9. cost of capital

Copyright © 2011 Pearson Prentice Hall.All rights reserved.

Chapter 9

Cost of Capital

9-2 © 2011 Pearson Prentice Hall. All rights reserved.

Learning Objectives

1. Describe the concepts underlying the firm’s cost of capital.

2. Calculate the after-tax cost of debt, preferred stock, and common equity.

3. Calculate a firm’s weighted average cost of capital.

4. Describe the procedure used by PepsiCo to estimate the cost of capital for a multidivisional firm.

5. Use the cost of capital to evaluate new investment opportunities.

6. Calculate equivalent interest rates for different countries.


Slide Contents

Cost of Capital: Key Definitions and Concepts

Determining the Cost of Individual Sources of Capital

The Weighted Average Cost of Capital

Calculating Divisional Costs of Capital for PepsiCo, Inc.

Cost of Capital and New Investment

Shareholder Value-Based Management

Multinational Firms and Interest Rates


1. Cost of Capital: Key Definitions and Concepts

Capital

Capital represents the funds used to finance a firm's assets and operations. Capital constitutes all items on the right hand side of balance sheet i.e. liabilities and common equity.

Main sources: Debt, Preferred stock, Retained earnings and Common Stock


Investor’s Required Rate of Return

Investor’s Required Rate of Return – is the minimum rate of return necessary to attract an investor to purchase or hold a security.

Investor’s required rate of return is not the same as cost of capital due to taxes and transaction costs. Impact of taxes: For example, a firm may pay 8%

interest on debt but due to tax benefit on interest expense, the net cost to the firm will be lower than 8%.


Investor’s Required Rate of Return

Impact of transaction costs on cost of capital: For example, If a firm sells new stock for $50.00 a share and incurs $5 in flotation costs, and the investors have a required rate of return of 15%, what is the cost of capital?

The firm has only $45.00 to invest after transaction cost..15 $50.00 = $7.5k = $7.5/($45.00)

= .1667 or 16.67% (rather than 15%)


Financial Policy

A firm’s financial policy indicates the desired sources of financing and the particular mix in which it will be used.

For example, a firm may choose to raise capital by issuing stocks and bonds in the ratio of 6:4 (60% stocks and 40% bonds). The choice of mix may impact the cost of capital.


2. Determining the Costs of the Individual Sources of Capital

The Cost of DebtThe bondholder’s required rate of return on debt is the return that bondholders demand. As seen in Chapter 7, this can be estimated using the bond price equation:


The Cost of Debt

Since firms must pay floatation costs when they sell bonds, the net proceeds per bond received by firm is less than the market price of the bond. Hence, the cost of debt capital (Kd) will be higher than the bondholder’s required rate of return. It can be calculated using the following equation:


The Cost of Debt

See Example 9-1 Investor’s required rate of return = 9%

However, due to floatation cost, the before-tax cost of capital for the firm is = 9.73%

After-tax cost of debt = Cost of debt*(1-tax rate)

At 34% tax bracket = 9.73*(1 – .34) = 6.422%


The Cost of Preferred Stock

Similar to bond issue, since floatation costs are incurred, preferred stockholder’s required rate of return will be less than the cost of preferred capital to the firm.

Thus, in order to determine the cost of preferred stock, we adjust the price of preferred stock for floatation cost to give us the net proceeds.

Net proceeds = issue price per share – floatation cost per share.


The Cost of Preferred Stock

Cost of Preferred Stock:

Pn = net proceeds (i.e. Issue price – Floatation costs)

Dp = Preferred stock dividend per share

Example: Determine the cost for a preferred stock that pays annual dividend of $4.25, has current stock price $58.50 and incurs flotation costs of $1.375 per share

Cost = $4.25/(58.50 – 1.375) = .074 or 7.44%


The Cost of Common Equity

Cost of equity is more challenging to estimate than the cost of debt or the cost of preferred stock because common stockholder’s rate of return is not fixed as there is no stated coupon rate or dividend.

Furthermore, the costs will vary for two sources of equity (i.e. retained earnings and new issue).


The Cost of Common Equity

There is no flotation costs on retained earnings but the firm incurs costs when it sells new common stock.

Note retained earnings are not a free source of capital. There is an opportunity cost.


Cost estimation techniques

Two commonly used methods for estimating common stockholder’s required rate of return are:

The Dividend Growth Model

The Capital Asset Pricing Model



Investors’ required rate of return (For Retained Earnings):

D1 = Dividends expected one year hence

Pcs = Price of common stock;

g = growth rate



Investors’ required rate of return (For new issues)

D1 = Dividends expected one year hence

Pcs = Net proceeds per share

g = growth rate



Example: A company expects dividends this year to be $1.10, based upon the fact that $1 were paid last year. The firm expects dividends to grow 10% next year and into the foreseeable future. Stock is trading at $35 a share.

Cost of retained earnings: Kcs = D1/Pcs + g1.1/35 + .10 = .1314 or 13.14%

Cost of new stock (with a $3 floatation cost):Kncs = D1/NPcs + g1.10/(35 – 3) + .10 = .1343 or 13.43%



Dividend growth model is simple to use but suffers from the following drawbacks:

It assumes a constant growth rate

It is not easy to forecast the growth rate


The Capital Asset Pricing Model

rf = Risk Free rate

= Beta

rm – rf = Market Risk Premium or Expected rate of return for “average security” minus the risk free rate


Capital Asset Pricing Model

Example: If beta is 1.25, risk-free rate is 1.5% and expected return on market is 10%

kc = rrf + (rm – rf)

= .015 + 1.25(.10 – .015)

= 12.125%


Capital Asset Pricing Model Variable estimates

CAPM is easy to apply. Also, the estimates for model variables are generally available from public sources.

Risk Free Rate: Wide range of US government securities on which to base risk-free rate

Beta: Estimates of beta are available from a wide range of services, or can be estimated using regression analysis of historical data.

Market risk premium: It can be estimated by looking at history of stock returns and premium earned over risk-free rate.


3. The Weighted Average Cost of Capital

Bringing it all together: WACC To estimate WACC, we need to know the capital

structure mix and the cost of each of the sources of capital.

For a firm with only two sources: debt and common equity,


WACC Example

A firm borrows money at 7% after taxes and pays 12% for equity. The company raises capital in equal proportions i.e. 50% debt and 50% equity.

WACC = (.07 .5) + (.12 .5) = .095 or 9.5%


Business world cost of capital

In practice, the calculation of cost of capital may be more complex:

If firms have multiple debt issues with different required rates of return.

If firms also use preferred stock in addition to common stock financing.


Table 9-1


Table 9-3


4. Calculating Divisional Costs of Capital for PepsiCo Inc.

PepsiCo calculated divisional cost of capital for each of its three major divisions: restaurants, food, and beverages.

The target ratios for debt/equity mix and the pre-tax cost of debt were different for each division.

PepsiCo estimated the WACC for each division in a 3 step process: Estimate the cost of debt for each division

Estimate the cost of equity for each division

Estimate the WACC (with target capital structure) for each division


Table 9-4PepsiCo’s Cost of Debt


Table 9-5 PepsiCo’s Cost of Equity


Table 9-6 PepsiCo’s WACC


5. Cost of Capital and New Investment

Cost of capital can serve as the discount rate in evaluating new investment when the projects offer the same risk as the firm as a whole.

If risk differs, it is better to calculate a different cost of capital for each division.


6. Multinational Firms and Interest Rates

In an international setting, there can be different rates of inflation among different countries.

The Fisher Model indicates that the nominal interest rate in the home or domestic country is a function of real interest rates and anticipated rate of inflation.


Fisher Model and Domestic Interest Rates

rn,h = (1 + rr,h)(1 + ih) – 1

rn,h = Nominal rate of interest at home, U.S.

rr,h = real interest rate at home, U.S.

Ih = inflation rate at home, U.S

Example: If Real interest rate is 3% and inflation rate is 5%, nominal rate will be 8.15%

(1.03)(1.05) – 1 = 8.15%


International or Foreign Rates and Fisher Effect

rn,h – rn,h = ih – if

Differences in observed nominal rates of interest between two countries should equal the difference in expected rates of inflation between the two countries.


Interest Rate Parity Theorem

rn,h = Domestic one-period rate of interest

rn,f = Corresponding rate in foreign country

E0 & E1 = Exchange rates corresponding to current period (i.e. spot exchange rate) and one-period hence (i.e. the one-period forward exchange rate)


Interest Rate Parity Theorem

Thus,

Nominal interest rates are tied to exchange rates

Differences in nominal interest rates are tied to expected rates of inflation


Interest Rates and Currency Exchange Rates

Example: If domestic one-period interest rate is 15.5%, and the Japanese rate of interest is 5%, the spot exchange rate is $1 to 1 yen and the forward exchange rate is $1.10 to 1 yen.

1 + .155 / 1 + .05 = 1.1/1= 1.10


Figure 9-1


Key Terms

Capital Structure

Financial Policy

Economic Profit

Market Value Added

Weighted Average Cost of Capital

9. cost of capital

Economy & Finance

net cost

tax cost of capital

cost of preferredstock

cost of capital copyright

aftertransaction cost

opportunity cost

cost of debt capital

aftertax cost of debt