chapter 11. assets liabilities & equity current assets current liabilities long-term debt...

Chapter 11

Assets Liabilities & EquityAssets Liabilities & Equity

Current assets Current LiabilitiesCurrent assets Current Liabilities

Long-term debtLong-term debt

Preferred StockPreferred Stock

Common EquityCommon Equity

}

Capital StructureCapital Structure

Ch. 11 - Cost of Capital

For InvestorsFor Investors, the rate of return on a , the rate of return on a security is a security is a benefitbenefit of investing. of investing.

For Financial ManagersFor Financial Managers, that same , that same rate of return is a rate of return is a costcost of raising funds of raising funds that are needed to operate the firm.that are needed to operate the firm.

In other words, the cost of raising In other words, the cost of raising funds is the firm’s funds is the firm’s cost of capitalcost of capital..

How can the firm raise capital?

BondsBonds Preferred StockPreferred Stock Common StockCommon Stock Each of these offers a Each of these offers a rate of returnrate of return to to

investors.investors. This return is a This return is a costcost to the firm. to the firm. ““Cost of capitalCost of capital”” actually refers to the actually refers to the

weighted cost of capitalweighted cost of capital - a weighted - a weighted average cost of financing sources. average cost of financing sources.

Cost of Debt

For the issuing firm, the For the issuing firm, the cost of cost of debtdebt is: is:

the the rate of returnrate of return required by required by investors,investors,

adjusted for adjusted for flotation costsflotation costs (any costs associated with (any costs associated with issuing new bonds), and issuing new bonds), and

adjusted for adjusted for taxes.taxes.

-= 11 After-tax Before-tax MarginalAfter-tax Before-tax Marginal % cost of % cost of x tax% cost of % cost of x tax Debt Debt rateDebt Debt rate

KKdd = k = kd d (1 - T) (1 - T)

.066 = .10 (1 - .34).066 = .10 (1 - .34)

Example: Cost of Debt

Prescott Corporation issues a Prescott Corporation issues a $1,000$1,000 par, par, 20 year20 year bond paying the market bond paying the market rate of rate of 10%.10%. Coupons are semi- Coupons are semi- annual. The bond will sell for par annual. The bond will sell for par since it pays the market rate, but since it pays the market rate, but flotation costs amount to flotation costs amount to $50$50 per per bond. The tax rate is 34%.bond. The tax rate is 34%.

What is the pre-tax and after-tax What is the pre-tax and after-tax cost cost of debtof debt for Prescott Corporation? for Prescott Corporation?

Pre-tax cost of debtPre-tax cost of debt: (using TVM): (using TVM)

N = 40 (remember it’s N = 40 (remember it’s semi-annualsemi-annual))

PMT = -50PMT = -50

FV = -1000FV = -1000 So, a 10% bondSo, a 10% bond

PV = 950PV = 950 costs the firmcosts the firm

solve: I = solve: I = 10.61%10.61% = kd = kd only only 7%7% (with (with After-tax cost of debtAfter-tax cost of debt:: flotation costs)flotation costs)

Kd = kd (1 - T) Kd = kd (1 - T) since the interestsince the interest

Kd = .1061 (1 - .34) Kd = .1061 (1 - .34) is tax deductible.is tax deductible.

Kd = .07 = Kd = .07 = 7%7%

Cost of Preferred Stock

Finding the Finding the costcost of preferred stock of preferred stock is similar to finding the is similar to finding the rate of rate of returnreturn, (from Chapter 8) except , (from Chapter 8) except that we have to consider the that we have to consider the flotation costsflotation costs associated with associated with issuing preferred stock.issuing preferred stock.

Cost of Preferred Stock

Recall:Recall:

kkpp = = = =

From the From the firm’sfirm’s point of view: point of view:

kkpp = = = =

NPo = price - flotation costs!NPo = price - flotation costs!

DDPoPo

DividendDividend PricePrice

DividendDividendNet PriceNet Price

DDNPoNPo

Example: Cost of Preferred

If Prescott Corporation issues If Prescott Corporation issues preferred stock, it will pay a preferred stock, it will pay a dividend of dividend of $8$8 per year and per year and should be valued at should be valued at $75$75 per share. per share. If flotation costs amount to If flotation costs amount to $1$1 per share, what is the cost of per share, what is the cost of preferred stock for Prescott?preferred stock for Prescott?

Cost of Preferred Stock

kpkp = = = =

= = 10.81% = = 10.81%

DividendDividendNet PriceNet Price

DDNPoNPo

8.008.0074.0074.00

Cost of Common Stock

There are 2 sources of Common There are 2 sources of Common Equity:Equity:

1) 1) Internal common equityInternal common equity (retained (retained earnings), and earnings), and

2) 2) External common equityExternal common equity (new (new common stock issue)common stock issue)

Do these 2 sources have the same Do these 2 sources have the same cost?cost?

Cost of Internal Equity

Since the stockholders own the firm’s Since the stockholders own the firm’s retained earnings, the cost is simply retained earnings, the cost is simply the stockholders’ required rate of the stockholders’ required rate of return.return.

Why?Why? If managers are investing If managers are investing

stockholders’ funds, stockholders will stockholders’ funds, stockholders will expect to earn an acceptable rate of expect to earn an acceptable rate of return.return.

Cost of Internal Equity

1) 1) Dividend Growth ModelDividend Growth Model

kkcc = + g = + g

2) 2) Capital Asset Pricing Model (CAPM)Capital Asset Pricing Model (CAPM)

kkjj = k = krfrf + + jj (k (kmm - k - krf rf ))

DD11

PoPo

Dividend Growth ModelDividend Growth Model

kkncnc = + g = + g

Cost of External Equity

DD11

NPoNPo

Net proceeds to the firmNet proceeds to the firmafter flotation costs!after flotation costs!

Weighted Cost of Capital

The weighted cost of capital is just The weighted cost of capital is just the weighted average cost of all of the weighted average cost of all of the financing sources.the financing sources.

Weighted Cost of Capital

CapitalCapital

Source Cost StructureSource Cost Structure

debt 6% 20%debt 6% 20%

preferred 10% 10%preferred 10% 10%

common 16% 70%common 16% 70%

Weighted cost of capital =Weighted cost of capital =

.20 (6%) + .10 (10%) + .70 (16%).20 (6%) + .10 (10%) + .70 (16%)

= = 13.4%13.4%

Weighted Cost of Capital(20% debt, 10% preferred, 70% common)