FIN320-CH11 - Chapter 11 Cost of Capital Where we’ve...

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: Chapter 11 Cost of Capital Where we’ve been... s Basic Skills: (Time value of money, Financial Statements) Financial s Investments: (Stocks, Bonds, Risk and Return) Return) s Corporate Finance: (The Investment Decision - Capital Budgeting) Decision Assets Assets Current assets Fixed assets Liabilities & Equity Current Liabilities Long-term debt Preferred Stock Preferred Common Equity Common The investment decision Assets Assets Current assets Fixed assets Liabilities & Equity Current Liabilities Long-term debt Preferred Stock Preferred Common Equity Common Where we’re going... s Corporate Finance: (The Financing Financing Decision) Decision) Cost of capital Cost Leverage Leverage Capital Structure Capital Dividends Dividends Assets Assets Current assets Fixed assets Liabilities & Equity Current Liabilities Long-term debt Preferred Stock Preferred Common Equity Common The financing decision Assets Assets Current assets Fixed assets Liabilities & Equity Current Liabilities Long-term debt Preferred Stock Preferred Common Equity Common Assets Assets Current assets Liabilities & Equity Current Liabilities Long-term debt Long-term Preferred Stock Preferred Common Equity Common Assets Assets Current assets Liabilities & Equity Current Liabilities Capital Structure } Long-term debt Long-term Preferred Stock Preferred Common Equity Common Ch. 11 - Cost of Capital s For Investors, the rate of return on a the security is a benefit of investing. benefit s For Financial Managers, that same that rate of return is a cost of raising funds cost that are needed to operate the firm. that s In other words, the cost of raising In funds is the firm’s cost of capital. cost How can the firm raise capital? Bonds s Preferred Stock s Common Stock s Each of these offers a rate of return to Each rate investors. investors. s This return is a cost to the firm. This cost s “Cost of capital” actually refers to the weighted cost of capital - a weighted weighted average cost of financing sources. s Cost of Debt Debt Cost of Debt For the issuing firm, the cost For of debt is: of s the rate of return required the rate by investors, by s adjusted for flotation costs adjusted flotation (any costs associated with issuing new bonds), and s adjusted for taxes. adjusted taxes. Example: Tax effects of financing with debt EBIT - interest expense EBT - taxes (34%) EAT with stock with 400,000 0 400,000 (136,000) (136,000) 264,000 with debt with 400,000 (50,000) (50,000) 350,000 (119,000) (119,000) 231,000 Example: Tax effects of financing with debt EBIT - interest expense EBT - taxes (34%) EAT s with stock with 400,000 0 400,000 (136,000) (136,000) 264,000 with debt with 400,000 (50,000) (50,000) 350,000 (119,000) (119,000) 231,000 Now, suppose the firm pays $50,000 in Now, dividends to the stockholders. dividends Example: Tax effects of financing with debt with stock with EBIT 400,000 - interest expense 0 EBT 400,000 - taxes (34%) (136,000) (136,000) EAT 264,000 - dividends (50,000) Retained earnings 214,000 Retained with debt with 400,000 (50,000) (50,000) 350,000 (119,000) (119,000) 231,000 0 231,000 After-tax After-tax % cost of cost Debt Debt = Before-tax % cost of Debt x 1 Marginal - tax rate After-tax After-tax % cost of cost Debt Debt = Before-tax % cost of Debt x 1 Marginal - tax rate Kd = kd (1 - T) After-tax After-tax % cost of cost Debt Debt = Before-tax % cost of Debt x 1 Marginal - tax rate Kd .066 .066 = = kd (1 - T) .10 (1 - .34) Example: Cost of Debt s Prescott Corporation issues a $1,000 Prescott $1,000 par, 20 year bond paying the market 20 rate of 10%. Coupons are semi10%. annual. The bond will sell for par since it pays the market rate, but flotation costs amount to $50 per $50 bond. The tax rate is 34%. bond. of debt for Prescott Corporation? of s What is the pre-tax and after-tax cost What s Pre-tax cost of debt: (using TVM) P/Y = 2 N = 40 PMT = -50 FV = -1000 PV = 950 solve: I = 10.61% = kd solve: 10.61% s After-tax cost of debt: Kd = kd (1 - T) Kd = .1061 (1 - .34) Kd = .07 = 7% Kd 7% s Pre-tax cost of debt: (using TVM) P/Y = 2 N = 40 PMT = -50 FV = -1000 PV = 950 solve: I = 10.61% = kd solve: 10.61% s After-tax cost of debt: Kd = kd (1 - T) Kd Kd = .1061 (1 - .34) Kd Kd = .07 = 7% Kd 7% So, a 10% bond costs the firm only 7% (with only 7% flotation costs) flotation since the interest since is tax deductible. is Cost of Preferred Stock s Finding the cost of preferred stock Finding cost is similar to finding the rate of return, (from Chapter 8) except return (from that we have to consider the flotation costs associated with flotation issuing preferred stock. issuing Cost of Preferred Stock s Recall: Cost of Preferred Stock s Recall: kp = D Po = Dividend Price Price Cost of Preferred Stock s Recall: kp = D Po = Dividend Price Price s From the firm’s point of view: From firm’s Cost of Preferred Stock s Recall: kp = D Po = Dividend Price Price s From the firm’s point of view: From firm’s kp = D NPo = Dividend Net Price Cost of Preferred Stock s Recall: kp = D Po = Dividend Price Price s From the firm’s point of view: From firm’s kp = D NPo = Dividend Net Price Example: Cost of Preferred s If Prescott Corporation issues If preferred stock, it will pay a dividend of $8 per year and $8 should be valued at $75 per share. $75 If flotation costs amount to $1 $1 per share, what is the cost of preferred stock for Prescott? preferred Cost of Preferred Stock Cost of Preferred Stock D kp = kp NPo = Dividend Dividend Net Price Cost of Preferred Stock D kp = kp NPo 8.00 74.00 = Dividend Net Price = = Cost of Preferred Stock D kp = kp NPo 8.00 74.00 = Dividend Dividend Net Price 10.81% = = Cost of Common Stock s There are 2 sources of Common There Equity: Equity: 1) Internal common equity (retained 1) Internal earnings), and 2) External common equity (new External common stock issue) common Do these 2 sources have the same Do cost? cost? Cost of Internal Equity s Since the stockholders own the firm’s Since retained earnings, the cost is simply the stockholders’ required rate of return. return. s Why? s If managers are investing If stockholders’ funds, stockholders will expect to earn an acceptable rate of return. return. Cost of Internal Equity Cost of Internal Equity 1) Dividend Growth Model 1) Dividend Cost of Internal Equity 1) Dividend Growth Model 1) Dividend D1 kc = Po +g Cost of Internal Equity 1) Dividend Growth Model 1) Dividend D1 kc = Po +g 2) Capital Asset Pricing Model (CAPM) 2) Capital Cost of Internal Equity 1) Dividend Growth Model 1) Dividend D1 kc = Po +g 2) Capital Asset Pricing Model (CAPM) 2) Capital kj = krf + βj (km - krrff ) Cost of External Equity Cost of External Equity Dividend Growth Model Dividend Cost of External Equity Dividend Growth Model Dividend D1 knc = NPo + g Cost of External Equity Dividend Growth Model Dividend D1 knc = NPo + g Net proceeds to the firm after flotation costs! Weighted Cost of Capital s The weighted cost of capital is just The the weighted average cost of all of the financing sources. the Weighted Cost of Capital Source Source debt debt preferred common Cost 6% 10% 16% Capital Capital Structure 20% 10% 70% Weighted Cost of Capital (20% debt, 10% preferred, 70% common) s Weighted cost of capital = .20 (6%) + .10 (10%) + .70 (16%) .20 = 13.4% 13.4% ...
View Full Document

This note was uploaded on 04/15/2009 for the course FINANCE FIN 320 taught by Professor Cpirinski during the Spring '09 term at CSU Fullerton.

Ask a homework question - tutors are online