Download Lesson 4 A cost ofcapital

9
Foundations of Financial
Management
NINTH
th
EDITION
Cost of Capital
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Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc. 2000
9
NINTH
th
EDITION
Foundations of Financial
Management
Chapter 7 - Outline
•
•
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Cost of Capital
Cost of Debt
Cost of Preferred Stock
Cost of Common Equity:
– Retained Earnings
– New Common Stock
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©The McGraw-Hill Companies, Inc. 2000
9
NINTH
th
EDITION
Foundations of Financial
Management
Cost of Capital
The cost of capital represents the overall cost of financing to the firm
The cost of capital is normally the relevant discount rate to u mnbvcse
in analyzing an investment.
The overall cost of capital is a weighted average of the various sources:
WACC = Weighted Average Cost of Capital
Cost of Debt
The cost of debt to the firm is the effective yield to maturity (or interest
rate) paid to its bondholders
Since interest is tax deductible to the firm, the actual cost of debt is less
than the yield to maturity:
After-tax cost of debt = yield x (1 - tax rate)
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Hirt Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc. 2000
9
NINTH
th
EDITION
Foundations of Financial
Management
Cost of Preferred Stock
-has a fixed dividend (similar to debt)
-has no maturity date
-dividends are not tax deductible and are expected to be perpetual or
infinite
Cost of preferred stock = dividend
price-flotation cost
Cost of Common Equity
-Common stock equity is available through retained earnings (R/E) or
by issuing new common stock:
Common equity = R/E + New common stock
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Hirt Irwin/McGraw-Hill
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9
Foundations of Financial
Management
NINTH
th
EDITION
The cost of common equity in the form of retained earnings is equal to the required
rate of return on the firm’s common stock.
RE 
D1
 g
P0
The cost of new common stock is higher than the cost of retained earnings because of
flotation costs.
Flotation costs : selling and distribution costs (such as sales commissions) for the new
securities.
Weighted Average Cost of Capital
We can use the individual costs of capital that we have computed to get our
“average” cost of capital for the firm.
This “average” is the required return on our assets, based on the market’s
perception of the risk of those assets.
The weights are determined by how much of each type of financing that we use.
Block
Hirt Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc. 2000
9
Foundations of Financial
Management
NINTH
th
EDITION
Capital Structure Weights
Notation
E = market value of CS = # outstanding shares CS times price per share CS
P= market value of PS = # outstanding shares PS times price per share PS
D = market value of debt = # outstanding bonds times bond price
V = market value of the firm = D + P + E
Weights
WE = E/V = percent financed with equity CS
WP = P/V = percent financed with equity PS
WD = D/V = percent financed with debt
WACC = WERE + WPRP + WDRD(1-TC)
Block
Hirt Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc. 2000
NINTH
9
Foundations of Financial
Management
th
EDITION
T 11-1
Table 11-1
Cost of capital–Baker Corporation
(1)
Cost
(aftertax)
Debt . . . . . . . . . .
Kd
Preferred stock . . . .
Kp
Common equity
(retained earnings) . . .
Ke
Weighted average
cost of capital . . . . .
Ka
Block
Hirt Irwin/McGraw-Hill
7.05%
(2)
Weights
(3)
Weighted
Cost
30%
2.12%
10.94
10
1.09
12.00
60
7.20
10.41%
©The McGraw-Hill Companies, Inc. 2000
NINTH
9
Foundations of Financial
Management
th
EDITION
T 11-2
Cost of capital curve
Cost of equity
Cost of capital
(percent)
Weighted
average cost
of captial
U-shaped
Cost of debt
Minimum point for
cost of capital
0
Block
Hirt Irwin/McGraw-Hill
40
Debt-assets mix (percent)
80
©The McGraw-Hill Companies, Inc. 2000
NINTH
9
Foundations of Financial
Management
th
EDITION
T 11-3
Table 11-3
Debt as a percentage of total assets
Selected Companies,
with Industry Designation
National Presto (electrical appliances)
Mylan Labs (pharmaceuticals) . .
Genetech (biochemistry) . . . .
Liz Claiborne (women’s clothing) . .
Diebold (automatic transmissions) .
Stanley Works (home tools) . . .
Sensormatic Electronics (theft control)
Alcan Aluminum (aluminum products)
Motorola (electronics). . . . .
Gannett (newspaper and publishing)
Fluor (engineering) . . . . .
Playboy Enterprises (entertainment).
Union Carbide (petrochemicals) . .
Reebok International (footwear)
.
Delta Airlines (air travel) . . . .
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Hirt Irwin/McGraw-Hill
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10%
15
20
22
33
35
47
50
52
54
58
65
77
78
80
©The McGraw-Hill Companies, Inc. 2000
NINTH
9
Foundations of Financial
Management
th
EDITION
T 11-4
Figure 11-2
Cost of capital over time
Cost of capital (Ka)
Ka t
Ka t + 1
Ka t + 2
Block
Hirt Irwin/McGraw-Hill
y
x
Debt-equity mix (percent)
©The McGraw-Hill Companies, Inc. 2000
NINTH
9
Foundations of Financial
Management
th
EDITION
T 11-5
Table 11-4
Investment projects available to the Baker Corporation
Projects
A . . . .
B. . . .
C. . . .
D. . . .
E. . . .
F. . . .
G. . . .
H. . . .
Expected
Returns
16.00%
14.00
13.50
11.80
10.65
9.50
8.60
7.00
Cost
($ millions)
$10
5
4
20
11
20
15
10
$95 million
Block
Hirt Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc. 2000
NINTH
9
Foundations of Financial
Management
th
EDITION
T 11-6
Figure 11-3
Cost of capital and investment projects for the Baker Corporation
Percent
16.0
14.0
12.0
10.0
8.0
-
A
B
C
10.41%
D
E
F
4.0 2.0 0.0 -
G
H
6.0
10 15 19
Block
Hirt Irwin/McGraw-Hill
39
50
70
Amount of capital ($ millions)
85
Ka Weighted
average
cost of
capital
95
©The McGraw-Hill Companies, Inc. 2000
NINTH
9
Foundations of Financial
Management
th
EDITION
T 11-7
Table 11-5
Cost of capital for different amounts of financing
First $39 Million
A/T
Cost
Debt . . . .
Kd
Preferred. .
Kp 10.94
Common
equity *. .
7.05%
Ke 12.00
Next $11 Million
Weighted
Wts. Cost
A/T
Cost
Wts.
.30
2.12%
Debt . . . Kd
.10
1.09
Preferred . Kp 10.94
.10
1.09
7.20
Common
equity † . . Kn 12.60
.60
7.56
.60
7.05% .30
Ka = 10.41%
*Retained earnings.
Block
Hirt Irwin/McGraw-Hill
Weighted
Cost
Kmc =
†New
2.12%
10.77%
common stock.
©The McGraw-Hill Companies, Inc. 2000
NINTH
9
Foundations of Financial
Management
th
EDITION
T 11-7
Table 11-6
Cost of capital for increasing amounts of financing
Over $50 Million
Cost
(aftertax)
Debt (higher cost)
Kd
Preferred stock
Kp
Common equity
(new common stock) Kn
Block
Hirt Irwin/McGraw-Hill
8.60%
Weights
Weighted
Cost
.30
2.58%
10.94
.10
1.09
12.60
.60
7.56
11.23%
Kmc =
©The McGraw-Hill Companies, Inc. 2000
NINTH
9
Foundations of Financial
Management
th
EDITION
T 11-8
Table 11-4
Marginal cost of capital and Baker Corporation projects
Percent
16.0
14.0
12.0
10.0
8.0
-
A
B
10.77%
C
11.23%
Kmc Marginal
cost of
capital
10.41%
D
E
F
4.0 2.0 0.0 -
G
H
6.0
10 15 19
Block
Hirt Irwin/McGraw-Hill
39
50
70
Amount of capital ($ millions)
85
95
©The McGraw-Hill Companies, Inc. 2000