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The Cost of Capital

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43 views24 pages

The Cost of Capital

Uploaded by

shayan.53260
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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The Cost of

Capital
The investor-supplied items—debt, preferred stock, and
common equity—are called capital components.

Capital Increase in assets must be financed by increase in these


Components capital components.

The cost of each component is called its component cost;


for example, Allied can borrow money at 10%, so its
component cost of debt is 10%. These costs are then
combined to form a WACC, which is used in the firm’s
capital budgeting analysis.
Weighted Average Cost of Capital
(WACC)
A weighted average of the component costs of debt, preferred
stock, and common equity
Cost of Debt, rd(1-T)
A company has outstanding 20-year noncallable bonds
with a face value of $1,000, an 11% annual coupon, and
a market price of $1,294.54. If the company was to issue
new debt, what would be a reasonable estimate of the
interest rate on that debt?
If the company’s tax rate is 40%, what is its after-tax cost
of debt?
(8.0%, 4.8%)
Cost of Preferred Stock, rp
The rate of return investors require on the firm’s
preferred stock.

Allied would sell this stock to a few large hedge funds, the stock would
have a $10.00 dividend per share, and it would be priced at $97.50 a
share.
Therefore, Allied’s cost of preferred stock would be 10.3%
Cost of
Preferred Stock,
rp
A company’s preferred stock
currently trades at $80 per
share and pays a $6 annual
dividend per share. Ignoring
flotation costs, what is the
firm’s cost of preferred
stock?

(7.50%)
The rate of return required by stockholders on a
firm’s common stock.
New common equity is raised in two ways:
(1) by retaining some of the current year’s
earnings and
Cost of
Retained (2) by issuing new common stock.
Earnings, rs We use the symbol rs to designate the cost of
retained earnings and re to designate the cost of
new common stock, or external equity.
Equity raised by issuing stock has a higher cost
than equity from retained earnings due to the
flotation costs required to sell new common stock.
CAPM APPROACH
The most widely used method for estimating the cost of common equity is the capital asset
pricing model (CAPM)
BOND-YIELD-PLUS-RISK-
PREMIUM APPROACH
In situations where reliable inputs for the CAPM approach are not available, analysts often use a
somewhat subjective procedure to estimate the cost of equity.
Empirical studies suggest that the risk premium on a firm’s stock over its own bonds generally
ranges from 3 to 5 percentage points.
Based on this evidence, one might simply add a judgmental risk premium of 3% to 5% to the
interest rate on the firm’s own long-term debt to estimate its cost of equity
DIVIDEND-YIELD-PLUS-GROWTH-
RATE
This method of estimating the cost of equity is called the discounted cash flow, or DCF,
method.

Allied’s stock sells for $23.06, its next expected dividend is $1.25, and analysts expect
its growth rate to be 8.3%. Thus, Allied’s expected and required rates of return (hence,
its cost of retained earnings) are estimated to be

13.7%:
ADD FLOTATION COSTS
TO A PROJECT’S COST
Consider a 1-year project with an initial cost (not including
flotation costs) of $100 million. After 1 year, the project is
expected to produce an inflow of $115 million.
Therefore, its expected rate of return is ($115⁄ $100 – 1) = 0.15 =
15.0%.
However, if the project requires the company to raise $100
million of new capital and incur $2 million of flotation costs,
the total upfront cost will rise to $102 million, which will lower
the expected rate of return to ($115⁄$102 – 1) = 0.1275 = 12.75%.
Cost of new common stock, re

Flotation Cost, F The percentage cost of issuing new common stock.

Allied’s stock sells for $23.06, its next expected dividend is $1.25, and analysts expect its
growth rate to be 8.3%. Allied has a flotation cost of 10%, its cost of new common
equity, re ?

= 14.3%
Flotation Cost Adjustment

Allied used 13.5% as the final estimate of its cost of retained earnings, rs ,
WHEN MUST EXTERNAL EQUITY
BE USED?
Because of flotation costs, dollars raised by selling new stock must “work harder” than dollars
raised by retaining earnings.
Moreover, because no flotation costs are involved, retained earnings cost less than new stock.
The total amount of capital that can be raised before new stock must be issued is defined as the
retained earnings breakpoint.
Retained
earnings
breakpoint
Allied’s addition to retained
earnings in 2019 is expected to be
$66 million, and its target capital
structure consists of 45% debt, 2%
preferred, and 53% equity.
Find retained earnings breakpoint
for 2019?

$124.5 million
(10.21%)

($196.08 million)
WACC.
Factors That Affect the WACC
The three most important factors that
the firm cannot directly control are:
• interest rates in the economy,
• the general level of stock prices,
• and tax rates.
FACTORS THE FIRM CAN
CONTROL
A firm can directly affect its cost of capital in three primary ways:

(1) by changing its capital structure,

(2) by changing its dividend payout ratio, and

(3) by altering its capital budgeting decision rules to accept projects with more
or less risk than projects

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