Chapter 12 -Chapter 12 - Cost of CapitalCost of Capital
© 2005, Pearson Prentice Hall
 Basic Skills:Basic Skills: (Time value of money,(Time value of money,
Financial Statements)Financial Statements)
 Inves...
Assets Liabilities & EquityAssets Liabilities & Equity
Current Assets Current LiabilitiesCurrent Assets Current Liabilitie...
Assets Liabilities & EquityAssets Liabilities & Equity
Current Assets Current LiabilitiesCurrent Assets Current Liabilitie...
Corporate Finance:Corporate Finance: (The(The FinancingFinancing
Decision)Decision)
 Cost of capitalCost of capital
 Lev...
Assets Liabilities & EquityAssets Liabilities & Equity
Current Assets Current LiabilitiesCurrent Assets Current Liabilitie...
Assets Liabilities & EquityAssets Liabilities & Equity
Current Assets Current LiabilitiesCurrent Assets Current Liabilitie...
Assets Liabilities & EquityAssets Liabilities & Equity
Current Assets Current LiabilitiesCurrent Assets Current Liabilitie...
Assets Liabilities & EquityAssets Liabilities & Equity
Current assets Current LiabilitiesCurrent assets Current Liabilitie...
Ch. 12 - Cost of CapitalCh. 12 - Cost of Capital
 For InvestorsFor Investors, the rate of return on a, the rate of return...
How can the firm raise capital?How can the firm raise capital?
 BondsBonds
 Preferred StockPreferred Stock
 Common Stoc...
Cost ofCost of
DebtDebt
Cost of DebtCost of Debt
For the issuing firm, theFor the issuing firm, the costcost
of debtof debt is:is:
 thethe rate o...
Example: Tax effectsExample: Tax effects
of financing with debtof financing with debt
with stockwith stock with debtwith d...
Example: Tax effectsExample: Tax effects
of financing with debtof financing with debt
with stockwith stock with debtwith d...
Example: Tax effectsExample: Tax effects
of financing with debtof financing with debt
with stockwith stock with debtwith d...
After-tax Before-tax MarginalAfter-tax Before-tax Marginal
% cost of % cost of x tax% cost of % cost of x tax
Debt Debt ra...
After-tax Before-tax MarginalAfter-tax Before-tax Marginal
% cost of % cost of x tax% cost of % cost of x tax
Debt Debt ra...
After-tax Before-tax MarginalAfter-tax Before-tax Marginal
% cost of % cost of x tax% cost of % cost of x tax
Debt Debt ra...
Example: Cost of DebtExample: Cost of Debt
 Prescott Corporation issues aPrescott Corporation issues a $1,000$1,000
par,p...
 Pre-tax cost of debtPre-tax cost of debt: (using TVM): (using TVM)
P/Y = 2P/Y = 2 N = 40N = 40
PMT = -50PMT = -50
FV = -...
 Pre-tax cost of debtPre-tax cost of debt: (using TVM): (using TVM)
P/Y = 2P/Y = 2 N = 40N = 40
PMT = -50PMT = -50
FV = -...
Cost of Preferred StockCost of Preferred Stock
 Finding theFinding the costcost of preferred stockof preferred stock
is s...
Cost of Preferred StockCost of Preferred Stock
 Recall:Recall:
Cost of Preferred StockCost of Preferred Stock
 Recall:Recall:
kkpp = == =D
Po
Dividend
Price
Cost of Preferred StockCost of Preferred Stock
 Recall:Recall:
kkpp = == =
 From theFrom the firm’sfirm’s point of view:...
Cost of Preferred StockCost of Preferred Stock
 Recall:Recall:
kkpp = == =
 From theFrom the firm’sfirm’s point of view:...
Cost of Preferred StockCost of Preferred Stock
 Recall:Recall:
kkpp = == =
 From theFrom the firm’sfirm’s point of view:...
Example: Cost of PreferredExample: Cost of Preferred
 If Prescott Corporation issuesIf Prescott Corporation issues
prefer...
Cost of Preferred StockCost of Preferred Stock
Cost of Preferred StockCost of Preferred Stock
kpkp == Dividend
Net Price
D
NPo =
Cost of Preferred StockCost of Preferred Stock
kpkp = == =
= == =
Dividend
Net Price
D
NPo
8.00
74.00
Cost of Preferred StockCost of Preferred Stock
kpkp = == =
= = 10.81%= = 10.81%
Dividend
Net Price
D
NPo
8.00
74.00
Cost of Common StockCost of Common Stock
There are two sources of Common Equity:There are two sources of Common Equity:
1)...
Cost of Internal EquityCost of Internal Equity
 Since the stockholders own the firm’sSince the stockholders own the firm’...
Cost of Internal EquityCost of Internal Equity
Cost of Internal EquityCost of Internal Equity
1)1) Dividend Growth ModelDividend Growth Model
Cost of Internal EquityCost of Internal Equity
1)1) Dividend Growth ModelDividend Growth Model
kkcc = + g= + g
D1
Po
Cost of Internal EquityCost of Internal Equity
1)1) Dividend Growth ModelDividend Growth Model
kkcc = + g= + g
2)2) Capita...
Cost of Internal EquityCost of Internal Equity
1)1) Dividend Growth ModelDividend Growth Model
kkcc = + g= + g
2)2) Capita...
Cost of External EquityCost of External Equity
Dividend Growth ModelDividend Growth Model
Cost of External EquityCost of External Equity
Dividend Growth ModelDividend Growth Model
kkncnc = + g= + g
Cost of External EquityCost of External Equity
D1
NPo
Dividend Growth ModelDividend Growth Model
kkncnc = + g= + g
Cost of External EquityCost of External Equity
D1
NPo
Net pro...
Weighted Cost of CapitalWeighted Cost of Capital
 The weighted cost of capital is just theThe weighted cost of capital is...
Weighted Cost of CapitalWeighted Cost of Capital
CapitalCapital
Source Cost StructureSource Cost Structure
debt 6% 20%debt...
Weighted cost of capital =Weighted cost of capital =
.20 (6%) + .10 (10%) + .70 (16%).20 (6%) + .10 (10%) + .70 (16%)
== 1...
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Fm10e ch12

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Fm10e ch12

  1. 1. Chapter 12 -Chapter 12 - Cost of CapitalCost of Capital © 2005, Pearson Prentice Hall
  2. 2.  Basic Skills:Basic Skills: (Time value of money,(Time value of money, Financial Statements)Financial Statements)  Investments:Investments: (Stocks, Bonds, Risk and(Stocks, Bonds, Risk and Return)Return)  Corporate Finance:Corporate Finance: (The Investment(The Investment Decision - Capital Budgeting)Decision - Capital Budgeting) Where we’ve been...Where we’ve been...
  3. 3. Assets Liabilities & EquityAssets Liabilities & Equity Current Assets Current LiabilitiesCurrent Assets Current Liabilities Fixed Assets Long-term DebtFixed Assets Long-term Debt Preferred StockPreferred Stock Common EquityCommon Equity
  4. 4. Assets Liabilities & EquityAssets Liabilities & Equity Current Assets Current LiabilitiesCurrent Assets Current Liabilities Fixed Assets Long-term DebtFixed Assets Long-term Debt Preferred StockPreferred Stock Common EquityCommon Equity The investment decision
  5. 5. Corporate Finance:Corporate Finance: (The(The FinancingFinancing Decision)Decision)  Cost of capitalCost of capital  LeverageLeverage  Capital StructureCapital Structure  DividendsDividends Where we’re going...Where we’re going...
  6. 6. Assets Liabilities & EquityAssets Liabilities & Equity Current Assets Current LiabilitiesCurrent Assets Current Liabilities Fixed Assets Long-term DebtFixed Assets Long-term Debt Preferred StockPreferred Stock Common EquityCommon Equity
  7. 7. Assets Liabilities & EquityAssets Liabilities & Equity Current Assets Current LiabilitiesCurrent Assets Current Liabilities Fixed Assets Long-term DebtFixed Assets Long-term Debt Preferred StockPreferred Stock Common EquityCommon Equity The financing decision
  8. 8. Assets Liabilities & EquityAssets Liabilities & Equity Current Assets Current LiabilitiesCurrent Assets Current Liabilities Long-term DebtLong-term Debt Preferred StockPreferred Stock Common EquityCommon Equity
  9. 9. Assets Liabilities & EquityAssets Liabilities & Equity Current assets Current LiabilitiesCurrent assets Current Liabilities Long-term DebtLong-term Debt Preferred StockPreferred Stock Common EquityCommon Equity }Capital Structure
  10. 10. Ch. 12 - Cost of CapitalCh. 12 - Cost of Capital  For InvestorsFor Investors, the rate of return on a, the rate of return on a security is asecurity is a benefitbenefit of investing.of investing.  For Financial ManagersFor Financial Managers, that same, that same rate of return is arate of return is a costcost of raising fundsof raising funds that are needed to operate the firm.that are needed to operate the firm.  In other words, the cost of raisingIn other words, the cost of raising funds is the firm’sfunds is the firm’s cost of capitalcost of capital..
  11. 11. How can the firm raise capital?How can the firm raise capital?  BondsBonds  Preferred StockPreferred Stock  Common StockCommon Stock  Each of these offers aEach of these offers a rate of returnrate of return toto investors.investors.  This return is aThis return is a costcost to the firm.to the firm.  ““Cost of capitalCost of capital”” actually refers to theactually refers to the weighted cost of capitalweighted cost of capital - a weighted- a weighted average cost of financing sources.average cost of financing sources.
  12. 12. Cost ofCost of DebtDebt
  13. 13. Cost of DebtCost of Debt For the issuing firm, theFor the issuing firm, the costcost of debtof debt is:is:  thethe rate of returnrate of return requiredrequired by investors,by investors,  adjusted foradjusted for flotation costsflotation costs (any costs associated with(any costs associated with issuing new bonds), andissuing new bonds), and  adjusted foradjusted for taxes.taxes.
  14. 14. Example: Tax effectsExample: Tax effects of financing with debtof financing with debt with stockwith stock with debtwith debt EBITEBIT 400,000400,000 400,000400,000 - interest expense- interest expense 00 (50,000)(50,000) EBTEBT 400,000400,000 350,000350,000 - taxes (34%)- taxes (34%) (136,000)(136,000) (119,000)(119,000) EATEAT 264,000264,000 231,000231,000
  15. 15. Example: Tax effectsExample: Tax effects of financing with debtof financing with debt with stockwith stock with debtwith debt EBITEBIT 400,000400,000 400,000400,000 - interest expense- interest expense 00 (50,000)(50,000) EBTEBT 400,000400,000 350,000350,000 - taxes (34%)- taxes (34%) (136,000)(136,000) (119,000)(119,000) EATEAT 264,000264,000 231,000231,000  Now, suppose the firm pays $50,000 inNow, suppose the firm pays $50,000 in dividends to the stockholders.dividends to the stockholders.
  16. 16. Example: Tax effectsExample: Tax effects of financing with debtof financing with debt with stockwith stock with debtwith debt EBITEBIT 400,000400,000 400,000400,000 - interest expense- interest expense 00 (50,000)(50,000) EBTEBT 400,000400,000 350,000350,000 - taxes (34%)- taxes (34%) (136,000)(136,000) (119,000)(119,000) EATEAT 264,000264,000 231,000231,000 - dividends- dividends (50,000)(50,000) 00 Retained earningsRetained earnings 214,000214,000 231,000231,000
  17. 17. After-tax Before-tax MarginalAfter-tax Before-tax Marginal % cost of % cost of x tax% cost of % cost of x tax Debt Debt rateDebt Debt rate -= 11
  18. 18. After-tax Before-tax MarginalAfter-tax Before-tax Marginal % cost of % cost of x tax% cost of % cost of x tax Debt Debt rateDebt Debt rate KKdd = k= kdd (1 - T)(1 - T) -= 11
  19. 19. After-tax Before-tax MarginalAfter-tax Before-tax Marginal % cost of % cost of x tax% cost of % cost of x tax Debt Debt rateDebt Debt rate KKdd = k= kdd (1 - T)(1 - T) .066 = .10 (1 - .34).066 = .10 (1 - .34) -= 11
  20. 20. Example: Cost of DebtExample: Cost of Debt  Prescott Corporation issues aPrescott Corporation issues a $1,000$1,000 par,par, 20 year20 year bond paying the marketbond paying the market rate ofrate of 10%.10%. Coupons areCoupons are semiannual. The bond will sell for parsemiannual. The bond will sell for par since it pays the market rate, butsince it pays the market rate, but flotation costs amount toflotation costs amount to $50$50 perper bond.bond.  What is the pre-tax and after-taxWhat is the pre-tax and after-tax costcost of debtof debt for Prescott Corporation?for Prescott Corporation?
  21. 21.  Pre-tax cost of debtPre-tax cost of debt: (using TVM): (using TVM) P/Y = 2P/Y = 2 N = 40N = 40 PMT = -50PMT = -50 FV = -1000FV = -1000 PV = 950PV = 950 solve: I =solve: I = 10.61%10.61% = kd= kd  After-tax cost of debtAfter-tax cost of debt:: Kd = kd (1 - T)Kd = kd (1 - T) Kd = .1061 (1 - .34)Kd = .1061 (1 - .34) Kd = .07 =Kd = .07 = 7%7%
  22. 22.  Pre-tax cost of debtPre-tax cost of debt: (using TVM): (using TVM) P/Y = 2P/Y = 2 N = 40N = 40 PMT = -50PMT = -50 FV = -1000FV = -1000 So, a 10% bondSo, a 10% bond PV = 950PV = 950 costs the firmcosts the firm solve: I =solve: I = 10.61%10.61% = kd= kd onlyonly 7%7% (with(with  After-tax cost of debtAfter-tax cost of debt:: flotation costs)flotation costs) Kd = kd (1 - T)Kd = kd (1 - T) since the interestsince the interest Kd = .1061 (1 - .34)Kd = .1061 (1 - .34) is tax deductible.is tax deductible. Kd = .07 =Kd = .07 = 7%7%
  23. 23. Cost of Preferred StockCost of Preferred Stock  Finding theFinding the costcost of preferred stockof preferred stock is similar to finding theis similar to finding the rate ofrate of returnreturn (from Chapter 8), except(from Chapter 8), except that we have to consider thethat we have to consider the flotation costsflotation costs associated withassociated with issuing preferred stock.issuing preferred stock.
  24. 24. Cost of Preferred StockCost of Preferred Stock  Recall:Recall:
  25. 25. Cost of Preferred StockCost of Preferred Stock  Recall:Recall: kkpp = == =D Po Dividend Price
  26. 26. Cost of Preferred StockCost of Preferred Stock  Recall:Recall: kkpp = == =  From theFrom the firm’sfirm’s point of view:point of view: D Po Dividend Price
  27. 27. Cost of Preferred StockCost of Preferred Stock  Recall:Recall: kkpp = == =  From theFrom the firm’sfirm’s point of view:point of view: kkpp = == = D Po Dividend Price Dividend Net Price D NPo
  28. 28. Cost of Preferred StockCost of Preferred Stock  Recall:Recall: kkpp = == =  From theFrom the firm’sfirm’s point of view:point of view: kkpp = == = NPo = price - flotation costs!NPo = price - flotation costs! D Po Dividend Price Dividend Net Price D NPo
  29. 29. Example: Cost of PreferredExample: Cost of Preferred  If Prescott Corporation issuesIf Prescott Corporation issues preferred stock, it will pay apreferred stock, it will pay a dividend ofdividend of $8$8 per year andper year and should be valued atshould be valued at $75$75 per share.per share. If flotation costs amount toIf flotation costs amount to $1$1 per share, what is the cost ofper share, what is the cost of preferred stock for Prescott?preferred stock for Prescott?
  30. 30. Cost of Preferred StockCost of Preferred Stock
  31. 31. Cost of Preferred StockCost of Preferred Stock kpkp == Dividend Net Price D NPo =
  32. 32. Cost of Preferred StockCost of Preferred Stock kpkp = == = = == = Dividend Net Price D NPo 8.00 74.00
  33. 33. Cost of Preferred StockCost of Preferred Stock kpkp = == = = = 10.81%= = 10.81% Dividend Net Price D NPo 8.00 74.00
  34. 34. Cost of Common StockCost of Common Stock There are two sources of Common Equity:There are two sources of Common Equity: 1)1) Internal common equityInternal common equity (retained(retained earnings).earnings). 2)2) External common equityExternal common equity (new common(new common stock issue).stock issue). Do these two sources have the same cost?Do these two sources have the same cost?
  35. 35. Cost of Internal EquityCost of Internal Equity  Since the stockholders own the firm’sSince the stockholders own the firm’s retained earnings, the cost is simplyretained earnings, the cost is simply the stockholders’ required rate ofthe stockholders’ required rate of return.return.  Why?Why?  If managers are investingIf managers are investing stockholders’ funds, stockholders willstockholders’ funds, stockholders will expect to earn an acceptable rate ofexpect to earn an acceptable rate of return.return.
  36. 36. Cost of Internal EquityCost of Internal Equity
  37. 37. Cost of Internal EquityCost of Internal Equity 1)1) Dividend Growth ModelDividend Growth Model
  38. 38. Cost of Internal EquityCost of Internal Equity 1)1) Dividend Growth ModelDividend Growth Model kkcc = + g= + g D1 Po
  39. 39. Cost of Internal EquityCost of Internal Equity 1)1) Dividend Growth ModelDividend Growth Model kkcc = + g= + g 2)2) Capital Asset Pricing Model (CAPM)Capital Asset Pricing Model (CAPM) D1 Po
  40. 40. Cost of Internal EquityCost of Internal Equity 1)1) Dividend Growth ModelDividend Growth Model kkcc = + g= + g 2)2) Capital Asset Pricing Model (CAPM)Capital Asset Pricing Model (CAPM) kkjj = k= krfrf ++ jj (k(kmm - k- krfrf )) D1 Po β
  41. 41. Cost of External EquityCost of External Equity
  42. 42. Dividend Growth ModelDividend Growth Model Cost of External EquityCost of External Equity
  43. 43. Dividend Growth ModelDividend Growth Model kkncnc = + g= + g Cost of External EquityCost of External Equity D1 NPo
  44. 44. Dividend Growth ModelDividend Growth Model kkncnc = + g= + g Cost of External EquityCost of External Equity D1 NPo Net proceeds to the firm after flotation costs!
  45. 45. Weighted Cost of CapitalWeighted Cost of Capital  The weighted cost of capital is just theThe weighted cost of capital is just the weighted average cost of all of theweighted average cost of all of the financing sources.financing sources.
  46. 46. Weighted Cost of CapitalWeighted Cost of Capital CapitalCapital Source Cost StructureSource Cost Structure debt 6% 20%debt 6% 20% preferred 10% 10%preferred 10% 10% common 16% 70%common 16% 70%
  47. 47. Weighted cost of capital =Weighted cost of capital = .20 (6%) + .10 (10%) + .70 (16%).20 (6%) + .10 (10%) + .70 (16%) == 13.4%13.4% Weighted Cost of CapitalWeighted Cost of Capital (20% debt, 10% preferred, 70% common)(20% debt, 10% preferred, 70% common)
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