The Cost of Capital Chapter 12 Cost of

Cost of Capital u The firm’s average cost of funds, which is the average

The Logic of the Weighted Average Cost of Capital u The use of debt

Basic Definitions u Capital component F types of capital used by firms to raise

Basic Definitions u WACC = weighted average cost of capital u Capital structure F

After-Tax Cost of Debt u The relevant cost of new debt—its yield to maturity

Cost of Preferred Stock u Rate of return investors require on the firm’s preferred

Cost of Retained Earnings u Rate of return investors require on the firm’s common

The Bond-Yield-Plus. Premium Approach u Estimate a risk premium above the bond interest rate

The Discounted Cash Flow (DCF) Approach u Price and expected rate of return on

DCF Approach u Internal equity, ks F based on the fact that investors demand

Cost of Newly Issued Common Stock u External equity, ke F based on the

Target Capital Structure u Optimal capital structure F percentage of debt, preferred stock, and

Weighted Average Cost of Capital, WACC u A weighted average of the component costs

Marginal Cost of Capital u MCC F the cost of obtaining another dollar of

MCC Schedule u Marginal cost of capital schedule F a graph that relates the

MCC Schedule u Weighted Average Cost of Capital (WACC) (%) WACC 3=11. 5% 11.

Break Point u BP F the dollar value of new capital that can be

MCC Schedule u Schedule and break points depend on capital structure used

MCC Schedule u Weighted Average Cost of Capital (WACC) (%) Smooth, or Continuous, Marginal

Combining the MCC and Investment Opportunity Schedules u Use the MCC schedule to find

Combining the MCC and Investment Opportunity Schedules Percent 12. 0 - Return. C =

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The Cost of Capital Chapter 12

Cost of Capital u The firm’s average cost of funds, which is the average return required by the firm’s investors u What must be paid to attract funds

The Logic of the Weighted Average Cost of Capital u The use of debt impacts a fim’s ability to use equity, and vice versa, so the weighted average cost must be used to evaluate projects, regardless of the specific financing used to fund a particular project

Basic Definitions u Capital component F types of capital used by firms to raise money F kd = before tax interest cost F kd. T = kd(1 -T) = after tax cost of debt F kps = cost of preferred stock F ks = cost of retained earnings F ke = cost of external equity (new stock)

Basic Definitions u WACC = weighted average cost of capital u Capital structure F combination of different types of capital used by a firm

After-Tax Cost of Debt u The relevant cost of new debt—its yield to maturity (YTM) u Taking into account the tax deductibility of interest u Used to calculate the WACC u kd. T = bondholders’ required rate of return minus tax savings u kd. T = kd - (kd T) = kd(1 -T)

Cost of Preferred Stock u Rate of return investors require on the firm’s preferred stock u the preferred dividend divided by the net issuing price

Cost of Retained Earnings u Rate of return investors require on the firm’s common stock Three solutions: 1. CAPM 2. Bond yield plus risk premium 3. Discounted cash flow (DCF)

The CAPM Approach

The Bond-Yield-Plus. Premium Approach u Estimate a risk premium above the bond interest rate u Judgmental estimate for premium u “Ballpark” figure only

The Discounted Cash Flow (DCF) Approach u Price and expected rate of return on a share of common stock depend on the dividends expected on the stock

DCF Approach u Internal equity, ks F based on the fact that investors demand the firm use funds that are retained to earn an appropriate rate of return

Cost of Newly Issued Common Stock u External equity, ke F based on the cost of retained earnings F adjusted for flotation costs (the expenses of selling new issues)

Target Capital Structure u Optimal capital structure F percentage of debt, preferred stock, and common equity that will maximize the price of the firm’s stock

Weighted Average Cost of Capital, WACC u A weighted average of the component costs of debt, preferred stock, and common equity

Marginal Cost of Capital u MCC F the cost of obtaining another dollar of new capital F the weighted average cost of the last dollar of new capital raised

MCC Schedule u Marginal cost of capital schedule F a graph that relates the firm’s weighted average of each dollar of capital to the total amount of new capital raised F reflects changing costs depending on amounts of capital raised

MCC Schedule u Weighted Average Cost of Capital (WACC) (%) WACC 3=11. 5% 11. 5 - WACC 2=11. 0% 11. 0 10. 5 - WACC 1=10. 5% New Capital Raised (millions of dollars) 100 150

Break Point u BP F the dollar value of new capital that can be raised before an increase in the firm’s weighted average cost of capital occurs

MCC Schedule u Weighted Average Cost of Capital (WACC) (%) WACC 3=11. 5% 11. 5 - WACC 2=11. 0% 11. 0 10. 5 - WACC 1=10. 5% BPRE 100 BPDebt New Capital Raised (millions of dollars) 150

MCC Schedule u Schedule and break points depend on capital structure used

MCC Schedule u Weighted Average Cost of Capital (WACC) (%) Smooth, or Continuous, Marginal Cost of Capital Schedule WACC 0 - Dollars of New Capital Raised

Combining the MCC and Investment Opportunity Schedules u Use the MCC schedule to find the cost of capital for determining whether a project should be purchased u Investment Opportunity Schedule (IOS) F graph of the firm’s investment opportunities ranked in order of the projects’ rates of return

Combining the MCC and Investment Opportunity Schedules Percent 12. 0 - Return. C = 12. 0% Return. B = 11. 6% Return. D = 11. 5% 11. 5 - Return. E = 11. 3% WACC 2=11. 0% 11. 0 10. 5 - WACC 3=11. 5% MCC IRRA = 10. 8% WACC 1=10. 5% IOS Optimal Capital Budget - $139 20 40 60 80 100 120 140 160 180 New Capital Raised and invested (millions of dollars)

End of Chapter 12 The Cost of Capital