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Chapter 12_ The Cost of Capital

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Chapter 12_ The Cost of Capital Powered By Docstoc
					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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