Sie sind auf Seite 1von 75

Chapter 9

The Cost of Capital

Understand the basic concept and sources of


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

Basic Skills: (Time value of money,


Financial Statements)

Investments: (Stocks, Bonds, Risk and


Return)

Later:
Corporate Finance: (The Investment
Decision - Capital Budgeting)

The investment decision

Assets
Current Assets
Fixed Assets

Liabilities & Equity


Current Liabilities
Long-term Debt
Preferred Stock
Common Equity

The financing decision

Assets
Current Assets
Fixed Assets

Liabilities & Equity


Current Liabilities
Long-term Debt
Preferred Stock
Common Stocks
Retained Earnings

Assets
Current Assets

Liabilities & Equity


Current Liabilities

Fixed Assets

Long-term Debt
Preferred Stock
Common Equity

Bonds
Preferred Stock
Common Equity

Each of these offers a rate of return to


investors.
This return is a cost to the firm.

Cost of capital actually refers to the


weighted cost of capital (WACC) - a
weighted average cost of financing
sources.
8

The cost of capital represents the firms cost of financing, and


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.

Most firms attempt to maintain an optimal mix of debt and


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.

A firm is currently faced with an investment


opportunity. Assume the following:
Best project available today
Cost = RM100,000
Life = 20 years
Expected Return = 7%

Least costly financing source available


Debt = 6%

Because it can earn 7% on the investment of funds costing


only 6%, the firm undertakes the opportunity.

10

Imagine that 1 week later a new investment opportunity


is available:
Best project available 1 week later
Cost = RM100,000
Life = 20 years
Expected Return = 12%

Least costly financing source available


Equity = 14%

In this instance, the firm rejects the opportunity, because the


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

11

What if instead the firm used a combined cost of


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

Most firms raise capital with a combination of debt,


equity, and hybrid securities.

WACC incorporates the required rates of return of the


firms lenders and investors and the particular mix of
financing sources that the firm uses.

13

We know that the return earned on assets depends on


the risk of those assets

The return to an investor is the same as the cost to the


company

Our cost of capital provides us with an indication of


how the market views the risk of our assets

Knowing our cost of capital can also help us determine


our required return for capital budgeting projects

14

The cost of debt is the required return on the


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

The pretax cost of debt is the financing cost associated with


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.

Underwriting costscompensation earned by investment bankers


for selling the security.
Administrative costsissuer expenses such as legal, accounting,
and printing.

16

The before-tax cost of debt, rd, is simply the rate of


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

Suppose ABC bond issue currently outstanding that has 25 years


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

Approximating the cost

where

I = annual interest in dollars


Nd = net proceeds from the sale of debt (bond)
n = number of years to the bonds maturity

19

For the issuing firm, the cost of debt is:


the rate of return required by the
creditors,
adjusted

for flotation costs (any costs


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

With debt, there is a tax savings of RM17,000


21

1-

= Before-tax
After-tax
Marginal cost of
cost of
tax
Debt
Debt
rate

rd

rd (1 - T)

***RM 17,000 = RM50,000 (1-0.34)


22

ABC bond with 25 years to maturity, has a coupon


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%.

What is the after-tax cost of debt ?

23

Price F = INT (PVIFA rd,n) + M (PVIF rd,n)


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

RM858.72 = RM45 (PVIFA rd, 50 ) + RM1000 (PVIF rd, 50 )


rd = 5.31%

YTM = 5.31 x 2 = 10.62%

But what we want is the after-tax cost of debt !


Therefore : rd (1-T) = 10.62% (1-0.30)
= 7.43%

24

Duchess Corporation, a major hardware manufacturer,


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

Approximating the cost

26

Duchess Corporation has a 40% tax rate. Using the


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

Preferred stock gives preferred stockholders the right to


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.

The cost of preferred stock, rp, is the ratio of the preferred


stock dividend to the firms net proceeds from the sale of
preferred stock.

28

Preferred stock generally pays a constant dividend each period


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

If ABC also issues preferred stock, it will pay


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

= RM8/ (RM75 RM1) = 10.81%

30

Duchess Corporation is contemplating the issuance of a


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

The cost of common stock, rs, is the rate at which


investors discount the expected dividends of the firm to
determine its share value.

There are two sources of Common Equity:


1) Internal common equity
(retained earnings).
2) External common equity
(new common stock issue).

Do these two sources have the same cost?


32

The cost of common stock is the return required by


equity investors given the risk of the cash flows from
the firm
Business risk
Financial risk

There are two major methods for determining the cost


of stock
Constant growth model
CAPM

33

The constant-growth valuation (Gordon) model assumes that


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

=
=
=
=

value of common stock


per-share dividend expected at the end of year 1
required return on common stock
constant rate of growth in dividends
34

Solving for rs results in the following expression for the


cost of common stock equity:

The equation indicates that the cost of common stock


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

Suppose that ABC is expected to pay a dividend of


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

Duchess Corporation wishes to determine its cost of common


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

We can calculate the annual rate at which dividends


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

The capital asset pricing model (CAPM) describes the


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

Another difference is that when the constant-growth


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

Suppose ABC has an equity beta of 0.6 and the


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%

Since we came up with similar numbers using both the


constant growth model and the SML approach, we should
feel pretty good about our estimate

42

Duchess Corporation now wishes to calculate its cost of


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

The cost of retained earnings, rr, is the same as the


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

Since the stockholders own the firms retained


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

Retained Earnings vs. Reinvesting Earnings


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

The cost of a new issue of common stock, rn, is the


cost of common stock, net of underpricing and
associated flotation costs.

New shares are underpriced if the stock is sold at a


price below its current market price, P0.

47

We can use the constant-growth valuation model


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

The net proceeds from sale of new common stock, Nn,


will be less than the current market price, P0.

Therefore, the cost of new issues, rn, will always be


greater than the cost of existing issues, rs, which is
equal to the cost of retained earnings, rr.

The cost of new common stock is normally greater


than any other long-term financing cost.
49

To determine its cost of new common stock, rn, Duchess


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

The weighted average cost of capital (WACC), ra,


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

Three important points should be noted in the equation for ra:


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

Book Value Weights


use accounting value for each type of capital

Market Value Weights


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

N = market value of common stock = # of outstanding shares


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

Suppose ABC needs RM985 million financing which


will come from common equity with a market value of
RM500 million, preferred stock = RM10 million and a
market value of debt = RM475 million.

What are the capital structure weights of ABC?


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 = wd rd (1-T) + wprp + wsrs


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

In earlier examples, we found the costs of the various types of


capital for Duchess Corporation to be as follows:

Cost of debt, ri = 5.6%


Cost of preferred stock, rp = 10.6%
Cost of retained earnings, rr = 13.0%
Cost of new common stock, rn = 14.0%

The company uses the following weights in calculating its


weighted average cost of capital:
Long-term debt = 40%
Preferred stock = 10%
Common stock equity = 50%

58

59

Using the WACC as our discount rate is only


appropriate for projects that have the SAME RISK as
the firms current operations

If we are looking at a project that does NOT have the


same risk as the firm, then we need to determine the
appropriate discount rate for that project

Divisions also often require separate discount rates

60

Suppose the Conglomerate Company has a cost of capital, based on the


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

When evaluating a new electrical generation investment,


which cost of capital should be used?

61

Project IRR

SML

24%

Investments in hard drives


or auto retailing should
have higher discount rates.

17%
10%

Projects risk (b)


0.6

1.3

2.0

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

10% reflects the opportunity cost of capital on an investment in electrical


generation, given the unique risk of the project.
62

Assume the WACC = 15%


Project
A
B
C

Required Return
20%
15%
10%

IRR
17%
18%
12%

What would happen if we use the WACC for all


projects regardless of risk?

63

SM
L

rF FIRM ( rM rF )

The SML can tell us why:

Hurdle
rate

Incorrectly accepted
negative NPV projects

Incorrectly rejected positive


NPV projects

rF

Firms risk (beta)

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

essentially the cost of another unit of capital raised.

As more capital is raised, the marginal cost of capital


rises.

65

Supposed we computed a companys weighted average


cost of capital as follows:

WACC = (wd)(rd)(1-t) + (wp)(rs) + (ws)(rr)


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

This cost of capital will remain unchanged as new debt,


preferred stock and retained earnings are issued until the
company's retained earnings are depleted.

Once retained earnings are depleted, the company decides to


access the capital markets to raise new equity.

Assume the company's stock is selling for RM40, next year's


dividend is RM2.00 and the company dividend growth rate is
7%.

Additionally, assume the company has a flotation cost of 5%.

67

The cost of new equity (rn) is thus 12.3%,


rn =

2
+ 0.07 = 0.123, or 12.3%
40(1-0.05)

Using this new cost of equity, we can determine the WACC as


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

When retained earnings have been depleted and new


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:

Breakpoint for retained earnings = retained earnings


ws

70

Assume the company expects to earn RM50 million


after-tax earnings next year. If the dividend payout
ratio is 30%.

If we assume ws = 55%, the break point on the


marginal cost curve is
RE Breakpoint = RM50 mil (1-0.3) = RM63.6 mil
0.55

71

Thus, the company raises roughly RM63.6 million of total


capital through internal fund, new common equity will need to
be issued and the WACC will increase to 8.6%.

RM63.6 mil

72

A ranking of possible investments ranging from best


(highest return) to worst(lowest return)

The first project selected will have the highest return,


next
project is the second highest and this
arrangement of the decreasing return on investments
continues.

Assumes independent investment projects

73

Assume the firm has identified 3 potential projects


Project
A
B
C

IRR
8.7%
9.5%
8.0%

Initial Investment
RM40 mil
RM35 mil
RM25mil

These projects need to be ranked according to the returns


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

Which projects will be


selected?

RM35 mil

RM75 mil

RM100 mil
75