Chapter 10: The Cost of Capital Remember: the Time Value of Money says "a dollar today is worth

more than a dollar tomorrow". But how much more? It depends on the Cost of Capital the amount you expect to make with your money Knowledge of Cost of Capital is important so a company knows what investments it should and should not make Hence Cost of Capital is also a company's Opportunity Cost, or Hurdle Rate

"Hurdle Rate" or WACC Hurdle Rate is a company's required return on investments If a project is expected to make less return than the Hurdle Rate, it is rejected. If it were accepted, it would never cover the costs the company pays to secure the capital in the first pla Companies pay dividends to shareholders and interest to banks in return for capital. If projects don't at least pay for the dividends and interest, the company loses value. In general, the minimum required rate of return is a weighted average of the individual required rates WACC= + + + Weight of Debt * Required Returns of Debt Weight of Preferred Equity * Required Returns of Preferred Equity Weight of Common Equity * Required Returns of Common Equity Weight of Retained Earnings * Required Returns of Retained Earnings

Determining the Weights The Balance Sheet's data is the BOOK VALUE Problem with Book Value: values are often outdated and represent historical weights The Market constantly reevaluates the firms securities Hence generally better to use the MARKET VALUE data Component Costs of WACC

Cost of Debt Process is similar to equity: Find the Market Price of the security, and the discount rate making future cash flows e We need to know about the market value of the bond, the face value, the payments, and the term. Then we can use the RATE function!

Cost of Common Equity The value of a share of stock is the discounted value of its dividends (or capital gains) in perpetuity We need the most recent dividend and dividend growth rates, plus current market price Req. Return of Common Stock =

(Dividend in Year 1 / Share Price) + expected growth ra

Cost of Preferred Equity Preferred Stock is essentially a perpetual Dividend that does not change Req. return on preferred equity = Dividend / Preferred Stock Price

Cost of Retained Earnings Money ploughed back into the business has an opportunity cost too! The cost is the same as if it were distributed as dividends to common shareholders, but there are no flo Req. return on retained earnings =

(Dividend in Year 1 / Share Price) + expected growth ra

ct to make with your money ts it should and should not make

to secure the capital in the first place

vidual required rates

tained Earnings

d represent historical weights

unt rate making future cash flows equal to Market Price nts, and the term.

gains) in perpetuity urrent market price Share Price) + expected growth rate of dividends

n shareholders, but there are no flotation costs Share Price) + expected growth rate of dividends

Funding for Company's Land Purchase Source of Company's Funds Debt Preferred Stock (Equity) Common Stock (Equity) Amount Dollar Cost $4,000 $280 $1,000 $100 $5,000 $600 $10,000 $980 Cost 7.0% 10.0% 12.0% 9.8%

The company pays $280 to the bank in interest payments for the $4,000 Debt The company pays a preferred dividend of $100 for the $1,000 of Preferred Stock The company pays a common dividend of $600 for the $5,000 in Common Stock The company's COST OF CAPITAL, when weighted, is 9.8% The WEIGHTED AVERAGE COST OF CAPITAL, or WACC, is 9.8% Suppose there are 3 possibilities: Expected Rate of Return Capital Invested Return Funds after Project Ends Debtholders' return Preferred Stockholders' return Remaining for Common Invested for Common Actual $ Return for Common Required % Return for Common Actual % Return for Common Marginal Return for Common Success? Result 1 8.0% $10,000 $800 $10,800 $4,280 $1,100 $5,420 $5,000 $420 12.0% 8.4% -3.6% No Result 2 9.8% $10,000 $980 $10,980 $4,280 $1,100 $5,600 $5,000 $600 12.0% 12.0% 0.0% Maybe Result 3 11.0% $10,000 $1,100 $11,100 $4,280 $1,100 $5,720 $5,000 $720 12.0% 14.4% 2.4% Yes

Version: Found in: Source of Capital Long-Term Debt Preferred Equity Common Stock Total

Book Value Balance Sheet Total $400,000 $100,000 $500,000 $1,000,000 % of Total 40% 10% 50% 100% Price/Unit $905 $100 $70

Market Value Wall St. Journal Units 400 1,000 10,000

Market Value Wall St. Journal Total $361,812 $100,000 $700,000 $1,161,812 % of Total 31% 9% 60% 100% After Tax Cost 7.0% 10.0% 12.0%

WACC Book WACC 2.8% 1.0% 6.0% 9.8% Market WACC 2.2% 0.9% 7.2% 10.3%

Assume 10-year bond, face value $1,000, coupon value 10% Pays $100 per year for 10 years, and returns $1,000 at the end

Tax Rate Coupon Rate Face Value Maturity Current Price Flotation Cost

40% 10% $1,000 10 ($904.53) 1%

Pre-tax requred return Pre-tax requred return After-tax required return After-tax required return

RATE ( 10, 11.84%

10%*1000,

-904.53 * 1-flotation cost,

1000)

= Pre-Tax required return * (1 - Tax rate) 7.10%

Market Value Source of Capital Long-Term Debt Preferred Equity Common Stock Retained Earnings Total Additional Information: DEBT Tax Rate Coupon Rate Face Value Maturity Current Price Flotation Cost PREFERRED STOCK Dividend Flotation Cost COMMON STOCK Dividend in Year 0 Dividend in Year 1 Dividend growth rate Flotation Cost RETAINED EARNINGS Dividend in Year 0 Dividend in Year 1 Dividend growth rate Flotation Cost Price/Unit $905 $100 $70 Units 400 1,000 10,000 Total $361,812 $100,000 $700,000 $150,000 $1,311,812

40% 10% $1,000 10 ($904.53) 1%

Cost of Capital 11.84% 7.10%

10.20% $10.00 2%

$3.96 $4.20 6% 5%

12.31%

$3.96 $4.20 6% 0%

12.00%

WACC % of Total 27.58% 7.62% 53.36% 11.43% 100.0% After Tax Cost 7.1% 10.2% 12.3% 12.0% Market WACC 2.0% 0.8% 6.6% 1.4% 10.7%