11-1 2014_5_15

The Cost of Capital

Sources of capital

Component costs

WACC

Adjusting for flotation costs

11-2 2014_5_15

What sources of long-term capital do firms use?

Long-Term Capital

Long-Term Debt Common Stock

Retained Earnings (Internal Equity)

New Common Stock (External Equity)

11-3 2014_5_15

Calculating the weighted average cost of capital

WACC = wdkd(1-t) + wsks

The ‘w’s refer to the firm’s capital structure weights.

The ‘k’s refer to the cost of each component.

11-4 2014_5_15

Should our analysis focus on before-tax or after-tax capital costs?

Stockholders focus on A-T CFs. Therefore, we should focus on A-T capital costs, i.e. use A-T costs of capital in WACC. Only kd needs adjustment, because interest is tax deductible.

11-5 2014_5_15

How are the weights determined?

WACC = wdkd(1-t) + wsks

Use accounting numbers or market value (book vs. market weights)?

Use actual numbers or target capital structure?

11-6 2014_5_15

Component cost of debt

WACC = wdkd(1-t) + wsks

kd is the interest rate on new debt, not that on already outstanding debt; YTM

Why tax-adjust, i.e. why kd(1-t)?

Interest is tax deductible.

11-7 2014_5_15

Component cost of equity

WACC = wdkd(1-t) + wsks

ks is the cost of common equity raised by retaining earnings.

ke is the cost of common equity raised by issuing new common stock.

Increased for floatation costs

11-8 2014_5_15

Why is there a cost for retained earnings?

Earnings can be reinvested or paid out as

dividends.

If earnings are retained, there is an

opportunity cost (the return that

stockholders could earn on alternative

investments of equal risk).

11-9 2014_5_15

Three ways to determine the cost of common equity, ks

CAPM: ks = kRF + (kM – kRF) β

DCF: ks = D1 / P0 + g

Bond-Yield-Plus-Risk Premium:

ks = kd + RP

11-10 2014_5_15

If the kRF = 7%, RPM = 6%, and the firm’s beta is 1.2, what’s the cost of common equity based upon the CAPM?

ks = kRF + (kM – kRF) β

= 7.0% + (6.0%)1.2 = 14.2%

11-11 2014_5_15

If D0 = $4.19, P0 = $50, and g = 5%, what’s the cost of common equity based upon the DCF approach?

D1 = D0 (1+g)

D1 = $4.19 (1 + .05)

D1 = $4.3995

ks = D1 / P0 + g

= $4.3995 / $50 + 0.05

= 13.8%

11-12 2014_5_15

If kd = 10% and RP = 4%, what is ks using the bond-yield-plus-risk-premium method?

This RP is not the same as the CAPM RPM.

This method produces a ballpark estimate of ks, and can serve as a useful check.

ks = kd + RP

ks = 10.0% + 4.0% = 14.0%

11-13 2014_5_15

What is a reasonable final estimate of ks?

Method Estimate

CAPM 14.2%

DCF 13.8%

kd + RP 14.0%

Average 14.0%

11-14 2014_5_15

Why is the cost of retained earnings cheaper than the cost of issuing new common stock?

When a company issues new common stock they also have to pay flotation costs to the underwriter.

Flotation costs depend on the size and risk of the firm and on the type of capital being raised.

11-15 2014_5_15

If issuing new common stock incurs a flotation cost of 15% of the proceeds, what is ke?

15.4%

5.0% $42.50

$4.3995

5.0% 0.15)$50(1-

)$4.19(1.05

g f)(1-P

g)(1D k

0

0e

11-16 2014_5_15

Ignoring flotation costs, what is the firm’s WACC?

WACC = wdkd(1-t) + wsks

= 0.4(10%)(0.6) + 0.6(14%)

= 2.4% + 8.4%

= 10.8%

11-17 2014_5_15

What factors influence a company’s composite WACC?

Uncontrollable Factors (Market conditions)

Interest rates

Tax rates

Controllable Factors

The firm’s capital structure

Firm’s dividend policy

Firm’s investment policy: Firms with riskier projects generally have a higher WACC.

WACC = wdkd(1-t) + wsks

11-18 2014_5_15

Calculating a cost of capital

(예) 보통주: D0 300원 (6%로 지속성장 기대), 시장가 4,000원,

발행경비 시장가의 10%; 만기수익률(YTM): 5%; 법인세율: 40%

구분 자본구조(천원) 구성비율(%) 원천별비용(%) 가중비율

채권 30,000 30 3 0.9

보통주(신주) 40,000 40 14.83 5.93

유보이익 30,000 30 13.95 4.19

합계 100,000 100 WACC= 11.02

WACC = wdkd(1-t) + wsks + weke