A1 Business and Technical College Leverage and Capital Structure Discussion download the files down below andfollow all the steps pleasethank you>>>>>>>>>>

A1 Business and Technical College Leverage and Capital Structure Discussion download the files down below andfollow all the steps pleasethank you>>>>>>>>>>>>>>>>>>>> CHAPTER 11
THE COST OF
CAPITAL
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1
Learning Outcomes
LO.1 Compute the component cost of capital
for (a) debt, (b) preferred stock, (c)
retained earnings, and (d) new common
equity.
LO.2 Describe the weighted average cost of
capital (WACC), and discuss the logic of
using WACC to make informed financial
decisions.
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2
Learning Outcomes (cont.)
LO.3 Describe how the marginal cost of
capital (MCC) is used to make capital
budgeting decisions.
LO.4 Discuss the relationship between the
firm’s WACC and investors’ required
rates of return.
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3
Cost of Capital
○ Represents the firm’s average cost of funds,
which is the average return required by
firm’s investors.
○ What must be paid to attract funds.
○ The return that must be earned on invested
funds to cover the cost of using those
funds.
○ The firm’s required rate of return, r
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4
Cost of Capital
○ Investors who are the participants in the
financial markets determine the firm’s costs
of funds.
○ The firm’s costs of funds change when
❑
conditions in the financial markets change.
❑
investors’ general risk aversion changes.
❑
firm’s risk changes.
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5
Basic Definitions
○ Capital Components
❑
Types of capital used by firms to raise money
• rd = before tax interest cost (cost of debt)
• rdT = rd(1 – T) = after-tax cost of debt
• rps = cost of preferred stock
• rs = cost of retained earnings
• re = cost of external equity (new stock)
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6
Basic Definitions
○ WACC
❑
Weighted average cost of capital
○ Capital Structure
❑
The combination of the different types of
capital (debt and equity) used by a firm.
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7
Cost of Debt, rdT
○ The relevant cost of new debt
○ Must account for the tax deductibility of interest
○ rd = before-tax cost of debt = yield to maturity
(YTM), which is the return required by investors
=
=
rd
–
rd x T
rd(1 – T)
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8
Cost of Debt, rdT—Example
A firm that currently has debt with the following
characteristics wants to issue new debt to raise
funds to support its future growth.
Maturity value, M
Coupon rate, C
Years to maturity
Market price
Marginal tax rate
$1,000
9.0% (paid semiannually)
12 yrs
$931
40%
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9
Cost of Debt, rdT—Example
Based on the preceding information, we know that
the following relationship exists:
Vd = $931 =

$45
1
(1 + rd )
+
$45
(1 + rd )
2
+ L +
$1,000 + $45
(1 + rd )24
Solving for rd gives us the YTM for this bond
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10
Cost of Debt, rdT—Example
Financial calculator solution:
N
=
24 = 12 years x 2
PV =
-931
PMT =
45 = (0.09 x 1,000)/2
FV =
1,000
Inputs: 24
N
Output:
?
-931
45
1,000
I/Y
PV
PMT
FV
= 5% = rd/2
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11
Cost of Debt, rdT—Example
○ Because interest is paid every six months,
the computation of the before-tax cost of
debt is based on semiannual compounding.
○ Thus, rd/2 = 5% is the six-month rate of
return.
○ The annual rate, rd = 5% x 2 = 10%
○ If the firm’s marginal tax rate is 40 percent,
rdT = 10%(1 – 0.4) = 10%(0.6) = 6%
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12
Cost of Equity
○ The cost of equity is based on the rate of return
required by the firm’s stockholders.
❑
Cost of preferred stock—dividends received by
preferred stockholders represent an annuity
❑
Cost of retained earnings (internal equity)—return
that common stockholders require the firm to earn on
the funds that have been retained, thus reinvested in
the firm, rather than paid out as dividends
❑
Cost of new (external) equity—rate of return required
by common stockholders after considering the cost
associated with issuing new stock (flotation costs)
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13
Cost of Preferred Stock, rps
○ Rate of return investors require on the firm’s
preferred stock:
F = percentage flotation costs stated as a decimal
NP0 = per share net proceeds the firm receives from the issue
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14
Cost of Preferred Stock, rps—
Example
○ A firm has preferred stock with the following
characteristics:
rps =
Market price, P0
$120.00
Dividend, Dps
Flotation cost, F
$12.80
3.0%
$12.80
$12.80
=
= 0.11% = 11.0%
$120(1 − 0.03) $116.40
○ There is no tax adjustment, because payment of
dividends is not a tax-deductible expense.
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15
Cost of Retained Earnings, rs
○ The firm must earn a return on reinvested
earnings that is sufficient to satisfy existing
common stockholders’ investment
demands.
○ If the firm does not earn a sufficient return
using retained earnings, then the earnings
should be paid out as dividends.
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16
Cost of Retained Earnings, rs
○ Assuming the stock market is at or near
equilibrium, we know that the following
relationship exists:
Required rate
Expected rate
=
of return
of return
Dˆ 1
+g
= rˆs
rs =
rRF + RPs
=
P0
rRF = risk-free rate of return
g = constant growth rate
RPs = risk premium for Stock S
P0 = current stock price
Dˆ 1 = next period’s expected dividend
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17
Cost of Retained Earnings, rs—The
CAPM Approach
RPM = risk premium for the market (average-risk stock)
rM = market (average-risk stock) return
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18
Cost of Retained Earnings, rs—The
CAPM Approach: Example
rs = rRF + (rM − rRF )β s
Suppose rRF = 6.0%, rM = 10.5%, and βs = 1.6
rs = 6.0% + (10.5% – 6.0%)1.6 = 13.2%
○ Assumes the firm’s stockholders are very well
diversified.
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19
Cost of Retained Earnings, rs—The
Discounted Cash Flow (DCF)
Approach ( r̂s )
ˆ
 Dividend   Capital 
D
1
 + 

rs = rˆs =
+ g = 
P0
 yield   gain 
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20
Cost of Retained Earnings, rs—The
Discounted Cash Flow (DCF)
Approach ( r̂s ): Example
○ A firm, which is growing at a constant rate of
7.5 percent, is expected to pay a dividend
equal to $1.28 at the end of the year; its stock
currently sells for $22.
$1.28
rs =
+ 0.075 = 0.058 + 0.075 = 0.133 = 13.3%
$22
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21
Cost of Retained Earnings, rs—The
Bond-Yield-Plus-Premium Approach
○ Studies have shown that the return on equity
for a particular firm is approximately 3 to 5
percentage points higher than its rd (before-tax cost
of debt).
○ As a general rule of thumb, firms estimate rs by
adding 3 to 5 percent to rd.
○ If rd = 10.0%, then, we might estimate the cost of
retained earnings as
rs ≈ rd + 4% = 10% + 4% = 14.0%
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22
Cost of Retained Earnings, rs
○ The three approaches we used to determine the
cost of retained earnings give three different
results.
○ The three approaches are based on different
assumptions:
❑
❑
❑
CAPM approach assumes investors are extremely well
diversified.
DCF approach assumes the firms grows at a constant
rate.
Bond-yield-plus-risk-premium approach assumes that
the return on equity is related to rd.
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23
Cost of Retained Earnings, rs
(cont.)
○ Ideally all three approaches should give the
same result; if not, however, we might
average the results:
rs = (13.2% + 13.3% + 14%)/3 = 13.5%
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24
Cost of Newly Issued Common
Stock, re (External Equity)
○ re = rate of return required by common stockholders
after considering the costs associated with issuing new
stock (flotation costs).
Dˆ 1
Dˆ 1
re =
+g=
+g
P0 (1 − F)
NP0
F = percentage flotation cost stated as a decimal
○ The cost of new equity is greater than the cost of
retained earnings—that is, re > rs—because the firm
must pay flotation costs to issue new stock.
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25
Cost of Newly Issued Common Stock,
re (External Equity); Example
○ A firm, which is growing at a constant rate of 7.5
percent, is expected to pay a dividend equal to $1.28
at the end of the year; its stock currently sells for
$22. When it issues new common stock, the firm
pays its investment banker 17 percent of the issue.
$1.28
$1.28
rs =
+ 0.075 =
+ 0.075
$22(1 − 0.17)
$18.26
= 0.070 + 0.075 = 0.145 = 14.5%
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26
Target Capital Structure
○ Optimal Capital Structure
❑
Percentage 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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27
Weighted Average Cost of Capital,
WACC
○ To make decisions about capital budgeting
projects, we need to combine the various costs of
capital—debt, preferred stock, and common
stock—into a single required rate of return.
○ Weighted average cost of capital, or WACC—the
weighted average of the component costs of
capital using as the weights the proportion each
type of financing that makes up the total financing
of the firm.
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28
Weighted Average Cost of Capital,
WACC
WACC = w r
+ w r + w (r or r )
d dT
ps ps
s s
e
wd = proportion of debt in firm’s capital structure
wps = proportion of preferred stock in firm’s capital structure
ws = proportion of common equity in firm’s capital structure
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29
Weighted Average Cost of Capital,
WACC: Example
○ Suppose our illustrative firm has the following
capital structure:
Type of Financing
Debt, d
Preferred stock, ps
Common equity, s
Percent
of total
45.0
5.0
50.0
100.0
After-Tax
Cost, r
6.0%
11.0
13.5 or 14.5
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30
Weighted Average Cost of Capital,
WACC: Example
○ If the firm can use retained earnings to finance new
projects (i.e., it does not have to issue new stock)
WACC1 = 0.45(6.0%) + 0.05(11.0%) + 0.50(13.5%) = 10.0%
○ If the firm must issue new common stock to finance
new projects
WACC2 = 0.45(6.0%) + 0.05(11.0%) + 0.50(14.5%) = 10.5%
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31
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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32
Marginal Cost of Capital, MCC
○ Weighted average cost of raising additional funds.
○ Generally, MCC often is greater than the existing
WACC—that is, the cost of new funding
increases—because the
❑
❑
firm’s risk increases as more funds are raised,
which causes investors to require a higher rate of
return.
costs of issuing new funds increase.
○ MCC schedule—a graph that shows the average
cost of funds at various levels of new financing .
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33
MCC Schedule for Unilate Textiles If It
Generates $30.5 million Retained Earnings
WACC
(%)
●
10.5
10.0
WACC2
● ●
●
WACC1
●
●
●
●
●
●
●
●
Break Point
0 2 4
6 8
61
64 New Capital Raised
($ millions)
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34
Break Point (BP)
○ A break point occurs when WACC increases,
which is caused by an increase in any of the
component costs of capital
○ Costs of funds often increase as the firm
uses significantly higher amounts capital—
risk increases.
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35
Break Point (BP)
 Maximum amount of lower cost 


of capital of a given type
Break 

=
point  Proportion of the type of capital 


in
the
capital
structure


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