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Unformatted text preview: The Cost of Capital The Cost of Capital Mind Map Mind
Why?: An important question is “how high does our return have to be in order to justify an investment in the project?” an s In this topic area, we consider what In financial capital costs the firm. In general, a firm must earn returns high enough to cover the cost of capital in order to avoid destroying shareholder value
s Mind Map Mind
s Learning objective:
– Articulate the relationship between the cost of Articulate funds and return funds – Describe how a firm can increase value – Calculate the weighed average cost of capital Calculate (WACC) (WACC) – Discuss when the WACC is an appropriate Discuss discount rate for potential investment projects discount Mind Map Mind
s Key words/concepts:
– – – – Cost of capital/ WACC Component costs Tax shield Appropriate use of WACC Appropriate The Cost of Capital
s In order to determine whether a In capital investment will increase the value of a firm, you have to understand the opportunity cost of the capital. capital. s Basically: Basically:
– ROA > C of C – ROA< C of C increase value decrease value The investment decision Assets Assets Current assets Fixed assets Liabilities & Equity Current Liabilities Longterm debt Preferred Stock Preferred Common Equity Common Cost of Capital Cost
For Investors the rate of return on an asset is the benefit of investing. is s For Financial Managers that same rate of return is a cost of raising funds that are needed to operate the firm. needed s For you (the stockholder) , the increase in firm value comes from the difference in the cost of capital and the rate of return earned by the firm. by
s How can the firm raise capital? How
Debt s Preferred Stock Preferred s Equity 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” refers to the weighted refers average cost of capital (WACC) a weighted average average cost of financing sources.
s The Weighted Cost of Capital The
s To calculate the firm’s weighted To average cost of capital, we must first calculate the costs of the individual financing sources. Let’s look at: look s Cost of Debt s Cost of Common Stock Cost of Debt Cost
For your firm, the cost of debt is the For cost rate of return required by the lender, rate adjusted for: adjusted s 1) flotation costs (any costs associated 1) flotation with obtain new debt), and with s 2) taxes. 2) taxes Example: Tax effects of financing with debt of
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 of
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 dividends Now, to the stockholders. to Example: Tax effects of financing with debt of
with stock with EBIT 400,000  interest expense 0 EBT 400,000  taxes (34%) (136,000) (136,000) EAT 264,000  dividends (50,000) ΔRetained earnings 214,000 Retained 214,000 with debt with 400,000 (50,000) (50,000) 350,000 (119,000) (119,000) 231,000 0 231,000 Example: Tax effects of financing with debt of
with stock with EBIT 400,000  interest expense 0 EBT 400,000  taxes (34%) (136,000) (136,000) EAT 264,000  dividends (50,000) ΔRetained earnings 214,000 Retained 214,000 with debt with 400,000 (50,000) (50,000) 350,000 (119,000) (119,000) 231,000 0 231,000 A $17,000 difference Example: Tax effects of financing with debt of
2006 tax bill story s My accountant gave me two options (numbers My changed to protect the innocent): changed
s – Option 1: pay an additional $9,800 in tax – Option 2: Pay $6,000 in tax and invest $11,000 in a Option SEPIRA SEPIRA
s Point: tax savings is real! Of the $11,000 saved, I Point: tax only “contributed” $7,200 (the other $3,800 was money that I didn’t pay in taxes). money Aftertax cost Aftertax of Debt of = Beforetax cost of Debt  Tax Savings Aftertax cost Aftertax of Debt of =
= Beforetax cost of Debt  Tax Savings 33,000 33,000 50,000 17,000 Aftertax cost Aftertax of Debt of =
= Beforetax cost of Debt  Tax Savings 33,000 33,000 OR OR 50,000 17,000 Aftertax cost Aftertax of Debt of =
= Beforetax cost of Debt  Tax Savings 33,000 33,000 OR OR 33,000 33,000 50,000 17,000 = 50,000 ( 1  .34) Aftertax cost Aftertax of Debt of =
= Beforetax cost of Debt  Tax Savings 33,000 33,000 OR OR 33,000 33,000 50,000 17,000 = 50,000 ( 1  .34) Or, if we want to look at percentage costs: Or, percentage Aftertax Beforetax Marginal % cost of % cost of  x = tax Debt Debt rate 1 Aftertax Beforetax Marginal % cost of % cost of  x = tax Debt Debt rate 1 Kd = kd (1  T) Aftertax Beforetax Marginal % cost of % cost of  x = tax Debt Debt rate 1 Kd .066 .066 = = kd (1  T) .10 (1  .34)
ade this ote: I m N ber up! num Example: Cost of Debt Example:
s Prescott Corporation issues a $1,000 Prescott $1,000 par, 20 year bond paying the market 20 rate of 10%. Coupons are annual. The 10%. bond will sell for par since it pays the market rate, but flotation costs amount market but to $50 per bond. Prescott’s marginal $50 tax rate is 34%. tax
s What is the pretax and aftertax cost of What debt for Prescott Corporation? debt Pretax cost of debt: 950 = 100(PVIFA 20, kd) + 1000(PVIF 20, kd) 20, 1000(PVIF 20, using the calculator (i.e., a YTM problem), using kd = 10.61%.
s (Calculator: PV=950, PMT = 100, FV = 1000, N = 20, => I/Yr) s Aftertax cost of debt: Kd = kd (1  T) Kd Kd = .1061 (1  .34) Kd Kd = .07 = 7% Kd s Pretax cost of debt: 950 = 100(PVIFA 20, kd) + 1000(PVIF 20, kd) 20, 950 1000(PVIF 20, using the calculator, using kd = 10.61%. So, a 10% bond So, costs the firm costs s Aftertax cost of debt: only 7% (with Kd = kd (1  T) flotation costs) flotation Kd = .1061 (1  .34) since the interest since Kd = .07 = 7% is tax deductible. Kd is Cost of Common Stock Cost
s There are 2 sources of Common Equity: 1) Internal common equity (retained 1) Internal earnings), and 2) External common equity (new common stock issue) common Do these 2 sources have the same cost? Cost of Internal Equity Cost
s Since the stockholders own the firm’s Since retained earnings, the cost is simply the stockholders’ required rate of return. stockholders’
– If managers are investing stockholders’ funds, If stockholders will expect to earn an acceptable rate of return. rate Therefore, internal and external equity have Therefore, the same cost from the stockholders point of view in frictionless markets. in s What about floatation costs?????
s Cost of Internal Equity Cost
s In the absence of floatation costs, In internal and external equity have the same cost. same s The cost of EXTERNAL equity with The EXTERNAL floatation costs is calculable floatation s But, it’s just too darn late in the But, semester to get excited about equity floatation costs today. floatation s In class, we will focus on internal equity. The Cost of Equity The The cost of equity can be calculated in The two ways: two
1) 2) Capital market analysis (CAPM) Buildup method The Cost of Equity The
Capital Asset Pricing Model (CAPM) Capital kc = krf + Bc ( km  krf) Based on strong assumptions, the Based cost of equity is determined by a single risk factor: beta risk single The Cost of Equity The
Build up method Build The build up method is much more common in small business. Basically, we take the component parts of the cost and add them together. add The Cost of Equity The
Build up method Build
What are the costs: Bond yield Equity risk premium MicroCap risk premium Liquidity risk premium Is this subjective? Yes. But, remember that we Is are gauging the risk of a small business against the risk of IBM. Where is your money safer? money The Cost of Equity The
For Three Dudes, this might look like:
LONG TREASURY BOND EQUITY RISK PREMIUM BASE EQUITY RATE MICRO CAP LIQUIDITY RISK PREMIUM DISCOUNT RATE 6.0% 5.0% 11.0% 4.0% 4.0% 19.0% Thought for the Day Thought
s s Teddy Roosevelt in a 1910 speech in France: It is not the critic who counts; not the man who points out It how the strong man stumbles, or where the doer of deeds could have done them better. The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood; who strives valiantly; who errs, who comes short again and again, because there is no effort without error and shortcoming; but who does actually strive to do the deeds; who knows great enthusiasms, the great devotions; who spends himself in a worthy cause; who at the who who best knows in the end the triumph of high achievement, and who at the worst, if he fails, at least fails while daring greatly, so that his place shall never be with those cold and timid souls who neither know victory nor defeat. timid Weighted Cost of Capital Weighted
s The weighted cost of capital is just The the weighted average cost of all of the financing sources. the EXAMPLE EXAMPLE Weighted Cost of Capital
Capital Capital Source Cost Structure debt 10% 20% debt preferred 10% 10% common 16% 70% Note: Marginal tax rate = 40% Weighted Cost of Capital
(20% debt, 10% preferred, 70% common)
s Weighted cost of capital = .20 (10%) (1.4) + .10 (10%) + .70 (16) (1.4) = 13.4% Calculating the WACC Calculating
s s Three steps: 1) Determine the cost of each individual source 1) of financing. of
– Stock: CAPM or buildup – Debt: borrowing rate s s 2) Estimate the weights for the different 2) financing sources financing 3) Calculate the weighted average of the aftertax cost of each source.
– Multiply weights times cost for each component – Weights should be based on market values! Weights market We know the WACCWe So what…
What can we do with the WACC?? s When is WACC the appropriate discount When rate?? rate?? s The WACC is the discount rate for The “extensions” of the firm “extensions” s What about new projects???
s We know the WACCWe So what…
What can we do with the WACC?? s When is WACC the appropriate discount When rate?? rate?? s The WACC is the discount rate for The “extensions” of the firm “extensions” s What about new projects???
s is an This lide! tant s mpor i NowYouDoIt Exercise NowYouDoIt
s Suppose you need the WACC for a firm Suppose that is financed with 50% equity and 50% debt. The firm can borrow at 12%. The longterm Tbond rate is 6%, the equity risk premium is 5%, the micro cap risk premium is 3% and the startup premium is 4%. Assume a marginal tax rate of 40%. Find the WACC. The Cost of Debt The
s The pretax cost of debt is simply the The borrowing cost for the firm. In this case, 12% 12% The Cost of Equity The
s Use the BUILD UP METHOD Bond rate = 6% 6% +Equity risk premium = 5% +Equity 5% +MicroCap premium = 3% +Liquidity risk premium = 4% Cost of Equity = 18% Calculate the WACC Calculate
WACC = kd (weight)(1T) + ke (weight) = 12%(.5)(.6) + 18% (.5) 12%(.5)(.6) = 3.6% + 9% 3.6% = 12.6% 12.6% ...
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This note was uploaded on 04/07/2011 for the course BUS M 301 taught by Professor Jimbrau during the Winter '11 term at BYU.
 Winter '11
 JimBrau
 Finance, Cost Of Capital

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