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You are on page 1of 48

Learning Goals

1.

2.

3.

concept, and the specific sources of capital

associated with the cost of capital.

Determine the cost of long-term debt and the

cost of preferred stock.

Calculate the cost of common stock equity and

convert it into the cost of retained earnings and

the cost of new issues of commons stock.

4.

5.

6.

(WACC) and discuss alternative weighting

schemes.

Describe the procedures used to determine break

points and the weighted marginal cost of capital

(WMCC).

Explain the weighted marginal cost of capital

(WMCC) and its use with the investment

opportunities schedule (IOS) to make financing and

investment decisions.

Capital

long-term investment decisions and the wealth of the

owners as determined by investors in the marketplace.

a proposed investment will increase or decrease the

firms stock price.

firm must earn on the projects in which it invests to

maintain the market value of its stock.

operating costsis assumed to be unchanged. This means

that the acceptance of a given project does not affect the

firms ability to meet operating costs.

required financial obligationsis assumed to be unchanged.

This means that the projects are financed in such a way that

the firms ability to meet financing costs is unchanged.

measured on an after-tax basis.

weighted average cost of capital?

Assume the ABC company has the following investment

opportunity:

- Initial Investment = $100,000

- Useful Life = 20 years

- IRR = 7%

- Least cost source of financing, Debt = 6%

Given the above information, a firms financial manager

would be inclined to accept and undertake the investment.

weighted average cost of capital?

Imagine now that only one week later, the firm has another

available investment opportunity

- Initial Investment = $100,000

- Useful Life = 20 years

- IRR = 12%

- Least cost source of financing, Equity = 14%

Given the above information, the firm would reject this

second, yet clearly more desirable investment opportunity.

weighted average cost of capital?

piecemeal approach to evaluate investment opportunities is

clearly not in the best interest of the firms shareholders.

that maximize firm value.

provide returns in excess of the firms overall weighted

average cost of financing (or WACC).

The Cost of Long-Term Debt

on the firms debt adjusted for flotation costs.

number of factors including the bonds coupon rate, maturity

date, par value, current market conditions, and selling price.

be made to account for the fact that interest is a taxdeductible expense.

The Cost of Long-Term Debt (cont.)

Net Proceeds

Duchess Corporation, a major hardware manufacturer, is

contemplating selling $10 million worth of 20-year, 9% coupon

bonds with a par value of $1,000. Because current market

interest rates are greater than 9%, the firm must sell the bonds

at $980. Flotation costs are 2% or $20. The net proceeds to

the firm for each bond is therefore $960 ($980 - $20).

The Cost of Long-Term Debt (cont.)

any one of three ways:

Calculating the cost

Approximating the cost

The Cost of Long-Term Debt (cont.)

equal its par value, the before-tax cost equals the

coupon interest rate.

yield-to-maturity (YTM) on a similar risk bond.

The Cost of Long-Term Debt (cont.)

This approach finds the before-tax cost of debt by

calculating the internal rate of return (IRR).

As discussed in earlier in the text, YTM can be

calculated using: (a) trial and error, (b) a financial

calculator, or (c) a spreadsheet.

The Cost of Long-Term Debt (cont.)

The Cost of Long-Term Debt (cont.)

The Cost of Long-Term Debt (cont.)

The Cost of Long-Term Debt (cont.)

assuming it has a 40% tax rate:

ri = 9.4% (1-.40) = 5.6%

debt capital for Duchess is 5.6%.

The Cost of Preferred Stock

10% preferred stock that is expected to sell for its $87-per

share value. The cost of issuing and selling the stock is

expected to be $5 per share. The dividend is $8.70 (10%

x $87). The net proceeds price (Np) is $82 ($87 - $5).

rP = DP/Np = $8.70/$82 = 10.6%

The Cost of Common Stock

earnings and new issues of common stock.

cost of common equity: any form of the dividend

valuation model, and the capital asset pricing model

(CAPM).

that the value of a share of stock is based on the present

value of all future dividends.

The Cost of Common Stock (cont.)

Using the constant growth model, we

rS = (D1/P0) + g

using the CAPM:

rE = rF + b(rM - rF).

The Cost of Common Stock (cont.)

models in that it explicitly considers the firms

risk as reflected in beta.

does not explicitly consider risk.

(P0) as a reflection of the expected risk-return

preference of investors in the marketplace.

The Cost of Common Stock (cont.)

valuation models are often preferred because the

data required are more readily available.

valuation models (unlike the CAPM) can easily be

adjusted for flotation costs when estimating the cost

of new equity.

The Cost of Common Stock (cont.)

rs = D1/P0 + g

For example, assume a firm has just paid a dividend of

$2.50 per share, expects dividends to grow at 10%

indefinitely, and is currently selling for $50.00 per share.

First, D1 = $2.50(1+.10) = $2.75, and

rS = ($2.75/$50.00) + .10 = 15.5%.

The Cost of Common Stock (cont.)

rs = rF + b(rM - rF).

For example, if the 3-month T-bill rate is currently 5.0%,

the market risk premium is 9%, and the firms beta is

1.20, the firms cost of retained earnings will be:

rs = 5.0% + 1.2 (9.0%) = 15.8%.

The Cost of Common Stock (cont.)

The previous example indicates that our estimate of the cost

of retained earnings is somewhere between 15.5% and

15.8%. At this point, we could either choose one or the

other estimate or average the two.

Using some managerial judgment and preferring to err on

the high side, we will use 15.8% as our final estimate of the

cost of retained earnings.

The Cost of Common Stock (cont.)

rn = = D1/Nn + g

Continuing with the previous example, how much would it

cost the firm to raise new equity if flotation costs amount

to $4.00 per share?

rn = [$2.75/($50.00 - $4.00)] + .10 = 15.97% or 16%.

WACC = ra = wiri + wprp + wsrr or n

The weights in the above equation are intended to

represent a specific financing mix (where wi = % of debt, wp

= % of preferred, and ws= % of common).

Specifically, these weights are the target percentages of

debt and equity that will minimize the firms overall cost of

raising funds.

WACC = ra = wiri + wprp + wsrr or n

One method uses book values from the firms balance

sheet. For example, to estimate the weight for debt, simply

divide the book value of the firms long-term debt by the

book value of its total assets.

To estimate the weight for equity, simply divide the total book

value of equity by the book value of total assets.

WACC = ra = wiri + wprp + wsrr or n

A second method uses the market values of the firms debt and

equity. To find the market value proportion of debt, simply

multiply the price of the firms bonds by the number

outstanding. This is equal to the total market value of the

firms debt.

Next, perform the same computation for the firms equity by

multiplying the price per share by the total number of shares

outstanding.

WACC = ra = wiri + wprp + wsrr or n

Finally, add together the total market value of the firms

equity to the total market value of the firms debt. This yields

the total market value of the firms assets.

To estimate the market value weights, simply divide the

market value of either debt or equity by the market value of

the firms assets .

WACC = ra = wiri + wprp + wsrr or n

For example, assume the market value of the firms debt is $40

million, the market value of the firms preferred stock is $10

million, and the market value of the firms equity is $50 million.

Dividing each component by the total of $100 million gives us

market value weights of 40% debt, 10% preferred, and 50%

common.

WACC = ra = wiri + wprp + wsrr or n

Using the costs previously calculated along with the market

value weights, we may calculate the weighted average cost of

capital as follows:

WACC = .40(5.67%) + .10(9.62%) + .50(15.8%)

= 11.13%

This assumes the firm has sufficient retained earnings to fund

any anticipated investment projects.

& Investment Decisions

capital raised within a given period increases.

This is true because companies need to raise the return

to investors in order to entice them to invest to

compensate them for the increased risk introduced by

larger volumes of capital raised.

In addition, the cost will eventually increase when the

firm runs out of cheaper retained equity and is forced to

raise new, more expensive equity capital.

& Investment Decisions (cont.)

Finding the break points in the WMCC schedule will allow us to

determine at what level of new financing the WACC will increase

due to the factors listed above.

BPj = AFj/wj

where:

BPj = breaking point frm financing source j

AFj = amount of funds available at a given cost

wj

& Investment Decisions (cont.)

Assume that in the example we have been using that the firm has

$2 million of retained earnings available. When it is exhausted,

the firm must issue new (more expensive) equity. Furthermore,

the company believes it can raise $1 million of cheap debt after

which it will cost 7% (after-tax) to raise additional debt.

Given this information, the firm can determine its break points as

follows:

& Investment Decisions (cont.)

BPequity

= $2,000,000/.50 = $4,000,000

BPdebt

= $1,000,000/.40 = $2,500,000

This implies that the firm can fund up to $4 million of new investment

before it is forced to issue new equity and $2.5 million of new investment

before it is forced to raise more expensive debt.

Given this information, we may calculate the WMCC as follows:

& Investment Decisions (cont.)

& Investment Decisions (cont.)

WMCC

11.76%

11.75%

11.66%

11.50%

11.25%

11.13%

$2.5

$4.0

Total Financing

(millions)

& Investment Decisions (cont.)

Now assume the firm has the following investment

opportunities available:

& Investment Decisions (cont.)

13.0%

12.0%

WMCC

B

11.66%

This indicates

that the firm can

accept only

Projects A & B.

11.5%

C

11.13%

11.0%

D

$1.0 $2.0 $2.5 $3.0 $4.0

Total Financing

(millions)

and Formulas for Cost of Capital (cont.)

and Formulas for Cost of Capital

Average Cost of Capital for Duchess

Corporation

for Ranges of Total New Financing for

Duchess Corporation

Schedule

Schedule (IOS) for Duchess Corporation

Schedules

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