Chapter 8 The Cost of Capital Fin 320 Dr. B. Asiri © 2005 Thomson/South-Western.
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Transcript of Chapter 8 The Cost of Capital Fin 320 Dr. B. Asiri © 2005 Thomson/South-Western.
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Chapter 8The Cost of Capital
Fin 320Dr. B. Asiri
© 2005 Thomson/South-Western
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Cost of Capital
Firm’s average cost of funds, which is the average return required by firm’s investors
What must be paid to attract funds
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Required Rate of Return(Opportunity Cost Rate)
The return that must be raised on invested funds to cover the cost of financing such investments
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The Logic of the Weighted Average Cost of Capital
The use of debt impacts the ability to use equity, and vice versa, so the weighted average cost must be used to evaluate projects, regardless of the specific financing used to fund a particular project.
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Basic Definitions
Capital ComponentTypes of capital used by firms to raise
moneykd = before tax interest costkdT = kd(1-T) = after tax cost of debtkps = cost of preferred stockks = cost of retained earningske = cost of external equity (new
stock)
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Basic Definitions
WACC Weighted Average Cost of Capital
Capital StructureA combination of different types of capital(debt and equity) used by a firm
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After-Tax Cost of Debt
The relevant cost of new debtTaking into account the tax deductibility of
interestUsed to calculate the WACC
kdT = bondholders’ RRR minus tax savings
kdT = kd - (kd x T) = kd(1-T)
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Cost of Preferred Stock
Rate of return investors require on the firm’s preferred stock
The preferred dividend divided by the net issuing price
)F1(P
D
costs FlotationP
D
NP
Dk
0
ps
0
pspsps
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s0
1RFs k̂ g
P
D̂ RP kk
Cost of Retained Earnings
Rate of return investors require on the firm’s common stock
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1. The CAPM Approach
s
RFk-
Mk
RFk
sk ( )
2. The Discounted CF Approach
Price and E(k) on a share of common stock depend on the dividends expected on the stock.
gP
D̂k̂k
0
1ss
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14% 4% 10%
premiumRisk yield Bond ks
3. The Bond-Yield-Plus-Premium Approach
Estimating a risk premium above the bond interest rate
Judgmental estimate for premium
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gF1P
D̂g
NP
D̂k
0
11s
Cost of Newly Issued Common Stock
External equity, ke
Based on the cost of retained earnings
Adjusted for flotation costs (the expenses of selling new issues)
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Target Capital Structure
Optimal Capital StructurePercentage of debt, preferred stock,
and common equity in the capital structure that will maximize the price of the firm’s stock
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sspspsdTd k
w
k
w
k
w
equity
common
of Cost
equity
common
of %
stock
preferred
of Cost
stock
preferred
of %
debt
of cost
tax-After
debt
of %
Weighted Average Cost of Capital, WACC
A weighted average of the component costs of debt, preferred stock, and common equity
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Marginal Cost of Capital
MCCCost of obtaining another dollar of new
capitalWeighted average cost of the last dollar
of new capital raised
Marginal Cost of Capital ScheduleA graph that relates the firm’s weighted
average of each dollar of capital to the total amount of new capital raised
Reflects changing costs, depending on amounts of capital raised
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Point structure capital in the capital of type thisof Proportion
given type a of capitalcost lower ofamount TotalBreak
Break Point
BPThe dollar value of new capital that
can be raised before an increase in the firm’s weighted average cost of capital occurs
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MCC Schedule
Weighted Average Cost of Capital (WACC) (%)
New Capital Raised (millions of dollars)
100 150
11.5 -
11.0 -
10.5 -WACC1=10.5%
WACC2=11.0%
WACC3=11.5%
BPRE BPDebt
Schedule and break points depend on capital structure used.
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0 -Dollars of New Capital Raised
WACC
Smooth, or Continuous, Marginal Cost of Capital Schedule
MCC Schedule
Weighted Average Cost of Capital (WACC) (%)
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Combining the MCC and Investment Opportunity Schedules
Use the MCC schedule to find the cost of capital for determining projects’ net present values.
Investment Opportunity Schedule (IOS)Graph of the firm’s investment
opportunities ranked in order of the projects’ internal rate of return
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Optimal Capital Budget - $115
Combining the MCC and Investment Opportunity Schedules
New Capital Raised and invested (millions of dollars)
IRRC = 12.1%
IRRB = 11.7%IRRD = 11.5%
IRRE = 11.3%
IRRA = 10.2%
Percent
20 40 60 80 100 120 140 160
12.0 -
11.0 -
10.0 -
MCC
IOSWACC1=10.0%
WACC3=11.0%
WACC2=10.5%