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CostofCapital
11-2ChapterOutlineCostofcapitalanditsimportanceDiscountratesusedtoanalyzeinvestmentsValuationandapplicationtobonds,preferredstock,andcommonstockMinimumcostofcapitalIncreaseincostofcapitalwithincreaseinutilizationoffinances11-3CostofCapitalIncorporatefinance,aninvestmentmadeisforananticipatedreturninfutureKnowingtheappropriatediscountrateisvitalCostofacquiringthefundsEarningatleastareturnequalingthecostsincurredtoacquireit–theminimumacceptablereturn11-4TheOverallConceptAninvestment:ShouldnotbejudgedagainstthespecificmeansoffinancingusedtoimplementitThiswouldmakeinvestmentselectiondecisionsinconsistentWithalow-costdebtmustbechosencarefullyMayresultinincreaseoftheoverallriskMaymakealleventualformsoffinancingmoreexpensive11-5DeterminationofCostofCapitalBestunderstoodbycapitalstructureofafirmTheafter-taxcostsoftheindividualsourcesoffinancingaremultipliedbytheweightsassignedtothemSumofallthesegivestheweightedaveragecost11-6CostofDebtMeasuredbyinterestrate,oryield,paidtobondholdersExample:$1,000bondpaying$100annualinterest–10%yieldCalculationiscomplexifabondispricedatdiscountorpremiumfromparvalueTodeterminethecostofanewdebtinthemarketplace:Thefirmwillcomputetheyieldonitscurrentlyoutstandingdebt11-7ApproximateYieldtoMaturity(Y')Annualinterestpayment+Numberofyearstomaturity0.6(Priceofthebond)+0.4(Principalpayment)Assuming:Annualinterestpayment=$101.50;Principalpayment=$1,000;Priceofthebond=$940;Numberofyearstomaturity=20Y'
=$101.50+20.6($940)+.4($1,000)
=$101.50+20$564+$400
Y’=$101.50+3=$104.50=10.84%$964$964Principalpayment–Priceofthebond$1,000-$9406011-8AdjustingYield
forTaxConsiderationsYieldtomaturityindicateshowmuchthefirmhastopayonabefore-taxbasisInterestpaymentonadebtisatax-deductibleexpenseDuetothis,thetruecostislessthanthestatedcost11-9AdjustingYield
forTaxConsiderations(cont’d)Theafter-taxcostofdebtiscalculatedasshownbelow:
Kd(Costofdebt)=Y(1–T)Assuming:Yield=10.84%andTaxrate=35%
Kd(Costofdebt)=Y(1–T) Kd(Costofdebt)=10.84%(1–0.35) =10.84%×0.65 =7.05%11-10CostofPreferredStockAconstantannualpaymentwithnomaturitydatefortheprincipalpaymentComputedbydividingdividendpaymentbynetpriceorproceedsreceivedRepresentstherateofreturntopreferredstockholdersandannualcosttocorporationforissuePreferredstockdividendisnotatax-deductibleexpense,withnodownwardtaxadjustmentTheproceedstothefirmequalssellingpriceinthemarketminusflotationcost11-11CostofPreferredStock(cont’d)Thecostofpreferredstockisasfollows:Where,=Costofpreferredstock;=Annualdividendonpreferredstock;=Priceofpreferredstock;F=Floatation,orsellingcostAssumingannualdividendas$10.50,preferredstockis$100,andflotation,orsellingcostis$4.Effectivecostis:=$10.50=$10.50=10.94%$100-$4$9611-12CostofCommonEquity–
ValuationApproachIndeterminingthecostofcommonstock,thefirmmustbesensitivetopricingandperformancedemandsofcurrentandfuturestockholdersDividendvaluationmodel:Where,=Priceofthestocktoday;=Dividendattheendoftheyear(orperiod);=Requiredrateofreturn;g=ConstantgrowthrateindividendsAssuming=$2;=$40andg=7%,equals12percent=$2+7%=5%+7%=12%$4011-13AlternateCalculationoftheRequiredReturnonCommonStockCapitalassetpricingmodel(CAPM)Where:=Requiredreturnoncommonstock;=Risk-freerateofreturn,usuallythecurrentrateonTreasurybillsecurities;=Betacoefficient(measuresthehistoricalvolatilityofanindividualstock’sreturnrelativetoastockmarketindex;=returninthemarketasmeasuredbyanapproximateindexAssuming=5.5%,=12%,=1.0,wouldbe:=5.5%+1.0(12%-5.5%)=5.5%+1.0(6.5%)=5.5%+6.5%=12%11-14CostofRetainedEarningsSourcesofcapitalforcommonstockequity:Purchaserofthenewshares–externalsourceRetainedearnings–internalsourceRepresentthepresentandpastearningsofthefirmminuspreviouslydistributeddividendsBelongtothecurrentstockholders–maybepaidintheformofdividendsorreinvestedinthefirmReinvestmentsrepresentasourceofequitycapitalsuppliedbythecurrentstockholdersAnopportunitycostisinvolved11-15CostofRetainedEarnings(cont’d)Thecostofretainedearningsisequivalenttotherateofreturnonthefirm’scommoncostrepresentingtheopportunitycostrepresentsboththerequiredrateofreturnoncommonstock,andthecostofequityintheformofretainedearningsAssuming:=Costofcommonequityintheformofretainedearnings=Dividendattheendofthefirstyear,$2=Priceofstocktoday,$40
g=Constantgrowthrateindividends,7%=$2+7%=5%+7%=12%$4011-16CostofNewCommonStockAslightlyhigherreturnthan,representingtherequiredrateofreturnofpresentstockholders,isexpectedNeededtocoverthedistributioncostsofthenewsecurities
Costofcommonequityintheformofretainedearnings=
Costofnewcommonstock11-17CostofNewCommonStock(cont’d)Assuming=$2,=$40,F(Flotationorsellingcosts)=$4andg=7%;
=$2+7%$40-$4=$2+7%$36=5.6%+7%=12.6%11-18OptimalCapitalStructure–WeightingCostsThedesiretoachieveaminimumoverallcostofcapitalCalculateddecisionsarerequiredontheappropriateweightsfor:DebtPreferredstockCommonstockfinancingCapitalmixisdeterminedby:ConsideringthepresentcapitalstructureAscertainingifthecurrentpositionisoptimal11-19OptimalCapitalStructure–WeightingCosts(cont’d)Assessmentofdifferentplans:FirmisabletoinitiallyreduceweightedaveragecostofcapitalwithdebtfinancingBeyondPlanB,continueduseofdebtbecomesunattractiveandgreatlyincreasescostsofsourcesoffinancingCost(After-tax) Weights WeightedCostFinancialPlanA:Debt…………6.5%20%1.3%Equity……….12.080
9.610.9%FinancialPlanB:Debt…………7.0%40%2.8%Equity……….12.5607.5
10.3%FinancialPlanC:Debt…………9.0%60%5.4%Equity……….15.0406.011.4%11-20CostofCapitalCurve11-21DebtasaPercentageofTotalAssets(2010)11-22CapitalAcquisitionand
InvestmentDecisionMakingFinancialcapitalconsistsofbonds,preferredstock,andcommonequityMoneyraisedbysaleofthesesecuritiesandretainedearningsisinvestedin:Therealcapitalofthefirm,thelong-termproductiveassetsofplantandequipmentTominimizecostofequity,afirmmaysellcommonstockwhenpricesarerelativelyhighAbalancebetweendebtandequityisrequiredtoachieveminimumcostofcapital11-23CostofCapitalOverTime 11-24CostofCapitalinthe
CapitalBudgetingDecisionCurrentcostofcapitalforeachsourceoffundsisimportantforcapitalbudgetingdecisionTherequiredrateofreturnwillbetheweightedaveragecostofcapitalThecommonstockvalueofthefirmwillbemaintainedorwillincrease,aslongasthefirmearnsitscostofcapital11-25InvestmentProjectsAvailable
totheBakerCorporation11-26CostofCapitalandInvestmentProjectsfortheBakerCorporation11-27TheMarginalCostofCapitalThemarketmaydemandahighercostofcapitalforeachamountoffundrequiredifalargeamountoffinancingisrequiredEquity(ownership)capitalisrepresentedbyretainedearningsRetainedearningscannotgrowindefinitelyasthefirm’scapitalneedstoexpandRetainedearningsislimitedtotheamountofpastandpresentearningsthatcanberedeployedintoinvestments11-28TheMarginalCostofCapital(cont’d)Assumptions:60%istheamountofequitycapitalafirmmustmaintaintokeepabalancebetweenfixedincomesecuritiesandownershipinterestThefirmhas$23.40millionofretainedearningavailableforinvestmentThereisadequateretainedearningtosupportthecapitalstructureasshownbelow:Assuming:X=Retainedearnings;PercentofretainedearningsinthecapitalstructureWhereXrepresentsthesizeofthecapitalstructurethatretainedearningswillsupportX=$23.40million=$39million.6011-29CostsofCapitalfor
DifferentAmountsofFinancingKmc,inthebottomright-handportionofthetable,representsthemarginalcostofcapital11-30IncreasingMarginalCostofCapitalBothandrepresentthecostofcapitalThemcsubscriptafterKindicatestheincreaseinmarginalcostofcapitalTheincreaseisbecausecommonequityisnowintheformofnewcommonstockratherthanretainedearningsTheafter-taxcostofthenewcommonstockismoreexpensivethanretainedearningsbecauseofflotationcosts11-31IncreasingMarginalCostofCapital(cont’d)Equationforthecostofnewcommonstock:
=$2+7%=$2+7%=5.6%+7%=12.6%$40-$4$36The$50millionfigurecanbederivedthus:Z=Amountoflower-costdebt;PercentofdebtinthecapitalstructureZ=$15million=$50million.30WhereZrepresentsthesizeofthecapitalstructureinwhichlower-costdebtcanbeused11-32CostofCapitalfor
IncreasingAmountsofFinancing11-33Changesinthe
MarginalCostsofCapital11-34MarginalCostofCapital
andBakerCorporationProjects11-35CostofComponents
intheCapitalStructure11-36PerformanceofPAIandtheMarket11-37LinearRegressionofReturns
BetweenPAIandtheMarketTheCAPMisanexpectational(exante)model,andthereisnoguaranteehistoricaldatawillreoc
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