Fm10e ch12
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Transcript of Fm10e ch12
Chapter 12 -Chapter 12 - Cost of Capital Cost of Capital
2005, Pearson Prentice Hall
Basic Skills:Basic Skills: (Time value of money, (Time value of money, Financial Statements)Financial Statements)
Investments:Investments: (Stocks, Bonds, Risk and (Stocks, Bonds, Risk and Return)Return)
Corporate Finance:Corporate Finance: (The Investment (The Investment Decision - Capital Budgeting)Decision - Capital Budgeting)
Where we’ve been...Where we’ve been...
Assets Liabilities & EquityAssets Liabilities & Equity
Current Assets Current LiabilitiesCurrent Assets Current Liabilities
Fixed Assets Long-term DebtFixed Assets Long-term Debt
Preferred StockPreferred Stock
Common EquityCommon Equity
Assets Liabilities & EquityAssets Liabilities & Equity
Current Assets Current LiabilitiesCurrent Assets Current Liabilities
Fixed Assets Long-term DebtFixed Assets Long-term Debt
Preferred StockPreferred Stock
Common EquityCommon Equity
The investment decision
Corporate Finance:Corporate Finance: (The (The FinancingFinancing Decision)Decision)
Cost of capitalCost of capital LeverageLeverage Capital StructureCapital Structure DividendsDividends
Where we’re going...Where we’re going...
Assets Liabilities & EquityAssets Liabilities & Equity
Current Assets Current LiabilitiesCurrent Assets Current Liabilities
Fixed Assets Long-term DebtFixed Assets Long-term Debt
Preferred StockPreferred Stock
Common EquityCommon Equity
Assets Liabilities & EquityAssets Liabilities & Equity
Current Assets Current LiabilitiesCurrent Assets Current Liabilities
Fixed Assets Long-term DebtFixed Assets Long-term Debt
Preferred StockPreferred Stock
Common EquityCommon Equity
The financing decision
Assets Liabilities & EquityAssets Liabilities & Equity
Current Assets Current LiabilitiesCurrent Assets Current Liabilities
Long-term DebtLong-term Debt
Preferred StockPreferred Stock
Common EquityCommon Equity
Assets Liabilities & EquityAssets Liabilities & Equity
Current assets Current LiabilitiesCurrent assets Current Liabilities
Long-term DebtLong-term Debt
Preferred StockPreferred Stock
Common EquityCommon Equity
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Capital Structure
Ch. 12 - Cost of CapitalCh. 12 - 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?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 Cost of DebtDebt
Cost of DebtCost 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.
Example: Tax effects Example: Tax effects of financing with debtof financing with debt
with stockwith stock with debtwith debt
EBITEBIT 400,000 400,000 400,000 400,000
- interest expense- interest expense 0 0 (50,000)(50,000)
EBTEBT 400,000 400,000 350,000 350,000
- taxes (34%)- taxes (34%) (136,000)(136,000) (119,000)(119,000)
EATEAT 264,000 264,000 231,000 231,000
Example: Tax effects Example: Tax effects of financing with debtof financing with debt
with stockwith stock with debtwith debt
EBITEBIT 400,000 400,000 400,000 400,000
- interest expense- interest expense 0 0 (50,000)(50,000)
EBTEBT 400,000 400,000 350,000 350,000
- taxes (34%)- taxes (34%) (136,000)(136,000) (119,000)(119,000)
EATEAT 264,000 264,000 231,000 231,000
Now, suppose the firm pays $50,000 in Now, suppose the firm pays $50,000 in dividends to the stockholders.dividends to the stockholders.
Example: Tax effects Example: Tax effects of financing with debtof financing with debt
with stockwith stock with debtwith debt
EBITEBIT 400,000 400,000 400,000 400,000
- interest expense- interest expense 0 0 (50,000)(50,000)
EBTEBT 400,000 400,000 350,000 350,000
- taxes (34%)- taxes (34%) (136,000)(136,000) (119,000)(119,000)
EATEAT 264,000 264,000 231,000 231,000
- dividends- dividends (50,000) (50,000) 0 0
Retained earnings Retained earnings 214,000 214,000 231,000 231,000
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
-= 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)
-= 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)
-= 11
Example: Cost of DebtExample: 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 Coupons are semiannual. The bond will sell for par semiannual. 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.bond.
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)
P/Y = 2P/Y = 2 N = 40N = 40
PMT = -50PMT = -50
FV = -1000FV = -1000
PV = 950PV = 950
solve: I = solve: I = 10.61%10.61% = kd = kd After-tax cost of debtAfter-tax cost of debt::
Kd = kd (1 - T)Kd = kd (1 - T)
Kd = .1061 (1 - .34)Kd = .1061 (1 - .34)
Kd = .07 = Kd = .07 = 7%7%
Pre-tax cost of debtPre-tax cost of debt: (using TVM): (using TVM)
P/Y = 2P/Y = 2 N = 40N = 40
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 StockCost 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 return return (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 StockCost of Preferred Stock
Recall:Recall:
Cost of Preferred StockCost of Preferred Stock
Recall:Recall:
kkpp = = = =
DPo
Dividend Price
Cost of Preferred StockCost of Preferred Stock
Recall:Recall:
kkpp = = = =
From the From the firm’sfirm’s point of view: point of view:
DPo
Dividend Price
Cost of Preferred StockCost of Preferred Stock
Recall:Recall:
kkpp = = = =
From the From the firm’sfirm’s point of view: point of view:
kkpp = = = =
DPo
Dividend Price
DividendNet Price
DNPo
Cost of Preferred StockCost 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!
DPo
Dividend Price
DividendNet Price
DNPo
Example: Cost of PreferredExample: 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 StockCost of Preferred Stock
Cost of Preferred StockCost of Preferred Stock
kpkp = = DividendNet Price
DNPo =
Cost of Preferred StockCost of Preferred Stock
kpkp = = = =
= == =
DividendNet Price
DNPo
8.0074.00
Cost of Preferred StockCost of Preferred Stock
kpkp = = = =
= = 10.81% = = 10.81%
DividendNet Price
DNPo
8.0074.00
Cost of Common StockCost of Common Stock
There are two sources of Common Equity:There are two sources of Common Equity:
1) 1) Internal common equityInternal common equity (retained (retained earnings).earnings).
2) 2) External common equityExternal common equity (new common (new common stock issue).stock issue).
Do these two sources have the same cost?Do these two sources have the same cost?
Cost of Internal EquityCost 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 EquityCost of Internal Equity
Cost of Internal EquityCost of Internal Equity
1) 1) Dividend Growth ModelDividend Growth Model
Cost of Internal EquityCost of Internal Equity
1) 1) Dividend Growth ModelDividend Growth Model
kkcc = + g = + gD1
Po
Cost of Internal EquityCost 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)
D1
Po
Cost of Internal EquityCost 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 ))
D1
Po
Cost of External EquityCost of External Equity
Dividend Growth ModelDividend Growth Model
Cost of External EquityCost of External Equity
Dividend Growth ModelDividend Growth Model
kkncnc = + g = + g
Cost of External EquityCost of External Equity
D1
NPo
Dividend Growth ModelDividend Growth Model
kkncnc = + g = + g
Cost of External EquityCost of External Equity
D1
NPo
Net proceeds to the firmafter flotation costs!
Weighted Cost of CapitalWeighted Cost of Capital
The weighted cost of capital is just the The weighted cost of capital is just the weighted average cost of all of the weighted average cost of all of the financing sources.financing sources.
Weighted Cost of CapitalWeighted 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 CapitalWeighted Cost of Capital(20% debt, 10% preferred, 70% common)(20% debt, 10% preferred, 70% common)