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COST OF CAPITAL
Cost of Capital
1 OBJECTIVE # # Managing the right-hand-side of the B/S By now, for valuation analysis, we know:
! ! ! ! criteria: NPV, IRR, payback what the relevant CFs are how to compute net CFs how to introduce forecast error in CFs (WHAT IF,. . . )
Sources of financing:
Debt, equity, retained earnings, preferred stock, warrants, venture capital, and bank loans, strategic alliances. ! ! Bank loans, venture capital, and warrants not discussed To simplify, we concentrate only on debt, equity, and retained earnings.
Cost of financing = cost of capital = ?
! ! ! Definition: The rate that must be earned to satisfy the required rate of return of the firm's investors.
What is the cost of each source of financing? What is a project's cost of capital?
Why might cost of capital in Japan be lower than in U.S.?
© morevalue.com, 1997
i.. not on the source.e. 1997 Alex Tajirian .com.1 WHY IS COST OF CAPITAL IMPORTANT? If financing cost is reduced Y NPV increases Y more projects end up with NPV > 0 Y more wealth created to shareholders. 2. ! The return generated by a security is the cost of that security to the company that issued it.2 SOME PRELIMINARIES ! Minimum required return / cost of capital= that particular discount rate “k” that makes NPV = 0. ] cost of capital to the firm = reward to investors. Q risk of CFs (systematic risk) Q company capital structure © morevalue. ! The cost of capital depends primarily on the use of funds. the risk of the CFs.Cost of Capital 13-3 2 MOTIVATION 2.
Remember from the chapter on Performance Measures: Net Income = total dividend + retained earnings If a company cannot find profitable projects. if the company is retaining your money. projects with return at least equal to ks . Thus.com. Case 2 Now suppose firm needs to issue new equity for an expansion project.. ˆ required return on equity = cost of retained earnings. then the firm should distribute retained earnings to shareholders as dividends. But reward to investor = cost of capital to the firm. © morevalue.3 COST COMPONENTS Case 1 Assume firm has no debt & has retained earnings.e. Obviously ke > ks ] (cost of new equity) > (cost of retained earnings) ] (required return on new equity) > (required return on retained earnings) since some transactions (floatation) costs have to be paid to investment banks for assisting firm in selling the new securities. i. then the minimum acceptable reward to you (an average investor) is the required return on equity Y required return on retained earnings = ks / required return on equity.Cost of Capital 13-4 2. 1997 Alex Tajirian .
2.com.e. company WACC © morevalue. 1997 Alex Tajirian .Cost of Capital 13-5 Case 3 If a company has a "good" project (NPV > 0). firm should consider using debt.4 OUTLINE Given a company's target capital structure.. i. should it be financed using equity? Not necessarily. Step 1: Estimate cost of each component Step 2: Calculate the cost of the combination of financing sources.
(c) Weights are based on the optimal company’s source of financing. the topic of next chapter. WACC Debt Equity wi = = = = Weighted Average Cost of Capital.Cost of Capital 13-6 In general. (b) B/S weights need not be reflective of market values. Market value of the company’s debt market value of the company’s equity the weights (proportions) of each source of capital. 1997 Alex Tajirian . and w d % ws ' 1 ws ' Debt % Equity where. wd ' Assets Debt % Equity Equity . based on the company’s optimal/target financing mix (capital structure). (a) It is not the source of financing that determined the cost of capital.com. Notes. © morevalue. WACC ' sum of weighted rewards to firm ) s capital providers ' w d(cost of debt) % w s(cost of equity) Debt Debt ' where.
the weights are given by the optimal capital structure.5 COST OF RETAINED EARNINGS. 1997 Alex Tajirian .com.Cost of Capital 13-7 CALCULATING COST OF EACH COMPONENT We first start with the cost of each source of new capital. ks L Cost of retained earnings = required rate of return on equity ? What are possible approaches to estimate ks © morevalue. Note. 2. then take their weighted average.
5%)(.com.1 CAPM Approach ks ' k RF % (k M & k RF)$s ' 7. 1997 Alex Tajirian .2% © morevalue.847) ' 14.Cost of Capital 13-8 Example: Calculating Cost of Retained Earnings Given: kRF = 7% Dividend0 = $4.5% P0 = $50 $ = 0.kRF = 8.19 kM .5.847 g = 5% ks = ? Solution: L # Two approaches when company stock is trading on an exchange: 2.0% % (8.
05 $50 % g ' ' 0. we have: Dividend1 P0 ks ' % g 7 ' Dividend0 × (1 % g) P0 4.com.Cost of Capital 13-9 # 2.19 × (1.5. g = 5%.19.088 % 0.05) % .05 ' 13.8% ˆ You can use the average of these two approaches = 14%. © morevalue. p0 = $50 ks = ? Solution: From equation (4) chapter 7. 1997 Alex Tajirian .2 DCF Approach: Given: Dividend0 = $4.
# © morevalue.6 COST OF NEWLY ISSUED COMMON STOCK. Thus. if existing shareholders finance projects using new equity. then additional cost per share = (50)(15%) = $7. ke # Floatation costs (F) are not part of capital budgeting CFS. 1997 Alex Tajirian . they require a higher return to cover this cost Y ke > ks .com.Cost of Capital 13-10 2.5. If P0 = $50 and F = 15% of issue price.
Dividend0 = 4. 1997 Alex Tajirian . Financial/Economic Valuation Dividend1 net value of new equity per share Dividend1 issue price & floatation cost Dividend1 P0 & (P0)(F) P0(1& F) % g % g % g ke ' ' ' ' Dividend0 × (1% g) % g ' $4. Chapter 7.19 .Cost of Capital 13-11 Example: Calculating Component Cost of New Equity Given: F = 15% of issue price.com.15) © morevalue.4% $50(1& . and including F. g = 5% .05 ' 15.19 × (1. P0 = $50 ke = ? Solution: Using equation (4).05) % . we have: # Accounting vs.
com.0% ' $113. we have: kps ' Dividend ps P ps& F $10 $10 ' ' 0.7 COST OF PREFERRED STOCK. perpetually paid price (Pps) = $113. and including F. Note.1& 2.00 per share Solution: Using equation (3). © morevalue. from Chapter 7.09 ' 9.1 No tax adjustment is needed since preferred dividends are paid from after-tax income.Cost of Capital 13-12 2. 1997 Alex Tajirian . kps Given: Dividendps = $10 annually.00 $111.1 per share (market price) F = floatation cost = $2.
Cost of Capital 13-13 2. 1997 Alex Tajirian . T = 40% kd(1-T) = ? © morevalue.tax benefit = kd .153.com.8 COST OF DEBT = kd (1-T) kd is the interest paid to new bond holders.T) Example: Calculating Component Cost of Debt Given: Semiannual bond. years to maturity = 15.72.T × kd = kd(1 . coupon rate = 12%. price of a similar bond = $1. But since interest is tax deductible Y effective cost of debt = after-tax cost of debt = before tax cost .
30) % 1.6) = 6% © morevalue.1 ' 999.30) ' 60(13.1741) ' 825.346. ˆ kd = 5% x 2 = 10% Y kd(1-T) = 10%(0. you will get it right.30 ) % $1.35 > price 2 2 If you try kd/2 = 5%. 1997 Alex Tajirian .Cost of Capital 13-14 Solution: Based on formula for PV of bonds Step 1: Calculate semi-annual coupon Step 2: Use Trial & Error methods Trial & Error Method: coupon ' coupon interest × par value 12% × $1.75 ' 60(PVIFAk d .000(PVIFk d .7648) % 1.153. say k d ' 4% Y 60(17.com.000(.000(.30) 2 2 Try k d ' 6% Y 60(PVIFA6.98 < price ' $1.88 % 174.000 ' ' 60 2 2 PV ' SUM of discounted CFs Y $1.000(PVIF6.3083) ' 1.2920)% 1.153.72 You have to try a number < 6%.
Cost of Capital 13-15 Example: Calculating Company WACC Given: ! optimal proportions are: 30% Debt.1% ? What is the amount raised of each component? © morevalue. 10% Preferred.3(10%)(0.4% ' 11.000 ! T = 40% ! Value of k from above examples is used.000 Solution: If retained earnings are to be used to finance projects.8% % 0.6(14%) % 0 ' 1. 60% common equity ! Retained Earnings = $300. WACC ' w dk d(1& T) % w psk ps % w sk s % w ek e ' 0. ! $ financing needed = $200. 1997 Alex Tajirian .6) % 0.1(9%) % 0. as in this example.com.9% % 8.
Cost of Capital 13-16 ? What is the maximum amount of financing that can be sustained without issuing new equity? © morevalue. 1997 Alex Tajirian .com.
Cost of Capital 13-17 Where do the weights come from? # Possibilities include: ! proportional current book value of each component ! proportional current market value of each component ! target capital structure # Should short-term debt be included in wd? © morevalue.com. 1997 Alex Tajirian .
If company has no debt.kRF)$project © morevalue. then you are implicitly assuming that the risk of projects = risk of company ? L Remember: discount rate reflects risk of CFs. then kproject = kRF + (km .Cost of Capital 13-18 3 WHAT IS A PROJECT'S COST OF CAPITAL Suppose debt = 0 and project is financed through 100% equity. Should firm use ks? If you use ks.com. 1997 Alex Tajirian .
Project k k Project risk < firm’s Project risk > firm’s firm’s k riskReject good projects free Accept Bad Projects Beta © morevalue.com. 1997 Alex Tajirian .Cost of Capital 13-19 USING COMPANY k Vs.
com.WACC) + + and NPVproject + + NPVWACC + + implication of using NPVWACC accepting bad projects no problem rejecting good projects no problem NPVproject = NPV using k project as the discount rate NPVWACC = NPV using company WACC as the discount rate L use k = kproject to appropriately incorporate project CF-risk © morevalue. if project risk $ Company risk yes yes No No Y (kproject .1 Project Required Return (k project) and NPV. 1997 Alex Tajirian .Cost of Capital 13-20 3.
Cost of Capital 13-21 3. ! To incorporate risk of CFS. hurdle rate = company WACC ± risk premium ! Assume company WACC = 15%. 1997 Alex Tajirian . It reflects both project risk and cost of capital. hurdle rates project category speculative venture new product expansion of existing business cost of improvement. companies have adopted a "crude" way of calculating kproject. The "hurdle rate" is one such method.com.2 PROJECT COST OF CAPITAL IN PRACTICE. known technology discount rate (k) 30% 25% 15% 10% risk premium 15% 10% 0 -5% © morevalue.
Cost of Capital 13-22 PROJECT COST OF CAPITAL Does Firm Have Debt? No Yes Is Project Same Risk As Firm? Yes No Is Project Same Risk As Firm? Yes No Use Firm K Use k Reflecting Project Beta © morevalue. 1997 Use Firm WACC Use “Hurdle Rate” Alex Tajirian .com.
k is lower ! Floatation cost is low # Government loans and subsidies. © morevalue.S. This has enhanced firm monitoring by creditors (banks).Cost of Capital 13-23 4 COST OF CAPITAL (k) IN JAPAN & U. especially for R&D. German firms have also traditionally relied more heavily on bank loans. thus. ? Why might the cost be lower in Japan? # Keiretsu (Companies aligned with financial giants) ! Agency problem lower.S. firms. 1997 Alex Tajirian . debt and equity financing has increased.? Unlike U. Recently.com. Japanese firms have traditionally relied more on bank loans as a source of financing.
The weights are determined by the target capital structure. The target proportions are not book values.Cost of Capital 13-24 5 From P0 ' SUMMARY T Dividendps Dividend Y k ps ' P ps k Dividend ps P ps& F % g Dividend1 P0(1& F) Including Floatation costs Y kps ' T From P0 ' Dividend1 k& g Yk ' Dividend1 P0 including Floatation costs Y k e ' T % g Long-term financing used for long-term projects. © morevalue. Only debt is tax deductible. 1997 Alex Tajirian . Short-term financing is used only if there is a temporary mismatch between timing of inflows and outflows.com. T WACC ' wdkd(1& T) % weke % wpskps % wsks Note.
com. firm incurs more debt b. debt and equity. Floatation costs are irrelevant to capital budgeting. interest rates increase c. 2 3 4 5 II. Agree/Disagree-Explain 1 If a manager. uses the firm's WACC as the cost of project finance. with no finance background. then he/she would be accepting bad projects. 1997 Alex Tajirian . If the target (Debt/Asset) = 0. tax rates are increased © morevalue. What Happens to kd(1-T) and WACC if: a. kd is the cost of debt financing to a firm. inflation increases d. A project's cost of capital > company WACC.Cost of Capital 13-25 6 QUESTIONS I. company undertakes risky projects e. then a company's WACC = ks. Consider the simple case of only two sources of financing.
000. calculate WAK's WACC.500 2.00 Long-term debt Equity Total liabilities and equity $500 1. (a) Using its balance sheet data below.000. Its equity and debt are trading at book value. has a cost of equity of 15%. before-tax cost of debt of 10%. and a marginal tax rate of 40%. 1 WAK Inc. Assets Cash Accounts receivable Inventories Plant and equipment Total assets $500 300 800 400 2. © morevalue.Cost of Capital 13-26 III. NUMERICAL.00 Liabilities and Equity (b) How would you calculate WACC if equity and debt were not trading at book values? Also assume that the firm is currently at its target capital structure.com. 1997 Alex Tajirian .
interest rates increase c. See p. 20. Disagree. company undertakes risky projects e. It depends on the project's risk. the WACC would have wd = 0 and ws = 1. Thus. Only if the project is more risky than the company. Disagree.Cost of Capital 13-27 ANSWERS TO QUESTIONS I. inflation increases d.com. Although floatation costs are not part of the relevant CFs. Thus. tax rates are increased © morevalue. Assuming that the only two components of assets are debt and equity. they do impact capital budgeting decisions. firm incurs more debt b. What Happens to kd(1-T) and WACC if: a. Disagree. WACC = ks. Agree/Disagree-Explain 1 2 3 4 Disagree. 1997 Alex Tajirian . Agree. at (Debt/Asset) = 0. they are part of the cost of capital (k). Thus cost of debt is kd(1-T). Interest is deductible. 5 II.
Step 1: Step 2: Calculate weights: proportions of each source of capital substitute in WACC equation Capital Sources Long-term debt Equity Amount 500 1.e.000 wd ' Debt 500 ' ' .25(. © morevalue.25 Asset 500% 1.6) % . Debt = Market value of Debt = sum of [(market price of each bond)(# of bonds outstanding)] Equity = Market value of Equity = (price of stock)(# of shares outstanding) Thus.75 Y WACC ' wdkd(1& T) % wsks ' .15) ' 12.Cost of Capital 13-28 III.500 ws ' 1& wd ' .com.75(. 1. Problems.. book value is different from market value? Calculate market values of debt and Equity. not book value proportions. the proportions have to be based on market-value proportions.10)(. 1997 Alex Tajirian .75% (b) What happens if stock is not trading at book value.500 2. i.