ch12 - CH 12 CH Cost of Capital Buy What? The investment...

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Unformatted text preview: CH 12 CH Cost of Capital Buy What? The investment decision Assets Assets Current Assets Fixed Assets Where do I get the money? The financing decision Liabilities & Equity Current Liabilities Long-term Debt Preferred Stock Preferred Common Equity Common Cost of Capital Cost For Investors, the rate of return on a the security is a benefit of investing. benefit For Financial Managers, that same that rate of return is a cost of raising funds cost that are needed to operate the firm. that In other words, the cost of raising In funds is the firm’s cost of capital. cost Cost of raising funds = Cost of capital Cost Cost Corporate Finance: (The Financing Decision) (The Financing Appropriately estimate a firm Cost of Appropriately capital is important for a company to make correct decision on its Capital Structure (mixture between debts and equities) equities) Assets Assets Current assets Liabilities & Equity Current Liabilities } Capital Structure Long-term Debt Long-term Preferred Stock Preferred Common Equity Common How can the firm raise capital? How Bonds Preferred Stock Common Stock Each of these offers a rate of return to Each rate investors. investors. This return is a cost to the firm. This cost “Cost of capital” actually refers to the weighted cost of capital - a weighted weighted average cost of all financing sources. Weighted Cost of Capital Weighted Source Source debt debt preferred common Cost 6% 10% 16% Capital Capital Structure 20% 10% 70% Weighted cost of capital =.20 (6%) + .10 (10%) + .70 (16%) = 13.4% Cost of Debt Debt Cost of Debt Cost For the issuing firm, the cost For of debt is: of the rate of return required the rate by investors, by adjusted for flotation costs adjusted flotation (any costs associated with issuing new bonds), and adjusted for taxes. adjusted 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 Now, suppose the firm pays $50,000 in Now, dividends to the stockholders. dividends 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) 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 Before-tax After-tax % cost of = % cost of cost Debt Debt Debt Kd .066 .066 = = x 1 Marginal - tax rate kd (1 - T) .10 (1 - .34) Example: Cost of Debt Example: Prescott Corporation issues a $1,000 Prescott $1,000 par, 20 year bond paying the market 20 rate of 10%. Coupons are 10%. semiannual. The bond will sell for par since it pays the market rate, but flotation costs amount to $50 per $50 bond. bond. What is the pre-tax and after-tax cost What of debt for Prescott Corporation? of Pre-tax cost of debt: (using TVM) P/Y = 2 N = 40 PMT = -50 FV = -1000 PV = 950 (Par –Floatation FV cost) cost) solve: I = 10.61% = kd solve: 10.61% After-tax cost of debt: Kd = kd (1 - T) Kd = .1061 (1 - .34) Kd = .07 = 7% Kd 7% 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% 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 Cost Finding the cost of preferred stock Finding cost is similar to finding the rate of return (from Chapter 8), except that we have to consider the flotation costs associated with flotation issuing preferred stock. issuing Cost of Preferred Stock Cost Recall: kp = D Po = Dividend Price From the firm’s point of view: From firm’s kp = D NPo = NPo = price - flotation costs! Dividend Net Price Example: Cost of Preferred Example: 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 D kp = kp NPo = 8.00 74.00 = Dividend Net Price = 10.81% Cost of Common Stock Cost There are two sources of Common Equity: 1) Internal common equity (retained 1) Internal earnings). earnings). 2) External common equity (new common 2) External stock issue). stock Do these two sources have the same cost? Cost of Internal Equity Cost Since the stockholders own the firm’s Since retained earnings, the cost is simply the stockholders’ required rate of return. return. Why? If managers are investing If stockholders’ funds, stockholders will expect to earn an acceptable rate of return. return. Cost of Internal vs. External Equity Cost Using the Dividend Growth Model (CH8) Using Dividend D1 kcs = +g Pcs Cost of Internal Equity D1 kcs = +g Pcs Cost of External Equity kncs D1 = +g NPcs Net proceeds to the firm after flotation costs! Weighted Cost of Capital Weighted The weighted cost of capital is just the The weighted average cost of all of the financing sources. financing Capital Source Cost Structure debt 6% 20% preferred 10% 10% common 16% 70% Weighted Cost of Capital (20% debt, 10% preferred, 70% common) Weighted cost of capital = Weighted .20 (6%) + .10 (10%) + .70 (16%) .20 = 13.4% 13.4% ...
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