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Corporate Finance

Cost of Capital

The Weighted Average Cost of Capital

The company cost of capital is a weighted average of the returns demanded by debt and equity investors.

What types of long-term capital do firms use?


Long-term debt Preferred stock Common equity

Capital Components

Capital components are sources of funding that come from investors. A/P, accruals, and deferred taxes are not sources of funding that come from investors, & not included in the calculation of the cost of capital. These items are adjusted for when calculating project cash flows, not when calculating the cost of capital.
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COST of CAPITAL

Raising $ & its Costs


Debt

Equity

Cost of Borrowing

Internal

Interest Rate

Retained Earning

External

Common Stock Prfd Stock

Weighted Average Cost of Capital (WACC)

WACC: Blended cost or raising capital considering mix of debt & equity WACC = (Wt of Debt)(After-tax cost of Debt) + Wt of Eqty)(Cost of Eqty) + (Wt of Prfd)(Cost of Prfd)

Cost of Equity

Know: = P0 = D1/ (rs g)


So

then: rs = D1/P0 + g

Cost of Preferred Stock

r = D1/P0 + g

g= 0, so cost of preferred = function of dividends paid. & floatation cost to issue.


Assume Newco's preferred stock pays a dividend of $2 per share and sells for $100 per share. If the cost to Newco to issue new shares is 4%, what is Newco's cost of preferred stock? Answer: Rps = Dps/Pnet = $2/$100(1-0.04) = 2.1%
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Determining Cost of Debt

Method 1: Ask an investment banker what coupon rate would be on new debt. Method 2: Find bond rating for the company and use yield on similarly rated bonds. Method 3: Find yield on the companys existing debt.

Current vs. Historical Cost of Debt

For cost of debt, dont use coupon rate on existing debt, which represents cost of past debt. Use the current interest rate on new debt (think YTM).

(More)
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A 15-year, 13.25% semiannual bond sells for $1,250. Tax = 40%. 60,000 Bonds o/s. Whats rd? 0 rd = ? 1 2 30

...
-66.25 -66.25 <66.25 + 1,000>

1,250.00

INPUTS

30
N I/YR

1250 -66.25 -1000


PV PMT FV

OUTPUT
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5.0% x 2 = rd = 10%

Component Cost of Debt

Cost of Debt = Rd (1 - t)

Newco plans to issue debt at a 7% interest rate. Newco's total (both federal and state) tax rate is 40%. What is Newco's cost of debt?
Answer: Rd (1-tc) = 7% (1-0.40) = 4.2%

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Example - WACC

Company has a 1 million shares of common stock currently trading at $30 per share. Current risk free rate is 4%, market risk premium is 8% and the company has a beta of 1.2. It also has 50,000 bonds with of $1,000 par paying 10% coupon annually maturing in 20 years currently trading at $950. The company's tax rate is 35%. Calculate the weighted average cost of capital.

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Example - WACC

First we need to calculate the weights of debt and equity.

Market Value of Equity = 1,000,000 $30 = $30,000,000


Market Value of Debt = 50,000 $950 = $47,500,000 Total Market Value of Debt and Equity = $77,500,000 Weight of Equity = $30,000,000 / $77,500,000 = 38.71% Weight of Debt = $47,500,000 / $77,500,000 = 61.29% Weight of Debt can be calculated as 100% minus cost of equity = 100% 38.71% = 61.29%
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Example - WACC

Cost of Equity = Risk Free Rate + Beta Market Risk Premium = 4% + 1.2 8% = 13.6% We also, need to find the cost of debt. Cost of debt is equal to the yield to maturity of the bonds. Yield to maturity is 10.51%. After tax cost of debt is hence 10.51% ( 1 .35% ) = 6.83%

And finally,

WACC = 38.71% 13.6% + 61.29% 6.83% = 9.45%

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Is preferred stock more or less risky to investors than debt?

More risky; company not required to pay preferred dividend. However, firms want to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, and (3) preferred stockholders may gain control of firm.

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Determining Weights for WACC


What are the % of firms capital to be financed by each component. If possible, always use the target wts for % financed by each type of capital.

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What factors influence a companys WACC?

Uncontrollable factors:

Market conditions, especially interest rates. The market risk premium. Tax rates.

Controllable factors:

Capital structure policy. Dividend policy. Investment policy. Firms with riskier projects generally have higher financing costs.

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Examples Cost of Equity


Cost of Equity Under the Capital Asset Pricing Model

The yield on 5 year US treasury bonds as at 30 December 2012 is 0.72%. We find that Caterpillar Inc.'s share price as at 30 December 2012 is $86.81 per share while it has a beta coefficient of 1.86. Trailing twelve months (TTM) return on S & P 500 is 11. 52%. Estimate the cost of equity. Cost of Equity = Risk Free Rate + Beta Coefficient (Market Rate of Return Risk Free Rate)
Cost of Equity = 0.72% + 1.86 (11.52% 0.72%) = 20.81%
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Examples Cost of Equity

Cost of Equity Under the Dividend Discount Model Caterpillar Inc.'s share price as at 30 December 2012 is $86.81 per share. Its last five year's average total dividends, return on equity and payout ratios are $1.6, 34.75% and 47.08%. Growth Rate = (1 47.08%) 34.75% = 18.39% D1 = $1.6 (1+18.39%) = $1.89 Cost of Equity = $1.89 $86.81 + 18.39% = 20.57%
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WACC Example

A firm is considering a new project. The firm needs a discount rate for evaluation purposes. The firm has 1,000,000 common shares outstanding current price $11.25 per share. Next years dividend expected to be $1 per share. Firm estimates dividends will grow at 5% per year after that. Firm has 150,000 preferred shares outstanding. Current price is $9.50 per share. Dividend is $0.95 per share. if new preferred are issued, they must be sold at 5% less than the current market price (to ensure they sell) and involve direct flotation costs of $0.25 per share. Firm has a total of $10,000,000 (par value) in debt outstanding. The debt is in the form of bonds with 10 years left to maturity. They pay annual coupons at a coupon rate of 11.3%. Currently, the bonds sell at 106% of par value. The firms tax rate is 40%. What is the appropriate discount rate for the new project?
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WACC Example

Market value of common = 11.25(1000000) = $11,250,000 Market value of preferred = 9.50(150000) = $1,425,000 Market value of debt = 10000000(1.06) = $10,600,000 Total value of firm = $23,275,000 Cost of common: Div
r
1

P 1 0.05 11.25 0.1389


Div net P

Cost of preferred:

0.95 9.50(1 0.05) 0.25 0.1083


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WACC Example

Cost of debt = 10.39% x (1-.40) = 6.23%

Therefore:

WACC = .4834 x .1389 + .0612 x .1083 + .4554 x .0623


= 10.21%

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