COST OF CAPITAL. Three major capital structure components: Debt Preferred stock Common Equity

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1 COST OF CAPITAL Three major capital structure components: Debt Preferred stock Common Equity

2 You have become the president of a large company and the first decision you face is whether to go ahead with a plan to renovate the company s warehouse distribution system. The plan will cost the company $50 m and it is expected to save $12 m per year after taxes over the next 6 years. To address it, you would determine the relevant cash flows, discount them and if NPV is positive, you would take on the project but what should you use as the discount rate? Correct discount rate depends on the riskiness of the project to renovate the warehouse distribution system. The new project would have a positive NPV only if its return exceeds what the financial markets offer on investments of similar risk. This minimum required return becomes cost of capital associated with the project. As a president you must examine what the capital markets have to offer and use this information to arrive at an estimate of the project s cost of capital.

3 Cost of capital is equal to the marginal investor s required return on the security in question, which is used for discounting future cash flow estimates; hence the terms cost of capital, required return and appropriate discount rate are all used interchangeably Companies in order to maximize shareholder value invest in projects that earn more than the cost of capital

4 Abbreviations: rd = interest rate on the firm s new debt = before tax component cost of debt rd(1-t) = after tax component cost of debt, where T is the firm s marginal tax rate rp = component cost of preferred stock found as yield investors expect to earn on preferred stock rs = component cost of common equity raised by retaining earnings or internal equity re = component cost of external equity or common equity raised by issuing new stock, re = rs + floatation costs wd, wp, ws, we = target weights of debt, preferred stock, retained earnings (internal equity), new common stock (external equity) WACC = Weighted Average Cost of Capital

5 WACC = Σ (PROPORTION X COST) Equity 50% Preference 10% Debt 40% Cost of equity 16% Cost of preference 12% Cost of debt 8% Calculate WACC for this company

6 COST OF DEBT The after tax cost of debt is used to calculate WACC It is the interest rate on debt less tax savings that result because the interest is deductible The relevant cost of new debt, taking into account the tax deductibility of interest, rd (1-T) A company borrows at an interest rate of 10% and has a tax rate of 40%, what is its after tax cost of debt?

7 COST OF PREFERRED STOCK Rate of Return investors require on the firm s preferred stock is rp rp = preferred dividend market price of preferred stock A company pays $10 dividend per preferred share and sells for $97.5 in the open market. What is the cost of preferred share?

8 COST OF RETAINED EARNINGS - RS Opportunity cost principle = what the stockholders themselves could earn from alternative investments of comparable risk Methods of estimating cost of common equity (the dividend growth model approach) Discounted Cash Flow approach = dividend yield + expected growth rate rs = D1 + g Po D1 is the dividend for the next year, Po is the current market price, g is the expected growth rate

9 EXPECTED GROWTH RATE Growth rate is an estimate using the following methods: Calculate the annual growth rates from historical data of preceding 5 10 years and project trends into the future Rely on analysts forecast for future growth rates (projected sales, profit margins, competitive factors) Use retention growth rate method g= retention rate x rate of return on equity

10 COST OF NEW EQUITY- RE It is the cost of external equity; based on the cost of retained earnings but increased for flotation costs. Flotation costs is the percentage cost of issuing new common stock Ke = D1 + g Po (1-F)

11 A company s stock sells for $ Its next expected dividend is $1.25. The company is expected to have a constant ROE of 13.4% and is expected to pay out 40% of its earnings. Calculate rs. If the company were to raise external equity it will incur flotation costs of 10%. Calculate re.

12 FACTORS THAT AFFECT COMPOSITE COST OF CAPITAL Factors the firm cannot control Level of interest rates in the economy Tax rates Factors the firm can control Capital structure policy Dividend policy Investment policy

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