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Sources of capital

Component costs
WACC

CHAPTER 13
The Cost of
Capital

Cost of Capital
The

cost of capital represents the overall


cost of financing to the firm
The cost of capital is normally the relevant
discount rate to use in analyzing an
investment
The overall cost of capital is a weighted
average of the various sources, including
debt, preferred stock, and common equity:
WACC = Weighted Average Cost of Capital
WACC = After-tax costs x weights

What sources of long-term


capital do firms use?
Long-Term Capital
Capital
Long-Term
Long-Term Debt
Debt Preferred
Preferred Stock
Stock Common
Common Stock
Stock
Long-Term
Retained Earnings
Earnings
Retained

New Common
Common Stock
Stock
New

Calculating the weighted


average cost of capital
WACC = xd(pretax kd)(1-Tax rate) + xpskps + xcskcs
The

xs refer to the firms capital structure


weights.
The ks refer to the cost of each component.

Should our analysis focus on


before-tax or after-tax costs?
Stockholders

focus on After-Tax CFs.


Therefore, we should focus on A-Tax
capital costs.
Only cost of debt needs adjustment,
because interest is tax deductible.

Should our analysis focus on


historical 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).

How are the weights


determined?
WACC = xd(pretax kd)(1-Tax rate) + xpkp + xcskcs

As

a percentage of total financing

Weighting example
Bonds
40
Pref. Stock 100
Common 100
Ret. Earn. 160
Total L & E 400
What is weight of each component?

Weighting example
Bonds
Pref. Stock
Common
Ret. Earn.
Total L & E

40
100
100
160
400

Bonds = 40/400 = 10%


Pref. Stock = 100/400 = 25%

Component cost of debt

WACC = xd(pretax kd)(1-T) + xpkp + xcskcs


kd

is the marginal cost of debt capital.

The

yield to maturity on outstanding L-T debt is


often used as a measure of kd.

Why

tax-adjust, i.e. why kd(1-Tax rate)?

If tax rate is 40% then


10% before tax = 6% after tax
Sales

1,000

1,000

100*

EBT

900

1,000

Tax 40%

360

400

EAT

540

600

Interest

60
difference

Component cost of debt


Interest

is tax deductible, so
aftertax kd = pretax kd (1-T)
= 10% (1 - 0.40) = 6%
T = tax rate =
40%

Cost of debt
What

is the current cost of debt for a


firm that has a 9% coupon bond with 5
years to maturity and a current price of
$962?
What is the after tax cost if it is in the
40% tax bracket?

Component cost of
preferred stock
WACC = xdkd(1-T) + xpkp + xcskcs
kp

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:
kp = Dp / Pp
= $8 / $111
= 7.2%

Component cost of
preferred stock
Preferred

dividends are not


tax-deductible, so no tax adjustments
necessary.

Component cost of equity


WACC = xd(pretax kd)(1-T) + xpkp + xcskcs
kcs

is the marginal cost of common equity

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 k cs.


Firm could repurchase its own stock and earn k cs.
Therefore, kcs is the cost of retained earnings.

Two ways to determine the


cost of common equity, kcs
1. CAPM: kcs = RRF + x (Mkt. risk premium [E(RM)
RRF])
RRF =
RM =

Risk Free Rate (now around 2.7%)


Return on the market

= Beta - the relation of its returns with that of


the stock market e.g.

0 not correlated
1 - moves with the market
2 twice as volatile

Two ways to determine


the cost of common
2. DCF: P = k
(D / r - g)
equity,
cs
0

r = kcs
kcs = (D1 / P0)+ g

If the market premium is 6%, risk-free


rate is 2.7% and the firms beta is 1.48,
whats the cost of common equity based
upon the CAPM?
kcs = RRF + (mkt premium)
= 2.7% + 1.48(6.0%) = 11.58%

If D0 = $1.72, P0 = $43, and g = 5%,


whats the cost of common equity based
upon the DCF approach?
D1 = D0 (1+g)
D1 = $1.72 (1 + .05)
D1 = $1.81
kcs = (D1 / P0)+ g
= ($1.81 / $43) + 0.05
= 9.2%

What is a reasonable final


estimate of kcs?
Method
Estimate
CAPM 11.58%
DCF
9.2%
Average

10.4%

Calculate WACC
If

40% of your financing is from debt at


an after tax cost of 8% and 60% is from
pref. stock at 10%, what is the WACC?
It will be between what two numbers?

40%

(.08) + 60% (.10)


.032 + .06 = .092
9.2%

Balance Sheet
use costs that were just calculated
Market values

Cash

5,000

LT Debt

3,000

Equipment

5,000

Pref. Stock

1,000

Stock

6,000

Tot. Debt & Eq.

10,000

Tot. Assets

10,000

Ignoring issuance costs, what


is the firms WACC?
WACC = xd(pretax kd)(1-Tax) + xpkp + xcskcs
= .3(10%)(0.6) + .1(7.2%) + .6(10.4%)
= 1.8% + 0.72% + 6.2%
= 8.7%

WACC
You

are analyzing the cost of capital for


a firm that is financed with 60 percent
equity and 40 percent debt. The aftertax cost of debt capital is 10 percent,
while the cost of equity capital is 20
percent for the firm. What is the overall
cost of capital for the firm?
(.6 x .2) + (.4 x .1) = 16%
Equity + Debt

Cardinal

Health has bonds outstanding


with 15 years to maturity and are
currently priced at $800. If the bonds
have a coupon rate of 8.5 percent, then
what is the after-tax cost of debt for
Beckham if its marginal tax rate is 30%?
7.9%

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.

Optimum Capital Structure


The

optimal (best) situation is associated with the


minimum overall cost of capital:

Optimum capital structure means the lowest WACC

Usually

occurs with 30-50% debt in a firms capital


structure
WACC is also referred to as the required rate of
return or the discount rate

Optimal Capital Structure


Cost
Financial Plan A:
Debt
Equity.
Financial Plan B:
Debt
Equity.

Cost (After-tax)
6.5%
12.0
7.0%
12.5

Weights

Weighted

20%
80

1.3%
9.6
10.9%

40%
60

2.8%
7.5
10.3%

Financial Plan C:
Debt
Equity.

9.0%
15.0

60%
40

5.4%
6.0
11.4%

Cost of capital curve