Prepared by:

Jammie Ann Felipe

The Cost of Capital

*The Cost of Capital

*Can be used only if the current projects of the firm are of similar risk and that investment proposals under consideration are of the same character

*Its advantage?

SIMPLICITY

*Required rate of return that will justify all capital providers

*Example

  (1) (2) (3)   (2) x (3)   (1) x (2)

Capital Providers

Invested Capital

Percentage Annual Cost (Investor Return)

Proportion of Total Financing   Wighted Cost  

Dollar Annual Cost (Investor Return)

Shula $2,000.00 5% 20% 1.00% $100.00

Lia 3,000.00 10% 30% 3.00% $300.00

Jam 5,000.00 15% 50% 7.50% $750.00

10,000.00 100% 11.50% $1,150.00

*Example

  (1) (2) (3)   (2) x (3)   (1) x (2)

Capital Providers Invested Capital

Percentage Annual Cost (Investor Return)

Proportion of Total Financing   Wighted Cost  

Dollar Annual Cost (Investor Return)

Debt $2,000.00 5% 20% 1.00% $100.00

Preferred Stock 3,000.00 10% 30% 3.00% $300.00

Common Stock 5,000.00 15% 50% 7.50% $750.00

10,000.00 100% 11.50% $1,150.00

*Sources of Long term Capital

Long-Term Capital

Long-Term Debt

Preferred Stock

Common Stock

Retained Earnings

New Common

Stock

*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 rd needs adjustment, because interest is tax deductible.

*Cost of Debt

*We ignore non seasonal debt that bears an explicit interest cost

*We are concerned on long term debt

*We assume that the firm is following hedging (maturity matching)

*Cost of Debt

*Ki = Kd (1-t)where Ki after-tax cost debt

Kd discount rate or YTM

t company’s marginal tax rate

Example: Interest Rate 11%

Marginal Tax Rate 40%

Ki = .11 (1 – 0.40)

= 6.6% Cost of Additional Debt

*Cost of Preferred Stock

*KP = DP / PO

Where KP Interest Rate

DP Dividend

PO Current Market Price

Example: 10% Preferred Stock Issue ($50 par value)

at a current market price of $49.00

KP = DP / PO

= $5 / $49

= 10.20% Explicit Cost of Preferred Stock

*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.

*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 ks.

*Firm could repurchase its own stock and earn ks.

*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.

*Cost of Equity:Dividend Discount Model Approach

*Example: If dividends are expected to grow at an 8% annual rate into the foreseeable future, the constant growth model, discussed in Stock Valuation, may be used to determine the required rate of return.

*If the expected dividend in the first year were $2 and the present market price were $27

*Cost of Equity:Dividend Discount Model Approach

*Ke = (D1 / PO) + g

= ($2 / $27) + 0.08

= 15.4% Cost of Equity

*Cost of Equity:Capital Asset Pricing Model Approach

*CAPM rs = rRF + (rM – rRF)b

*Example:

The rRF = 7%, RPM = 6%,

and the firm’s beta is 1.2.

Find Cost of Common Equity?

rs = rRF + (rM – rRF)b

= 7.0% + (6.0%)1.2

= 14.2% Cost of Equity

*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.

*Weighted Average Cost of Capital

  Amount of Financing   Proportion of Total Financing

Debt 30 million 30%Preferred Stock 10 million 10%Common Stock Equity 60 million 60%

$100 million 100%

  CostDebt 6.60%Preferred Stock 10.02%Common Stock Equity 14.00%

(1)   (2)   (1) x (2)

  Cost   Proportion of Total Financing Weighted Cost

Debt 6.60% 30% 1.98%

Preferred Stock 10.02% 10% 1.00%

Common Stock Equity 14.00% 60% 8.40%

100% 11.38%

*Weighted Average Cost of Capital

*END