Cost of Capital

The Purpose of the Cost of Capital

   The cost of capital is the average rate paid for the use of the firms capital funds Capital refers to money acquired for use over long periods
 Generally used to start businesses and acquire long-lived assets

The cost of capital provides a benchmark against which to evaluate investment returns
 Projects should not be undertaken unless they return more than the cost of the funds invested in them => the cost of capital. Project IRR exceeds the cost of capital Project NPV > 0 when calculated at the cost of capital

Rule is equivalent to
 

Capital Components
 A firms Capital Components are
   Debt
   Borrowed money, either loans or bonds Ownership interest A hybrid security, a cross between debt and equity

Common equity Preferred stock

Capital structure is the mix of the three capital components generally expressed in percentages

Capital Structure
 Target Capital Structure
 A mix of components that management considers optimal and strives to maintain

 Raising Money in the Proportions of the Capital Structure

 In cost of capital calculations, we assume money is raised in a constant proportion of debt, preferred and common equity
 Usually either the current or a target structure  Idea used despite being somewhat unrealistic
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Returns on Investments and the Costs of Capital Components

 Investors provide capital by purchasing securities
 Returns paid to investors adjusted for taxes and administrative expenses are the firms costs Leads to different investor returns for each component
 And different costs to the issuing firm for each component

The risk levels of Capital Component securities differ

    Equity is the riskiest investment, earns the highest return, and has the highest cost Debt is the safest investment, earns the lowest return, and costs the firm least Preferred Stock offers investors intermediate risk and return levels and has a cost between that of equity and debt
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The Weighted Average CalculationThe WACC

 A firms cost of capital is a weighted average of the costs of the three capital components where the weights reflect the $ amounts of each component in use  Referred to in two ways
 k, the cost of capital  WACC, for weighted average cost of capital

The Weighted Average Calculation

Example 13.1

Q: Calculate the WACC for the Zodiac Company given the following information about its capital structure.
Capital Component Debt Preferred Stock Common stock Value $60,000 50,000 90,000 $200,000 Cost 9% 11 14

Example

A: First calculate the capital structure weights based on the values given. For example the weight of debt is $60,000 z $200,000 = 30%. Next, each components cost is multiplied by its weight and the results are summed as shown:
Capital Component Debt Preferred Stock Common stock Value $60,000 50,000 90,000 $200,000 Weight 30% 25% 45% 100% Cost 9% 11 14 WACC = 2.70% 2.75% 6.30% 11.75%

Capital Structure and CostBook Versus Market Value

 We can think of the WACC in terms of either book or market values of capital components
 For both structure and component costs
 Which is the correct focus?

WACC used to evaluate next years capital projects

   Must be supported by capital raised next year Book values reflect capital raised and spent years ago Current market values represent our best estimate of next years capital market conditions For capital structure For component costs
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Market values are the appropriate basis for WACC

 

Capital Structure Customary Approach

 Structure: Assume the firm will either
 Maintain present capital structure based on the current market prices of its securities  Or strive to achieve some target structure also based on current market prices.

 Costs: Always use market-based component costs to develop the WACC.

Calculating the WACC

 Step 1: Develop a market-based capital structure  Step 2: Adjust market returns on the underlying securities to reflect the costs of the three capital component  Step 3: Combine in calculating the WACC

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Developing Market-Value-Based Capital Structures

Example 13.2

Q: The Wachusett Corporation has the following capital situation. Debt: Two thousand bonds were issued five years ago at a coupon rate of 12%. They had 30-year terms and $1,000 face values. They are now selling to yield 10%.

Example

Preferred stock: Four thousand shares of preferred are outstanding, each of which pays an annual dividend of $7.50. They originally sold to yield 15% of their $50 face value. They're now selling to yield 13%. Equity: Wachusett has 200,000 shares of common stock outstanding, currently selling at $15 per share. Develop Wachusett's market-value-based capital structure.
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Developing Market-Value-Based Capital Structures

Example 13.2

A: The market value of each capital component is the current price of each security multiplied by the number outstanding. The price of Wachusett's bonds in the market must be determined. We know the bonds have 25 years remaining until maturity, pay interest of $120 annually ($60 semi-annually) and are yielding 10% annually (5% semi-annually). Thus, each bond is selling for $1,182.55 in the market, calculated as shown below.
Pb = PMT[PVFAk,n] + FV[PVFk,n] = $60[PVFA5,50] + $1,000[PVF5,50] = $60(18.2559) + $1,000(0.0872) = $1,182.55

Example

Because there are 2,000 bonds outstanding, the market value of debt is $1,182.55 x 2,000 = $2,365,100
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Developing Market-Value-Based Capital Structures

Example 13.2

The firm's preferred stock represents a perpetuity that pays $7.50 annually and is yielding 13%. Thus, the value of each share of preferred stock is $7.50 / .13 = $57.69 And the total market value of Wachusett's preferred stock is $57.69 x 4,000 = $230,760

Example

Each share of Wachusett's common stock is trading at $15, thus the total market value of the firm's equity is $15 x 200,000 shares = $3,000,000 Next summarize and calculate the component weights: Debt Preferred Equity $2,365,100 230,760 3,000,000 $5,595,860 42.3% 4.1 53.6 100.0%
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Calculating Component Costs of Capital

 Begin with the market return received by new investors in each capital component
 kd, kp, and ke

 

Make adjustments for the effects of taxes and transaction costs to arrive at cost to the issuing firm Tax adjustment applies only to debt (Tax rate is T)
   Interest is tax deductible to the paying firm Cost of debt = kd (1 T) Debt, the cheapest source, made even cheaper by tax adjustment Apply to preferred and new sales of common equity Increases effective cost Cost of component = kp / (1 f) or ke / (1 f)

Flotation costs are a percentage of a securitys price (f)

  

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Cost of Debt
Example 13.3

Q. Blackstone Inc. has 12% coupon rate bonds outstanding that yield 8% to investors buying them now. Blackstones marginal tax rate including federal and state taxes is 37%. What is Blackstones cost of debt?

Example

A. First notice that kd is the current market yield of 8%, not the coupon rate. To calculate the cost of debt we simply write equation 13.1 and substitute from the information given. cost of debt = kd(1 - T) = .08(1 - .37) = 5.04%

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The Cost of Preferred Stock

Example 13.4

Q: The preferred stock of the Francis Corporation was issued several years ago with each share paying 6% of a $100 par value. Flotation costs on new preferred are expected to average 11% of the funds raised. (a) What is the cost of preferred if the return on similar issues is now 9%? (b) Calculate the cost of preferred if shares are selling at $75.

Example

A: (a) and (b) ask the same question in different situations and with different given information. In (a) we have the market return, and in (b) we have the information needed to calculate it . (a) cost of preferred = kp / (1 - f) = 9% / (1 - .11) = 10.1%. cost of preferred = Dp / (1 f) Pp = $6 / (1 - .11) $75 = 9.0%
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(b)

The Cost of Common Equity

 Unlike debt and preferred, the cost of common stock is not precise due to the uncertainty of future equity cash flows
 The market return on common equity is estimated
   CAPM Gordon model Risk premium

 The sources of new common equity include

 Retained earnings  Newly sold stock  Costs are different
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The Cost of Retained Earnings

 Retained earnings (RE) are not free
 Reinvested earnings that belong to stockholders  Stockholders could have spent if paid as dividends  Stockholders are entitled to a return on these funds
 So theres a cost to RE capital

 No adjustments to the return on RE necessary to calculate component cost of equity from RE

 Payments to stockholders not tax deductible to firm  No new securities issued so no flotation costs  Investor return on RE = Component cost of RE
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The CAPM Approach

 The market return on a stock can be approximated by estimating the required or expected return using the CAPMs SML kx = kRF + (kM - kRF) bX
where: kX is the required return on stock X kRF is the risk-free rate (return on three-month T bills) kM is the return on the market or on an average stock (usually estimated through a market index like the S&P 500) bX is stock Xs beta, the measure of its market risk
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The CAPM Approach

Example 13.5

Q. The return on the Strand Corporations stock is relatively volatile as reflected by the companys beta of 1.8. The return on the S&P 500 is currently 12% and is expected to remain at that level. Treasury bills are yielding 6.5%. Estimate Strands cost of retained earnings.

Example

A. Write equation 13.5 and substitute directly, using the return on the S&P 500 as kM and the treasury bill yield as kRF. cost of RE = kX kRF (kM kRF)bX = 6.5% (12% 6.5%)1.8 = 16.4%

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The Dividend Growth Approach

 The Dividend Growth Approach (the Gordon Model)
The Gordon model is used to calculate the intrinsic value of a stock  However, we can use the Gordon model to solve for the expected return by plugging in the current price of the stock

Use actual price

D 0 (1  g) P0 ! ke  g
Solve for ke, which represents expected return.

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The Dividend Growth Approach

Example 13.6

Q. Periwinkle Inc. paid a dividend of $1.65 last year and its stock is currently selling for $33.60 a share. The company is expected to grow at 7.5% indefinitely. Estimate the firms cost of retained earnings. A. Write equation 13.7 and substitute for Periwinkles expected return and the cost of RE. cost of RE = ke

Example

D 0 (1  g) ! g P0 $1.65(1.075 ) !  .075 $33.60 ! .053  .075 ! 12.8%

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The Risk Premium Approach

 The relationship between the risks of debt and equity is fairly constant among firms.
 The incremental risk premium between debt and equity returns is similar for high-risk and low-risk firms.  The return on a firm's equity can be estimated by adding 3 to 5 percentage points to the market return on its debt, if rpe is the additional risk premium on equity:

ke = kd + rpe

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The Risk Premium Approach

Example 13.7

Q. The Carter Companys long-term bonds are currently yielding 12%. Estimate Carters cost of retained earnings.

Example

A. Simply write equation 13.8 and substitute, using 4% for the incremental risk premium. cost of RE = ke kd rPe = 12% + 4% = 16%

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The Cost of New Common Stock

   Firms often need to raise more equity than that generated by retained earnings Equity from new stock is just like equity from RE, except it involves flotation costs Market return estimates for RE must be adjusted for flotation costs to determine the cost of issuing new common stock
  Use the Gordon model Insert (1-f) to recognize flotation cost (receive less than P0 for new stock

D 0 (1  g) ke ! g (1  f )P0
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The Cost of New Common Stock

Example 13.8

Q. Suppose Periwinkle Inc. of Example 13.6 had to raise capital beyond that available from retained earnings. What would be its cost of equity from new stock if flotation costs were 12% of money raised?

Example

A. Write equation 13.9 and substitute from Example 13.6, including a 12% flotation cost.

D 0 (1  g) g cost of new equity = ke ! (1  f )P0 $1.65(1.075 )  .075 (.88 )$33.60 ! .06  .075 ! 13.5% !

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The Marginal Cost of Capital (MCC)

 A firm's WACC is not independent of the amount of capital raised  WACC typically rises as the firm raises more capital  The Marginal Cost of Capital (MCC) is a graph of the WACC showing abrupt increases as larger amounts of capital are raised in a planning period
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The Break in MCC When Retained Earnings Run Out

 Breaks (jumps) in the MCC occur when cheap sources of financing are used up  First increase in MCC usually occurs when the firm runs out of RE and starts raising external equity by selling stock  Locating the Break
 The first breakpoint is always found by dividing the amount of RE expected to be available by the fractional proportion of equity in the capital structure

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The Break in MCC When Retained Earnings Run Out

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The Break in MCC When Retained Earnings Run Out

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Locating the Break In Brightons MCC Schedule

 Assume the business plan projects RE of $3,000,000  Note that capital structure is 60% equity  Since capital is raised in the proportions of the capital structure we ask
 $3M is 60% of what number?

$3M / .6 = $5M
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Brightons MCC Schedule

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Other Breaks in the MCC Schedule

 Other Breaks in the MCC Schedule occur when the cost of borrowing increases
 As debt increases the firm becomes riskier so lenders require higher interest rates  Causes further upward breaks in the MCC

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Combining the MCC and IOS

 The investment opportunity schedule (IOS) is a plot of the IRRs of available projects arranged in descending order  The MCC and IOS plotted together show which projects should be undertaken  Interpreting the MCC
 The firm's WACC for the planning period is at the intersection of the MCC and the IOS
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MCC Schedule and IOS

Figure 13.2

Projects A, B and C should be undertaken because their expected returns exceed the expected costs.

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Comprehensive Example Baxter Metalworks Inc Example 13.9

Baxter Metalworks Inc. has the following elements of capital. Debt: Baxter issued $1,000, thirty year bonds ten years ago at a coupon rate of 9%. Five thousand (5,000) bonds were sold at par. Similar bonds are now selling to yield 12%. Preferred Stock: Twenty thousand (20,000) shares of 10% preferred stock were sold five years ago at their $100 par value. Similar securities now yield 13%. Equity: The company was originally financed with the sale of one million shares of common stock at $10. Accumulated retained earnings are currently $3 million. The stock is now selling at $12.50.

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Comprehensive Example Baxter Metalworks Inc Example 13.9

Target Capital Structure: Debt 20% Preferred Stock 10% Equity 70% Other information: Baxter's marginal income tax rate is 40%. Flotation costs average 10% for stocks. Short term treasury bills currently yield 7%. An average stock currently yields a return of 13.5% Baxter's beta is 1.4. The firm is expected to grow at 6.5% indefinitely. The annual dividend paid last year was $1.10 per share. Next year's business plan includes earnings of $2 million of which $1.4 million will be retained.
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Baxter Metalworks Inc.

Problem:
Calculate Baxter's capital component weights and its WACC before and after the retained earnings break. Sketch the firm's MCC.

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Baxter Metalworks
MARKET VALUES AND WEIGHTS
Debt: Pb = PMT[PVFAk,n] + FV[PVFk,n] = $45[PVFA6,40] + $1,000[PVF6,40] = $45(15.0463) + $1,000(.0972) = $774.28 Market Value = $774.28 x 5,000 = $3,871,400

Preferred Stock: Dp = $10 kp = .13 Pp = Dp / kp = $10 / .13 = $76.92 Market Value = $76.92 x 20,000 = $1,538,400 Common Equity: Market Value =$12.50 x 1,000,000 = $12,500,000 Market Value Based Weights: $ % Debt $ 3,871,400 21.6% Preferred $ 1,538,400 8.6% 69.8% Equity $12,500,000 $17,909,800 100.0%
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Baxter Metalworks Inc

CAPITAL COMPONENT COSTS
Debt: Cost of debt = kd (1 - T) = .12 (1-.40) = 7.2% Preferred Stock: Cost of kp 13% Preferred = = = 14.4% Stock (1-f) 1-.10 Equity - Retained Earnings: CAPM: Cost of RE = kB = kRF + (kM - kRF)bB = 7.0% + (13.5% - 7.0%) 1.8 = 16.1% Dividend Growth: D0(1+g) Cost of RE = ke = + g. P0 $1.10 (1.065) = + .065 = 15.9% $12.50
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Baxter Metalworks Inc

Risk Premium: Cost of RE = ke = kd + rpe = 12% + 4% = 16% Reconciliation - Cost of RE CAPM 16.1% Dividend Growth 15.9% Risk Premium 16.0% Use 16.0% Equity - New Stock: D0(1+g) Cost of RE = ke = + g. (1-f)P0 $1.10 (1.065) = + .065 = 16.9% (.90)$12.50
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Baxter Metalworks Inc.

Computation of WACCs

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Baxter Metalworks Inc.

 Break in the MCC
 $1,400,000 / .698 = $2,005,731

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A Potential MistakeHandling Separately Funded Projects

 A project can be funded entirely by a source of capital single

 Should the cost of capital used to evaluate that project be the cost of the single source, or the firm's overall WACC?
 It should be the firm's overall WACC because firms cannot continue to raise a single source of capital indefinitely, such as cheap debt
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