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# 9. cost of capital

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### 9. cost of capital

2. 2. Learning Objectives 1. Describe the concepts underlying the firm’s cost of capital. 2. Calculate the after-tax cost of debt, preferred stock, and common equity. 3. Calculate a firm’s weighted average cost of capital. 4. Describe the procedure used by PepsiCo to estimate the cost of capital for a multidivisional firm. 5. Use the cost of capital to evaluate new investment opportunities. 6. Calculate equivalent interest rates for different countries. © 2011 Pearson Prentice Hall. All rightsreserved. 9-2
3. 3. Slide Contents  Cost of Capital: Key Definitions and Concepts  Determining the Cost of Individual Sources of Capital  The Weighted Average Cost of Capital  Calculating Divisional Costs of Capital for PepsiCo, Inc.  Cost of Capital and New Investment  Shareholder Value-Based Management  Multinational Firms and Interest Rates © 2011 Pearson Prentice Hall. All rightsreserved. 9-3
4. 4. 1. Cost of Capital: Key Definitions and Concepts Capital  Capital represents the funds used to finance a firms assets and operations. Capital constitutes all items on the right hand side of balance sheet i.e. liabilities and common equity.  Main sources: Debt, Preferred stock, Retained earnings and Common Stock © 2011 Pearson Prentice Hall. All rightsreserved. 9-4
5. 5. Investor’s Required Rate of Return  Investor’s Required Rate of Return – is the minimum rate of return necessary to attract an investor to purchase or hold a security.  Investor’s required rate of return is not the same as cost of capital due to taxes and transaction costs.  Impact of taxes: For example, a firm may pay 8% interest on debt but due to tax benefit on interest expense, the net cost to the firm will be lower than 8%. © 2011 Pearson Prentice Hall. All rightsreserved. 9-5
6. 6. Investor’s Required Rate of Return  Impact of transaction costs on cost of capital: For example, If a firm sells new stock for \$50.00 a share and incurs \$5 in flotation costs, and the investors have a required rate of return of 15%, what is the cost of capital?  The firm has only \$45.00 to invest after transaction cost. .15 × \$50.00 = \$7.5 k = \$7.5/(\$45.00) = .1667 or 16.67% (rather than 15%) © 2011 Pearson Prentice Hall. All rightsreserved. 9-6
7. 7. Financial Policy  A firm’s financial policy indicates the desired sources of financing and the particular mix in which it will be used.  For example, a firm may choose to raise capital by issuing stocks and bonds in the ratio of 6:4 (60% stocks and 40% bonds). The choice of mix may impact the cost of capital. © 2011 Pearson Prentice Hall. All rightsreserved. 9-7
8. 8. 2. Determining the Costs of the Individual Sources of Capital The Cost of Debt The bondholder’s required rate of return on debt is the return that bondholders demand. As seen in Chapter 7, this can be estimated using the bond price equation: © 2011 Pearson Prentice Hall. All rightsreserved. 9-8
9. 9. The Cost of Debt Since firms must pay floatation costs when they sell bonds, the net proceeds per bond received by firm is less than the market price of the bond. Hence, the cost of debt capital (Kd) will be higher than the bondholder’s required rate of return. It can be calculated using the following equation: © 2011 Pearson Prentice Hall. All rightsreserved. 9-9
10. 10. The Cost of Debt See Example 9-1  Investor’s required rate of return = 9%  However, due to floatation cost, the before- tax cost of capital for the firm is = 9.73%  After-tax cost of debt = Cost of debt*(1-tax rate)  At 34% tax bracket = 9.73*(1 – .34) = 6.422% © 2011 Pearson Prentice Hall. All rightsreserved. 9-10
11. 11. The Cost of Preferred Stock  Similar to bond issue, since floatation costs are incurred, preferred stockholder’s required rate of return will be less than the cost of preferred capital to the firm.  Thus, in order to determine the cost of preferred stock, we adjust the price of preferred stock for floatation cost to give us the net proceeds.  Net proceeds = issue price per share – floatation cost per share. © 2011 Pearson Prentice Hall. All rightsreserved. 9-11
12. 12. The Cost of Preferred Stock  Cost of Preferred Stock:  Pn = net proceeds (i.e. Issue price – Floatation costs)  Dp = Preferred stock dividend per share Example: Determine the cost for a preferred stock that pays annual dividend of \$4.25, has current stock price \$58.50 and incurs flotation costs of \$1.375 per share Cost = \$4.25/(58.50 – 1.375) = .074 or 7.44% © 2011 Pearson Prentice Hall. All rightsreserved. 9-12
13. 13. The Cost of Common Equity  Cost of equity is more challenging to estimate than the cost of debt or the cost of preferred stock because common stockholder’s rate of return is not fixed as there is no stated coupon rate or dividend.  Furthermore, the costs will vary for two sources of equity (i.e. retained earnings and new issue). © 2011 Pearson Prentice Hall. All rightsreserved. 9-13
14. 14. The Cost of Common Equity  There is no flotation costs on retained earnings but the firm incurs costs when it sells new common stock.  Note retained earnings are not a free source of capital. There is an opportunity cost. © 2011 Pearson Prentice Hall. All rightsreserved. 9-14
15. 15. Cost estimation techniques  Two commonly used methods for estimating common stockholder’s required rate of return are:  The Dividend Growth Model  The Capital Asset Pricing Model © 2011 Pearson Prentice Hall. All rightsreserved. 9-15
16. 16. The Dividend Growth Model  Investors’ required rate of return (For Retained Earnings):  D1 = Dividends expected one year hence  Pcs = Price of common stock;  g = growth rate © 2011 Pearson Prentice Hall. All rightsreserved. 9-16
17. 17. The Dividend Growth Model  Investors’ required rate of return (For new issues)  D1 = Dividends expected one year hence  Pcs = Net proceeds per share  g = growth rate © 2011 Pearson Prentice Hall. All rightsreserved. 9-17
18. 18. The Dividend Growth Model Example: A company expects dividends this year to be \$1.10, based upon the fact that \$1 were paid last year. The firm expects dividends to grow 10% next year and into the foreseeable future. Stock is trading at \$35 a share. Cost of retained earnings: Kcs = D1/Pcs + g 1.1/35 + .10 = .1314 or 13.14% Cost of new stock (with a \$3 floatation cost): Kncs = D1/NPcs + g 1.10/(35 – 3) + .10 = .1343 or 13.43% © 2011 Pearson Prentice Hall. All rightsreserved. 9-18
19. 19. The Dividend Growth Model  Dividend growth model is simple to use but suffers from the following drawbacks:  It assumes a constant growth rate  It is not easy to forecast the growth rate © 2011 Pearson Prentice Hall. All rightsreserved. 9-19
20. 20. The Capital Asset Pricing Model rf = Risk Free rate β = Beta rm – rf = Market Risk Premium or Expected rate of return for “average security” minus the risk free rate© 2011 Pearson Prentice Hall. All rightsreserved. 9-20
21. 21. Capital Asset Pricing Model Example: If beta is 1.25, risk-free rate is 1.5% and expected return on market is 10% kc = rrf + β (rm – rf) = .015 + 1.25(.10 – .015) = 12.125% © 2011 Pearson Prentice Hall. All rightsreserved. 9-21
22. 22. Capital Asset Pricing Model Variable estimates  CAPM is easy to apply. Also, the estimates for model variables are generally available from public sources.  Risk Free Rate: Wide range of US government securities on which to base risk-free rate  Beta: Estimates of beta are available from a wide range of services, or can be estimated using regression analysis of historical data.  Market risk premium: It can be estimated by looking at history of stock returns and premium earned over risk-free rate. © 2011 Pearson Prentice Hall. All rightsreserved. 9-22
23. 23. 3. The Weighted Average Cost of Capital Bringing it all together: WACC  To estimate WACC, we need to know the capital structure mix and the cost of each of the sources of capital.  For a firm with only two sources: debt and common equity, © 2011 Pearson Prentice Hall. All rightsreserved. 9-23
24. 24. WACC Example  A firm borrows money at 7% after taxes and pays 12% for equity. The company raises capital in equal proportions i.e. 50% debt and 50% equity.  WACC = (.07 × .5) + (.12 × .5) = .095 or 9.5% © 2011 Pearson Prentice Hall. All rightsreserved. 9-24
25. 25. Business world cost of capital  In practice, the calculation of cost of capital may be more complex:  If firms have multiple debt issues with different required rates of return.  If firms also use preferred stock in addition to common stock financing. © 2011 Pearson Prentice Hall. All rightsreserved. 9-25
26. 26. Table 9-1 © 2011 Pearson Prentice Hall. All rightsreserved. 9-26
27. 27. Table 9-1 © 2011 Pearson Prentice Hall. All rightsreserved. 9-27
28. 28. Table 9-3 © 2011 Pearson Prentice Hall. All rightsreserved. 9-28
29. 29. 4. Calculating Divisional Costs of Capital for PepsiCo Inc.  PepsiCo calculated divisional cost of capital for each of its three major divisions: restaurants, food, and beverages.  The target ratios for debt/equity mix and the pre-tax cost of debt were different for each division.  PepsiCo estimated the WACC for each division in a 3 step process:  Estimate the cost of debt for each division  Estimate the cost of equity for each division  Estimate the WACC (with target capital structure) for each division © 2011 Pearson Prentice Hall. All rightsreserved. 9-29
30. 30. Table 9-4 PepsiCo’s Cost of Debt © 2011 Pearson Prentice Hall. All rightsreserved. 9-30
31. 31. Table 9-5 PepsiCo’s Cost of Equity © 2011 Pearson Prentice Hall. All rightsreserved. 9-31
32. 32. Table 9-6 PepsiCo’s WACC © 2011 Pearson Prentice Hall. All rightsreserved. 9-32
33. 33. 5. Cost of Capital and New Investment  Cost of capital can serve as the discount rate in evaluating new investment when the projects offer the same risk as the firm as a whole.  If risk differs, it is better to calculate a different cost of capital for each division. © 2011 Pearson Prentice Hall. All rightsreserved. 9-33
34. 34. 6. Multinational Firms and Interest Rates  In an international setting, there can be different rates of inflation among different countries.  The Fisher Model indicates that the nominal interest rate in the home or domestic country is a function of real interest rates and anticipated rate of inflation. © 2011 Pearson Prentice Hall. All rightsreserved. 9-34
35. 35. Fisher Model and Domestic Interest Rates rn,h = (1 + rr,h)(1 + ih) – 1 rn,h = Nominal rate of interest at home, U.S. rr,h = real interest rate at home, U.S. Ih = inflation rate at home, U.S Example: If Real interest rate is 3% and inflation rate is 5%, nominal rate will be 8.15% © 2011 Pearson (1.03)(1.05) All 1 = 8.15% Prentice Hall. – rightsreserved. 9-35
36. 36. International or Foreign Rates and Fisher Effect rn,h – rn,h = ih – if Differences in observed nominal rates of interest between two countries should equal the difference in expected rates of inflation between the two countries. © 2011 Pearson Prentice Hall. All rightsreserved. 9-36
37. 37. Interest Rate Parity Theorem  rn,h = Domestic one-period rate of interest  rn,f = Corresponding rate in foreign country  E0 & E1 = Exchange rates corresponding to current period (i.e. spot exchange rate) and one-period hence (i.e. the one-period forward exchange rate) © 2011 Pearson Prentice Hall. All rightsreserved. 9-37
38. 38. Interest Rate Parity Theorem Thus,  Nominal interest rates are tied to exchange rates  Differences in nominal interest rates are tied to expected rates of inflation © 2011 Pearson Prentice Hall. All rightsreserved. 9-38
39. 39. Interest Rates and Currency Exchange Rates  Example: If domestic one-period interest rate is 15.5%, and the Japanese rate of interest is 5%, the spot exchange rate is \$1 to 1 yen and the forward exchange rate is \$1.10 to 1 yen. 1 + .155 / 1 + .05 = 1.1/1= 1.10 © 2011 Pearson Prentice Hall. All rightsreserved. 9-39
40. 40. Figure 9-1 © 2011 Pearson Prentice Hall. All rightsreserved. 9-40
41. 41. Key Terms  Capital Structure  Financial Policy  Economic Profit  Market Value Added  Weighted Average Cost of Capital © 2011 Pearson Prentice Hall. All rightsreserved. 9-41