9. cost of capital
TRANSCRIPT
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Chapter 9
Cost of Capital
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Learning Objectives
1. Describe the concepts underlying the firm’s cost of capital.
2. Calculate the after-tax cost of debt, preferred stock, and common equity.
3. Calculate a firm’s weighted average cost of capital.
4. Describe the procedure used by PepsiCo to estimate the cost of capital for a multidivisional firm.
5. Use the cost of capital to evaluate new investment opportunities.
6. Calculate equivalent interest rates for different countries.
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Slide Contents
Cost of Capital: Key Definitions and Concepts
Determining the Cost of Individual Sources of Capital
The Weighted Average Cost of Capital
Calculating Divisional Costs of Capital for PepsiCo, Inc.
Cost of Capital and New Investment
Shareholder Value-Based Management
Multinational Firms and Interest Rates
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1. Cost of Capital: Key Definitions and Concepts
Capital
Capital represents the funds used to finance a firm's assets and operations. Capital constitutes all items on the right hand side of balance sheet i.e. liabilities and common equity.
Main sources: Debt, Preferred stock, Retained earnings and Common Stock
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Investor’s Required Rate of Return
Investor’s Required Rate of Return – is the minimum rate of return necessary to attract an investor to purchase or hold a security.
Investor’s required rate of return is not the same as cost of capital due to taxes and transaction costs. Impact of taxes: For example, a firm may pay 8%
interest on debt but due to tax benefit on interest expense, the net cost to the firm will be lower than 8%.
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Investor’s Required Rate of Return
Impact of transaction costs on cost of capital: For example, If a firm sells new stock for $50.00 a share and incurs $5 in flotation costs, and the investors have a required rate of return of 15%, what is the cost of capital?
The firm has only $45.00 to invest after transaction cost..15 $50.00 = $7.5k = $7.5/($45.00)
= .1667 or 16.67% (rather than 15%)
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Financial Policy
A firm’s financial policy indicates the desired sources of financing and the particular mix in which it will be used.
For example, a firm may choose to raise capital by issuing stocks and bonds in the ratio of 6:4 (60% stocks and 40% bonds). The choice of mix may impact the cost of capital.
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2. Determining the Costs of the Individual Sources of Capital
The Cost of DebtThe bondholder’s required rate of return on debt is the return that bondholders demand. As seen in Chapter 7, this can be estimated using the bond price equation:
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The Cost of Debt
Since firms must pay floatation costs when they sell bonds, the net proceeds per bond received by firm is less than the market price of the bond. Hence, the cost of debt capital (Kd) will be higher than the bondholder’s required rate of return. It can be calculated using the following equation:
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The Cost of Debt
See Example 9-1 Investor’s required rate of return = 9%
However, due to floatation cost, the before-tax cost of capital for the firm is = 9.73%
After-tax cost of debt = Cost of debt*(1-tax rate)
At 34% tax bracket = 9.73*(1 – .34) = 6.422%
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The Cost of Preferred Stock
Similar to bond issue, since floatation costs are incurred, preferred stockholder’s required rate of return will be less than the cost of preferred capital to the firm.
Thus, in order to determine the cost of preferred stock, we adjust the price of preferred stock for floatation cost to give us the net proceeds.
Net proceeds = issue price per share – floatation cost per share.
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The Cost of Preferred Stock
Cost of Preferred Stock:
Pn = net proceeds (i.e. Issue price – Floatation costs)
Dp = Preferred stock dividend per share
Example: Determine the cost for a preferred stock that pays annual dividend of $4.25, has current stock price $58.50 and incurs flotation costs of $1.375 per share
Cost = $4.25/(58.50 – 1.375) = .074 or 7.44%
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The Cost of Common Equity
Cost of equity is more challenging to estimate than the cost of debt or the cost of preferred stock because common stockholder’s rate of return is not fixed as there is no stated coupon rate or dividend.
Furthermore, the costs will vary for two sources of equity (i.e. retained earnings and new issue).
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The Cost of Common Equity
There is no flotation costs on retained earnings but the firm incurs costs when it sells new common stock.
Note retained earnings are not a free source of capital. There is an opportunity cost.
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Cost estimation techniques
Two commonly used methods for estimating common stockholder’s required rate of return are:
The Dividend Growth Model
The Capital Asset Pricing Model
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The Dividend Growth Model
Investors’ required rate of return (For Retained Earnings):
D1 = Dividends expected one year hence
Pcs = Price of common stock;
g = growth rate
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The Dividend Growth Model
Investors’ required rate of return (For new issues)
D1 = Dividends expected one year hence
Pcs = Net proceeds per share
g = growth rate
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The Dividend Growth Model
Example: A company expects dividends this year to be $1.10, based upon the fact that $1 were paid last year. The firm expects dividends to grow 10% next year and into the foreseeable future. Stock is trading at $35 a share.
Cost of retained earnings: Kcs = D1/Pcs + g1.1/35 + .10 = .1314 or 13.14%
Cost of new stock (with a $3 floatation cost):Kncs = D1/NPcs + g1.10/(35 – 3) + .10 = .1343 or 13.43%
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The Dividend Growth Model
Dividend growth model is simple to use but suffers from the following drawbacks:
It assumes a constant growth rate
It is not easy to forecast the growth rate
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The Capital Asset Pricing Model
rf = Risk Free rate
= Beta
rm – rf = Market Risk Premium or Expected rate of return for “average security” minus the risk free rate
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Capital Asset Pricing Model
Example: If beta is 1.25, risk-free rate is 1.5% and expected return on market is 10%
kc = rrf + (rm – rf)
= .015 + 1.25(.10 – .015)
= 12.125%
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Capital Asset Pricing Model Variable estimates
CAPM is easy to apply. Also, the estimates for model variables are generally available from public sources.
Risk Free Rate: Wide range of US government securities on which to base risk-free rate
Beta: Estimates of beta are available from a wide range of services, or can be estimated using regression analysis of historical data.
Market risk premium: It can be estimated by looking at history of stock returns and premium earned over risk-free rate.
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3. The Weighted Average Cost of Capital
Bringing it all together: WACC To estimate WACC, we need to know the capital
structure mix and the cost of each of the sources of capital.
For a firm with only two sources: debt and common equity,
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WACC Example
A firm borrows money at 7% after taxes and pays 12% for equity. The company raises capital in equal proportions i.e. 50% debt and 50% equity.
WACC = (.07 .5) + (.12 .5) = .095 or 9.5%
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Business world cost of capital
In practice, the calculation of cost of capital may be more complex:
If firms have multiple debt issues with different required rates of return.
If firms also use preferred stock in addition to common stock financing.
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Table 9-1
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Table 9-1
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Table 9-3
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4. Calculating Divisional Costs of Capital for PepsiCo Inc.
PepsiCo calculated divisional cost of capital for each of its three major divisions: restaurants, food, and beverages.
The target ratios for debt/equity mix and the pre-tax cost of debt were different for each division.
PepsiCo estimated the WACC for each division in a 3 step process: Estimate the cost of debt for each division
Estimate the cost of equity for each division
Estimate the WACC (with target capital structure) for each division
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Table 9-4PepsiCo’s Cost of Debt
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Table 9-5 PepsiCo’s Cost of Equity
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Table 9-6 PepsiCo’s WACC
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5. Cost of Capital and New Investment
Cost of capital can serve as the discount rate in evaluating new investment when the projects offer the same risk as the firm as a whole.
If risk differs, it is better to calculate a different cost of capital for each division.
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6. Multinational Firms and Interest Rates
In an international setting, there can be different rates of inflation among different countries.
The Fisher Model indicates that the nominal interest rate in the home or domestic country is a function of real interest rates and anticipated rate of inflation.
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Fisher Model and Domestic Interest Rates
rn,h = (1 + rr,h)(1 + ih) – 1
rn,h = Nominal rate of interest at home, U.S.
rr,h = real interest rate at home, U.S.
Ih = inflation rate at home, U.S
Example: If Real interest rate is 3% and inflation rate is 5%, nominal rate will be 8.15%
(1.03)(1.05) – 1 = 8.15%
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International or Foreign Rates and Fisher Effect
rn,h – rn,h = ih – if
Differences in observed nominal rates of interest between two countries should equal the difference in expected rates of inflation between the two countries.
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Interest Rate Parity Theorem
rn,h = Domestic one-period rate of interest
rn,f = Corresponding rate in foreign country
E0 & E1 = Exchange rates corresponding to current period (i.e. spot exchange rate) and one-period hence (i.e. the one-period forward exchange rate)
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Interest Rate Parity Theorem
Thus,
Nominal interest rates are tied to exchange rates
Differences in nominal interest rates are tied to expected rates of inflation
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Interest Rates and Currency Exchange Rates
Example: If domestic one-period interest rate is 15.5%, and the Japanese rate of interest is 5%, the spot exchange rate is $1 to 1 yen and the forward exchange rate is $1.10 to 1 yen.
1 + .155 / 1 + .05 = 1.1/1= 1.10
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Figure 9-1
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Key Terms
Capital Structure
Financial Policy
Economic Profit
Market Value Added
Weighted Average Cost of Capital