Cost of Capital

Chapter 11

Chapter 11 - OutlineWeighted Average Cost of CapitalCost of DebtCost of Preferred StockCost of Common Equity:

– Retained Earnings– New Common Stock

Optimum Capital StructureMarginal Cost of Capital and Break Points

Weighted Average Cost of Capital

The weighted average cost of capital is the correct discount rate for projects that have the same risk as the company’s existing business but not for those projects that are safer or riskier than the company’s average.

The weighted average cost of capital equals the company cost of equity for companies that are financed with 100% equity (i.e. companies without any debt).

WACC = Ka = KD (1 - Tc) D + Kp P + KE E V V V

•WACC is a weighted average of the various sources, including debt, preferred stock, and common equity. It reflects the tax advantage of debt.

• WACC refers to the firm as a whole, i.e. it works only if a project has same risk & debt capacity as firm

•Tc is the marginal corporate tax rate

Weighted Average Cost of Capital (WACC)

PPT 11-1

Cost of DebtThe cost of debt to the firm is the effective

yield to maturity (or interest rate) paid to its bondholders

Since interest is tax deductible to the firm, the actual cost of debt is less than the yield to maturity:After-tax cost of debt = yield x (1 - tax rate)

Cost of Preferred StockPreferred stock:

– has a fixed dividend (similar to debt)– has no maturity date– dividends are not tax deductible to the firm

and are expected to be perpetual or infinite

Cost of preferred stock = dividend (price-

Flotation Cost)Flotation cost:

selling and distribution costs (such as sales commissions) for the new securities

Two basic ideas about risk and return

1. Investors require compensation for risk

2. They care only about a stock's contribution to portfolio risk

Cost of Common Equity: Retained Earnings

Common stock equity is available through retained earnings (R/E) or by issuing new common stock:

Common equity = R/E + New common stock

The cost of common equity in the form of retained earnings is equal to the required rate of return on the firm’s common stock (this is the opportunity cost)

The cost of new common stock is higher than the cost of retained earnings because of flotation costs

PPT 11-9

Note: That Gordon growth model only works if constant growth assumption is valid. What is alternative way to get Ke?

Capital asset pricing model

Expectedreturn

Expectedmarketreturn

Riskfreerate

0 .5 1.0 Beta

Ke = rf + (rm - rf )

PPT 11-13

Capital asset pricing model - example

If Treasury bill rate = 5.6% Bristol Myers Squibb beta = .81 Expected market risk premium = 8.4%

Ke = rf + beta (rm - rf )

= 5.6 + .81 (8.4) = 12.4%

Capital asset pricing modelis attractiveBecause:

1. It is simple and usually gives sensible answers.

2. It distinguishes between diversifiable and non-diversifiable risk.

CAPM is controversial

BECAUSE:

1. No one knows for sure how to define and measure the market portfolio -- and using

the wrong market index could lead to the wrong answers.

2. The model is hard to prove -- or disprove.

3. The model has competitors.

Optimum Capital StructureThe optimal (best) situation is associated

with the minimum overall cost of capital:Optimum capital structure means the lowest

WACC

The optimal capital structure is found at the point where the marginal benefits of using more debt are equal to the marginal costs of doing so. However, finding the optimal is difficult because it is hard to quantify the marginal costs of debt (i.e., the increased costs associated with financial distress).

All else equal, there are increases in the WACC when there is an increase in one component in the WACC. Z represents how much can be invested before facing an increase in the WACC.

Z = Amount of lower cost capital / (% of that capital in capital structure)

Marginal Cost of Capital and Break Points

Which projects should you invest in?