Essentials of Managerial Finance - PowerPoint by HC120727213242

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									                                                             Chapter 8

                                                             The Cost of
                                                               Capital


Essentials of Managerial Finance by S. Besley & E. Brigham         Slide 1 of 21
                                 The Cost of Capital
• The cost of capital acts as a link between the firm’s
   long-term investment decisions and the wealth of the
   owners as determined by investors in the marketplace.
• It is used to decide whether a proposed investment
   will increase or decrease the firm’s stock price.
• Formally, the cost of capital is the rate of return that a
   firm must earn on the projects in which it invests to
   maintain the market value of its stock.

Essentials of Managerial Finance by S. Besley & E. Brigham   Slide 2 of 21
               The Firm’s Capital Structure

                    Current                            Current
                    Assets                            Liabilities


                                                             Long-    The Firm’s
                                                             Term      Capital
                                                                      Structure
                                                             Debt
                                                                      & Cost of
                      Fixed                                            Capital
                      Assets                                 Equity

Essentials of Managerial Finance by S. Besley & E. Brigham                  Slide 3 of 21
                          The Weighted Average
                             Cost of Capital
• Capital—refers to the long-term funds used by
  a firm to finance its assets.
• Capital components—the types of capital used
  by a firm—long-term debt and equity
• WACC—the average percentage cost, based
  on the proportion of each type of capital, of all
  the funds used by the firm to finance its assets.


Essentials of Managerial Finance by S. Besley & E. Brigham   Slide 4 of 21
                                          The Cost of Debt
• The pretax cost of debt is equal to the the yield-to-
  maturity on the firm’s debt adjusted for flotation costs.
• Recall that a bond’s yield-to-maturity depends upon a
  number of factors including the bond’s coupon rate,
  maturity date, par value, current market conditions,
  and selling price.
• After obtaining the bond’s yield, a simple adjustment
  must be made to account for the fact that interest is a
  tax-deductible expense.
• This will have the effect of reducing the cost of debt.

Essentials of Managerial Finance by S. Besley & E. Brigham   Slide 5 of 21
                     The Cost of Debt - Example
 Suppose a company could issue 9% coupon, 20 year debt
 face value of €1,000 for €980. Suppose that flotation costs
   will amount to 2% of par value. Find the after-tax cost of
    debt assuming the company is in the 40% tax bracket.
              Finding the Cost of Debt
      Par Value                                              -1000
      Flotation Costs (% of Par)                               2%
      Flotation Costs (€)                                      -20
      Issue Price                                              980
      Net Proceeds Price                                       960
      Coupon Interest (%)                                      9%
      Coupon Interest (€)                                      -90
      Time to maturity                                          20      EXCEL Formula for
      Tax                                                     40%    computing the before - tax
      Before-tax cost of debt                                9,45%
                                                                            cost of debt
      After-tax cost of debt                                 5,67%
                                                                        =RATE(B9,B8,B6,B2)
Essentials of Managerial Finance by S. Besley & E. Brigham                            Slide 6 of 21
                                   The Cost of Equity
 The cost of equity is based on the rate of return
  required by the firm’s stockholders.
      Cost of preferred stock - dividends received by preferred
       stockholders represent an annuity
      Cost of retained earnings (internal equity)—return that
       common stockholders require the firm to earn on the funds
       that have been retained, thus reinvested in the firm, rather
       than paid out as dividends
      Cost of new (external) equity—rate of return required by
       common stockholders after considering the cost associated
       with issuing new stock (flotation costs)




Essentials of Managerial Finance by S. Besley & E. Brigham   Slide 7 of 21
      The Cost of Preferred Stock (kp)
                            KP = DP/(PP - F) = DP/(NP)


 In the above equation, “F” represents flotation costs
 (in €). As was the case for debt, the cost of raising
 new preferred stock will be more than the yield on the
 firm’s existing preferred stock since the firm must pay
 investment bankers to sell (or float) the issue.



Essentials of Managerial Finance by S. Besley & E. Brigham   Slide 8 of 21
   The Cost of Preferred Stock (kp) -
               Example
                                              KP = DP/(PP - F)
    A company can issue preferred stock that pays a €5
    annual dividend, sell it for €55 per share, and have
    to pay €3 per share to sell it. Then, the cost of
    preferred stock would be:

                                     kP = €5/(€55 - €3) = 9.62%

      There is no tax adjustment, because dividends are
                                   not a tax-deductible expense.
Essentials of Managerial Finance by S. Besley & E. Brigham         Slide 9 of 21
       The Cost of Retained Earnings
• The firm must earn a return on reinvested
  earnings that is sufficient to satisfy existing
  common stockholders’ investment demands.
• If the firm does not earn a sufficient return using
  retained earnings, then the earnings should be
  paid out as dividends so that stockholders can
  invest the funds outside the firm to earn an
  appropriate rate.



Essentials of Managerial Finance by S. Besley & E. Brigham   Slide 10 of 21
The Cost of Retained Earnings (ks)
                   Discounted Cash Flow (DCF) approach

                                                  kS = (D1/P0) + g.


  For example, assume a firm has just paid a dividend
    of €2.50 per share, expects dividends to grow at
   10% indefinitely, and is currently selling for €50 per
                          share.
           First, D1 = 2.50(1+.10) = 2.75, and
                                kS = (2.75/50) + .10 = 15.5%.

Essentials of Managerial Finance by S. Besley & E. Brigham            Slide 11 of 21
The Cost of Retained Earnings (kE)
                            Security Market Line Approach

                                           kE = rF + b(kM - RF).


   For example, if the 3-month government bond rate is
    currently 5.0%, the market risk premium is 9%, and
     the firm’s beta is 1.20, the firm’s cost of retained
                       earnings will be:
                                    kE = 5.0 + 1.2(9) = 15.8%.



Essentials of Managerial Finance by S. Besley & E. Brigham         Slide 12 of 21
  The Cost of Retained Earnings, ks—
Bond-Yield-Plus-Risk-Premium Approach
        • Studies have shown that the return on equity for
          a particular firm is approximately 3 to 5
          percentage points higher than the return on its
          debt.
        • As a general rule of thumb, firms often compute
          the YTM, or kd, for their bonds and then add 3 to
          5 percent.
        • In the current example, kd = 6.0%. As a rough
          estimate, then, we might say the cost of
          retained earnings is
              ks . kd + 4% = 6% + 4% = 10.0%
Essentials of Managerial Finance by S. Besley & E. Brigham   Slide 13 of 21
                        The Cost of New Equity
  • Rate of return required by common stockholders
    after considering the costs associated with issuing
    new stock, which are called flotation costs.
  • Because the firm has to provide the same gross
    return to new stockholders as existing
    stockholders, when the flotation costs associated
    with a common stock issue are considered, the
    cost of new common stock always must be greater
    than the cost of existing stock—that is, the cost of
    retained earnings.
  • Modify the DCF approach for computing the cost
    of retained earnings to include flotation costs
Essentials of Managerial Finance by S. Besley & E. Brigham   Slide 14 of 21
               The Cost of New Equity (kn)
                 Discounted Cash Flow (DCF) approach

                         Kn = [D1/(P0 - F)] + g = D1/Nn - g

      Αssume a firm has just paid a dividend of €2.50 per
           share, expects dividends to grow at 10%
        indefinitely, and is currently selling for €50 per
      share.Ηow much would it cost the firm to raise new
      equity if flotation costs amount to €4.00 per share?
               Kn = [2.75/(50 - 4)] + .10 = 15.97% or 16%.


Essentials of Managerial Finance by S. Besley & E. Brigham    Slide 15 of 21
The Weighted Average Cost of Capital

                           WACC = ka = wiki + wpkp + wskr or n

                                         Capital Structure Weights


    The weights in the above equation are intended to
    represent a specific financing mix (where wi = % of
    debt, wp = % of preferred, and ws= % of common).
    Specifically, these weights are the target percentages
    of debt and equity that will minimize the firm’s overall
    cost of raising funds.
Essentials of Managerial Finance by S. Besley & E. Brigham           Slide 16 of 21
The Weighted Average Cost of Capital
                         WACC = ka = wiki + wpkp + wskr or n

                                      Capital Structure Weights


 One method uses book values from the firm’s
 balance sheet. For example, to estimate the weight
 for debt, simply divide the book value of the firm’s
 long-term debt by the book value of its total assets.
 To estimate the weight for equity, simply divide the
 total book value of equity by the book value of total
 assets.
Essentials of Managerial Finance by S. Besley & E. Brigham        Slide 17 of 21
The Weighted Average Cost of Capital
                         WACC = ka = wiki + wpkp + wskr or n

                                      Capital Structure Weights

 A second method uses the market values of the firm’s
 debt and equity. To find the market value proportion
 of debt, simply multiply the price of the firm’s bonds
 by the number outstanding. This is equal to the total
 market value of the firm’s debt.
 Next, perform the same computation for the firm’s
 equity by multiplying the price per share by the total
 number of shares outstanding.
Essentials of Managerial Finance by S. Besley & E. Brigham        Slide 18 of 21
The Weighted Average Cost of Capital
                         WACC = ka = wiki + wpkp + wskr or n

                                      Capital Structure Weights


     Finally, add together the total market value of the
     firm’s equity to the total market value of the firm’s
     debt. This yields the total market value of the firm’s
     assets.
     To estimate the market value weights, simply divide
     the market value of either debt or equity by the
     market value of the firm’s assets .
Essentials of Managerial Finance by S. Besley & E. Brigham        Slide 19 of 21
The Weighted Average Cost of Capital
                         WACC = ka = wiki + wpkp + wskr or n

                                      Capital Structure Weights

 For example, assume the market value of the firm’s
 debt is €40 million, the market value of the firm’s
 preferred stock is €10 million, and the market value of
 the firm’s equity is €50 million.
 Dividing each component by the total of €100 million
 gives us market value weights of 40% debt, 10%
 preferred, and 50% common.
Essentials of Managerial Finance by S. Besley & E. Brigham        Slide 20 of 21
The Weighted Average Cost of Capital
                         WACC = ka = wiki + wpkp + wskr or n

                                      Capital Structure Weights

 Using the costs previously calculated along with the
 market value weights, we may calculate the weighted
 average cost of capital as follows:
             WACC = .4(5.67%) + .1(9.62%) + .5 (15.8%)
                                        = 11.13%
 This assumes the firm has sufficient retained
 earnings to fund any anticipated investment projects.
Essentials of Managerial Finance by S. Besley & E. Brigham        Slide 21 of 21

								
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