cost of capital - Cost of Capital Cost of Capital For...

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Unformatted text preview: Cost of Capital Cost of Capital For Investors the rate of return on a security is a benefit of investing. For Financial Managers that same rate of return is a cost of raising funds that are needed to operate the firm. In other words, the cost of raising funds is the firm’s cost of capital. How can the firm raise capital? Bonds Preferred Stock Common Stock Each of these offers a rate of return to investors. This return is a cost to the firm. “Cost of capital” actually refers to the weighted cost of capital - a weighted average cost of financing sources. The Weighted Cost of Capital To calculate the firm’s weighted cost of capital, we must first calculate the costs of the individual financing sources: Cost of Debt Cost of Preferred Stock Cost of Common Stock Cost of Debt Cost of Debt For the issuing firm, the cost of debt is: the rate of return required by investors, adjusted for flotation costs (any costs associated with issuing new bonds), and adjusted for taxes. Example: Tax effects of financing with debt EBIT - interest expense EBT - taxes (34%) EAT with stock 400,000 0 400,000 (136,000) 264,000 with debt 400,000 (50,000) 350,000 (119,000) 231,000 Example: Tax effects of financing with debt EBIT - interest expense EBT - taxes (34%) EAT with stock 400,000 0 400,000 (136,000) 264,000 with debt 400,000 (50,000) 350,000 (119,000) 231,000 Now, suppose the firm pays Rs50,000 in dividends to the stockholders. Example: Tax effects of financing with debt with stock EBIT 400,000 - interest expense 0 EBT 400,000 - taxes (34%) (136,000) EAT 264,000 - dividends (50,000) Retained earnings 214,000 with debt 400,000 (50,000) 350,000 (119,000) 231,000 0 231,000 After-tax cost of Debt = Before-tax cost of Debt - Tax Savings After-tax cost of Debt 33,000 = = Before-tax cost of Debt 50,000 - Tax Savings - 17,000 After-tax cost of Debt 33,000 OR = = Before-tax cost of Debt 50,000 - Tax Savings - 17,000 After-tax cost of Debt 33,000 OR 33,000 = = = Before-tax cost of Debt 50,000 - Tax Savings - 17,000 50,000 ( 1 - .34) After-tax cost of Debt 33,000 OR 33,000 = = = Before-tax cost of Debt 50,000 - Tax Savings - 17,000 50,000 ( 1 - .34) Or, if we want to look at percentage costs: After-tax % cost of = Debt rate Before-tax % cost of x Debt 1 Marginal - tax After-tax % cost of = Debt rate Kd Before-tax % cost of x Debt = 1 Marginal - tax kd (1 - T) After-tax % cost of = Debt rate Before-tax % cost of x Debt 1 Marginal - tax Kd = kd (1 - T) .066 = .10 (1 - .34) Cost of irredeemable debt kd = I/NP Post tax Kdt= I(1-t) /NP (or) kd (1-t) Pretax Kd= I/NP Eg ; 12% debt of Rs 100/- each .50% tax .what is Kd? Kd = 12/100 = 0.12 = 12%( interest rate = cost) Kdt = 12(1-0.50)/100 = 0.06 = 6% ( cost will be less than interest rate) 15 % ,Debentures of Rs 100/- each for Rs 10,00,000/-,t=35%; i) Issued at Par value ii) Issued at 10%Premium iii) Issued at 10%Discount Find out kd before and after tax? Cost of redeemable debt BE company issues Rs100/- par value of debentures carrying 15% interest.The debentures are repayable after a period of 7 years at face value.The cost of issue is 3% and tax is 35%.What is Kd? Example: Cost of Debt Prescott Corporation issues a Rs1,000 par, 20 year bond paying the market rate of 10%. Coupons are annual. The bond will sell for par since it pays the market rate, but flotation costs amount to Rs50 per bond. What is the pre-tax and after-tax cost of debt for Prescott Corporation? Pre-tax cost of debt: 950 = 100(PVIFA 20, kd) + 1000(PVIF 20, kd) using the calculator, kd = 10.61%. After-tax cost of debt: Kd = kd (1 - T) Kd = .1061 (1 - .34) Kd = .07 = 7% Pre-tax cost of debt: 950 = 100(PVIFA 20, kd) + 1000(PVIF 20, kd) using the calculator, kd = 10.61%. So, a 10% bond costs the firm After-tax cost of debt: only 7% (with Kd = kd (1 - T) flotation costs) Kd = .1061 (1 - .34) since the interest Kd = .07 = 7% is tax deductible. Cost of Preferred Stock Finding the cost of preferred stock is similar to finding the rate of return, (from Chapter 8) except that we have to consider the flotation costs associated with issuing preferred stock. Recall: Cost of Preferred Stock kp = D Po = Dividend Price Recall: Cost of Preferred Stock kp = D Po = Dividend Price From the firm’s point of view: kp = D NPo = NPo = price - flotation costs! Dividend Net Price Example: Cost of Preferred If Prescott Corporation issues preferred stock, it will pay a dividend of Rs8 per year and should be valued at Rs75 per share. If flotation costs amount to Rs1 per share, what is the cost of preferred stock for Prescott? Cost of Preferred Stock D kp = NPo = Dividend Net Price Cost of Preferred Stock D kp = NPo = 8.00 74.00 = Dividend Net Price = 10.81% Cost of Common Stock There are 2 sources of Common Equity: 1) Internal common equity (retained earnings), and 2) External common equity (new common stock issue) Do these 2 sources have the same cost? Cost of Internal Equity Since the stockholders own the firm’s retained earnings, the cost is simply the stockholders’ required rate of return. Why? If managers are investing stockholders’ funds, stockholders will expect to earn an acceptable rate of return. Cost of Internal Equity Cost of Internal Equity 1) Dividend Growth Model Cost of Internal Equity 1) Dividend Growth Model D1 Kc = Po +g Cost of Internal Equity 1) Dividend Growth Model D1 Kc = Po +g 2) Capital Asset Pricing Model (CAPM) Cost of Internal Equity 1) Dividend Growth Model D1 Kc = Po +g 2) Capital Asset Pricing Model (CAPM) kc = krf + B ( km - krf ) Cost of External Equity Dividend Growth Model Cost of External Equity Dividend Growth Model D1 knc = +g NPo Cost of External Equity Dividend Growth Model D1 knc = +g NPo Net proceeds to the firm after flotation costs! Weighted Cost of Capital The weighted cost of capital is just the weighted average cost of all of the financing sources. Weighted Cost of Capital Source Cost debt preferred common 6% 10% 16% Capital Structure 20% 10% 70% Weighted Cost of Capital (20% debt, 10% preferred, 70% common) Weighted cost of capital = .20 (6%) + .10 (10%) + .70 (16) = 13.4% ...
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