Chapter 10. Cost of Capital

. Capital components

. Cost of debt

. Cost of preferred stock

. Cost of retained earnings

. Cost of new common stock

. Weighted average cost of capital (WACC)

. Adjusting the cost of capital for risk

Cost of capital has to be calculated by finance managers and they have to communicate it to operating managers so that they come out with project proposals having return higher than the cost of capital. To calculate cost of valuation formulas developed for bonds, equity, and preferred stock are used with current market prices of company's securities. The assumption being that company can sell securities in the market at the current prices. Generally, company may have to sell at a lesser price than the market and this figure is included in floatation cost. Floatation cost also includes advertisement, underwriting and brokerage charges.

. Capital components

Debt: debt financing

Preferred stock: preferred stock financing

Equity: equity financing (internal vs. external)

Internal: retained earnings

External: new common stock

Weighted average cost of capital (WACC)

. Cost of debt

Recall the bond valuation formula

Replace VB by the net price of the bond and solve for I/YR

I/YR = rd (cost of debt before tax)

Net price = market price - flotation cost of bonds

If we ignore flotation costs which are generally small, we can just use the actual

market price to calculate rd

Cost of debt after tax = cost of debt before tax (1-T) = rd (1-T)

Example: if a firm can issue a 10-year 8% coupon bond with a face value of

$1,000 to raise money. The firm pays interest semiannually. The net price for

each bond is $950. What is the cost of debt before tax? If the firm’s marginal tax

rate is 40%, what is the cost of debt after tax?

Answer: PMT = -40, FV = -1,000, N = 20, PV = 950, solve for I/YR = 4.38%

Cost of debt before tax = rd = 8.76%

Cost of debt after tax = rd*(1-T) = 8.76*(1-0.4) = 5.26%

. Cost of preferred stock

Recall the preferred stock valuation formula

Replace Vp by the net price and solve for rp (cost of preferred stock)

Net price = market price - flotation cost (for preferred stock)

If we ignore flotation costs, we can just use the actual market price to calculate rp

. Cost of retained earnings

CAPM approach

DCF approach

Bond yield plus risk premium approach

rs = bond yield + risk premium

When must a firm use external equity financing?

It depends on the capital structure policy of the company and amount retained from the earnings.

R/E

Retained earning breakpoint = -----------------

% of equity

It is the dollar amount of capital beyond which new common stock must be issued

For example, suppose the target capital structure for XYZ is 40% debt, 10%

preferred stock and 50% equity. If the firm’s net income is $5,000,000 and the

dividend payout ratio is 40% (i.e., the firm pays out $2,000,000 as cash dividend

and retains $3,000,000), then the retained earning breakpoint will be

3,000,000

--------------- = $6,000,000,

50%

which means that if XYZ needs to raise more than $6,000,000 it has to issue new

common stock

. Cost of new common stock

## . Weighted average cost of capital (WACC)

Target capital structure: the percentages (weights) of debt, preferred stock, and

common equity that will maximize the firm’s stock price

WACC = wd rd (1-T) + wp rp + wc (rs or re)

Comprehensive example

A company's target capital structure is 20% debt, 20% preferred stock, and 60% common equity. Its bonds have a 12% coupon, paid semiannually, a current maturity of 20 years, and a net price of

$960. The firm could sell, at par, $100 preferred stock that pays a $10 annual dividend, but flotation costs of 5% would be incurred. The company's beta is 1.5, the risk-free rate in the economy is 4%, and the market return is 12%. The company is a constant growth firm (8%) which just paid a dividend of $2.00, sells for $27.00 per share. Flotation cost on new common stock is 6%, and the firm’s marginal tax rate is 40%.

Solution

a) Cost of debt before tax = 12.55%

Cost of debt after tax = 7.53%

b) cost of preferred stock?

Cost of P/S = 10.53%

c) Cost of R/E using the CAPM approach?

Cost of R/E = 16%

d) Cost of R/E using the DCF approach?

Cost of R/E = 16%

e) WACC till the company uses retained earnings

Answer: WACC (R/E) = 13.21%

f) WACC once it starts using new common stock financing

Cost of N/C = 16.51%

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