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# CHAPTER 10 The Cost of Capital Sources of capital Component costs WACC What sources of long-term capital do firms use?

Calculating the weighted average cost of capital WACC = wd rd(1-T) + wp rp + wcrs The ws refer to the firms capital structure weights. The rs refer to the cost of each component. Should our analysis focus on before-tax or after-tax capital costs? Stockholders focus on After Tax (AT) Cash Flows. 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. Should our analysis focus on historical (embedded) costs or new (marginal) costs? The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on todays marginal costs (for WACC). Component cost of debt WACC = wd rd(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)? A 15-year, 12% semiannual coupon bond sells for \$1,153.72. What is the cost of debt (rd)? Remember, the bond pays a semiannual coupon, so rd = 5.0% x 2 = 10%.

## Component cost of debt 1

Interest is tax deductible, so A-T rd = B-T rd (1-T) = 10% (1 - 0.40) = 6% Use nominal rate. Flotation costs are small, so ignore them. Component cost of preferred stock WACC = wd rd(1-T) + wp rp + wc rs rp is the marginal cost of preferred stock. The rate of return investors require on the firms preferred stock. What is the cost of preferred stock? The cost of preferred stock can be solved by using this formula: rp = Dp / Pp = \$10 / \$111.10 = 9% Component cost of preferred stock Preferred dividends are not tax-deductible, so no tax adjustments necessary. Just use rp. Nominal rp is used. Our calculation ignores possible flotation costs. Is preferred stock more or less risky to investors than debt? More risky; company not required to pay preferred dividend. However, firms try to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, (3) preferred stockholders may gain control of firm.

## Why is the yield on preferred stock lower than debt? 2

Corporations own most preferred stock, because 70% of preferred dividends are nontaxable to corporations. Therefore, preferred stock often has a lower Before Tax (BT) yield than the B-T yield on debt. The After Tax (AT) yield to an investor, and the A-T cost to the issuer, are higher on preferred stock than on debt. Consistent with higher risk of preferred stock. Illustrating the differences between A-T costs of debt and preferred stock Recall, that the firms tax rate is 40%, and its before-tax costs of debt and preferred stock are rd = 10% and rp = 9%, respectively. A-T rp = rp rp (1 0.7)(T) = 9% - 9% (0.3)(0.4) A-T rd = 10% - 10% (0.4) A-T Risk Premium on Preferred 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 firms common equity using new equity is re. Why is there a cost for retained earnings? Earnings can be reinvested or paid out as dividends. Investors could buy other securities, earn a return. If earnings are retained, there is an opportunity cost (the return that stockholders could earn on alternative investments of equal risk). Investors could buy similar stocks and earn rs. Firm could repurchase its own stock and earn rs. Therefore, rs is the cost of retained earnings. Three ways to determine the cost of common equity, rs = = = 7.92% 6.00% 1.92%

CAPM:

## rs = rRF + (rM rRF)

DCF: rs = D1 / P0 + g Own-Bond-Yield-Plus-Risk Premium: rs = rd + RP If the rRF = 7%, RPM = 6%, and the firms beta is 1.2, whats the cost of common equity based upon the CAPM? rs = rRF + (rM rRF) = 7.0% + (6.0%)1.2 = 14.2%

If D0 = \$4.19, P0 = \$50, and g = 5%, whats the cost of common equity based upon the DCF approach? D1 D1 D1 rs = D0 (1+g) = \$4.19 (1 + .05) = \$4.3995 = D1 / P0 + g = \$4.3995 / \$50 + 0.05 = 13.8%

If rd = 10% and RP = 4%, what is rs using the own-bond-yield-plus-riskpremium method? This RP is not the same as the CAPM RPM. This method produces a ballpark estimate of rs, and can serve as a useful check. rs = rd + RP rs = 10.0% + 4.0% = 14.0% What is a reasonable final estimate of rs? Method Estimate 4

## 14.2% 13.8% 14.0% 14.0%

Why is the cost of retained earnings cheaper than the cost of issuing new common stock? When a company issues new common stock they also have to pay flotation costs to the underwriter. Issuing new common stock may send a negative signal to the capital markets, which may depress the stock price.
Percy Motors has a target capital structure of 40 percent debt and 60 percent equity. The yield to maturity on the company's outstanding bonds is 9 percent, and the company's tax rate is 40 percent. Percy's CFO has calculated the company's WACC as 9.96 percent. What is the company's cost of common equity?

1.

The Heuser Company's currently outstanding 10 percent coupon bonds have a yield to maturity of 12 percent. Heuser believes it could issue at par new bonds that would provide a similar yield to maturity. If its marginal tax rate is 35 percent, what is Heuser's after-tax cost of debt?

2.

Tunney Industries can issue perpetual preferred stock at a price of \$47.50 a share. The issue is expected to pay a constant annual dividend of \$3.80 a share. What is the company's cost of preferred stock, rp?

3.

Patton Paints Corporation has a target capital structure of 40 percent debt and 60 percent common equity. The company's before-tax cost of debt is 12 percent and its marginal tax rate is 40 percent. The current stock price is Po = \$22.50; the last dividend was Do = \$2.00; and the dividend is expected to grow at a constant rate of 7 percent. What will be the firm's cost of common equity and its WACC?

What factors influence a companys composite WACC? Market conditions. The firms capital structure and dividend policy. 5

The firms investment policy. Firms with riskier projects generally have a higher WACC. Should the company use the composite WACC as the hurdle rate for each of its projects? NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the hurdle rate for a typical project with average risk. Different projects have different risks. The projects WACC should be adjusted to reflect the projects risk. How are risk-adjusted costs of capital determined for specific projects or divisions? Subjective adjustments to the firms composite WACC. Attempt to estimate what the cost of capital would be if the project/division were a stand-alone firm. This requires estimating the projects beta. Finding a divisional cost of capital: Using similar stand-alone firms to estimate a projects cost of capital Comparison firms have the following characteristics: Target capital structure consists of 40% debt and 60% equity. rd = 12% rRF = 7% RPM = 6% DIV = 1.7 Tax rate = 40% Calculating a divisional cost of capital Divisions required return on equity rs = rRF + (rM rRF) = 7% + (6%)1.7 = 17.2% Divisions weighted average cost of capital WACC = wd rd ( 1 T ) + wc rs = 0.4 (12%)(0.6) + 0.6 (17.2%) =13.2% Typical projects in this division are acceptable if their returns exceed 13.2%.