Cannan) Cost of Capital of aus) Cost of capital Te ‘roquited rato of turn fon the various types ‘of fnancing. The ‘overall cost of capital Isa melgmes average of the individual required rates of return (costs). Cost of equity capital “The required rate of tetum on investment ‘the eormon ‘shareholders of the company. Cost of debt (captal) “The required rte of retum on Frvestmant of the lenders of ‘company. Cost of preferred stock (capital) “The required rate ot tetum on fvestment (of the poeferen ‘sharanotaors ot te ‘A company can be viewed as a collection of projects. As a result, the use of an overall cost of pital as the acceptance criterion (hurdle rate) for investment decisions is appropriate only ‘under certain circumstances. These circumstances are that the current projects of the firm are of similar risk and that investment proposals under consideration are of the same characte. IF investment proposals vary widely with respect to risk, the required rate of return for the company asa whole is not appropriate as the sole acceptance criterion. The advantage of using the firm's overall required rate of return is, of course, its simplicity. Once itis computed, projects can be evaluated using a single rate that does not change unless underlying business and financial market conditions change. Using a single hurdle rate avoids the problem of computing individual required rates of return for each investment proposal. It is important to note, however, that ifthe firm's overall required rate of returm is used as an acceptance terion, projects should generally correspond to the foregoing conditions. Otherwise, one should determine an individual acceptance criterion for each project, atopic that we take up in the later part of this chapter. ‘The overall cost of capital of a firm is a proportionate average ofthe costs of the various components of the firm's financing, The cost of equity capital is the most diffcalt to mea- sure, and it will occupy most of our attention. We also consider the component costs of debt and preferred stock. We will rely on return (yield) calculations to determine cost figures ‘because “cost” and “return” are essentially two sides of the same coin,' Our concern through- ‘out will be with the marginal cost of a specific source of financing. The use of marginal costs follows from the fact that we use the cost of capital to decide whether to invest in new projects. Past costs of financing have no bearing on this decision. All costs will be expressed (on an after-tax basis, to conform to the expression of investinent project cash flows on an ‘after-tax basis. Once we have examined the explicit costs ofthe various sources of financing, ‘ve will assign weights to cach source. Finally, we will compute a weighted average of the ‘component costs of financing to obtain an overall cost of capital to the fim. We assume in the development of this chapter that the reader has covered the foundation materials in ‘Chapters 3 and 4 on the mathematics of finance and on valuation. Cay ‘The cost of capital —what is it, really? Cana 1 is the firm's roquired rate of return that will just satisfy all capital providers. To get some feel for what this cost of capital figure really means, let's look ata simple, personal example. Assume that you borrow some money from two friends (at two different ‘osts), add some of your own money withthe expectation of at last a certain minimam ‘return, and seck out an investment. What is the minimum return you can earn that will just satisfy the return expectations of all capital providers (as listed in column number 2of the table below)? o @) @ Oxo @ PERCENTAGE DOLLAR ANNUALCOST PROPORTION ANNUAL COST CAPITAL INVESTED “(INVESTOR OFTOTAL WEIGHTED "(INVESTOR PROVIDERS CAPITAL RETUHN) FINANCING ©" COsT. RETURN) Bubba = 200 3% 2 S10 Dally 3000 0 » You 5000 1S 50 ‘Assume that your “firm” earns a yearly 11.5 percent return (the weighted average ‘ost of capital employed) on the $10,000 of invested capital. The $1,150 so provided will just satisfy the return requirements of all the capital providers. Now, replace “Bubba,” “Dolly.” and “You” with the terms “Debt.” “Preferred Stock.” and “Common Stock”Hedging (maturity {and yes, we still need to consider tax implications; but let's assume no taxes for the ‘moment). With these new terms in place you should begin to understand the direction that we will be taking in finding the firm's required rate of return the cost of capital — that will just satisfy all capital providers. © @ Cost of Debt Although the liabilities of company are varied, our focas is only on nonscasonal debt that bears an explicit interest cost. We ignore accounts payable, acerued expenses, and other ‘obligations not having an explicit interest cost. For the most part, our concern is with long- ‘term debt. However, continuous short-term debt, such as an accounts-receivable-backed loan, also qualifies. (A bank loan to finance seasonal inventory requirements would not qualify.) ‘The assumption is that the firm is following a hedging (maturity matching) approach to matching) approsen project financing, That is the firm will finance a capital project, whose benefits extend over a A method of fnancing number of years, with financing that is generally long term in nature, ‘whore each asset ‘would be offset with ‘The explicit cost of debt can be derived by solving for the discount rate, ky that equates the 3 nancing instrument market price of the debt issue with the present value of interest plus principal payments and corte same bby then adjusting the explicit cost obtained for the tax deductibility of interest payments. The approximate maturity. discount rate, k,, known asthe yield to maturity, is solved for by making use of the formula w= k= 0) (15.21 Where ky remains as previously stated and ¢ is now defined as the company’s marginal tax rate, Because interest charges are tax deductible to the issuer, the after-tax cost of debt is substantially less than the before-tax cost. Ifthe before-tax cost, ky, in Eq, (15.1) was found t0 be 11 percent and the marginal tax rate (Iederal plus state) was 40 percent, the after-tax cost of debt would be k= 11.0001 ~ 0.40) ~ 6.60% You should note thatthe 6.60 percent after-tax cost in our example represents the eincrcmental cont of adiignl des. Te doesnot represent the cosot debt funds aveady employed, Timplied in the calculation ofan after-tax cost of debt isthe fact that the firm has taxable income. Otherwise, it docs not gain the tax benefit associated with intrest payment The ‘xpliit cost of debt fora frm without taxable income i the before-ax cos. ky © © Cost of Preferred Stock “The cost of preferred stack is a function of its stated dividend. As we discuss in Chapter 20, this dividend is not a contractual obligation of the firm but, rather, is payable atthe discretion of the firm’s board of directors. Consequently, unlike debt, it docs not create a risk of legal bankruptcy. To the holders of common stock, however, preferred stock is security that takes priority over their securities when it comes to the payment of dividends and to the distribu- tion of assets if the company is dissolved. Most corporations that isrue preferred stock fully Intend to pay the stated dividend, ‘The market-required return for this stock, or simply the yield on preferred stock, serves as our estimate of the cost of preferred stock. Because pre- ferred stock has no maturity date, its cost, k,, may be represented as, ko= Do/Pe (15.31 ‘whore D, is the stated annual dividend and P, is the current marict price of the preferred Stock: Ifa company were able to sell a 10 percent preferred stock issue ($50 par vale) at a current market price of $49 a share, the cost of preferred stock would be $5/$49 = 10.20%. Note that this cot nt adjted for aes betas the reer sock vied! wid Fg. (15.3) isalready an after-tax figure ~ preferred stock dividends being paid after taxes. Thus the explicit cost of preferred stock is greater than that for debt. Virtually all preferred stock issues have cl eaure (a provision that allows the company to force retirement), [the issuer anticipates retiring (calling) preferred stock ata particular date we can apply a modified version of the formula used to solve forthe yield on debt, Eg, (15.1, to find the ye (cost) of preferred stock that willbe calle. In Eg (15.1) the periodic preferred dividend replaces the periodic interest payment, and the “cll price” replaces the principal pay rent at final maturity (call date). The discount rate that equates all payments to the price of the preferred stockis the cost ofthe preferred stock 385