cost of capital minggu 10 lecture notes. learning objectives –explain the concept and purpose of...

Cost of CapitalCost of Capital Minggu 10 Minggu 10

Lecture NotesLecture Notes

• Learning Objectives– Explain the concept and purpose of determining a firm’s cost of capital.– Identify the factors that determine a company’s cost of capital.– Describe the assumptions made in computing a firm’s weighted average

cost of capital.– Calculate a corporation’s weighted cost of capital.– Explain how PepsiCo calculates its cost of capital.– Compute the cost of capital for an individual project when the firm’s

weighted cost of capital is not appropriate as the discount rate.

0 1

Example: Consider the following project

+1,100-1,000

If Required Rate = 9%: NPV = -1,000 + 1,100 (1+ .09 )

= $9.17

Accept Project since NPV > 0

Required Rates on Projects

• An important part of capital budgeting is setting the required rate for the individual project

Remember:Remember:

NPV = PV of Cash Inflows - PV of Cash OutflowsNPV = PV of Cash Inflows - PV of Cash Outflows

(or Initial Outlay)(or Initial Outlay)

Remember:Remember:

NPV = PV of Cash Inflows - PV of Cash OutflowsNPV = PV of Cash Inflows - PV of Cash Outflows

(or Initial Outlay)(or Initial Outlay)

0 1


+1,100-1,000


= $9.17



= –$9.01

Reject Project since NPV < 0

Required Rates on Projects

• An important part of capital budgeting is setting the required rate for the individual project

0 1


+1,100-1,000


= $9.17



= –$9.01

In order to estimate correct required rate, companies must find their own unique cost of raising capital

In order to estimate correct required rate, companies must find their own unique cost of raising capital

Required Rates on Projects• An important part of capital budgeting is setting

the required rate for the individual project

Factors Determining Cost of Capital

• General Economic Conditions– Affect interest rates

• Market Conditions– Affect risk premiums

• When the economy is doing well, most companies do well. This reduces the risk that the company will fail.

• When the economy is doing poorly, many companies will also do

poorly. This increases the risk that a company will fail.

• Operating and Financing Decisions– Affect business risk– Affect financial risk

• Amount of Financing– Affect flotation costs and market price of security

Weighted Cost of Capital ModelWeighted Cost of Capital Model

Model Assumptions

• Constant Business Risk– The company is not undertaking any new projects that will

substantially change the risk of the company.

• Constant Financial Risk– The financing mix of the company will not substantially change.

• Constant Dividend Policy– Assume that there are no major changes in Dividend policy.

Weighted Cost of Capital ModelWeighted Cost of Capital Model

Computing Weighted Cost of Capital

• 1. Compute the cost of each source of capital– Ex: cost of debt, cost of equity, cost of preferred

stock.

• 2. Determine the weight of each source of capital in the total company’s financing mix.

• 3. Calculate Weighted Average Cost of Capital (WACC)

1. Compute Cost of Debt1. Compute Cost of Debt

P0 = +I

k

t

dn

t

n

( )11 $M

(1+kd)n

where:where:It = Dollar Interest Payment

Po = Market Price of DebtM = Maturity Value of Debt

Computing Cost of Each Source

• Required rate of return for creditors

• Same cost found in Chapter 6 as “required rate for debtholders (kd)”


938.55 = +

12

110)1(

90$

t dk $1,000

(1+kd)10

P0 = +I

k

t

dn

t

n

( )11 $M

(1+kd)n


• Example– Investors are willing to pay $985 for a

bond that pays $90 a year for 10 years. Fees for issuing the bonds bring the net price (NP0) down to $938.55. What is the before tax cost of debt?


938.55 = + $1,000

(1+kd)10

P0 = +I

k

t

dn

t

n

( )11 $M

(1+kd)n 10.0010.00

N I% PV PMT FV

10 ? -938.55 90 1000


• Example– Investors are willing to pay $985 for a bond

that pays $90 a year for 10 years. Fees for issuing the bonds bring the net price (NP0) down to $938.55. What is the before tax cost of debt?

12

110)1(

90$

t dk


The before tax cost of debt is 10%

10.0010.00

N I% PV PMT FV

10 ? -938.55 90 1000






Interest is tax deductibleInterest is tax deductible







After tax cost of bonds = kd(1 - T)

Marginal Tax Rate = 40%Marginal Tax Rate = 40%







After tax cost of bonds = kd(1 - T)

= 10.0%(1– 0.40) = 6 %

Marginal Tax Rate = 40%Marginal Tax Rate = 40%




2. Compute Cost Preferred Stock2. Compute Cost Preferred Stock

Dividend (D)Market Price (P0)

Required rate kps =

However, there are floatation costs of issuing preferred stock:However, there are floatation costs of issuing preferred stock:

Cost of Preferred Stock with floatation costsCost of Preferred Stock with floatation costs

Dividend (D)Net Price (NP0)

kps =


– Cost to raise a dollar of preferred stock.

2. Compute Cost Preferred Stock2. Compute Cost Preferred Stock

Cost of Preferred StockCost of Preferred Stock

$5.00 $42.00

= 11.90%kps =

No adjustment is made for taxes as dividends are not tax deductible.

No adjustment is made for taxes as dividends are not tax deductible.


• Example– Your company can issue preferred stock for

a price of $45, but it only receives $42 after floatation costs. The preferred stock pays a $5 dividend.

3. Compute Cost of Common Equity3. Compute Cost of Common Equity


• Cost of Internal Common Equity– Management should retain earnings only if they earn as much as

stockholder’s next best investment opportunity.

– Cost of Internal Equity = opportunity cost of common stockholders’ funds.

– Cost of internal equity must equal common stockholders’ required rate of return.

– Three methods to determine• Dividend Growth Model• Capital Asset Pricing Model• Risk Premium Model


Cost of internal equity--dividend growth modelCost of internal equity--dividend growth model

D1 P0

kcs = + gExampleExample

The market price of a share of common stock is $60. The dividend just paid is $3, and the expected growth rate is 10%.

3(1+0.10) 60

kcs = + .10 = .155 = 15.5%

The main limitation in this method is estimating growth accurately.The main limitation in this method is estimating growth accurately.


• Cost of Internal Common Equity– Dividend Growth Model

• Assume constant growth in dividends


ExampleExampleThe estimated Beta of a stock is 1.2. The risk-free rate is 5% and the expected market return is 13%.

kcs = rrf + (rm – rrf)

Cost of internal equity--CAPMCost of internal equity--CAPM

kcs = 5% + 1.2(13% – 5%) = 14.6%


• Cost of Internal Common Equity– Capital Asset Pricing Model

• Estimate the cost of equity from the CAPM


ExampleExampleIf the risk premium is 5% and kd is 10%

kcs = kd + RPc

Cost of internal equity--Risk PremiumCost of internal equity--Risk Premium

kcs = 10% + 5% = 15%

Where:Where:

RPc = Common stock risk premium


• Cost of Internal Common Equity– Risk Premium Approach

• Adds a risk premium to the bondholder’s required rate of return.


Cost of new common stockCost of new common stock

D1 NP0

kcs = + g


• Cost of New Common Stock– If retained earnings cannot provide all the equity

capital that is needed, firms may issue new shares of common stock.

– Using Dividend Growth Model, must adjust for floatation costs of the new common shares.

NPNP00 = Current stock price - Cost of issuing securities = Current stock price - Cost of issuing securitiesNPNP00 = Current stock price - Cost of issuing securities = Current stock price - Cost of issuing securities



D1 NP0

knc = + g

ExampleExampleUsing the above example. Common stock price is currently $60. If additional shares are issued floatation costs will be 12%. D0 = $3.00 and estimated growth is 10%.

NP0 = $60.00 – (.12x 60) = $52.80

FloatationCosts

FloatationCosts


• Cost of New Common Stock



D1 NP0

knc = + g

ExampleExampleUsing the above example. Common stock price is currently $60. If additional shares are issued floatation costs will be 12%. D0 = $3.00 and estimated growth is 10%.

NP0 = $60.00 – (.12x 60) = $52.80

3(1+0.10) 52.80

kcs = + .10 = .1625 = 16.25%


• Cost of New Common Stock

Capital Structure Weights• Long Term Liabilities and EquityLong Term Liabilities and Equity• Weights of each source should reflect expected financing mix• Assume a stable financial mix–so use Balance Sheet percentages to calculate the weighted average cost of

capital.

• In reality, most companies don’t issue debt, preferred, and equity to finance every project. They usually just issue one.

• However, most companies DO have a target capital structure and will stagger the issuance of securities so as to maintain that target.

Long Term Liabilities and EquityLong Term Liabilities and Equity

Balance Sheet Green Apple Company

Current Assets $5,000 Current Liabilities $2,000Plant & Equipment 7,000 Bonds 4,000Total Assets $12,000 Preferred Stock 1,000

Common Stock 5,000 Total Liabilities and

Owners Equity $12,000

Assets Liabilities

Firm Raises $10,000 of capital from long term sources

Capital Structure Weights





Assets Liabilities

Compute Firm’s Capital Structure (% of each source)

Bonds: 4,000 10,000

= 40%

Amount of Bonds

Total Capital Sources







Assets Liabilities

Compute Firm’s Capital Structure (% of each source)Amount of Preferred Stock


Preferred Stock: 1,000 10,000

= 10%







Assets Liabilities

Compute Firm’s Capital Structure (% of each source)Amount of Common Stock


Common Stock: 5,000 10,000

= 50%







Assets Liabilities

40%10%50%

When money is raised for capital projects, approximately 40% of the money comes from selling bonds, 10% comes from selling preferred stock and 50% comes from retaining earnings or selling common stock



Green Apple Company estimates the following costs Green Apple Company estimates the following costs for each component in its capital structure:for each component in its capital structure:

Source of CapitalSource of Capital Cost Cost

Bonds kd = 10%Preferred Stock kps = 11.9%Common Stock

Retained Earnings kcs = 15%New Shares knc = 16.25%

Green Apple’s tax rate is 40%

Computing WACC

If using retained earnings to finance the common stock portion the capital structure

WACC= k0 = %Bonds x Cost of Bonds x (1-T)+ %Preferred x Cost of Preferred+ %Common x Cost of Common Stock

Computing WACC

Where: %Bonds = Weight of Debt in company %Preferred = Weight of Preferred in company %Common = Weight of Common Stock in co.

Where: %Bonds = Weight of Debt in company %Preferred = Weight of Preferred in company %Common = Weight of Common Stock in co.

Balance Sheet

Current Assets $5,000 Current Liabilities $2,000Plant & Equipment 7,000 Bonds (9%) 4,000Total Assets $12,000 Preferred Stock (10%) 1,000

Common Stock(13%) 5,000Tax Rate = 40% Total Liabilities and


Assets Liabilities

40%10%50%


Computing WACC - using Retained Earnings

Balance Sheet

Current Assets $5,000 Current Liabilities $2,000Plant & Equipment 7,000 Bonds (10%) 4,000Total Assets $12,000 Preferred Stock (11.9%)1,000



Assets Liabilities

40%10%50%


WACC = .40 x 10% (1-.4)


Balance Sheet

Assets Liabilities

40%10%50%


WACC = .40 x 10% (1-.4)+ .10 x 11.9%





Balance Sheet

Assets Liabilities

40%10%50%


WACC = .40 x 10% (1-.4)+ .10 x 11.9%+ .50 x 15%





Balance Sheet

Assets Liabilities

40%10%50%

WACC = .40 x 10% (1-.4)+ .10 x 11.9%+ .50 x 15% = 11.09%






If use newly issued common stock, use kIf use newly issued common stock, use kncnc rather rather than kthan kcscs for the cost of the equity portion. for the cost of the equity portion.


kncknc

Computing WACC

Balance Sheet

Assets Liabilities

WACC = .40 x 10% (1-.4)+ .10 x 11.9%+ .50 x 16.25% = 11.72%



Common Stock(16.25%)5,000Tax Rate = 40% Total Liabilities and


Computing WACC-using New Common Shares

Break in costof capital curve

Retained earningsavailable for reinvesting

Percentage of common financing

=

Weighted Marginal Cost of Capital

• A firm’s cost of capital will changes as it is raising more and more capital– Retained earnings will be used up at some level– The cost of other sources may rise beyond a certain

amount of money raised

• Calculate the point at which the cost of capital increases


Retained earningsavailable for reinvesting

Percentage of common financing

=

If Green Apple Company has $100,000 of internally generated common:


$100,000.50

= = $200,000

Once $200,000 is raised from all sources, the cost of capital will rise because all the lower cost retained earnings will be used up.

Once $200,000 is raised from all sources, the cost of capital will rise because all the lower cost retained earnings will be used up.


We

igh

ted

Co

st

of

Cap

ita

l

Total Financing

9%

10%

11%

12%

0 100,000 200,000 300,000 400,000

11.09%

Cost of Capital using internal common stock



• Marginal weighted cost of capital curve:

We

igh

ted

Co

st

of

Cap

ita

l

Total Financing

9%

10%

11%

12%

0 100,000 200,000 300,000 400,000

11.09%

Break-Point for common equity

Break-Point for common equity



We

igh

ted

Co

st

of

Cap

ita

l

Total Financing

9%

10%

11%

12%

0 100,000 200,000 300,000 400,000

11.09%



11.72%Cost of Capital using new common equity

Cost of Capital using new common equity



We

igh

ted

Co

st

of

Cap

ita

l

Total Financing

9%

10%

11%

12%

0 100,000 200,000 300,000 400,000

11.09%

11.72%



We

igh

ted

Co

st

of

Cap

ita

l

Total Financing

9%

10%

11%

12%

0 100,000 200,000 300,000 400,000

Marginal weighted cost of capital curve:

Project 1IRR = 12.4%

Project 2IRR = 12.1% Project 3

IRR = 11.5%

Making Decisions

• Choosing Projects Using Weighted Marginal Cost of Capital– Graph IRR’s of potential projects

Making Decisions

• Choosing Projects Using Weighted Marginal Cost of Capital– Graph IRR’s of potential projects– Graph Weighted Marginal Cost of Capital

We

igh

ted

Co

st

of

Ca

pit

al

Total Financing

9%

10%

11%

12%

0 100,000 200,000 300,000 400,000




IRR = 11.5%

We

igh

ted

Co

st

of

Ca

pit

al

Total Financing

9%

10%

11%

12%

0 100,000 200,000 300,000 400,000




IRR = 11.5%

Accept Projects #1 & #2Accept Projects #1 & #2

Making Decisions• Choosing Projects Using Weighted Marginal Cost

of Capital– Graph IRR’s of potential projects– Graph Weighted Marginal Cost of Capital– Choose projects whose IRR is above the weighted

marginal cost of capital

cost of capital minggu 10 lecture notes. learning objectives –explain the concept and purpose of...

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companys cost of capital

cost of capital minggu

capital budgeting

cost of equity

unique cost

required rates

correct required rate

individual project slide