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capital associated with the cost of capital

Determine the cost of long-term debt, and explain

why after-tax cost of debt is the relevant cost of

debt.

Determine the cost of preferred stock

Determine the cost of common stock equity

Calculate the weighted average cost of capital

(WACC)

Explain what is meant by the marginal cost of

capital

Determine the weighted marginal cost of capital

(WMCC)

7-2

Financial Statements)

Return)

Later:

Corporate Finance: (The Investment

Decision - Capital Budgeting)

Assets

Current Assets

Fixed Assets

Current Liabilities

Long-term Debt

Preferred Stock

Common Equity

Assets

Current Assets

Fixed Assets

Current Liabilities

Long-term Debt

Preferred Stock

Common Stocks

Retained Earnings

Assets

Current Assets

Current Liabilities

Fixed Assets

Long-term Debt

Preferred Stock

Common Equity

Bonds

Preferred Stock

Common Equity

investors.

This return is a cost to the firm.

weighted cost of capital (WACC) - a

weighted average cost of financing

sources.

8

is the minimum rate of return that a project must earn to

increase firm value.

Financial managers are ethically bound to only invest in projects that

they expect to exceed the cost of capital.

The cost of capital reflects the entirety of the firms financing activities.

equity financing.

To capture all of the relevant financing costs, assuming some desired

mix of financing, we need to look at the overall cost of capital rather

than just the cost of any single source of financing.

opportunity. Assume the following:

Best project available today

Cost = RM100,000

Life = 20 years

Expected Return = 7%

Debt = 6%

only 6%, the firm undertakes the opportunity.

10

is available:

Best project available 1 week later

Cost = RM100,000

Life = 20 years

Expected Return = 12%

Equity = 14%

14% financing cost is greater than the 12% expected return.

11

financing?

Assuming that a 5050 mix of debt and equity is targeted,

the weighted average cost here would be:

(0.50 6% debt) + (0.50 14% equity) = 10%

With this average cost of financing, the first opportunity

would have been rejected (7% expected return < 10%

weighted average cost), and the second would have been

accepted

(12% expected return > 10% weighted average cost).

12

equity, and hybrid securities.

firms lenders and investors and the particular mix of

financing sources that the firm uses.

13

the risk of those assets

company

how the market views the risk of our assets

our required return for capital budgeting projects

14

companys debt

We usually focus on the cost of long-term debt or

bonds

The required return is best estimated by computing

the yield-to-maturity on the existing debt

The cost of debt is NOT the coupon rate

15

new funds through long-term borrowing.

Typically, the funds are raised through the sale of corporate bonds.

Net proceeds are the funds actually received by the firm from

the sale of a security.

Flotation costs are the total costs of issuing and selling a

security. They include two components:

1.

2.

for selling the security.

Administrative costsissuer expenses such as legal, accounting,

and printing.

16

return the firm must pay on new borrowing.

The before-tax cost of debt can be calculated in any

one of three ways:

1. Using market quotations: observe the yield to maturity

(YTM) on the firms existing bonds or bonds of similar

risk issued by other companies

2. Calculating the cost: find the before-tax cost of debt by

calculating the YTM generated by the bond cash flows

3. Approximating the cost

17

left to maturity. The coupon rate is 9% and coupons are paid

semiannually. The bond has a par value of RM1000 and is

currently selling for RM908.72. What is the cost of debt?

RM908.72= RM45 (PVIFA rd, 50 ) + RM1000 (PVIF rd, 50 )

rd = 5%

YTM = 5% x 2 = 10%

18

where

Nd = net proceeds from the sale of debt (bond)

n = number of years to the bonds maturity

19

the rate of return required by the

creditors,

adjusted

associated with issuing new bonds), We

only receive NET PROCEEDS

adjusted

for taxes.

20

EBIT

- interest expense

EBT

- taxes (34%)

EAT

- dividends

Retained earnings

with stock

400,000

0

400,000

(136,000)

264,000

(50,000)

214,000

with debt

400,000

(50,000)

350,000

(119,000)

231,000

0

231,000

21

1-

= Before-tax

After-tax

Marginal cost of

cost of

tax

Debt

Debt

rate

rd

rd (1 - T)

22

rate of 9% and coupons are paid semiannually. The

bond has a par value of RM1000 and is currently

selling for RM908.72, but flotation costs amount to

RM50 per bond. The marginal tax rate is 30%.

23

RM908.72 - RM50= RM45 (PVIFA rd, 50 ) + RM1000 (PVIF rd, 50 )

rd = 5.31%

Therefore : rd (1-T) = 10.62% (1-0.30)

= 7.43%

24

is contemplating selling $10 million worth of 20-year,

9% coupon bonds with a par value of $1,000. Because

current market interest rates are greater than 9%, the

firm must sell the bonds at $980. Flotation costs are 2%

or $20. The net proceeds to the firm for each bond is

therefore $960 ($980 $20).

25

26

9.388% before-tax debt cost calculated above, we find

an after-tax cost of debt of 5.63% [9.39% (1 0.40)].

Typically, the cost of long-term debt for a given firm is

less than the cost of preferred or common stock, partly

because of the tax deductibility of interest.

27

receive their stated dividends before the firm can distribute

any earnings to common stockholders.

Most preferred stock dividends are stated as a dollar amount.

Sometimes preferred stock dividends are stated as an annual percentage

rate, which represents the percentage of the stocks par, or face, value

that equals the annual dividend.

stock dividend to the firms net proceeds from the sale of

preferred stock.

28

Dividends are expected to be paid every period forever

rP = DP / P0

Since preferred stock is an external financing, we

should consider flotation costs associated with issuing

preferred stock

29

a dividend of RM8 per year and should be

valued at RM75 per share. If flotation costs

amount to RM1 per share, what is the cost of

preferred stock for ABC?

rP

30

10% preferred stock that is expected to sell for its

RM87 per share value. The cost of issuing and selling

the stock is expected to be RM5 per share. The dividend

is RM8.70 (10% RM87). The net proceeds price (Np)

is RM82 (RM87 RM5).

rP = DP/Np = RM8.70/RM82 = 10.6%

31

investors discount the expected dividends of the firm to

determine its share value.

1) Internal common equity

(retained earnings).

2) External common equity

(new common stock issue).

32

equity investors given the risk of the cash flows from

the firm

Business risk

Financial risk

of stock

Constant growth model

CAPM

33

the value of a share of stock equals the present value of all future

dividends (assumed to grow at a constant rate) that it is expected

to provide over an infinite time horizon.

where

P0

D1

rs

g

=

=

=

=

per-share dividend expected at the end of year 1

required return on common stock

constant rate of growth in dividends

34

cost of common stock equity:

equity can be found by dividing the dividend expected

at the end of year 1 by the current market price of the

stock (the dividend yield) and adding the expected

growth rate (the capital gains yield).

35

RM1.50 per share next year. There has been a steady

growth in dividends of 5.1% per year and the market

expects that to continue. The current price of ABC

stock is RM25. If ABC were to issue additional shares,

the company has to pay RM1 flotation cost per share.

What is the cost of equity?

1.50

rs

.051 .1135 11.35%

(25 1)

36

stock equity, rs. The market price, P0, of its common stock is $50

per share. The firm expects to pay a dividend, D1, of $4 at the end

of the coming year, 2013. The dividends paid on the outstanding

stock over the past 6 years (20072012) were as follows:

37

have grown, g, from 2007 to 2012. It turns out to be

approximately 5% (more precisely, it is 5.05%).

Substituting D1 = $4, P0 = $50, and g = 5% into the

previous equation yields the cost of common stock

equity:

rs = ($4/$50) + 0.05 = 0.08 + 0.05 = 0.130, or 13.0%

38

relationship between the required return, rs, and the

nondiversifiable risk of the firm as measured by the beta

coefficient, b.

rs = RF + [b (rm RF)]

where

RF = risk-free rate of return

rm = market return; return on the market portfolio of

assets

39

The CAPM technique differs from the constantgrowth valuation model in that it directly considers the

firms risk, as reflected by beta, in determining the

required return or cost of common stock equity.

The constant-growth model does not look at risk; it

uses the market price, P0, as a reflection of the

expected riskreturn preference of investors in the

marketplace.

The constant-growth valuation and CAPM techniques

for finding rs are theoretically equivalent, though in

practice estimates from the two methods do not always

agree.

40

valuation model is used to find the cost of common

stock equity, it can easily be adjusted for flotation

costs to find the cost of new common stock; the

CAPM does not provide a simple adjustment

mechanism.

The difficulty in adjusting the cost of common stock

equity calculated by using CAPM occurs because in

its common form the model does not include the

market price, P0, a variable needed to make such an

adjustment.

41

current risk-free rate is 6.1%. If the expected market

risk premium is 8.6%, what is the cost of equity

capital?

rs = 6.1 + 0.61 (8.6) = 11.35%

constant growth model and the SML approach, we should

feel pretty good about our estimate

42

common stock equity, rs, by using the capital asset

pricing model. The firms investment advisors and its

own analysts indicate that the risk-free rate, RF, equals

7%; the firms beta, b, equals 1.5; and the market return,

rm, equals 11%.

Substituting these values into the CAPM, the company

estimates the cost of common stock equity, rs, to be:

rs = 7.0% + [1.5 (11.0% 7.0%)] = 7.0% + 6.0% = 13.0%

43

cost of an equivalent fully subscribed issue of additional

common stock, which is equal to the cost of common

stock equity, rs.

rr = rs

The cost of retained earnings for Duchess Corporation

was actually calculated in the preceding examples: It is

equal to the cost of common stock equity. Thus rr equals

13.0%.

44

earnings, the cost is simply the stockholders

required rate of return.

Why?

Opportunity costs

If managers are investing stockholders funds,

stockholders will expect to earn an acceptable rate

of return.

45

Technically, if a stockholder received dividends and wished

to invest them in additional shares of the firms stock, he or

she would first have to pay personal taxes on the dividends

and then pay brokerage fees before acquiring additional

shares.

By using pt as the average stockholders personal tax rate

and bf as the average brokerage fees stated as a percentage,

we can specify the cost of retained earnings, rr, as

rr = rs (1 pt) (1 bf).

46

cost of common stock, net of underpricing and

associated flotation costs.

price below its current market price, P0.

47

expression for the cost of existing common stock, rs, as

a starting point. If we let Nn represent the net proceeds

from the sale of new common stock after subtracting

underpricing and flotation costs, the cost of the new

issue, rn, can be expressed as follows:

48

will be less than the current market price, P0.

greater than the cost of existing issues, rs, which is

equal to the cost of retained earnings, rr.

than any other long-term financing cost.

49

Corporation has estimated that on average, new shares

can be sold for $47. The $3-per-share underpricing is

due to the competitive nature of the market. A second

cost associated with a new issue is flotation costs of

$2.50 per share that would be paid to issue and sell the

new shares.

rn = ($4.00/$44.50) + 0.05 = 0.09 + 0.05 = 0.140, or 14.0%

50

reflects the expected average future cost of capital over

the long run; found by weighting the cost of each

specific type of capital by its proportion in the firms

capital structure.

ra = (wi ri) + (wp rp) + (ws rr or n)

where

wi = proportion of long-term debt in capital structure

wp = proportion of preferred stock in capital structure

ws = proportion of common stock equity in capital

structure

wi + wp + ws = 1.0

51

1. For computational convenience, it is best to convert the weights into

decimal form and leave the individual costs in percentage terms.

2. The weights must be non-negative and sum to 1.0. Simply stated,

WACC must account for all financing costs within the firms capital

structure.

3. The firms common stock equity weight, ws, is multiplied by either the

cost of retained earnings, rr, or the cost of new common stock, rn.

Which cost is used depends on whether the firms common stock

equity will be financed using retained earnings, rr, or new common

stock, rn.

52

use accounting value for each type of capital

Based on the market value of each type of capital

Historical Weights

based on actual capital structure proportions.

Target Weights

Reflects the firms desired capital structure proportion.

53

times price per share

D = market value of debt = # of outstanding bonds times bond

price

P= market value of preferred stock = # of outstanding shares

times price per share

V = market value of the firm = D + P + N

Weights

wN = N/V = percent financed with common equity

wp = P/V = percent financed with preferred stock

wd = D/V = percent financed with debt

54

will come from common equity with a market value of

RM500 million, preferred stock = RM10 million and a

market value of debt = RM475 million.

V = 500 mil + 10 mil + 475 mil = 985 million

ws = S/V = 500 / 985 = .5076 = 50.76%

wp = P/V = 10 / 985 = .0102= 1.02%

wd = D/V = 475 / 985 = .4822 = 48.22%

55

WACC = wd rd (1-T) + wp rp + ws rs

56

Source

Cost

Capital

Structure

debt

preferred

common

10.62%

10.81%

11.35%

48.22 %

1.02 %

50.76 %

WACC = 0.4822(10.62%) (1-0.30) + 0.0102(10.81%) + 0.5076 (11.35%)

= 3.58% + 0.11% + 5.76% = 9.45%

57

capital for Duchess Corporation to be as follows:

Cost of preferred stock, rp = 10.6%

Cost of retained earnings, rr = 13.0%

Cost of new common stock, rn = 14.0%

weighted average cost of capital:

Long-term debt = 40%

Preferred stock = 10%

Common stock equity = 50%

58

59

appropriate for projects that have the SAME RISK as

the firms current operations

same risk as the firm, then we need to determine the

appropriate discount rate for that project

60

CAPM, of 17%. The risk-free rate is 4%, the market risk premium is 10%,

and the firms beta is 1.3.

17% = 4% + 1.3 10%

This is a breakdown of the companys investment projects:

1/3 Automotive Retailer b = 2.0

1/3 Computer Hard Drive Manufacturer b = 1.3

1/3 Electric Utility b = 0.6

average b of assets = 1.3

which cost of capital should be used?

61

Project IRR

SML

24%

or auto retailing should

have higher discount rates.

17%

10%

0.6

1.3

2.0

k = 4% + 0.6(14% 4% ) = 10%

generation, given the unique risk of the project.

62

Project

A

B

C

Required Return

20%

15%

10%

IRR

17%

18%

12%

projects regardless of risk?

63

SM

L

rF FIRM ( rM rF )

Hurdle

rate

Incorrectly accepted

negative NPV projects

NPV projects

rF

FIRM

A firm that uses one discount rate for all projects may over time increase the risk

of the firm while decreasing its value

64

rises.

65

cost of capital as follows:

WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) +

(0.55)(0.12)

WACC = 0.084, or 8.4%

We originally determined the WACC to be 8.4%.

66

preferred stock and retained earnings are issued until the

company's retained earnings are depleted.

access the capital markets to raise new equity.

dividend is RM2.00 and the company dividend growth rate is

7%.

67

rn =

2

+ 0.07 = 0.123, or 12.3%

40(1-0.05)

follows:

WACC = (wd)(rd)(1-T) + (wp)(rp) + (ws)(rn)

WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.123)

WACC = 0.086, or 8.6%

68

69

common stock has to be used. When this occurs, the

company's cost of capital increases. This is known as

the "breakpoint" and can be calculated as follows:

ws

70

after-tax earnings next year. If the dividend payout

ratio is 30%.

marginal cost curve is

RE Breakpoint = RM50 mil (1-0.3) = RM63.6 mil

0.55

71

capital through internal fund, new common equity will need to

be issued and the WACC will increase to 8.6%.

RM63.6 mil

72

(highest return) to worst(lowest return)

next

project is the second highest and this

arrangement of the decreasing return on investments

continues.

73

Project

A

B

C

IRR

8.7%

9.5%

8.0%

Initial Investment

RM40 mil

RM35 mil

RM25mil

Project

B

A

C

IRR

9.5%

8.7%

8.0%

Initial Investment

RM35 mil

RM40 mil

RM25mil

Cumulative Investment

RM 35 mil

RM 75 mil

RM100 mil

74

B (9.5%)

A (8.7%)

Investment

Opportunity Schedule

C (8.0%)

RM63.6 mil

selected?

RM35 mil

RM75 mil

RM100 mil

75

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