1、 Chapter 11 The Cost of Capital Lecturer: GU Ren School of Economics and Commerce 2013.12.9 Chapter 11 - Outline Cost of Capital (COC) Cost of Debt Cost of Preferred Stock Cost of Common Equity: Retained Earnings New Common Stock WACC Optimum Capital Structure South China University of Tech. Financi
2、al Management-Chap 11 I. What is the “Cost” of Capital? How can the firm raise capital? Debts Preferred Stock Common Stock Each of these offers a rate of return to investors. This return is a cost to the firm. Usually a firm has several sources of funds and each source may have a different cost. The
3、 overall cost of the funds employed is a proportionate average of the various sources. South China University of Tech. Financial Management-Chap 11 What is the “Cost” of Capital? For Investors, the rate of return on a security is a benefit of investing. For Financial Managers that same rate of retur
4、n is a cost of raising funds that are needed to operate the firm. In other words, the cost of raising funds is the firms cost of capital. The firms required rate of return that will satisfy all suppliers of capital is called its cost of capital. South China University of Tech. Financial Management-C
5、hap 11 The “cost” of capital is also referred to as a “hurdle” rate because this is the minimum acceptable rate of return. A business firm must strive to earn at least as much as the cost of the funds that it uses. Any investment which does not cover the firms cost of funds will reduce shareholder w
6、ealth. The “Cost” of Capital is Hurdle Rate South China University of Tech. Financial Management-Chap 11 II. Cost of Debt For the issuing firm, the cost of debt is: the rate of return required by investors adjusted for flotation costs (any costs associated with issuing new bonds) adjusted for taxes.
7、 South China University of Tech. Financial Management-Chap 11 II-A. Flotation Costs (P299) When a company sells securities to the public, it must use the services of an investment banker. The investment banker provides a number of services for the firm, including: Setting the price of the issue, and
8、 Selling the issue to the public The cost of these services are referred to as “flotation costs” Generally, we do this by reducing the proceeds from the issue by the amount of the flotation costs, and recalculating the cost of capital. South China University of Tech. Financial Management-Chap 11 II-
9、B. Tax effects of financing with debt with stock with debt EBIT *400,000 400, 000 - interest expense 0 ( 50,000) EBT 400,000 350,000 - taxes (34%) (136,000) (119,000) EAT 264,000 231,000 EBIT: earnings before interest and tax Tax benefit: 136,000-119,000=17,000 South China University of Tech. Financ
10、ial Management-Chap 11 with stock with debt EBIT 400,000 400, 000 - interest expense 0 ( 50,000) EBT 400,000 350,000 - taxes (34%) (136,000) (119,000) EAT 264,000 231,000 - dividends ( 50,000) 0 Retained earnings 214,000 231,000 Now, suppose the firm should pay $50,000 in dividends to the stockholde
11、rs. 17000 South China University of Tech. Financial Management-Chap 11 II-C. Cost of Debt a. The basic cost of debt to the firm is the effective yield to maturity. The yield to maturity for a corporate bond may be found by: ) P ( 0.4 + ) P ( 0.6 n P- P+ I= Y n b b n t South China University of Tech.
12、 Financial Management-Chap 11 Y= the approximate yield to maturity P b = the market price of the bond I t= the periodic (annual, monthly, etc.), interest payments P n = the principal at maturity t = the period from 1 to n n = the total number of periods Equation (11-1): ) P ( 0.4 + ) P ( 0.6 n P- P+
13、 I= Y n b b n t South China University of Tech. Financial Management-Chap 11 b. Since interest is tax deductible, the actual cost of debt to the firm is less than the yield to maturity. C. The aftertax cost of debt is: The aftertax cost to a firm of bonds issued at par paying $100 annually in intere
14、st would be 7.05 percent if the firms marginal tax rate were 35 percent. % 05 . 7 ) 35 . 1 %( 84 . 10 ) 1 ( = = = T Y Kd South China University of Tech. Financial Management-Chap 11 Important: After-tax basis and market price basis The cost of preferred stock and common stock is calculated on an aft
15、er-tax basis, the cost of debt is adjusted for taxes so that all three sources of capital are on an after-tax cost basis. Price of debt, preferred stock, common stock and firm value are all market values. South China University of Tech. Financial Management-Chap 11 Example: Cost of Debt Prescott Cor
16、poration issues a $1,000 par, 20 year bond paying the market rate of 10%. Coupons are annual. The bond will sell for par since it pays the market rate, but flotation costs amount to $50 per bond. What is the pre-tax and after-tax cost of debt for Prescott Corporation? Marginal tax rate:34% South Chi
17、na University of Tech. Financial Management-Chap 11 Pre-tax cost of debt: n n n t t t b Y P Y I P ) 1 ( ) 1 ( 1 + + + = = P b =1000-50=950, I t =100010100, P n 1000, n=20 Y=? using the calculator, Y = 10.6%. After-tax cost of debt: K d= Y (1 - T) = 10.6% (1 - .34) = 7% So, a 10% bond costs the firm
18、only 7% (with flotation costs) since the interest is tax deductible. South China University of Tech. Financial Management-Chap 11 III. The Cost of Preferred Stock A. Preferred stock is similar to debt in that the preferred dividend is fixed but dissimilar in that dividends are not tax deductible. B.
19、 The cost of preferred stock to a firm may be determined by: examining the relationship of its annual (usually fixed) dividend and its market determined price. Preferred stock, unlike debt, has no maturity and therefore the dividends are expected to be perpetual. South China University of Tech. Fina
20、ncial Management-Chap 11 C. The cost of preferred stock (Kp) is computed by dividing the annual dividend payment by the net proceeds received by the firm in the sale of preferred stock. K p = cost of preferred stock D = preferred stock dividend F = flotation costs per share P = market price of prefe
21、rred stock F) (P- D = K p South China University of Tech. Financial Management-Chap 11 Example: Cost of Preferred Stock If Prescott Corporation issues preferred stock, it will pay a dividend of $8 per year and should be valued at $75 per share. If flotation costs amount to $1 per share, what is the
22、cost of preferred stock for Prescott? F) (P- D = K p D=8 P=75 F=1 K p =8/74=10.81% South China University of Tech. Financial Management-Chap 11 IV. The Cost of Common Equity IV-A. The basis of computation of the price of common stock is the Dividend Valuation Model (DVM). g) - K ( D= P e 1 o P 0 =pr
23、ice of the stock today D 1 =dividend at the end of the first year (or period) Ke=required rate of return g=constant growth rate in dividends South China University of Tech. Financial Management-Chap 11 B. then solved for the required rate of return Ke: g + P D= K o 1 e C. The equation for common sto
24、ck cost is composed of two parts, the dividend yield, D 1 /P 0plus the anticipated growth rate, g, of dividends. South China University of Tech. Financial Management-Chap 11 D. Alternative Calculation of the Required Return on Common Stock - using the Capital Asset Pricing Model (CAPM). Under the CA
25、PM, the required return for common stock can be described by ： ) R- K ( + R= K f m f j Kj = Required Return on Common Stock Rf = Risk-free rate of return; usually the current rate on Treasury bill securities = Beta coefficient. The beta measures the historical volatility of an individual stocks retu
26、rn relative to a stock market index. A beta greater than 1 indicates greater volatility (price movements) than the market, while the reverse would be true for a beta less than 1. Km = Return in the market as measured by an appropriate index Both K j and K eshould be equal under the case of market eq
27、uilibrium. Dividend Valuation Model & CAPM South China University of Tech. Financial Management-Chap 11 E. There are 2 sources of Common Equity: (1) Internal common equity (retained earnings), and (2) External common equity (new common stock issue) Do these 2 sources have the same cost? South China
28、University of Tech. Financial Management-Chap 11 (1)Cost of Internal Equity Since the stockholders own the firms retained earnings, the cost is simply the stockholders required rate of return. Why? If managers are investing stockholders funds, stockholders will expect to earn an acceptable rate of r
29、eturn. South China University of Tech. Financial Management-Chap 11 (1)Cost of Internal Equity g P D K e + = 0 1 This is the opportunity cost. Thus the cost of common equity in the form of retained earnings is: South China University of Tech. Financial Management-Chap 11 (2)Cost of External Equity T
30、he cost of new common stock is higher than the cost of retained earnings because the firms proceeds from sale of the stock is less than the price paid by the stockholder due to flotation costs (F). The cost of new common stock, Kn is: g + F) - P ( D= K 0 1 n South China University of Tech. Financial
31、 Management-Chap 11 V. The “Cost” of Capital is WACC “Cost of capital” actually refers to the weigh- a weighted average cost of financing sources. South China University of Tech. Financial Management-Chap 11 How To Calculate the WACC? There are several steps in measuring a firms cost of capital. 1.
32、Compute the cost of each source of capital. 2. Assign weights to each source. 3. Compute the weighted average of the component costs. Example : The Appropriate WACC The managers of Rocky Mountain Motors(RMM) are considering the purchase of a new tract of land which will be held for one year. The pur
33、chase price of the land is $10,000. RMMs capital structure is currently made up of 40% debt, 10% preferred stock, and 50% common equity(considered to be optimal), so any new funds will need to be raised in the same proportions. Before making the decision, RMMs managers must determine what minimum ra
34、te of return will simultaneously satisfy all of the firms capital providers? South China University of Tech. Financial Management-Chap 11 Example (cont.) Source of Funds Amount Dollar Cost After-tax Cost Debt $4,000 $280 7% Preferred $1,000 $100 10% Common $5,000 $600 12% Total $10,000 $980 9.8% Bec
35、ause the current capital structure （4:1:5 ） is optimal, the firm will raise funds as follows: South China University of Tech. Financial Management-Chap 11 RMM Example (Cont.) Rate of Return 8% 9.8% 11% Total Funds Available $10,800 $10,980 $11,100 Less: Debt Costs $4,280 $4,280 $4,280 Less: Preferre
36、d Costs $1,100 $1,100 $1,100 = Remainder to Common $5,420 $5,600 $5,720 The following table shows three possible scenarios: Obviously, the firm must earn at least 9.8%. Any less, and the common shareholders will not be satisfied. South China University of Tech. Financial Management-Chap 11 RMM Examp
37、le (Cont.) A general way to determine the minimum required return ： Recall that 40% of funds were from debt. Therefore, 40% of the required return must go to satisfy the debt holders. Similarly, 10% should go to preferred shareholders, and 50% to common shareholders This is a weighted-average, which
38、 can be calculated as: WACC w k w k w k d d p p cs cs = + + South China University of Tech. Financial Management-Chap 11 RMM Example (Cont.) Using the numbers from the RMM example, we can calculate RMMs Weighted-Average Cost of Capital (WACC) as follows: Note that this is the same as we found earlie
39、r WACC = + + = 0 40 0 07 010 010 050 012 0 098 . ( . ) . ( . ) . ( . ) . South China University of Tech. Financial Management-Chap 11 Source of Funds Amount Dollar Cost After-tax Cost Debt $4,000 $280 7% Preferred $1,000 $100 10% Common $5,000 $600 12% Total $10,000 $980 9.8%Summary: To calculate th
40、e firms weighted cost of capital, we must first calculate the costs of the individual financing sources: Cost of Debt Cost of Preferred Stock Cost of Common Stock The weights that we use to calculate the WACC will obviously affect the result. South China University of Tech. Financial Management-Chap
41、 11 IV. Optimal Capital Structure - Weighing Costs A. The firm should seek to minimize its cost of capital by employing the optimal mix of capital financing. B. The Baker Corporation example on page 310 demonstrates the concept of weighted average cost of capital numerically while Figure 11-1 does s
42、o graphically. (P310) South China University of Tech. Financial Management-Chap 11 Cost of Capital Curve (Figure 11-1) The optimal debt-equity mix varies among industries. The more cyclical the business, the lower the D/E ratio is required to be. Cyclical factors: The expected debt to equity ratio v
43、aries depending on whether markets are bullish or bearish whether the economic sector to which a company belongs is more sunrise or sunset whether a company is in an early development phase or at maturity. V. Cost of Capital in the Capital Budgeting Decision South China University of Tech. Financial
44、 Management-Chap 11 A. The discount rate used in evaluating capital projects should be the weighted average cost of capital (WACC). B. the current cost of each source of funds C. The cost of each source of capital will vary with the amount of capital derived from that source. (1) For most firms, the
45、 cost of capital is fairly constant within a reasonable range of debt-equity mixes (flat portion of curve in Figure 11-2 on Page 313). (2) However, Changes in money and capital market conditions (supply and demand for money) cause the cost of capital for all firms to vary upward and downward over ti
46、me. Example: Investment Projects Available to the Baker Corporation South China University of Tech. Financial Management-Chap 11 Using constant WACC, We will choose A-E South China University of Tech. Financial Management-Chap 11 V. Cost of Capital in the Capital Budgeting Decision : Marginal Cost o
47、f Capital(MCC) The marginal cost of debt (the cost of the last amount of debt financing) will rise as more debt financing is used. The marginal cost of equity also rises when the shift from retained earnings to external (common stock) equity financing is necessary. South China University of Tech. Fi
48、nancial Management-Chap 11 South China University of Tech. Financial Management-Chap 11 Background of Baker Corporation Debt Kd 7.05% 30% 2.12% Preferred Stock Kp 10.94 10 1.09 Common Stock (Retained earnings) Ke 12 60 7.20 WACC Ka 10.41% The equity (ownership) capital is retained earnings. Cost (af
49、tertax) weights Weighted cost Retained earnings is limited to the amount of past and present earnings. First $39 million South China University of Tech. Financial Management-Chap 11 Calculation: Assume retained earnings of Baker Corp. is $23.4 million. The size of the capital structure that retained earnings will support is X= Retained
