Cost Of Capital

The Cost of CapitalElvira E. OngyMaster in Management major in Business ManagementDept. of Business ManagementVisayas State UniversityViSCA, Baybay, Philippines 6521-A

Learning GoalsCost of CapitalUnderstand the key assumptions , the basic concept, and the specific sources of capital associated with the cost of capitalDetermine the cost of long-term debt and the cost of preferred stockCalculate the cost of common stock equity and convert it into the cost of retained earnings and the cost of new of common stock

Learning GoalsCost of CapitalCalculate the weighted average cost of capital (WACC) and discuss weighing alternative schemes.Describe the procedures used to determine break points and the weighted marginal cost of capital (WMCC)Explain the WMCC and its use with the investment opportunities schedule (IOS) to make financing investment decisions.

OverviewCost of CapitalCost of capitalThe rate of return that a firm must earn on the projects in which it invests to maintain its market value and attract funds.

Key AssumptionsCost of CapitalThe risk to the firm of being unable to cover operating costs-is assumed unchangedBusiness RiskFinancial RiskThe risk to the firm of being unable to cover required financial obligations – is assumed to be unchangedAfter-tax costs are considered relevantThe cost of capital is measured on an after-tax basis.

Sample ProblemCost of CapitalA firm is currently faced with an investment opportunity.Best project available todayBest project 1 week laterCost = $100,000Life = 20 yearsIRR = 12%Cost = $100,000Life = 20 yearsIRR = 7%Cost of least-cost financing source availableCost of least-cost financing source availableDebt = 6%Debt = 14%Decision: The firm rejects the opportunity because the 14% financing cost is greater than the 12% expected return.Decision: The firm undertakes the opportunity because it can earn 7% on the investment of funds costing only 6%.

Sample ProblemCost of CapitalQuestion?Were the firm’s actions in the best interests of its owners?The answer is……NO. It accepted a project yielding a 7% return and rejected one with a 12% return.

Sample ProblemCost of CapitalClearly, there should be a better way, and there is:The firm can use a combined cost, which over the long run will yield better decisions.By weighting the cost of each source of financing by its target proportion in the firm’s capital structure, the firm can obtain a weighted average cost that reflects the interrelationship of financing decisions.

Sample ProblemCost of CapitalAssuming that a 50-50 mix of debt and equity is targeted, the weighted average cost here would be 10% ((0.5 X 6% debt) + (0.50X14% equity))With this cost, the first opportunity would have been rejected (7% IRR < 10% weighted average cost)The second would have been accepted(12% IRR > 10% weighted average cost)Such as an outcome would clearly be more desirable.

Specific Sources of CapitalCost of CapitalBasic sources of long-term funds for the business firm:Long-term debtPreferred stockCommon stockRetained earnings

Cost of Long-Term DebtCost of CapitalCost of long-term debt (ri)The after-tax cost today of raising long-term funds through borrowing. Net Proceeds

After-Tax Cost of DebtNet ProceedsCost of CapitalNet proceedsfunds actually received from the sale of securityFloatation coststhe total costs of issuing and selling a security-reduce the net proceeds from the sale.These costs apply to all public offerings of securities – debt, preferred stock, and common stock.(1) Underwriting costs – compensation earned by investment bankers for selling the security(2) Administrative costs – issuer expenses such as legal, accounting, printing, and other expenses

Net Proceeds..exampleCost of CapitalDuchess Corp., a major hardware manufacturer, is contemplating selling $10 million worth of 20-year, 9% coupon (stated annual interest rate0 bonds, each with a par value of $1,000. Because similar risk bonds earn returns greater than 9%, the firm must sell the bonds for $980 to compensate for the lower coupon interest rate. The floatation costs are 2% of the par value of the bond (0.02 X $1,000), or $20.Then the net proceeds to the firm from the sale of each bond are therefore $960 ($980-$20).

Before-Tax Cost of DebtCost of CapitalBefore-tax cost of debt(rd) for a bond can be obtained in 3 ways:Approximating the CostCalculating the CostUsing Cost QuotationsCan be calculated using the formulaThis approach finds the before-tax cost of debt by calculating the IRR on the bond cash flows. This value is the cost to maturity of the cash flows associated with the debt. When the net proceeds from sale of a bond equal its par value, the before-tax cost just equals the coupon interest rate .Nd-Par valueI+nrd=Nd+Par value2A bond with a 10% coupon interest rate that nets proceeds equal to the bond’s $1,000 par value would have a before-tax cost, rd, of 10%.Where:I = annual interestNd = net proceeds from the sale of debt (bond)n = no. of years to the bond’s maturityCalculated by: Financial calculator, an electronic calculator, or trial-and-error technique. It represents the annual before-tax percentages cost of the debt.

Before-Tax Cost of Debt..exampleCost of CapitalCalculating the CostIn the preceding example, the net proceeds of a $1,000, 9% coupon interest rate, 20-year bond were found to be $960. The calculation of the annual cost is quite simple. The cash flow pattern is exactly the opposite of a conventional pattern; it consists of an initial inflow (the net proceeds) followed by a series of annual outlays (the interest payments). In the final year, when the debt is retired, an outlay representing the repayment of the principal also occurs. The cash flows associated with Duchess Corp.’s bond issue are as follows;Spreadsheet Analysis

Before-Tax Cost of Debt..exampleCost of CapitalApproximating the CostThe before-tax cost of debt, rd, for a bond with a $1,000 par value can be approximated by using the following equation:Where:I = annual interestNd = net proceeds from the sale of debt (bond)n = no. of years to the bond’s maturityBy substituting the values, this approximate before-tax cost of debt is 9.4% which is close to 9.452 value calculated precisely in the preceding example

After-Tax Cost of DebtCost of CapitalThe specific cost of financing must be stated on an after-tax basis. Because interest on debt is tax deductible, it reduces the firm’s taxable income. The after-tax cost of debt, ri, can be found by:ri = rd X ( 1 - T )

After-Tax Cost of Debt..exampleCost of CapitalDuchess Corp. has a 40% tax rate . Using the 9.4 before-tax debt cost calculated, and using the equation ri = rd X ( 1 - T ), we find an after-tax cost of debt of 5.6% (9.4% X (1-0.40)). Typically, the cost of long-term debt is less than a given firm’s cost of any of the alternative forms of long-term financing, primarily because of the tax deductibility of interest.

Cost of Preferred StockCost of CapitalPreferred stock represents a special type of ownership interest in the firm. It gives preferred stockholders the right to receive their stated dividends before the firm can distribute any earnings to common stockholders.Because the preferred stock is a form of ownership, the proceeds from its sale are expected to be held for an infinite period of time.

Cost of Preferred StockCost of CapitalCalculating the Cost of Preferred StockThe cost of preferred stock, rp, is the ratio of the preferred stock dividend to the firm’s net proceeds from the sale of the preferred stock. The net proceeds represent the amount of money to be received minus any floatation costsWhere:Dp = Annual dollar dividendNp = Net proceeds from the sale of the stockrp = Dp / NpBecause preferred stock dividends are paid out of the firm’s after-tax cash flows, a tax adjustment is not required.

Cost of Preferred Stock..exampleCost of CapitalDuchess Corp. is contemplating issuance of a 10% preferred stock that is expected to sell for its $87-per-share par value. The cost of issuing and selling the stock is expected to be $5 per share. Find the cost of the stock.Solution:Calculate the dollar amount of the annual preferred dividend Dp= $8.70 = (0.10 X $87)The net proceeds per share from the proposed sale of stock equals the sale price minus the floatation costsNp = $82 = $87 - $5Substituting the values in the formula, rp = 10.6% = $8.70/$82

Cost of Common StockCost of CapitalThe cost of preferred stock is the return required on the stock by investors in the marketplace.2 Forms of common stock financingRetained EarningsNew issues of common stock

Cost of Common StockCost of CapitalFinding the Cost of Common Stock EquityThe cost of common stock equity, rs , is the rate at which investors discount the expected dividends of the firm to determine its share value.Two techniques are used for its measurement:Constant-growth valuation modelCapital Asset Pricing Model (CAPM)

Cost of Common StockCost of CapitalUsing the Constant-Growth Valuation (Gordon) ModelConstant-growth valuation or 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 is expected to provide over an infinite time horizon.Where:P0= value of common stockD1= per-share dividend expected at the end of year 1rs= required return on common stock (cost of common stock equity)g= constant rate of growth in dividendsP0 = D1 / (rs –g)rs = (D1/P0) + g

Cost of Common StockCost of CapitalUsing the Capital Asset Pricing Model (CAPM)CAPM– describes the relationship between the required return, rs, and the non-diversifiable risk of the firm as measure by the beta coefficient, b.Where:RF= risk-free rate of returnrm= market rater return; return on the market portfolio of assetsrs= RF + (b X (rm –rF ))Using CAPM indicates that the cost of common stock equity is the return required by investors as compensation for the firm’s non-diversifiable risk, measured by beta.

Cost of Common StockCost of CapitalCost of Retained Earnings (rr)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.Cost of New Issues of Common Stock (rn)The cost of common stock, net of under-pricing and associated floatation costs.Underpriced – stock sold at a price below its current market price, P0Where:Nn= net proceeds from sale of new common stockD1= per-share dividend expected at the end of year 1g= constant rate of growth in dividendsrn= (D1/Nn)+g)

Weighted Average Cost of Capital Cost of CapitalThe weighted average cost of capital (WACC), ra , reflects the expected average future cost of funds over the long run. It is found by weighting the cost of each specific type of capital by its proportion in the firm’s capital structure.

Weighted Average Cost of Capital Cost of CapitalCalculating Weighted Average Cost of Capital (WACC)ra= (wiX ri) + (wpX rp) + (wsX rr or n) Where:wi= proportion of long-term debt in capital structurewp= proportion of preferred stock in capital structurews= proportion of common stock equity in capital structurewi+wp+ ws= 1.0ri= cost of debtrp= cost of preferred stockrr= cost or retained earningsrn= cost of new common stock

Weighted Average Cost of Capital..example Cost of CapitalThe company uses the ff. weights in calculating its weighted average cost of capital:Costs of the various types of capital for Duchess Corp.: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%Assuming an unchanged risk level, the firm should accept all projects that will earn a return greater than 9.8%.

Weighted Average Cost of CapitalCost of CapitalWeighting SchemesBook Value Vs. Market ValueBook value weights use accounting values to measure the proportion of each type of capital in the firm’s financial structure while market value weights measure the proportion of each type of capital at its market value.

Market value weights are appealing, because the market values of securities closely approximate the actual dollars to be received from their sale.

Market value weights are clearly preferred over book value weightsWeighted Average Cost of CapitalCost of CapitalWeighting SchemesHistorical Vs. TargetHistorical weights can be either book or market value weights based on actual capital structure proportions while target weights, which can also be based on either book or market values, reflect the firm’s desired capital structure proportions.

The preferred weighing scheme is target market value proportions.Weighted Average Cost of Capital..exampleCost of CapitalChuck Solis currently has 3 loans outstanding, all of which mature in exactly 6 yrs and can be repaid w/o penalty any time prior to maturity. The outstanding balances and annual interest rates on these loans are noted below.After a thorough search, Chuck found a lender who would loan him $80,000 for 6 yrs at annual interest rate 9.2% on the condition that the loan proceeds be used to fully pay the 3 outsatnding loans, which combined have an outstanding balance of $80,000.

Weighted Average Cost of Capital..exampleCost of CapitalChuck Solis currently has 3 loans outstanding, all of which mature in exactly 6 yrs and can be repaid w/o penalty any time prior to maturity. The outstanding balances and annual interest rates on these loans are noted below.After a thorough search, Chuck found a lender who would loan h$80,000 for 6 yrs at annual interest rate 9.2% on the condition that the loan proceeds be used to fully pay the 3 outstanding loans, which combined have an outstanding balance of $80,000. Chuck wishes to choose the less costly alternative: (1) do nothing or (2) borrow the $80,000 and pay off all three loans.

Weighted Average Cost of Capital..exampleCost of CapitalANALYSIS:Calculates the weighted average cost of Chuck’s current debt by weighing each debt’s annual interest cost by the proportion of the $80,000 total it represents and summing the 3 weighted values.Using the formula, the weighted average cost of current debt is,Given that the weighted ave. cost of the $80,000 of current debt of 8.5% is below the 9.2% cost of the new $80,000 loan, Chuck should do nothing, and just continue to pay off the 3 loans as originally scheduled .ra= ($26,000/$80,000/9.6%i) + ($9,000/$80,000X10.6%) + ($45,000/$80,000,7.4%) ra= (0.3250/9.6%i) + (0.1125/$80,000X10.6%) + (0.5625/$80,000,7.4%) ra= 3.12% + 1.19% + 4.16% = 8.5%

Marginal Cost and Investment DecisionsCost of CapitalWeighted Marginal Cost of Capital (WMCC)WMCC– the firm’s weighted average cost of capital (WACC) associated with its next dollar of total new financing.How to calculate WMCC?1. Calculate break points, which reflect the level of total new financing at which the cost of one of the financing component arises.Where:BPj= break-point for financing source jAFj= amt of funds available from financing source j at a given costWj= capital structure weight (stated in decimal form) for financing sourcesBPj= AFj/ Wj

Marginal Cost and Investment DecisionsCost of CapitalHow to calculate WMCC…..?2. Calculate WACC, for a level of total new financing bet. break points.First, we find the WACC for a level of total new financing bet. Zero and the first break point.

Second, we find the WACC for a level of total new financing bet. the first and second break points, and so on.3. Together, the data computed above can be used to prepare a weighted marginal cost of capital (WACC) schedule. This graph relates the firm’s weighted average cost of capital to the level of total new financing.

Marginal Cost and Investment Decisions..exampleCost of CapitalProblem: When Duchess Corp. exhausts its $300,000 of available retained earnings (at rr=13%), it must use the more expensive new common stock financing (at rn=14%) to meet its common stock equity needs. In addition, the firm expects that it ca borrow only $400,000 of debt at the 5.6% costs; additional debt will have an after-tax cost (ri) of 8.4%.Analysis: 2 break points therefore exists: (1) when the $300,000 of retained earnings costing 13% is exhausted, (2) when the $400,000 of a long-term debt costing 5.6% is exhausted.Using the formula,BPcommon equity= $300,000/ 0.5 = $600,000BPlong-term debt= $400,000/ 0.4= $1,000,000

Marginal Cost and Investment Decisions..exampleCost of CapitalAnalysis…contComputing for the WACC:

Cost Of Capital

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Cost Of Capital