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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1of 21
The Cost of Capital
The cost of capitalacts as a link between the firms
long-term investment decisions and the wealth of the
owners as determined by investors in the marketplace.
It is used to decide whether a proposed investment
will increase or decrease the firms stock price.
Formally, the cost of capital is the rate of returnthat a
firm must earn on the projects in which it invests to
maintain the market value of its stock.
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The Firms Capital StructureThe Firms Capital
Structure
CurrentAssets
FixedAssets
CurrentLiabilities
Long-
Term
Debt
Equity
The Firms
CapitalStructure
& Cost ofCapital
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The Weighted Average
Cost of Capital
Capitalrefers to the long-term funds used by
a firm to finance its assets.
Capital componentsthe types of capital usedby a firmlong-term debt and equity
WACCthe average percentage cost, based
on the proportion of each type of capital, of allthe funds used by the firm to finance its assets.
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The pretax cost of debtis equal to the the yield-to-
maturity on the firms debt adjusted for flotation costs.
Recall that a bonds yield-to-maturitydepends upon a
number of factors including the bonds coupon rate,
maturity date, par value, current market conditions,and selling price.
After obtaining the bonds yield, a simple adjustment
must be made to account for the fact that interest is atax-deductibleexpense.
This will have the effect of reducing the cost of debt.
The Cost of Debt
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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 5of 21
Par Value -1000
Flotation Costs (% of Par) 2%
Flotation Costs () -20
Issue Price 980
Net Proceeds Price 960
Coupon Interest (%) 9%
Coupon Interest () -90
Time to maturity 20
Tax 40%
Before-tax cost of debt 9,45%
After-tax cost of debt 5,67%
Finding the Cost of Debt
The Cost of Debt - Example
Suppose a company could issue 9% coupon, 20 year debt
face value of1,000 for980. Suppose that flotation costswill amount to 2% of par value. Find the after-tax cost of
debt assuming the company is in the 40% tax bracket.
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The Cost of Equity The cost of equity is based on the rate of return
required by the firms stockholders. Cost of preferred stock - dividends received by preferred
stockholders represent an annuity
Cost of retained earnings (internal equity)return that
common stockholders require the firm to earn on the fundsthat have been retained, thus reinvested in the firm, rather
than paid out as dividends
Cost of new (external) equityrate of return required by
common stockholders after considering the cost associatedwith issuing new stock (flotation costs)
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The Cost of Preferred Stock (kp)
KP = DP/(PP- F) = DP/(NP)
In the above equation, F represents flotation costs
(in). As was the case for debt, the cost of raising
new preferred stock will be more than the yield on the
firms existing preferred stock since the firm must pay
investment bankers to sell (or float) the issue.
C f f S ( )
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A company can issue preferred stock that pays a5
annual dividend, sell it for55 per share, and haveto pay3 per share to sell it. Then, the cost of
preferred stock would be:
kP=5/(55 -3) = 9.62%
There is no tax adjustment, because dividends are
not a tax-deductible expense.
KP = DP/(PP- F)
The Cost of Preferred Stock (kp) -
Example
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The Cost of Retained Earnings
The firm must earn a return on reinvested
earnings that is sufficient to satisfy existing
common stockholders investment demands.
If the firm does not earn a sufficient return usingretained earnings, then the earnings should be
paid out as dividends so that stockholders can
invest the funds outside the firm to earn an
appropriate rate.
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Discounted Cash Flow (DCF) approach
kS = (D1/P0) + g.
For example, assume a firm has just paid a dividendof2.50 per share, expects dividends to grow at
10% indefinitely, and is currently selling for50 pershare.
First, D1= 2.50(1+.10) = 2.75, and
kS = (2.75/50) + .10 = 15.5%.
The Cost of Retained Earnings (ks)
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Security Market Line Approach
kE = rF + b(kM- RF).
For example, if the 3-month government bond rate iscurrently 5.0%, the market risk premium is 9%, and
the firms beta is 1.20, the firms cost of retained
earnings will be:
kE= 5.0 + 1.2(9) = 15.8%.
The Cost of Retained Earnings (kE)
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The Cost of Retained Earnings, ks
Bond-Yield-Plus-Risk-Premium Approach
Studies have shown that the return on equity fora particular firm is approximately 3 to 5
percentage points higher than the return on its
debt.
As a general rule of thumb, firms often compute
the YTM, or kd, for their bonds and then add 3 to
5 percent.
In the current example, kd= 6.0%. As a roughestimate, then, we might say the cost of
retained earnings is
ks.kd+ 4% = 6% + 4% = 10.0%
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The Cost of New Equity
Rate of return required by common stockholders
after considering the costs associated with issuingnew stock, which are called flotation costs.
Because the firm has to provide the same gross
return to new stockholders as existing
stockholders, when the flotation costs associated
with a common stock issue are considered, the
cost of new common stock always must be greater
than the cost of existing stockthat is, the cost ofretained earnings.
Modify the DCF approach for computing the cost
of retained earnings to include flotation costs
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Discounted Cash Flow (DCF) approach
Kn = [D1/(P0 - F)] + g = D1/Nn+g
ssume a firm has just paid a dividend of2.50 pershare, expects dividends to grow at 10%
indefinitely, and is currently selling for50 pershare.ow much would it cost the firm to raise new
equity if flotation costs amount to4.00 per share?Kn = [2.75/(50 - 4)] + .10 = 15.97% or 16%.
The Cost of New Equity (kn)
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The Weighted Average Cost of Capital
Capital Structure Weights
WACC = ka = wiki+ wpkp+ wskr or n
The weights in the above equation are intended to
represent a specific financing mix (where wi= % of
debt, wp= % of preferred, and ws= % of common).
Specifically, these weights are the target percentages
of debt and equity that will minimize the firms overall
cost of raising funds.
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One method uses book valuesfrom the firms
balance sheet. For example, to estimate the weight
for debt, simply divide the book value of the firms
long-term debt by the book value of its total assets.To estimate the weight for equity, simply divide the
total book value of equity by the book value of total
assets.
The Weighted Average Cost of Capital
Capital Structure Weights
WACC = ka = wiki+ wpkp+ wskr or n
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A second method uses the market valuesof the firmsdebt and equity. To find the market value proportion
of debt, simply multiply the price of the firms bonds
by the number outstanding. This is equal to the total
market value of the firms debt.
Next, perform the same computation for the firmsequity by multiplying the price per share by the totalnumber of shares outstanding.
The Weighted Average Cost of Capital
Capital Structure Weights
WACC = ka = wiki+ wpkp+ wskr or n
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Finally, add together the total market value of the
firms equity to the total market value of the firms
debt. This yields the total market value of the firms
assets.To estimate the market value weights, simply divide
the market value of either debt or equity by the
market value of the firms assets .
The Weighted Average Cost of Capital
Capital Structure Weights
WACC = ka = w
ik
i+ w
pk
p+ w
sk
r or n
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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 19of 21
For example, assume the market value of the firmsdebt is40 million, the market value of the firms
preferred stock is10 million, and the market value of
the firms equity is 50 million.
Dividing each component by the total of100 million
gives us market value weights of 40% debt, 10%
preferred, and 50% common.
The Weighted Average Cost of Capital
Capital Structure Weights
WACC = ka = w
ik
i+ w
pk
p+ w
sk
r or n
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Essentials of Managerial Finance by S Besley & E Brigham Slide 20 of 21
Using the costs previously calculated along with themarket value weights, we may calculate the weighted
average cost of capital as follows:
WACC = .4(5.67%) + .1(9.62%) + .5 (15.8%)
= 11.13%
This assumes the firm has sufficient retained
earnings to fund any anticipated investment projects.
The Weighted Average Cost of Capital
Capital Structure Weights
WACC = ka = w
ik
i+ w
pk
p+ w
sk
r or n