Cost of Capital

1
Chapter 11
2
Cost of Capital
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Chapter Objectives

• Cost of Capital
• After-tax cost of debt, preferred stock and
  common stock
  
• Weighted average cost of capital
• PepsiCos cost of capital
• Cost of capital and new investments
• Economic profit
• Equivalent interest rates for different countries

4
Economic Value

• Created by earning a return greater than
  investors required return
  
• Destroyed by earning a return less than they
  require
  

5
EVA Measurement

• Encourages management to make business decisions
  that create economic value through improved
  operating efficiency, better asset utilization,
  and growth that generates returns which exceed
  the cost of capital

6
Shareholder Value-Based Management

• Rewards the firms employees in ways that
  continually encourage them to seek out new ways
  to create shareholder value

7
EVA

• Emphasis on EVA will more closely align the
  interests of employees and shareholders

8
Cost of Capital

• Link between financing decisions and investment
  decisions
  
• Hurdle rate that must be achieved by an
  investment before it will increase shareholder
  wealth
  
• Basis for evaluating division or firm performance

9
Cost of Capital

• Also called
• Hurdle rate for new investment
• Discount rate
• Opportunity cost of funds
• Required rate of return

10
Discount Rate

• Investors required rate of return
• or
• Minimum rate of return necessary to attract an
  investor to purchase or hold a security
  
• Considers opportunity cost

11
Required Rate of Return and Cost of Capital

• Cost of capital incorporates
• Taxes or Tax Savings
• Flotation Costs

12
Cost of Capital

• If a firm sells new stock for 30.00 a share and
  incurs 5 in flotation costs, and the investors
  have a required rate of return of 12, what is
  the cost of capital?
• .12 x30 3.60
• 3.60 / (30-5) 14.40

13
Financial Policy

• Policies regarding the sources of finances a firm
  plans to use and the particular mix in which they
  will be used
  
• Governs the use of debt and equity financing.
• The particular mixture of debt and equity a firm
  utilizes impacts the firms cost of capital.

14
Weighted Average Cost of Capital

• Combined costs of all the sources of financing
  used by the firm. The weighted average of the
  after-tax costs of each of the sources of capital
  used by a firm to finance a project where the
  weights reflect the proportion of total financing
  from each source.

15
Financing Instruments

• Debt
• Preferred Stock
• Common Stock

16
Cost of Debt

• After tax cost of debt kd(1-Tc)
• Before tax cost of capital less the effect of tax
  savings
  
• Example
• Debt at 9.75 and tax rate of 34
• After-tax cost of debt .0975(1-.34) 6.435

17
Cost of Preferred Stock

• Cost of preferred stock Preferred Stock
  dividend/ Net proceeds per share
  
• Example Annual dividend 5, Stock price 65 and
  flotation costs of 1.50
  
• Cost 5/(65 - 1.50) 5/(63.50) .07874
• or
• Cost of preferred stock 7.874

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Common Equity

• Sources
• Retained Earnings
• Sales of new shares
• No Flotation costs on retained earnings

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Cost of Equity Capital

• First estimate common stockholders required rate
  of return
  
• Dividend Growth Model
• Capital Asset Pricing Model

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Dividend Growth Model

• Investors required rate of return
• Kcs D1/Pcs g
• Dividends divided by price of stock plus growth
  rate
  
• Issue new common stock
• Kncs D1/NPcs g
• Dividends divided by net proceeds plus growth

21
Dividend Growth Model

• Example A company expects dividends this year
  to be 2.20, based upon the fact that 2 were
  paid last year. The firm expects dividends to
  grow 10 next year and into the foreseeable
  future. Stock is trading at 50 a share.
• Cost of retained earnings
• Kcs D1/Pcs g
• 2.20/50 .10 14.4
• Cost of new stock
• Kncs D1/NPcs g
• 2.20/(50-7.50) .10 15.18

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Issues with the Dividend Growth Model

• Simplicity
• Assume constant growth rate
• Estimating rate of growth

23
Capital Asset Pricing Model

• Combines
• Risk Free rate krf
• Systematic risk or Beta (B)
• Market Risk Premium or Expected rate of return
  for market or average security less the risk free
  rate km krf
  
• kc krf B(km krf)

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Capital Asset Pricing Model

• Example
• Beta is 1.4 Risk-free rate is 3.75 Expected
  market rate is 12
  
• .0375 1.4(.12 - .0375) 15.3

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Issues with the Capital Asset Pricing Model

• Simple/Easy to understand
• Variables available from public sources
• No reliance upon dividends or growth rate
  assumptions

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Weighted Average Cost of Capital

• Need cost of each of the sources of capital used
  and capital structure mix
  
• Capital Structure Mix proportions of each source
  of financing used by the firm
  
• WACoC (After tax cost of debt X proportion of
  debt financing) (Cost of equity X proportion of
  equity financing)
  

27
Weighted Average Cost of Capital

• Example
• A firm borrows money at 6 after taxes and pays
  10 for equity. The company raises capital in
  equal proportions 50/50
  
• WACoC (.06 X .5) (.1 X .5) .08 or 8

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PepsiCo

• Calculated divisional cost of capital
• Different target ratios for debt/equity mix per
  division
  
• Different pretax cost of debt for each division

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PepsiCo

• Division Cost of Cost of WA
• Equity X Debt X COC
• ratio ratio
• Restaurant (12.20 X .7) (5.54 X .3) 10.2
• Snack Foods (11.56 X .8) (5.23 X .2) 10.29
• Beverages (11.77 X .74) (5.28 X .26) 10.08

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Cost of Capital and New Investment

• Cost of Capital can serve as the discount rate in
  evaluating new investment when the projects offer
  the same risk as the firm as a whole.
  
• If risk differs, may calculate a different cost
  of capital for each division.
  
• Generally, calculate the cost of capital per
  division, not per project.

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Market Value AddedMVA

• Difference in the current market value of the
  firm and the sum of all the funds that have been
  invested in the firm over its entire operating
  life
• MVA
• Total value of the firm Invested capital

32
Economic Profit

• Accounting profit less a charge for use of
  capital
  
• Calculated by
• Net operating profit after tax (NOPAT) invested
  capital X cost of capital

33
Kmart Example

• Economic Profit NOPAT Invested capital X cost
  of capital
  
• 568.979 950M (19,727M X .0770)
• Note return is 4.82 and cost of capital is
  7.70.
  
• Note Kmart declared bankruptcy in Jan 2002

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Economic Profit

• Increase economic profit by
• Identifying and eliminating operating
  deficiencies
  
• Investing in projects that earn returns in excess
  of cost of capital
  
• Reduce capital charge

35
Incentive Based Compensation

• Way to align shareholder and manager interests
• Incentive Base Pay X Percentage X
  actual Eco pro
  
• compensation incentive Target Eco
  prof
  
• compensation

36
Multinational Firms and Interest Rates

• In an international setting, there can be
  different rates of inflation among different
  countries.
  
• The Fisher Model indicates that the nominal
  interest rate in the home or domestic country is
  a function of real interest rates and anticipated
  rate of inflation

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Fisher Model and Domestic Interest Rates

• rn,h (1 r r,h)(1 ih) 1
• or
• Nominal rate of interest (1 plus real interest
  rate) (1 plus inflation rate)
  
• Example
• Real interest rate is 5 and inflation rate is
  10
  
• (1.05)(1.10) 1 15.5

38
International or Foreign Rates and Fisher Effect

• rn,h - rn,f ih if
• Differences in observed nominal rates of interest
  between two countries should equal the
  difference in expected rates of inflation between
  the two countries

39
Interest Rates and Currency Exchange Rates

• Interest Rate Parity Theorem
• 1 r n,h E1
• 1 rn,f E0
• rn,h Domestic one period rate of interest
• rn,f Corresponding rate in foreign country
• Ej Exchange rates corresponding to current
  period I.e. spot rate E0 and one-period forward
  
• -- Nominal interest rates are tied to exchange
  rates
  
• -- Differences in nominal interest rates are tied
  to expected rates of inflation
  

40
Interest Rates and Currency Exchange Rates

• Example
• Domestic interest rate is 15.5 and the Japanese
  interest rate is 5
  
• 1 .155 / 1 .05 1.10