Cost of Capital n Rate of return required

Cost of Capital n Rate of return required by firm’s investors ¨ Cost of capital is required rate of return for projects with same level of risk as overall firm ¨ Required rate of return must be adjusted to reflect anticipated risk of project Cost of Capital 1

The Big Picture…. Cost of Capital n Cost of Capital = Average cost of debt and equity ¨ For now, assume ratio of debt to equity constant n As debt increases, required will start to increase at some point Cost of Capital 2

Cost of debt After-tax YTM on debt n Includes flotation costs n Cost of Capital 3

Cost of Debt n Rate of return required by firm’s investors ¨ YTM n (required return) on IBM’s bonds is 10% (Ms. Investor demands a 10% rate of return) ¨ However, IBM’s after-tax cost of debt is 7% Assuming IBM has a 30% tax rate $100 Interest (10%) n - 30 Tax Savings n = 70 After-Tax Interest Cost n Cost of Capital (7%) 4

Cost of Debt n Rate of return required by firm’s investors ¨ Coupon rate on debt is not relevant 12% coupon bond, trading at $1, 117 has a 9% YTM n Would issue additional debt at 9% (before tax) n This would be 6. 3% after-tax (assume 30% tax rate) n Cost of Capital 5

Calculating Required Rate of Return (Yield to Maturity) n Bond has 6. 5% coupon rate, 7 years to maturity and has net price of $870. What is yield to maturity? ¨ Required rate of return (YTM) = 9. 09% ¨ After-tax rate required rate of return = 9. 09% - (38% x 9. 09%) = 5. 64% Cost of Capital 6

Cost of Preferred Stock Cost of preferred stock = annual dividend / net price of preferred stock n Net price is after flotation costs n Cost of Capital 7

Cost of Equity Must be estimated. No stated rate like YTM on bonds or loans. n Calculate cost for both: n ¨ Retained earnings ¨ Issuing new equity Cost of Capital 8

Cost of Equity Dividend Growth Model n NP = D 1 / (RR – G) n RR = (D 1/NP) + G n Calculate cost of retained earnings n ¨ Price (P) , Dividend (D) are known. ¨ Can estimate growth rate (G). ¨ Then solve for required return (RR) n Use Net Price after flotation costs for P Cost of Capital 9

Cost of Equity Dividend Growth Model n NP = D 1 / (RR – G) n RR = (D 1/NP) + G n P = $32, D = $2. 20, G = 4%, NP = $32. 00, D 1 = $2. 29 n RR = ($2. 29/$32. 00)+4% n RR = 11. 15% n Cost of Capital 10

Cost of Equity Dividend Growth Model n Advantage: n ¨ Simple n Issues: ¨ Must estimate growth rate ¨ Some companies don’t pay dividends ¨ Take into account risk? Cost of Capital 11

Cost of Equity Capital Asset Pricing Model (CAPM) n RR = RF + (RM – RF) X Beta n ¨ Risk-free rate of return (RF) is known ¨ Beta is generally known ¨ Required Return for Market (RM) must be estimated Cost of Capital 12

Cost of Equity Capital Asset Pricing Model (CAPM) n RR = RF + (RM – RF) X Beta n ¨ Advantages Adjusts for risk n Can be used for companies with no dividends n Cost of Capital 13

Cost of Equity Capital Asset Pricing Model (CAPM) n RR = RF + (RM – RF) X Beta n ¨ Issues: n Calculating Market Risk Premium (RM – RF) ¨ ¨ ¨ One study: 9. 2% for large cap stocks Another study: 9. 5% for large cap stocks Another study: 4 -6% for large cap stocks Cost of Capital 14

Cost of Equity Bond-yield plus equity risk n RR = YTM + (RM – RF) n ¨ Advantage Uses YTM for company’s bonds as starting point n Can be used to compare with other two methods n Cost of Capital 15

WACC n Market Value Company = Equity Value + Debt Value ¨ Equity n Number of shares x Price of stock ¨ Debt n Value = Market cap Value Number of bonds x Value of Bonds Cost of Capital 16

WACC n WACC = ¨ (Debt Value x Cost of Debt) + ¨ (Equity Value x Cost of Equity) Due to risk premium for equity, generally equity will have a larger cost than debt n But required return on debt will increase if very little equity n Cost of Capital 17

WACC: cost of capital n Debt: usually cheapest after-tax cost ¨ Deduct interest ¨ Barclays 2006 study: n n Investment grade: 4. 0%; high-yield: 5. 6% Preferred stock ¨ Less n Internal equity (retained earnings) ¨ No n risk than common stock flotation costs External equity (issue new stock) ¨ Usually most expensive ¨ Barclays 2006 study: 9% Cost of Capital 18

WACC n n Value of firm maximized when WACC is minimized Should reduce Required Return ¨ This n would increase NPV of projects WACC is not Required Return for all projects ¨ Adjust Required Return based on risk of project ¨ If use WACC for all projects, will accept risky projects and decline safe projects n Since safe projects will generally have low IRR Cost of Capital 19