Cost of Capital

1
Chapter 6

• Cost of Capital

2
Finance Decisions

• Investment What assets to own?
• Financing How to pay for assets?
• Dividends What to do with EAT - pay dividends
  or reinvest in the company?
• Chapter 6 - Financing Decision

3
Sources of Long-term Financing

• Debt
• Preferred Stock
• Common Equity
• Retained Earnings
• New Common Stock
• To figure out the best mix of these sources, need
  an estimate of cost of raising funds from each
  source

4
Cost of Capital

• Firms cost of raising money is based on what
  investors require as a rate of return for
  providing the money
• Kd Bondholders Req. ROR
• Kp Preferred Stockholders Req. ROR
• Kc Common Shareholders Req. ROR

5
Estimating Cost of Capital

• Start with investors required rate of return
• Adjust for flotation costs (costs of issuing new
  securities)
• Adjust for tax benefits (debt financing only)

6
Cost of Debt Financing

• Investors Required Rate of Return on Bonds YTM
• To adjust for flotation costs, use net proceeds
  to issuing company instead of full selling price
  to public as PV in YTM calculation
• Adjusted YTM Kd

7
Tax Benefit for Corporate Debt

• Layout of Income Statement
• Sales - CGS - OE - Interest Expense - Taxes EAT
• Corps can deduct interest paid on debt before
  calculating income tax expense - dont pay taxes
  on interest paid
• Paying interest on debt reduces tax obligation,
  thus reducing cost of debt

8
After-Tax Cost of Debt

• YTM Kd Before-Tax Cost of Debt
• Ki After-Tax Cost of Debt
• Ki Kd(1 - Tax Rate)
• Summary Find YTM (adjusted for flotation costs)
  and multiply it by the after-tax rate (1 - T)
  to get cost of debt

9
Cost of Preferred Stock Financing

• Have seen P/S required rate of return previously
  VP Dp/Kp
• Solve equation for Kp, but use net proceeds to
  issuing company (Pnet) instead of full selling
  price to public (VP) to adjust for floatation
  costs
• Kp Dp/Pnet Cost of P/S
• No tax benefit to selling stock!

10
Cost of Using Retained Earnings

• Using the Constant Dividend Growth Model
• Kc D1/VC g
• Using the Capital Asset Pricing Model
• Kc Rf (Km - Rf)ß
• Using Rule of Thumb Method
• Kc Bond YTM Historical Yield on Stock over
  Bonds
• (3 to 6)

11
Cost of New Common Stock Financing

• Unlike retained earnings, which accrue through
  business operations, issuing new common stock
  involves flotation costs that increases the
  required rate of return
• Knc D1/Pnet g

12
Average Cost of Capital

• Ka WiKi WpKp WcKc
• Ka Weighted Average Cost of Capital
• Ki After-Tax Cost of Debt
• Kp Cost of Preferred
• Kc Cost of Common
• W Proportion of Total Capital From a Source
• Wi Wp Wc 1

13
Market Value Weights

• Market Value of Debt 5,000,000
• Market Value of Preferred 1,000,000
• Market Value of Common 4,000,000
• TotalFinancing 10,000,000
• Wd 5,000,000/10,000,000 .50
• Wp 1,000,000/10,000,000 .10
• Wc 4,000,000/10,000,000 .40

14
Financial Leverage

• Because debt is cheaper than equity, increasing
  the proportion of financing from debt initially
  reduces the average cost of capital. But because
  of the risks associated with debt financing,
  increasing the amount of debt will eventually
  lead to stock holders demanding a greater return
  to compensate them for the increased risk and,
  thus, the average cost will begin to increase.

15
Optimal Level of Debt

• Firms look at different possible combinations of
  debt and equity using a spreadsheet.
• Find the combination that yields the lowest WACC.
• That combination is called the Optimal Capital
  Structure.

16
Raising Additional Funds

• Once firm establishes optimal capital structure,
  it should try to raise new funds in those optimal
  proportions
• Easy to do in theory
• Harder to do in practice

17
Marginal Cost of Capital

• Because some sources of financing eventually run
  out, the cost (Ka) of the last raised may be
  higher than the cost of the first raised
• MCC Ka of last dollar raised in optimal
  proportions

18
MCC Example

• Optimal Capital Structure identified as 30 debt,
  10 P/S, 60 common equity.
• Firm needs to raise 150,000,000

19
Sources Available to Firm

• Debt Ki 6 for borrowing 36,000,000 or less
  Ki 8 for borrowing gt 36,000,000
• P/S Kp !2 (no limit)
• Common Equity Expected R/E 100,000,000,
  Dividend Payout Ratio 55, Kc 15, Knc 16
  (no limit)

20
Finding Breakpoints

• In determining MCC, must first see how much money
  can be raised in total (from all sources) before
  running out of one source and switching to a more
  expensive source
• R/E Breakpoint (R/E Available)/Wc
• Shows how much can be raised in total before
  exhausting available R/E

21
Example of R/E Breakpoint

• R/E Available .45(100,000,000) 45,000,000
• If in keeping op cap structure, 60 of new funds
  must come from common equity, the most we can
  raise in total using only R/E as common equity
  source .60x 45,000,000
• x 45,000,000/.60 75,000,000
• 75,000,000 1st Breakpoint

22
Debt Breakpoint

• Amount of debt that can be raised at a certain
  interest rate may be limited
• Debt Breakpoint Limit on Debt/Ki
• Shows how much money can be raised in total
  before low-cost debt is exhausted

23
Example of Debt Breakpoint

• Limit on borrowing at 6 36,000,000
• If 30 of total amount raised comes from 6 debt
  .30x 36,000,000
• x 36,000,000/.30 120,000,000
• 120,000,000 2nd Breakpoint

24
Using Breakpoints

• Once you have breakpoints established (for R/E
  and/or for debt), you use them to identify
  different increments of fund raising
• 1st increment is always raised with cheapest
  sources
• Subsequent increments have more expensive sources
  substituted for cheaper sources that are used up

25
Calculating MCC

• Once the increments have been identified using
  breakpoints, you can calculate Ka for each
  increment
• MCC Ka for last dollar raised (in an increment)
• MCC Schedule shows costs of different increments
  in raising a certain amount of money

26
Using Breakpoints from Example to Calculate MCC

• Trying to raise 150,000,000
• 1st 75,000,000 will be raised using 6 debt and
  retained earnings
• MCC for 1st 75,000,000 .30(.06) .10(.12)
  .60(.15) .12
• After raising 75,000,000, R/E run out and we
  substitute new C/S

27

• Can raise up to 120,000,000 using 6 debt
• MCC for money raised gt 75,000,000 but less than
  or equal to 120,000,000 .30(.06) .10 (.12)
  .60(.16) .126
• Run out of 6 debt after raising a total of
  120,000,000

28

• MCC of amounts raised over 120,000,000
  .30(.08) .10(.12) .60(.16) .132
• Summary 1st 75,000,000 raised cost firm 12
  next 45,000,000 raised cost 12.6 final
  30,000,000 raised cost 13.2

29
MCC Schedule

• Graph showing MCC as different amounts of capital
  are raised
• X axis raised
• Y axis MCC (Ka)
• Ends up looking like series of rising steps