fmch12cost of capital
TRANSCRIPT
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Ch. 12
Cost of Capital2002, Prentice Hall, Inc.
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Where weve been...
Basic Skills: (Time value of money, Financial Statements)Investments: (Stocks, Bonds, Risk and Return)Corporate Finance: (The Investment Decision - Capital Budgeting) -
Assets Liabilities & Equity
Current assets Current Liabilities
Fixed assets Long-term debt
Preferred Stock
Common Equity
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Assets Liabilities & Equity
Current assets Current Liabilities
Fixed assets Long-term debt
Preferred Stock
Common Equity
The investment decision
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Where were going...
Corporate Finance: (The Financing Decision)Cost of capital
Leverage
Capital Structure
Dividends
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Assets Liabilities & Equity
Current assets Current Liabilities
Fixed assets Long-term debt
Preferred Stock
Common Equity
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Assets Liabilities & Equity
Current assets Current Liabilities
Fixed assets Long-term debt
Preferred Stock
Common Equity
The financing decision
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Assets Liabilities & Equity
Current assets Current Liabilities
Long-term debt
Preferred Stock
Common Equity
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Assets Liabilities & Equity
Current assets Current Liabilities
Long-term debt
Preferred Stock
Common Equity
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Capital Structure
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Ch. 12 - Cost of Capital
For Investors, the rate of return on a security is a benefit of investing.For Financial Managers, that same rate of return is a cost of raising funds that are needed to operate the firm.In other words, the cost of raising funds is the firms cost of capital. -
How can the firm raise capital?
BondsPreferred StockCommon StockEach of these offers a rate of return to investors.This return is a cost to the firm.Cost of capital actually refers to the weighted cost of capital - a weighted average cost of financing sources. -
Cost of Debt
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Cost of Debt
For the issuing firm, the cost of debt is:
the rate of return required by investors,adjusted for flotation costs (any costs associated with issuing new bonds), and adjusted for taxes. -
Example: Tax effects of financing with debt
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000
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Example: Tax effects of financing with debt
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000
Now, suppose the firm pays $50,000 in dividends to the stockholders. -
Example: Tax effects of financing with debt
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000
- dividends (50,000) 0
Retained earnings 214,000 231,000
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After-tax Before-tax Marginal
% cost of % cost of x tax
Debt Debt rate
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=
1
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After-tax Before-tax Marginal
% cost of % cost of x tax
Debt Debt rate
Kd = kd (1 - T)
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=
1
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After-tax Before-tax Marginal
% cost of % cost of x tax
Debt Debt rate
Kd = kd (1 - T)
.066 = .10 (1 - .34)
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=
1
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Example: Cost of Debt
Prescott Corporation issues a $1,000 par, 20 year bond paying the market rate of 10%. Coupons are semiannual. The bond will sell for par since it pays the market rate, but flotation costs amount to $50 per bond.What is the pre-tax and after-tax cost of debt for Prescott Corporation? - Pre-tax cost of debt: (using TVM)
P/Y = 2N = 40
PMT = -50
FV = -1000
PV = 950
solve: I = 10.61% = kd
After-tax cost of debt:Kd = kd (1 - T)
Kd = .1061 (1 - .34)
Kd = .07 = 7%
- Pre-tax cost of debt: (using TVM)
P/Y = 2N = 40
PMT = -50
FV = -1000So, a 10% bond
PV = 950costs the firm
solve: I = 10.61% = kdonly 7% (with
After-tax cost of debt: flotation costs)Kd = kd (1 - T) since the interest
Kd = .1061 (1 - .34) is tax deductible.
Kd = .07 = 7%
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Cost of Preferred Stock
Finding the cost of preferred stock is similar to finding the rate of return, (from Chapter 8) except that we have to consider the flotation costs associated with issuing preferred stock. -
Cost of Preferred Stock
Recall: -
Cost of Preferred Stock
Recall:kp = =
D
Po
Dividend
Price
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Cost of Preferred Stock
Recall:kp = =
From the firms point of view:D
Po
Dividend
Price
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Cost of Preferred Stock
Recall:kp = =
From the firms point of view:kp = =
D
Po
Dividend
Price
Dividend
Net Price
D
NPo
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Cost of Preferred Stock
Recall:kp = =
From the firms point of view:kp = =
NPo = price - flotation costs!
D
Po
Dividend
Price
Dividend
Net Price
D
NPo
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Example: Cost of Preferred
If Prescott Corporation issues preferred stock, it will pay a dividend of $8 per year and should be valued at $75 per share. If flotation costs amount to $1 per share, what is the cost of preferred stock for Prescott? -
Cost of Preferred Stock
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Cost of Preferred Stock
kp =
Dividend
Net Price
=
D
NPo
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Cost of Preferred Stock
kp = =
= =
Dividend
Net Price
8.00
74.00
D
NPo
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Cost of Preferred Stock
kp = =
= = 10.81%
Dividend
Net Price
8.00
74.00
D
NPo
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Cost of Common Stock
There are 2 sources of Common Equity:1) Internal common equity (retained earnings), and
2) External common equity (new common stock issue)
Do these 2 sources have the same cost?
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Cost of Internal Equity
Since the stockholders own the firms retained earnings, the cost is simply the stockholders required rate of return.Why?If managers are investing stockholders funds, stockholders will expect to earn an acceptable rate of return. -
Cost of Internal Equity
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Cost of Internal Equity
1) Dividend Growth Model
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Cost of Internal Equity
1) Dividend Growth Model
kc = + g
D1
Po
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Cost of Internal Equity
1) Dividend Growth Model
kc = + g
2) Capital Asset Pricing Model (CAPM)
D1
Po
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Cost of Internal Equity
1) Dividend Growth Model
kc = + g
2) Capital Asset Pricing Model (CAPM)
kj = krf + j (km - krf )
D1
Po
b
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Cost of External Equity
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Cost of External Equity
Dividend Growth Model
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Cost of External Equity
Dividend Growth Model
knc = + g
D1
NPo
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Cost of External Equity
Dividend Growth Model
knc = + g
D1
NPo
Net proceeds to the firm
after flotation costs!
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Weighted Cost of Capital
The weighted cost of capital is just the weighted average cost of all of the financing sources. -
Weighted Cost of Capital
Capital
Source Cost Structure
debt 6% 20%
preferred 10% 10%
common 16% 70%
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Weighted Cost of Capital
Weighted cost of capital =
(20% debt, 10% preferred, 70% common).20 (6%) + .10 (10%) + .70 (16%)
= 13.4%