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Cost of Capital
Cost of Capital
Sources of capital
Component costs
WACC
Adjusting for flotation costs
Adjusting for risk
9-1
What sources of long-term
capital do firms use?
Long-Term Capital
Long-Term Capital
Long-Term Debt
Long-Term Debt Preferred
Preferred Stock
Stock Common
Common Stock
Stock
Retained Earnings
Retained Earnings New Common
New Common Stock
Stock
9-2
Calculating the weighted
average cost of capital
9-3
Should our analysis focus on
before-tax or after-tax capital
costs?
Stockholders focus on A-T CFs.
Therefore, we should focus on A-T
capital costs, i.e. use A-T costs of
capital in WACC. Only kd needs
adjustment, because interest is tax
deductible.
9-4
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).
9-5
How are the weights
determined?
9-6
Component cost of debt
WACC = wdkd(1-T) + wpkp + wcks
9-8
Component cost of debt
Interest is tax deductible, so
A-T kd = B-T kd (1-T)
= 10% (1 - 0.40) = 6%
Use nominal rate.
Flotation costs are small, so ignore
them.
9-9
Component cost of preferred
stock
WACC = wdkd(1-T) + wpkp + wcks
kp = Dp / Pp
= $10 / $111.10
= 9%
9-11
Component cost of preferred
stock
Preferred dividends are not tax-
deductible, so no tax adjustments
necessary. Just use kp.
Nominal kp is used.
Our calculation ignores possible
flotation costs.
9-12
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.
9-13
Why is the yield on preferred
stock lower than debt?
Corporations own most preferred stock,
because 70% of preferred dividends are
nontaxable to corporations.
Therefore, preferred stock often has a
lower B-T yield than the B-T yield on debt.
The A-T 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.
9-14
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 kd = 10% and kp = 9%, respectively.
A-T kp = kp kp (1 0.7)(T)
= 9% - 9% (0.3)(0.4) = 7.92%
A-T kd = 10% - 10% (0.4) = 6.00%
9-15
Component cost of equity
WACC = wdkd(1-T) + wpkp + wcks
9-17
Three ways to determine
the cost of common
equity, k s
CAPM: ks = kRF + (kM kRF)
DCF: ks = D 1 / P0 + g
Own-Bond-Yield-Plus-Risk Premium:
ks = kd + RP
9-18
If the kRF = 7%, RPM = 6%, and the
firms beta is 1.2, whats the cost of
common equity based upon the
CAPM?
9-19
If D0 = $4.19, P0 = $50, and g = 5%,
whats the cost of common equity
based upon the DCF approach?
D1 = D0 (1+g)
D1 = $4.19 (1 + .05)
D1 = $4.3995
ks = D 1 / P0 + g
= $4.3995 / $50 + 0.05
= 13.8%
9-20
What is the expected future growth
rate?
The firm has been earning 15% on equity
(ROE = 15%) and retaining 35% of its
earnings (dividend payout = 65%). This
situation is expected to continue.
g = ( 1 Payout ) (ROE)
= (0.35) (15%)
= 5.25%
9-22
If kd = 10% and RP = 4%, what is ks
using the own-bond-yield-plus-risk-
premium method?
This RP is not the same as the
CAPM RPM.
This method produces a ballpark
estimate of ks, and can serve as a
useful check.
ks = kd + RP
ks = 10.0% + 4.0% = 14.0%
9-23
What is a reasonable final
estimate of ks?
Method Estimate
CAPM 14.2%
DCF 13.8%
kd + RP 14.0%
Average 14.0%
9-24
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.
9-25
If issuing new common stock incurs
a flotation cost of 15% of the
proceeds, what is ke?
D0 (1 g)
ke g
P0 (1- F)
$4.19(1.05)
5.0%
$50(1- 0.15)
$4.3995
5.0%
$42.50
15.4%
9-26
Flotation costs
Flotation costs depend on the risk of the
firm and the type of capital being raised.
The flotation costs are highest for
common equity. However, since most
firms issue equity infrequently, the per-
project cost is fairly small.
We will frequently ignore flotation costs
when calculating the WACC.
9-27
Ignoring floatation costs, what
is the firms WACC?
9-28
What factors influence a
companys composite
WACC?
Market conditions.
The firms capital structure and
dividend policy.
The firms investment policy.
Firms with riskier projects
generally have a higher WACC.
9-29
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.
9-30
Risk and the Cost of
Capital
Rate of Return
(%) Acceptance Region
WACC
12.0 H
Risk
0 RiskL RiskA RiskH
9-31
What are the three types of
project risk?
Stand-alone risk
Corporate risk
Market risk
9-32
How is each type of risk
used?
Market risk is theoretically best in
most situations.
However, creditors, customers,
suppliers, and employees are more
affected by corporate risk.
Therefore, corporate risk is also
relevant.
9-33
Problem areas in cost of
capital
Depreciation-generated funds
Privately owned firms
Measurement problems
Adjusting costs of capital for
different risk
Capital structure weights
9-34
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.
9-35
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.
kd = 12%
kRF = 7%
RPM = 6%
DIV = 1.7
Tax rate = 40%
9-36
Calculating a divisional cost of
capital