mgt 326 ch 13: the cost of capital (bdh2e)v1.1 1 the cost of capital what is capital? in the...

MGT 326 Ch 13: The Cost of Capital (bdh2e)v1.1

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The Cost of Capital

What is Capital?In the finance world, capital refers to the sources of financing available to a firmThis is usually debt, stock (equity) and other types of securities

When investors (individuals & other corporations) provide a corporation with funds, they expect the company to generate a return on these funds…..

to at least compensate them for opportunity cost and inflation to compensate them for various risks (i.e. default, interest rate and reinvestment risks, etc.) to justify their investment in this specific firm versus investing in other firms or other types of investments (i.e. Opportunity Costs)

Point: These are the cost firms pay to use capital; these are the costs of financing

Firm’s generate returns for their investors by using funds to expand and improve operations/NI

stock returns are generated through dividends and increased stock value (opportunity for capital gains) bond returns in the form interest (Note: any capital gain resulting from falling rd is not the result of any specific firm) lowered risk derived from a firm’s increased ability to cover debt (thru increased NI)

Point: This is how firms meet the cost of financing

What we want is a single number that expresses the overall cost of financing the firm. This is the Weighted Average Cost of Capital (WACC)

2e created Summer 11


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Bonds and stocks(common and preferred) are referred to as capital componentsThe required ROR of each component from the investor’s perspective are referred to as a component cost from the firm’s point of viewCapital Structure: the proportions of debt and equity(common & preferred) used to finance a firmExample: Diamond Jim’s Inc.’s assets are financed 60% by debt, 35% by common stock and 5% by preferred stock. The capital structure is:

A = D + SE (Share Holder’s Equity) Capital Structure: 60% 35% CS + 5% PS

Capital Component Costs:

Cost of Debt(rdT or rEFF):Recall from Ch 5 that the cost of debt to a firm (or an individual) is the interest paid on any borrowed fundsThe firm’s cost of debt is the interest rate the firm would have to pay to refinance it’s existing debtThus a firm’s cost of debt is the current market interest rate / YTMrd is the “before tax” cost of debtInterest payments are usually federal tax-deductibleThe tax deduction lowers the total cost of debt

it lowers the actual cash costs of debt by the amount deducted it effectively lowers the interest rate (from the borrower’s perspective)

Thus the actual relevant cost of debt is the “after tax” or “effective” rate; rdT

After tax cost/effective of debt = rdT = rEFF = rd(1 - TC)

Example: ATT&T annually pays $3.4m to service its debt with an average interest rate of 8%. If the firm’s marginal tax rate is 40%, what is it after tax cost of debt?

rdT = rd(1 - TC) = 8%(1 - 0.40) = 4.8%


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Capital Component Costs: (continued)Cost of Debt: (continued)

Consider a firm that has $150m in debt and has an average cost of debt of 8%. Its annual sales are $600m and annual COGS is $475m. The firm is subject to a 35% marginal tax rate

Find the firm’s NI under the following two cases:Case 1: The fed allows interest payments to be deducted prior to computing taxes

Case 2: The fed doesn’t allow interest payment deductions:

($ x 1m)Sales $600.00COGS $475.00EBIT $125.00

Interest $12.00EBT $113.00

Taxes $39.55NI $73.45

($ x 1m)Sales $600.00COGS $475.00EBIT $125.00Taxes $43.75EAT $81.25

Interest $12.00NI $69.25

($ x 1m)Sales $600.00COGS $475.00EBIT $125.00Taxes $43.75EAT $81.25

Interest $7.80NI $73.45

Case 2a: The fed doesn’t allow interest payment deductions but you compute interest using rEFF: rEFF = rd(1-TC) = 8%(1-0.35) = 5.2%

= $150m x 0.08

= $113m x 0.35

= $150m x 0.08

= $125m x 0.35

= $125m x 0.35

= $150m x 0.052


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Capital Component Costs: (continued)

Cost of Debt: (continued)

What to do if the firm has debt costing several different interest rates? (i.e. several different bond issues)Answer: compute a weighted average interest rateExample: 40% of a firm’s debt costs 6%, 30% costs 6.5% and 30% costs 6.7%. The firm’s marginal tax rate is 40%. What is the firm’s after-tax cost of debt?1) Find weighted average rd: 0.40(6%) + 0.30(6.5) + 0.30(6.7%) = 6.36%2) Find rdT: rd(1 - TC) = 6.36%(1 - 0.40) = 3.81%

Cost of Preferred Stock (rps):Recall that preferred stock usually pays a fixed dividend on a specified schedule (it’s kind of like a perpetuity)rps = Dps / (P0 - Flotation Costs)

Flotation Costs: the cost (per share) to issue the stock

Example: A share of a firm’s preferred stock cost $100 and it will pay a $10 dividend annually. It cost the firm $3 per share to issue this stock. What is the cost of the firm’s preferred stock?

rps = Dps / (P0 - Flotation Costs) = $10/($100 -$3) = 10.3%


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The Cost of Common Stock (rs):rs is the required ROR from an investor’s perspective and thus it’s a cost from the firm’s perspectiverdT is easy to determine and accurately reflects cost of debt based on the contractual nature of borrowing/lendingrs is harder to determine since its based on overall expectations rather than contractual obligationsThree methods to estimate rs:

CAPM (Ch 10): rs = rRF + (rM - rRF)s

Discounted Cash Flow (DCF) (Ch 7): rs = rs =D1/P0 + g Bond-Yield-plus-Risk Premium approach they produce different estimates for rs

these methods are not mutually exclusive; one can average them or..make an educated guess based on confidence of the data used to choose one method over the others

The CAPM method is most commonly used Provides a rs that reflects a correspondingly appropriate amount of risk measures a stock’s price volatility relative to that of the market portfolio is a measure of a security’s sensitivity to changes in the market Betas may not totally reflect true risk characteristics but they are at least widely and consistently used

Capital Component Costs: (continued)

CE 350 The Cost of Capital

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Weighted Average Cost of Capital (WACC):

What we want is a single number that expresses the overall cost of financing the firm. This is the Weighted Average Cost of Capital (WACC)Definition: the weighted average of the component costs of capitalIt is the overall cost of financing the firm

WACC = wdrdT + wpsrps + wsrs

Component Costs

Recall: Capital Structure: A = D + SE These are the weights CS + PS

Example: A firm’s common stock cost $23.50 per share and it has a of 1.3. The firm’s preferred stock costs $75 per share, pays an annual dividend of $7 and cost $0.50 per share to issue. The firm’s average cost of debt is 7%. The firm’s marginal tax rate is 35%. Its capital structure is 60% debt, 35% common stock and 5% preferred stock. The firm’s common stock trades on the NASDAQ which is currently has had an average return of 7% for the last 24 months. A 30-day T bill has returned an average of 2.7% for the last 24 months. What is the firm’s WACC?

Capital Structure: 60%D 35% CS + 5% PS

a) Find rdT: rdT = rd(1 - TC) = 0.07(1 - 0.35) = 4.5000%

b) Find rs : rs = rRF + (rM - rRF) = 2.7% + (7% - 2.7%)1.3 = 8.2900%

c) Find rps : rps = Dps / (P0 - Flotation Costs) = $7 / ($75-$0.5) = 9.4000%

d) Find WACC: WACC = wd(rdT) + ws(rs) + wps(rps) = 0.60(4.5%) + 0.35(8.29%) + 0.05(9.4%) = 6.0715%

Note: Use decimal numbers for proportions (weights)


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Weighted Average Cost of Capital (WACC): (continued)Factors that Affect WACC:Factors that the firm cannot control:

debt market interest rates (rd) stock market risk premium tax rates

Factors that the firm can control: capital structure policy (i.e. the proportion of debt and equity) dividend policy (affects firm’s ability to meet investor’s rs) its own risk position

affects bond ratingaffects rs (firm specific risk component)measured by financial ratios, and other metrics

Some Problem Areas in determining WACC:rs of privately owned firms: since stocks from these firms are not publicly traded, the concept of investor expectation as a cost of stock is meaningless

most small businesses are privately owned Accuracy of and g (as previously discussed)

Why should we care about WACC?WACC is the required ROR of the entire firm.

ROA = NI / Ave. Total Assets = RORfirm

A firm’s ROA (ROR) must be at least equal to its WACC or the firm is losing money

WACC is often used in NPV calculations (Chapter 8) as the discount rate for finding the present value of future cash flows

the ROR of the project must at least equal the cost of capital (the cost of financing the project) or the firm loses moneythus WACC is often used as a project’s required ROR

WACC is often used to do Financial Planning & Control

mgt 326 ch 13: the cost of capital (bdh2e)v1.1 1 the cost of capital what is capital? in the...

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