7 9 th CHAPTER NINT H EDITIO N

7 9 th CHAPTER NINT H EDITIO N Foundations of Financial Management SEVEN Cost of Capital Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 th NINT H EDITIO N Foundations of Financial Management Chapter 7 - Outline • • Cost of Capital Cost of Debt Cost of Preferred Stock Cost of Common Equity: – Retained Earnings – New Common Stock Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 th NINT H EDITIO N Foundations of Financial Management Cost of Capital The cost of capital represents the overall cost of financing to the firm The cost of capital is normally the relevant discount rate to u mnbvcse in analyzing an investment. The overall cost of capital is a weighted average of the various sources: WACC = Weighted Average Cost of Capital Cost of Debt The cost of debt to the firm is the effective yield to maturity (or interest rate) paid to its bondholders Since interest is tax deductible to the firm, the actual cost of debt is less than the yield to maturity: After-tax cost of debt = yield x (1 - tax rate) Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 th NINT H EDITIO N Foundations of Financial Management Cost of Preferred Stock -has a fixed dividend (similar to debt) -has no maturity date -dividends are not tax deductible and are expected to be perpetual or infinite Cost of preferred stock = dividend price-flotation cost Cost of Common Equity -Common stock equity is available through retained earnings (R/E) or by issuing new common stock: Common equity = R/E + New common stock Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 th NINT H EDITIO N Foundations of Financial Management The cost of common equity in the form of retained earnings is equal to the required rate of return on the firm’s common stock. The cost of new common stock is higher than the cost of retained earnings because of flotation costs. Flotation costs : selling and distribution costs (such as sales commissions) for the new securities. Weighted Average Cost of Capital We can use the individual costs of capital that we have computed to get our “average” cost of capital for the firm. This “average” is the required return on our assets, based on the market’s perception of the risk of those assets. The weights are determined by how much of each type of financing that we use. Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 Foundations of Financial Management th NINT H EDITIO N Capital Structure Weights Notation E = market value of CS = # outstanding shares CS times price per share CS P= market value of PS = # outstanding shares PS times price per share PS D = market value of debt = # outstanding bonds times bond price V = market value of the firm = D + P + E Weights WE = E/V = percent financed with equity CS WP = P/V = percent financed with equity PS WD = D/V = percent financed with debt WACC = WERE + WPRP + WDRD(1 -TC) Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 Foundations of Financial Management th EDITIO NINT H N T 11 -1 Table 11 -1 Cost of capital–Baker Corporation (1) Cost Weighted (2) (aftertax) Weights Debt. . Kd 7. 05% Preferred stock. . Kp 10. 94 Common equity (retained earnings). . . Ke 12. 00 Weighted average cost of capital. . . 10. 41% Block Hirt Irwin/Mc. Graw-Hill (3) Cost 30% 2. 12% 10 1. 09 60 7. 20 Ka ©The Mc. Graw-Hill Companies, Inc. 2000

9 Foundations of Financial Management th EDITIO T 11 -2 NINT H N Cost of capital curve Cost of equity Cost of capital (percent) Weighted average cost of captial U-shaped Cost of debt Minimum point for cost of capital 0 Block Hirt Irwin/Mc. Graw-Hill 40 Debt-assets mix (percent) 80 ©The Mc. Graw-Hill Companies, Inc. 2000

9 Foundations of Financial Management th EDITIO NINT H N T 11 -3 Table 11 -3 Debt as a percentage of total assets Selected Companies, with Industry Designation Percent National Presto (electrical appliances). . 10% Mylan Labs (pharmaceuticals). . Genetech (biochemistry). . . Liz Claiborne (women’s clothing). . 22 Diebold (automatic transmissions). . . 33 Stanley Works (home tools). . . Sensormatic Electronics (theft control). . 47 Alcan Aluminum (aluminum products). . 50 Block Motorola (electronics). . . Hirt Irwin/Mc. Graw-Hill. . . 15. . . . 20. . . . 35. . . . 52 ©The Mc. Graw-Hill Companies, Inc. 2000

9 Foundations of Financial Management th EDITIO NINT H N T 11 -4 Figure 11 -2 Cost of capital over time Cost of capital (Ka) Block Hirt Irwin/Mc. Graw-Hill Kat + 1 Kat + 2 y x Debt-equity mix (percent) ©The Mc. Graw-Hill Companies, Inc. 2000

9 Foundations of Financial Management th EDITIO NINT H N T 11 -5 Table 11 -4 Investment projects available to the Baker Corporation Projects A. . 16. 00% B. . 14. 00 C. . 13. 50 D. . 11. 80 E. . 10. 65 F. . 9. 50 G. . 8. 60 H. . 7. 00 Block Hirt Irwin/Mc. Graw-Hill Expected Returns Cost ($ millions) $10 5 4 20 11 20 15 10 $95 million ©The Mc. Graw-Hill Companies, Inc. 2000

9 Foundations of Financial Management th EDITIO NINT H N T 11 -6 Figure 11 -3 Cost of capital and investment projects for the Baker Corporation Percent 14. 0 12. 0 10. 0 8. 0 16. 0 A B C 10. 41% D E F 4. 0 2. 0 0. 0 - G H 6. 0 Block Hirt Irwin/Mc. Graw-Hill 10 15 19 39 50 70 Amount of capital ($ millions) 85 Ka Weighted average cost of capital 95 ©The Mc. Graw-Hill Companies, Inc. 2000

9 Foundations of Financial Management th EDITIO NINT H N T 11 -7 Table 11 -5 Cost of capital for different amounts of financing Million First $39 Million A/T Weighted Cost Debt. . . 2. 12% Preferred. . Kp Common equity *. . Ke Kn Block Hirt Irwin/Mc. Graw-Hill Next $11 A/T Weighted Cost Wts. Kd. 7. 05% Kd . 30 Kp 10. 94 . 10 12. 00 . 60 12. 60 7. 05% Wts. 2. 12%. 30 Debt 1. 09 Preferred. 1. 09 Common. . 7. 56 . 10 7. 20. 60 Cost equity † . ©The Mc. Graw-Hill Companies, Inc. 2000

9 Foundations of Financial Management th EDITIO NINT H N T 11 -7 Table 11 -6 Cost of capital for increasing amounts of financing Over $50 Million Cost Weighted (aftertax) Cost Debt (higher cost). 30 Preferred stock Kd 8. 60% 2. 58% Kp . 10 1. 09 Common equity (new common stock). 60 Kn 7. 56 Block Hirt Irwin/Mc. Graw-Hill Weights 10. 94 12. 60 Kmc = 11. 23% ©The Mc. Graw-Hill Companies, Inc. 2000

9 Foundations of Financial Management th EDITIO NINT H N T 11 -8 Table 11 -4 Marginal cost of capital and Baker Corporation projects Percent 14. 0 12. 0 10. 0 8. 0 16. 0 A B C 10. 77% 11. 23% 10. 41% D E F 4. 0 2. 0 0. 0 - Kmc Marginal cost of capital G H 6. 0 Block Hirt Irwin/Mc. Graw-Hill 10 15 19 39 50 70 Amount of capital ($ millions) 85 95 ©The Mc. Graw-Hill Companies, Inc. 2000