# Understanding the Cost of Capital

Learn about the various types of long-term capital that firms use, including debt, preferred stock, and common equity. Understand capital components and how they affect the calculation of the cost of capital.

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## About Understanding the Cost of Capital

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1. 1 CHAPTER 9 The Cost of Capital

2. 2 Topics in Chapter Cost of capital components Debt Preferred stock Common equity WACC We ignore flotation cost in this course.

3. 3 What types of long-term capital do firms use? Long-term debt Preferred stock Common equity

4. 4 Capital Components Capital components are sources of funding that come from investors. Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the cost of capital. We do adjust for these items when calculating the cash flows of a project, but not when calculating the cost of capital.

5. 5 Before-tax vs. After-tax Capital Costs Tax effects associated with financing can be incorporated either in capital budgeting cash flows or in cost of capital. Most firms incorporate tax effects in the cost of capital. Therefore, focus on after-tax costs. Only cost of debt is affected.

6. 6 Cost of Debt Method 1: Ask an investment banker what the coupon rate would be on new debt if sold at par value. Method 2: Find the bond rating for the company and use the yield on other bonds with a similar rating. Method 3: Find the yield on the companys long-term debt, if it has any.

7. 7 A 15-year, 12% semiannual bond sells for \$1,153.72. Whats r d ? 60 60 + 1,000 60 0 1 2 30 r d = ? -1,153.72 ... 30 -1153.72 60 1000 5.0% x 2 = r d = 10% N I/YR PV FV PMT INPUTS OUTPUT

8. 8 Component Cost of Debt Interest is tax deductible, so the after tax (AT) cost of debt is: r d AT = r d BT(1 T) r d AT = 10%(1 0.40) = 6%. Use nominal rate.

9. 9 Preferred stock without maturity date: P ps = \$116.95; 10% div. annually; Par = \$100 r ps = D ps P ps = 0.1(\$100) \$116.95 = 8.55%

10. 10 Preferred div. paid every qtr. 2.50 2.50 2.50 0 1 2 r ps = ? -111.10 ... \$111.10 = D Q r Per = \$2.50 r Per r Per = \$2.50 \$111.10 = 2.25%; r ps(Nom) = 2.25%(4) = 9%

11. 11 What are the two ways that companies can raise common equity? Directly, by issuing new shares of common stock. Indirectly, by reinvesting earnings that are not paid out as dividends (i.e., retaining earnings).

12. 12 Three ways to determine the cost of common equity, r s 1. CAPM: r s = r RF + (r M r RF )b = r RF + (RP M )b 2. r s = D 1 /P 0 + g

13. 13 CAPM Cost of Equity: r RF = 5.6%, RP M = 6%, b = 1.2 r s = r RF + (RP M )b = 5.6% + (6.0%)1.2 = 12.8%.

14. 14 DCF Cost of Equity, r s : D 0 = \$3.26; P 0 = \$50; g = 5.8% r s = D 1 P 0 + g = D 0 (1 + g) P 0 + g = \$3.12(1.058) \$50 + 0.058 = 6.6% + 5.8% = 12.4%

15. 15 Determining the Weights for the WACC The weights are the percentages of the firm that will be financed by each component. If possible, always use the target weights for the percentages of the firm that will be financed with the various types of capital.

16. 16 Estimating Weights for the Capital Structure If you dont know the targets, it is better to estimate the weights using current market values than current book values. If you dont know the market value of debt, then it is usually reasonable to use the book values of debt, especially if the debt is short-term. (More)

17. 17 Estimating Weights (Continued) Suppose the stock price is \$50, there are 3 million shares of stock, the firm has \$25 million of preferred stock, and \$75 million of debt. (More)

18. 18 Estimating Weights (Continued) V s = \$50(3 million) = \$150 million. V ps = \$25 million. V d = \$75 million. Total value = \$150 + \$25 + \$75 = \$250 million.

19. 19 Estimating Weights (Continued) w s = \$150/\$250 = 0.6 w ps = \$25/\$250 = 0.1 w d = \$75/\$250 = 0.3

20. 20 Whats the WACC using the target weights? WACC = w d r d (1 T) + w ps r ps + w s r s WACC = 0.3(10%)(1 0.4) + 0.1(9%) + 0.6(12.8%) WACC = 10.38% 10.4%

21. 21 Is the firms WACC correct for each of its divisions? NO! The composite WACC reflects the risk of an average project undertaken by the firm. Different divisions may have different risks. The divisions WACC should be adjusted to reflect the divisions risk and capital structure.

22. 22 The Risk-Adjusted Divisional Cost of Capital Estimate the cost of capital that the division would have if it were a stand-alone firm. This requires estimating the divisions beta, cost of debt, and capital structure.

23. 23 Comments about flotation costs: Flotation costs depend on the risk of the firm and the type of capital being raised. The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small. We will frequently ignore flotation costs when calculating the WACC.

24. Homework Assignment Problems: 1,2,3,5,6,7,8,9,10(a,b),11,12,16 24