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Cost of Capital

Prepared by: Aguilar, De los Santos, Garcia


What is Cost of Capital?
- “The cost of capital is the minimum required rate of earnings or
the cut-off rate of expenditure.” – Solomon Ezra

- “The cost of capital represents a cut-off rate for the allocation of


capital to investment projects. It is the rate of return on a project
that will leave unchanged the market price of the stock.” – James
Van Home

- It is required rate of return on invested funds.


What is the importance of Cost of Capital?
•The cost of capital aids businesses and investors in evaluating
all investment opportunities. It does so by turning future cash
flows into present value by keeping it discounted.
•The cost of capital can also aid in making key company budget
calls that use company financial sources as capital.
•In a cost of opportunity scenario, the cost of capital can be
used to evaluate the progress of ongoing projects and
investments by matching up the progress of those investments
against the cost of capital.
Cost of debt
 Required rate of return for creditors
 kd = before tax cost of debt
 T = Marginal Tax

After tax cost of debt = kd (1 + T)


Cost of Debt
Example: Investors are willing to pay $985 for a bond that pays $90 a
year for 10 years. Fees for issuing the bonds bring the net price (NP0)
down to $938.55. Marginal tax is 40%. What is the before tax cost of
debt?

After tax cost of debt = .10 (1 + .40) = 6%


Cost of Preferred Stock
- Required rate of return by holders of a company’s
preferred stock.

Dividend (D)
Required rate of kps =
Market Price (Po)
Cost of Preferred Stock
Example: Your company can issue preferred stock for a price
of $45, but it only receives $42 after floatation costs. The
preferred stock pays a $5 dividend.

$5
Required rate of kps = = 11.90%
$42
Cost of Equity
a. Retained Earnings
 Management should retain earnings only if they earn as much
as stockholder’s next best investment opportunity.
 Cost of Retained Earnings = opportunity cost of common
stockholders’ funds.
 Cost of retained earnings must equal common stockholders’
required rate of return.
Cost of Retained Earnings
Three methods to determine Cost of Retained Earnings

 Capital Asset Pricing Method (CAPM)


 Risk Premium Model
 Dividend Growth Model or Discounted Cash Flow (DCF)
Capital Asset Pricing Method (CAPM)
ks = cost of retained earnings
krf = risk-free rate
km = expected market return
bi = estimated beta coefficient, i signifies the ith company’s beta

ks = krf + (km – krf) bi


Capital Asset Pricing Method (CAPM)
Example: The estimated Beta of a stock is 1.2. The risk-
free rate is 5% and the expected market return is
13%.

kcs = 5% + 1.2(13% – 5%) = 14.6%


Risk Premium Model
 Adds a risk premium to the bondholder’s required rate of return.

kcs = Bond Yield + Risk Premium

Example: If the risk premium is 5% and kd is 10%

kcs = 10% + 5% = 15%


Dividend Growth Model or Discounted Cash Flow
(DCF)
 Assumes constant growth in dividends
D1 = next expected dividend
Po = Market Price
g = expected growth rate

kcs = D1 + g
P0
Dividend Growth Model or Discounted Cash Flow
(DCF)
Example:
The market price of a share of common stock is $60. The
dividend just paid is $3, and the expected growth rate is
10%.

3(1+0.10)
kcs = 60
+ .10 = .155 = 15.5%

The main limitation in this method is estimating growth accurately.


Cost of Equity
b. New Common Stock
 If retained earnings cannot provide all the equity capital that is
needed, firms may issue new shares of common stock
 Uses Dividend Growth Model but must adjust for flotation cost
of the stock

D1 F = floatation cost
kcs = +g
P0 (1 – F)
Cost of New Common Stock
Example:
Using the above example. Common stock price is currently $60.
If additional shares are issued floatation costs will be 12%.
D0 = $3.00 and estimated growth is 10%.

NP0 = $60.00 – (.12x 60) = $52.80

Floatation
Costs
Cost of New Common Stock
Example:
Using the above example. Common stock price is currently $60.
If additional shares are issued floatation costs will be 12%.
D0 = $3.00 and estimated growth is 10%.

NP0 = $60.00 – (.12x 60) = $52.80

kcs = 3(1+0.10) + .10 = .1625 = 16.25%


52.80
Target (Optimal) Capital Structure
Balance Sheet Green Apple Company
Assets Liabilities

4000
Bonds = = 40%
10000
Target (Optimal) Capital Structure
Balance Sheet Green Apple Company
Assets Liabilities

1000
Preferred Stock = = 10%
10000
Target (Optimal) Capital Structure
Balance Sheet Green Apple Company
Assets Liabilities

5000
Common Stock = = 50%
10000
Target (Optimal) Capital Structure
Balance Sheet Green Apple Company
Assets Liabilities

40%
10%
50%

When money is raised for capital projects, approximately 40% of the


money comes from selling bonds, 10% comes from selling preferred
stock and 50% comes from retaining earnings or selling common stock
Computing WACC
Green Apple Company estimates the following costs for each
component in its capital structure:

Source of Capital Cost

Bonds kd = 10%
Preferred Stock kps = 11.9%
Common Stock
Retained Earnings kcs = 15%
New Shares knc = 16.25%

Green Apple’s Tax rate is 40%


Computing WACC
 If using retained earnings to finance the common stock portion
the capital structure.

WACC= k0 = %Bonds x Cost of Bonds x (1-T)


+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock

WACC = .40 x 10% (1-.4)


+ .10 x 11.9%
+ .50 x 15%
Computing WACC
If use newly issued common stock, use knc rather than kcs for the
cost of the equity portion.

WACC= k0 = %Bonds x Cost of Bonds x (1-T)


+ %Preferred x Cost of Preferred
+ %Common x Cost of Common Stock

WACC = .40 x 10% (1-.4)


+ .10 x 11.9%
+ .50 x 16.25% = 11.72%
Weighted Marginal Cost of Capital
Addition to retained
Retained Earnings earnings
Breakpoint =
Equity fraction

If Green Apple Company has additional $100,000 of internally generated common:

Retained Earnings 100000


Breakpoint = = 200,000
.50
Weighted Marginal Cost of Capital
Cost of Capital using
new common equity
12% 11.72%
Weighted Cost of Capital

11.09%
11%
Cost of Capital
using internal
common stock
10%

Break-Point for
9% common equity

0 100,000 200,000 300,000 400,000

Total Financing
Factors that Affect Cost of Capital

FACTORS THAT FIRM CAN CONTROL FACTORS THAT FIRM CANNOT CONTROL

Capital Structure Policy


The level of interest rate
Dividend Policy
Tax rate
Investment Policy
ESTIMATING PROJECT RISK

 Stand-alone Risk
 Corporate, or within-firm risk
 Market, or beta risk
SOME PROBLEM AREAS IN COST OF CAPITAL

 Depreciation-generated Funds
 Privately Owned Firms
 Measurement Problems
 Cost of Capital for projects of differing riskiness
 Capital Structure Weights