measurement of cost

8/10/2019 Measurement of Cost

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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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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)


7/20Essentials of Managerial Finance by S. Besley & E. Brigham Slide 7of 21

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 ( )



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



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.



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)



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)



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%



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



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.





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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.





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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 .



WACC = ka = w

ik

i+ w

pk

p+ w

sk

r or n


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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.



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.



WACC = ka = w

ik

i+ w

pk

p+ w

sk

r or n

measurement of cost

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