Cost of Capital

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The cost of funds used for financing a business. Cost of capital depends on the mode of financing used – it refers to the cost of equity if the business is financed solely through equity, or to the cost of debt if it is financed solely through debt. Many companies use a combination of debt and equity to finance their businesses, and for such companies, their overall cost of capital is derived from a weighted average of all capital sources, widely known as the weighted average cost of capital (WACC). Since the cost of capital represents a hurdle rate that a company must overcome before it can generate value, it is extensively used in the capital budgeting process to determine whether the company should proceed with a project.

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  • For value box in Ch 4 time value FM13.
  • Cost of Capital

    1. 1. Corporate Finance Cost of Capital 1
    2. 2. The Weighted Average Cost of Capital The company cost of capital is a weighted average of the returns demanded by debt and equity investors.
    3. 3. What types of long-term capital do firms use?    3 Long-term debt Preferred stock Common equity
    4. 4. Capital Components  Capital components are sources of funding that come from investors.  A/P, accruals, and deferred taxes are not sources of funding that come from investors, & not included in the calculation of the cost of capital.  These items are adjusted for when calculating project cash flows, not when calculating the cost of capital. 4
    5. 5. COST of CAPITAL Raising $ & its Costs Debt  Cost of Borrowing  Equity  Interest Rate Internal   External   5 Retained Earning Common Stock Prfd Stock
    6. 6. Weighted Average Cost of Capital (WACC)  WACC: Blended cost or raising capital considering mix of debt & equity  WACC = (Wt of Debt)(After-tax cost of Debt) + Wt of Eqty)(Cost of Eqty) + (Wt of Prfd)(Cost of Prfd) 6
    7. 7. Cost of Equity  Know: = P0 = D1/ (rs –g)  So 7 then: rs = D1/P0 + g
    8. 8. Cost of Preferred Stock  r = D1/P0 + g  g= 0, so cost of preferred = function of dividends paid. & floatation cost to issue.  Assume Newco's preferred stock pays a dividend of $2 per share and sells for $100 per share. If the cost to Newco to issue new shares is 4%, what is Newco's cost of preferred stock? Answer: Rps = Dps/Pnet = $2/$100(1-0.04) = 2.1% 8
    9. 9. Determining Cost of Debt  Method 1: Ask an investment banker what coupon rate would be on new debt.  Method 2: Find bond rating for the company and use yield on similarly rated bonds.  Method 3: Find yield on the company’s existing debt. 9
    10. 10. Current vs. Historical Cost of Debt   For cost of debt, don’t use coupon rate on existing debt, which represents cost of past debt. Use the current interest rate on new debt (think YTM). (More…) 10
    11. 11. A 15-year, 13.25% semiannual bond sells for $1,250. Tax = 40%. 60,000 Bonds o/s. What’s rd? 0 rd = ? 1,250.00 INPUTS 1 2 -66.25 -66.25 30 N OUTPUT 11 30 ... <66.25 + 1,000> 1250 -66.25 -1000 I/YR PV PMT 5.0% x 2 = rd = 10% FV
    12. 12. Component Cost of Debt  Cost of Debt = Rd (1 - t)  Newco plans to issue debt at a 7% interest rate. Newco's total (both federal and state) tax rate is 40%. What is Newco's cost of debt? Answer: Rd (1-tc) = 7% (1-0.40) = 4.2% 12
    13. 13. Example - WACC  Company λ has a 1 million shares of common stock currently trading at $30 per share. Current risk free rate is 4%, market risk premium is 8% and the company has a beta of 1.2.  It also has 50,000 bonds with of $1,000 par paying 10% coupon annually maturing in 20 years currently trading at $950.  The company's tax rate is 35%.  Calculate the weighted average cost of capital. 13
    14. 14. Example - WACC  First we need to calculate the weights of debt and equity.  Market Value of Equity = 1,000,000 × $30 = $30,000,000  Market Value of Debt = 50,000 × $950 = $47,500,000  Total Market Value of Debt and Equity = $77,500,000  Weight of Equity = $30,000,000 / $77,500,000 = 38.71%  Weight of Debt = $47,500,000 / $77,500,000 = 61.29%  Weight of Debt can be calculated as 100% minus cost of equity = 100% − 38.71% = 61.29%  14
    15. 15. Example - WACC  Cost of Equity = Risk Free Rate + Beta × Market Risk Premium = 4% + 1.2 × 8% = 13.6%  We also, need to find the cost of debt. Cost of debt is equal to the yield to maturity of the bonds. Yield to maturity is 10.51%.  After tax cost of debt is hence 10.51% × ( 1 − .35% ) = 6.83% And finally,  WACC = 38.71% × 13.6% + 61.29% × 6.83% = 9.45% 15
    16. 16. Is preferred stock more or less risky to investors than debt?   More risky; company not required to pay preferred dividend. However, firms want to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, and (3) preferred stockholders may gain control of firm. 16
    17. 17. Determining Weights for WACC   17 What are the % of firm’s capital to be financed by each component. If possible, always use the target wts for % financed by each type of capital.
    18. 18. What factors influence a company’s WACC?  Uncontrollable factors:     Market conditions, especially interest rates. The market risk premium. Tax rates. Controllable factors:    18 Capital structure policy. Dividend policy. Investment policy. Firms with riskier projects generally have higher financing costs.
    19. 19. Examples – Cost of Equity Cost of Equity Under the Capital Asset Pricing Model  The yield on 5 year US treasury bonds as at 30 December 2012 is 0.72%. We find that Caterpillar Inc.'s share price as at 30 December 2012 is $86.81 per share while it has a beta coefficient of 1.86. Trailing twelve months (TTM) return on S & P 500 is 11. 52%. Estimate the cost of equity. Cost of Equity = Risk Free Rate + Beta Coefficient × (Market Rate of Return − Risk Free Rate)  Cost of Equity = 0.72% + 1.86 × (11.52% − 0.72%) = 20.81% 19
    20. 20. Examples – Cost of Equity  Cost of Equity Under the Dividend Discount Model  Caterpillar Inc.'s share price as at 30 December 2012 is $86.81 per share. Its last five year's average total dividends, return on equity and payout ratios are $1.6, 34.75% and 47.08%.   Growth Rate = (1 − 47.08%) × 34.75% = 18.39% D1 = $1.6 × (1+18.39%) = $1.89  Cost of Equity = $1.89 ÷ $86.81 + 18.39% = 20.57% 20
    21. 21. WACC Example  A firm is considering a new project. The firm needs a discount rate for evaluation purposes. The firm has 1,000,000 common shares outstanding current price $11.25 per share. Next year’s dividend expected to be $1 per share. Firm estimates dividends will grow at 5% per year after that.  Firm has 150,000 preferred shares outstanding. Current price is $9.50 per share. Dividend is $0.95 per share. if new preferred are issued, they must be sold at 5% less than the current market price (to ensure they sell) and involve direct flotation costs of $0.25 per share.  Firm has a total of $10,000,000 (par value) in debt outstanding. The debt is in the form of bonds with 10 years left to maturity. They pay annual coupons at a coupon rate of 11.3%. Currently, the bonds sell at 106% of par value.  The firm’s tax rate is 40%. What is the appropriate discount rate for the new project? 21
    22. 22. WACC Example      Market value of common = 11.25(1000000) = Market value of preferred = 9.50(150000) = Market value of debt = 10000000(1.06) = Total value of firm =  Cost of common: Div r =    1 $11,250,000 $1,425,000 $10,600,000 $23,275,000 + g P 1 = + .05 0 11.25 = .1389 0 Cost of preferred: r = Div net P 0.95 9.50(1 −0.05) −0.25 =0.1083 = 22
    23. 23. WACC Example  Cost of debt = 10.39% x (1-.40) = 6.23% Therefore:  WACC = .4834 x .1389 + .0612 x .1083 + .4554 x .0623 = 10.21% 23

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