Chapter 11- Cost of Capital

2005, Pearson Prentice Hall

Where weve been...

Basic Skills: (Time value of money,

Financial markets , Risk and returns) Investments: (Stocks, Bonds) Corporate Finance: (The Investment Decision - Capital Budgeting)

The investment decision

Assets Current Assets Fixed Assets

Liabilities & Equity Current Liabilities Long-term Debt Preferred Stock Common Equity

Where were going...

Corporate Finance: (The Financing Decision) Cost of capital Leverage Capital Structure Dividends

The financing decision

Assets Current Assets Fixed Assets

Liabilities & Equity Current Liabilities Long-term Debt Preferred Stock Common Equity

Assets Current assets

Liabilities & Equity Current Liabilities Long-term Debt Preferred Stock Common Equity

Capital Structure

Ch. 12 - Cost of Capital

For Investors, the rate of return on a

security is a benefit of investing. For Financial Managers, that same rate of return is a cost of raising funds that are needed to operate the firm. In other words, the cost of raising funds is the firms cost of capital.

How can the firm raise capital?

Bonds Preferred Stock Common Stock Each of these offers a rate of return to
investors. This return is a cost to the firm. Cost of capital actually refers to the weighted cost of capital - a weighted average cost of financing sources.

Cost of Debt
For the issuing firm, the cost of debt is: the rate of return required by investors, adjusted for flotation costs (any costs associated with issuing new bonds), and adjusted for taxes.

Example: Tax effects of financing with debt

EBIT - interest expense EBT - taxes (34%) EAT

with stock 400,000 0 400,000 (136,000) 264,000

with debt 400,000 (50,000) 350,000 (119,000) 231,000

Example: Tax effects of financing with debt

EBIT - interest expense EBT - taxes (34%) EAT

with stock 400,000 0 400,000 (136,000) 264,000

with debt 400,000 (50,000) 350,000 (119,000) 231,000

Now, suppose the firm pays $50,000 in

dividends to the stockholders.

Example: Tax effects of financing with debt

with stock EBIT 400,000 - interest expense 0 EBT 400,000 - taxes (34%) (136,000) EAT 264,000 - dividends (50,000) Retained earnings 214,000 with debt 400,000 (50,000) 350,000 (119,000) 231,000 0 231,000

After-tax Before-tax % cost of = % cost of Debt Debt

Marginal - tax rate

Kd .066 =

kd (1 - T) .10 (1 - .34)

Example: Cost of Debt

Prescott Corporation issues a $1,000

par, 20 year bond paying the market rate of 10%. Coupons are semiannual. The bond will sell for par since it pays the market rate, but flotation costs amount to $50 per bond.

What is the pre-tax and after-tax cost

of debt for Prescott Corporation?

 Pre-tax cost of debt: (using TVM)

P/Y = 2 N = 40 PMT = -50 FV = -1000 PV = 950 solve: I = 10.61% = kd After-tax cost of debt: Kd = kd (1 - T) Kd = .1061 (1 - .34) Kd = .07 = 7%

So, a 10% bond costs the firm only 7% (with flotation costs) since the interest is tax deductible.

Cost of Preferred Stock

Finding the cost of preferred stock
is similar to finding the rate of return (from Chapter 8), except that we have to consider the flotation costs associated with issuing preferred stock.

Cost of Preferred Stock

Recall:
kp = D Po =

Dividend Price

From the firms point of view:

kp = D NPo = Dividend Net Price

NPo = price - flotation costs!

Example: Cost of Preferred

If Prescott Corporation issues

preferred stock, it will pay a dividend of $8 per year and should be valued at $75 per share. If flotation costs amount to $1 per share, what is the cost of preferred stock for Prescott?

Cost of Preferred Stock

D kp = NPo 8.00 74.00 = Dividend Net Price

10.81%

Cost of Common Stock

There are two sources of Common Equity:

1) Internal common equity (retained earnings). 2) External common equity (new common stock issue). Do these two sources have the same cost?

Cost of Internal Equity

Since the stockholders own the firms
retained earnings, the cost is simply the stockholders required rate of return. Why? If managers are investing stockholders funds, stockholders will expect to earn an acceptable rate of return.

Cost of Internal Equity

1) Dividend Growth Model D1 kc = Po +g

2) Capital Asset Pricing Model (CAPM)

kj = krf + b j (km - krf )

Cost of External Equity

Dividend Growth Model

D1 knc = NPo + g
Net proceeds to the firm after flotation costs!

Weighted Cost of Capital

The weighted cost of capital is just the

weighted average cost of all of the financing sources.

WACC = wERE + wDRD(1-TC)

Weighted Cost of Capital

Capital Structure 20% 10% 70%

Source debt preferred common

Cost 6% 10% 16%

Weighted Cost of Capital

(20% debt, 10% preferred, 70% common)

Weighted cost of capital = .20 (6%) + .10 (10%) + .70 (16%) = 13.4%