost of each source of capital, i.e., debt, preferred stock, common stock, retained earnings Determine percentage (weights) of each source of capital in the firms optimal capital structure Calculate Weighted Average Cost of Capital (WACC)
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Required rate of return for creditors e.g. Suppose that a company issues bonds with a before tax cost of 10%. Since interest payments are tax deductible, the true cost of the debt is the A fter T ax cost (AT kd = Int Rate (1 T), where T is tax rate) If the companys tax rate (state and federal combined) is 40%, the after tax cost of debt AT kd = 10%(1-.4) = 6% (show numerical example)
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Flotation Costs
Accounting Legal Prospectus (pass out examples) Underwriting (investment banker) Filing Fees (SEC)
Dp = preferred stock dividend Pp = Market price per share F = flotation costs per share Flotation costs reduce the amount of money you get when you sell preferred stock
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You can issue preferred stock with a market price of $45, and flotation costs of $3 per share, for a net price of $42 and if the preferred stock pays a $5 dividend, The cost of preferred stock:
kp = $5.00 = 11.9% $42.00 (vs 11.1)
Two Types of Common Equity Financing Retained Earnings (internal common equity) Issuing new shares of common stock (external common equity)
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Cost of Common Equity (Retained Earnings) Management should retain earnings only if they earn as much as stockholders next best investment opportunity of the same risk. Cost of Common Equity = opportunity cost of common stockholders funds. Two methods to determine Dividend Growth Model Capital Asset Pricing Model
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Ks = cost of internal common equity D1 = the next dividend to be paid Po = the current market price of the stock
Example: The market price (Po) of a share of common stock is $60. The prior dividend paid (D0) was $3, and the expected growth rate (g) is 10%.
If you are given D0, you must calculate D1 D1 = D0 (1 + g)
Example: The market price of a share of common stock is $60. The prior dividend (D0) is $3, and the expected growth rate is 10%.
(D1 = 3.00 x 1.10 = 3.30)
kS =
3.30 60
+ .10
Kn = cost of sale of new common stock D1 is the next dividend to be paid Po is the current market price of shares outstanding F is the flotation cost G is the rate of growth 17
kn =
WACC = weighted average cost of capital WT = the weight, or percentage of each element of (% of debt, preferred and common stock to total Tkd = after tax cost of debt p = Cost of preferred stock s = Cost of equity (Internal retained earnings)
Assume that Gallaghers desired capital structure is 40% debt, 10% preferred and 50% common equity.
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Assume that Gallaghers desired capital structure is 40% debt, 10% preferred and 50% common equity. WACC = Cost of Debt .40 x 6.0% = 2.40% + Cost of Preferred .10 x 11.9% = 1.19% + Cost of Int. Equity .50 x 15.5% = 7.75% 1.00 = 11.34%
Then we must use the cost of stock adjusted for the Flotation costs
WACC = Cost of Debt .40 x 6.0% = 2.40% + Cost of Pref .10 x 11.9% = 1.19% + Cost of Ext. Eq. .50 x 16.25% = 8.13% = 11.72%
Gallaghers weighted average cost will change if one component cost of capital changes. This may occur when a firm raises a particularly large amount of capital such that investors think that the firm is riskier. The WACC of the next dollar of capital raised is called the marginal cost of capital.
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The assumption is that the capital money is spent in direct proportion to the optimal capital structure. So, if we spend $100,000, it would be in the following proportions: Capital Structure Spend Debt 40% 40,000 Preferred 10% 10,000 Common 50% 50,000 (Buckets) Total 100,000
Assume now that Gallagher Corporation has $100,000 in retained earnings with which to finance its capital budget. We can calculate the point at which they will need to issue new equity since we know that Gallaghers desired capital structure calls for 50% common equity.
Breakpoint = Available Retained Earnings Equity Percentage of Total
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What this means is that once we spend $200,000 in total on capital projects, we will have used up our retained earnings of $100,000 (internal equity). Therefore, if we spend over $200,000, we will need additional financing from the issue of new shares of stock since 50% of our spending must come from Equity. The cost of issuing new shares is greater than internal equity due to flotation costs
11.72% 11.34%
Using new Using new common equity common equity
200,000 300,000 400,000
Total Financing
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Total Financing
200,000
300,000
400,000 29
Total Financing
200,000
300,000
400,000 30
Graph MCC Curve Choose projects whose IRR is above the weighted marginal cost of capital 11.72% 11.34%
Project 1 IRR = 12.4% Project 2 IRR = 12.1% Project 3 IRR = 11.5%
Total Financing
200,000
300,000
400,000 31
See pages 250 256 Calculate the breakpoints Calculate the new MCCs Plot MCCs and Investment Projects See Figures 9-5 and 9-6 for results Do all the Self-test problems before doing the homework