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The Cost of Capital Oct 17, 2012 1 Learning Goals n Determining the value of K, the required rate of return for an investor n Sources of capital funding (Debt, Equity) n Cost of each type of funding n Calculation of the weighted average cost of capital funding (WACC) = K n Construction and use of the marginal cost of capital schedule (MCC) for decision making 2 Cost of Capital n Capital is the term used by firms for funds needed for investment purposes, i.e., capital equipment (not for day to day operating needs) n This capital carries a cost because each source of capital funding costs money to raise (i.e., issuing stock costs a lot of money) Cost of Capital n To properly evaluate investment decisions, the firm must know how much it will cost them to raise capital funds from all sources n WACC = K = hurdle rate n If it costs more to raise the capital (K) than you make on your investment, then you don’t make the investment! Sources of Capital n Borrowing: issue Bonds, bank loans, n Issuing Preferred stock n Issuing Common stock n Net Income (earnings) n Each of these sources carries a different cost based on the required rate of return of each provider (source) of these funds Optimal Capital Structure n The capital structure of a firm is how the firm has elected to finance its assets n It is the level or percentage of total assets financed by debt, preferred stock and common equity (common stock and retained earnings) n Each firm has an optimal level of debt and equity at which it can operate most efficiently and profitability (Draw curve) Weighted Cost of Capital Model n Compute the cost of each source of capital, i.e., debt, preferred stock, common stock, retained earnings n Determine percentage (weights) of each source of capital in the firm’s optimal capital structure n Calculate Weighted Average Cost of Capital (WACC) 7 1. Compute Cost of Debt n Required rate of return for creditors n e.g. Suppose that a company issues bonds with a before tax cost of 10%. n Since interest payments are tax deductible, the true cost of the debt is the After Tax cost (ATkd = Int Rate (1 – T), where T is tax rate) n If the company’s tax rate (state and federal combined) is 40%, the after tax cost of debt AT kd = 10%(1-.4) = 6% (show example) 8 Flotation Costs – cost of issuing securities to the general public n Accounting n Legal n Prospectus – (pass out examples) n Underwriting (investment banker) n Filing Fees (SEC) 2. Compute Cost Preferred Stock n Cost to raise a dollar of preferred stock. Dividend (Dp) Required rate kp = Market Price (PP) - F v Dp = preferred stock dividend v Pp = Market price per share v F = flotation costs per share v Flotation costs reduce the amount of money you get when you sell preferred stock 10 Cost of Preferred Stock v Example: You can issue preferred stock with a market price of $45, and flotation costs of $3 per share, for a net price of $42 and if the preferred stock pays a $5 dividend, vThe cost of preferred stock: kp = $5.00 = 11.9% (vs 11.1%) $42.00 3. Compute Cost of Common Equity n Two Types of Common Equity Financing – Retained Earnings (internal common equity) – Issuing new shares of common stock (external common equity) 12 3. Compute Cost of Common Equity n Cost of Common Equity (Retained Earnings) – Management should retain earnings only if they earn as much as stockholder’s next best investment opportunity of the same risk. – Cost of Common Equity = opportunity cost of common stockholders’ funds. – Two methods to determine n Dividend Growth Model n Capital Asset Pricing Model 13 3. Compute Cost of Common Equity n Cost of Common Equity (Retained Earnings) – Dividend Growth Model D1 kS = P0 + g Ks = cost of internal common equity D1 = the next dividend to be paid Po = the current market price of the stock g = the projected rate of growth of the company 3. Compute Cost of Common Equity n Cost of Internal Common Equity – Dividend Growth Model kS = D1 + g P0 Example: The market price (Po) of a share of common stock is $60. The prior dividend paid (D0) was $3, and the expected growth rate (g) is 10%. If you are given D0, you must calculate D1 D1 = D0 (1 + g) D1 = 3.00 (1.10) = 3.30 3. Compute Cost of Common Equity n Cost of Internal Common Equity – Dividend Growth Model D1 kS = + g P0 Example: The market price of a share of common stock is $60. The prior dividend (D0) is $3, and the expected growth rate is 10%. (D1 = 3.00 x 1.10 = 3.30) 3.30 + .10 =.055 + .10 = 15.5% kS = 60 3. Compute Cost of Common Equity n Cost of New Common Stock – Must adjust the Dividend Growth Model equation for flotation (F) costs of the new common shares. D1 kn = P - F + g 0 Kn = cost of sale of new common stock D1 is the next dividend to be paid Po is the current market price of shares outstanding F is the flotation cost G is the rate of growth 17 3. Compute Cost of Common Equity Example: If additional shares are issued, floatation costs will be 12% of price per share. D0 = $3.00 and estimated growth is 10%, Price is $60 as before. Flotation cost = $60 x .12 = $7.20. (Po – F = $60.00 – 7.20 = $52.80) (D1 = 3.00 x 1.10 = 3.30) 3.30 kn = + .10 = .0625 + .10 = 16.25% 52.80 18 Weighted Average Cost of Capital Gallagher Corporation estimates the following costs for each component in its capital structure: Source of Capital Cost Bonds (after tax) kd = 6.0% Preferred Stock kp = 11.9% Common Stock Retained Earnings ks = 15.5% New Shares kn = 16.25% 19 Gallagher’s tax rate is 40% Weighted Average Cost of Capital vIf using retained earnings (Internal Equity) to finance the equity portion: WACC = (WTd x AT kd ) + (WTp x kp ) + (WTs x ks) WACC = weighted average cost of capital WT = the weight, or percentage of each element of capital (% of debt, preferred and common stock to total assets) ATkd = after tax cost of debt Kp = Cost of preferred stock Ks = Cost of equity (Internal – retained earnings) Weighted Average Cost of Capital vIf using retained earnings (internal equity) to finance the common equity portion : WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x k s) v Assume that Gallagher’s desired capital structure is 40% debt, 10% preferred and 50% common equity. 21 Weighted Average Cost of Capital vIf using retained earnings (Internal Equity) to finance the equity portion: WACC = (WTd x AT kd ) + (WTp x kp ) + (WTs x ks) v Assume that Gallagher’s desired capital structure is 40% debt, 10% preferred and 50% common equity. WACC = Cost of Debt .40 x 6.0% = 2.40% + Cost of Preferred .10 x 11.9% = 1.19% + Cost of Int. Equity .50 x 15.5% = 7.75% 1.00 = 11.34% Weighted Average Cost of Capital vIf using new common stock (External Equity) to finance the common stock portion: WACC = (WTd x AT kd ) + (WTp x kp ) + (WTs x ks) Then we must use the cost of stock adjusted for the Flotation costs WACC = Cost of Debt .40 x 6.0% = 2.40% + Cost of Pref .10 x 11.9% = 1.19% + Cost of Ext. Eq. .50 x 16.25% = 8.13% = 11.72% Marginal Cost of Capital n Gallagher’s weighted average cost will change if one component cost of capital changes. n This may occur when a firm raises a particularly large amount of capital such that investors think that the firm is riskier. n The WACC of the next dollar of capital raised is called the marginal cost of capital. 24 Spending Capital Money n The assumption is that the capital money is spent in direct proportion to the optimal capital structure. n So, if we spend $100,000, it would be in the following proportions: Capital Structure Spend Debt 40% 40,000 Preferred 10% 10,000 Common 50% 50,000 (Buckets) Total 100,000 Calculating the Breakpoint n Assume now that Gallagher Corporation has $100,000 in retained earnings with which to finance its capital budget. n We can calculate the point at which they will need to issue new equity since we know that Gallagher’s desired capital structure calls for 50% common equity. Breakpoint = Available Retained Earnings Equity Percentage of Total 26 Calculating the Breakpoint Breakpoint = ($100,000)/.5 = $200,000 n What this means is that once we spend $200,000 in total on capital projects, we will have used up our retained earnings of $100,000 (internal equity). n Therefore, if we spend over $200,000, we will need additional financing from the issue of new shares of stock since 50% of our spending must come from Equity. n The cost of issuing new shares is greater than internal equity due to flotation costs Making Decisions Using MCC Marginal weighted cost of capital curve: Weighted Cost of Capital 13% 11.72% 12% 11.34% 11% Using new Using new 10% Using internal Using internal common equity common equity common equity common equity 0 100,000 200,000 300,000 400,000 Total Financing 28 Making Decisions Using MCC n Graph IRRs of potential projects Marginal weighted cost of capital curve: Weighted Cost of Capital 12% 11% Project 1 IRR = Project 2 Project 3 10% 12.4% IRR = IRR = 12.1% 11.5% 9% 0 100,000 200,000 300,000 400,000 29 Total Financing Making Decisions Using MCC n Graph IRRs of potential projects Graph MCC Curve Marginal weighted cost of capital curve: 11.72% Weighted Cost of Capital 12% 11.34% 11% Project 1 IRR = Project 2 Project 3 10% 12.4% IRR = IRR = 12.1% 11.5% 9% 0 100,000 200,000 300,000 400,000 30 Total Financing Making Decisions Using MCC n Graph IRRs of potential projects n Graph MCC Curve v Choose projects whose IRR is above the weighted marginal cost of capital Marginal weighted cost of capital curve: 11.72% Weighted Cost of Capital 12% 11.34% 11% Project 1 IRR = Project 2 Project 3 10% 12.4% IRR = IRR = 12.1% 11.5% 9% Accept Projects #1 & #2 0 100,000 200,000 300,000 400,000 31 Total Financing MCC and Capital Budgeting Decisons n See pages 250 – 256 n Calculate the breakpoints Calculate the new MCC’s Plot MCC’s and Investment Projects n See Figures 9-5 and 9-6 for results n Do all the Self-test problems before doing the homework

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