Cost of Capital & Weighted Average Cost of Capital.pptx

Cost of capital

1. COST Of CAPITAL AND WEIGHTED AVERAGE COST OF CAPITAL

2. Overview of the Cost of Capital The cost of capital represents the firm ’ s cost of financing, and is the minimum rate of return that a project must earn to increase firm value. Financial managers are ethically bound to only invest in projects that they expect to exceed the cost of capital. The cost of capital reflects the entirety of the firm ’ s financing activities.

3. Cost of Irredeemable debt Market value = PV of future interest payments discounted at debt providers required rate of return P =i/K d P₀ is current market price, i = annual interest and K d = cost of debt before tax Therefore; K d =i/P Irredeemable debt – example A plc has $100, 8 % irredeemable debentures quoted at 82% What is the cost of debt? K d = 8/82 = 9.76% What is the cost of debt if the company pays tax at 30 %? Cost of debt after tax= K d (1-t ) {= 9.76% x (1-0.30)= 0.0683=6.83 %}

4. Redeemable Debt The cost of debt for redeemable debt will be the internal rate of return (IRR) of the net of tax cash flows associated with the debt It will not be simply the return required by the debt provider x (1-t) This is because there is no tax relief on the redemption payment. We usually assume no delay in the tax when calculating cost of debt.

5. Redeemable debt - example Duchess Corporation has $10 million , 20-year , 9% coupon bonds with a par value of $ 100 in issue. Interest is paid annually on 31 December. The ex-interest market value of the stock at the beginning of the year is quoted at 96% and the stock is redeemable at a par in 20 years time. The company pays corporation tax at 40%.

6. Redeemable debt - example $ DF(5%) PV DF(10%) PV T₀ (96) 1 (96) 1 (96) T₁-T 20 9 x (1 – 0.4) =5.40 12.462 67.295 8.514 45.976 T 20 100 0.377 37.70 0.149 14.90 8.995 (35.124) IRR = 5% + 8.995/(8.995 + 35.124) (10% -5%) = 6.02% = 6%

7. Cost of Preferred Stock Preferred stock gives preferred stockholders the right to receive their stated dividends before the firm can distribute any earnings to common stockholders. The cost of preferred stock, r p , is the ratio of the preferred stock dividend to the firm ’ s net proceeds from the sale of preferred stock.

8. Cost of Preferred Stock (cont.) Duchess Corporation is contemplating the issuance of a 10% preferred stock that is expected to sell for its $87-per share value. The cost of issuing and selling the stock is expected to be $5 per share. The dividend is $8.70 (10%  $87). The net proceeds price (N p ) is $82 ($87 – $5). r P = D P / N p = $8.70/$82 = 10.6%

9. Cost of Common Stock The cost of common stock is the return required on the stock by investors in the marketplace. There are two forms of common stock financing: retained earnings new issues of common stock The cost of common stock equity, r s , is the rate at which investors discount the expected dividends of the firm to determine its share value.

10. Cost of Common Stock (cont.) The constant-growth valuation (Gordon) model assumes that the value of a share of stock equals the present value of all future dividends (assumed to grow at a constant rate) that it is expected to provide over an infinite time horizon. where P = value of common stock D 1 = per-share dividend expected at the end of year 1 r s = required return on common stock g = constant rate of growth in dividends

11. Cost of Common Stock (cont.) Solving for r s results in the following expression for the cost of common stock equity: The equation indicates that the cost of common stock equity can be found by dividing the dividend expected at the end of year 1 by the current market price of the stock (the “ dividend yield ” ) and adding the expected growth rate (the “ capital gains yield ” ).

12. Cost of Common Stock (cont.) Duchess Corporation wishes to determine its cost of common stock equity, r s . The market price, P , of its common stock is $50 per share. The firm expects to pay a dividend, D 1 , of $4 at the end of the coming year, 2018. The dividends paid on the outstanding stock over the past 6 years (2012 – 2017) were as follows: S o l u t io n : D n = D ( 1 + g ) n - 1 3.80 = 2.97 ( 1+ g ) 6 - 1 g = 0.0505 = 5.05%   Year Dividend 2017 $3.8 2016 3.62 2015 3.47 2014 3.33 2013 3.12 2012 2.97

13. Cost of Common Stock (cont.) We can calculate the annual rate at which dividends have grown, g, from 2012 to 2017. It turns out to be approximately 5% (more precisely, it is 5.05%). Substituting D 1 = $4, P = $50, and g = 5% into the previous equation yields the cost of common stock equity: r s = ($4/$50) + 0.05 = 0.08 + 0.05 = 0.130, or 13.0 %

14. Cost of Common Stock (cont.) The capital asset pricing model (CAPM) describes the relationship between the required return, r s , and the non-diversifiable risk of the firm as measured by the beta coefficient, b. r s = R f + [ b  ( r m – R f )] where R f = risk-free rate of return r m = market return; return on the market portfolio of assets

15. Cost of Common Stock (cont.) Duchess Corporation now wishes to calculate its cost of common stock equity, r s , by using the capital asset pricing model. The firm ’ s investment advisors and its own analysts indicate that the risk-free rate, R f , equals 7%; the firm ’ s beta, b, equals 1.5; and the market return, r m , equals 11%. Substituting these values into the CAPM, the company estimates the cost of common stock equity, r s , to be: r s = 7.0% + [1.5  (11.0% – 7.0%)] = 7.0% + 6.0% = 13.0 %

16. Cost of Common Stock: Cost of New Issues of Common Stock The cost of a new issue of common stock, r n , is the cost of common stock, net of underpricing and associated flotation costs. New shares are underpriced if the stock is sold at a price below its current market price, P .

17. Cost of Common Stock: Cost of New Issues of Common Stock (cont.) We can use the constant-growth valuation model expression for the cost of existing common stock, r s , as a starting point. If we let N n represent the net proceeds from the sale of new common stock after subtracting underpricing and flotation costs, the cost of the new issue, r n , can be expressed as follows:

18. Cost of Common Stock: Cost of New Issues of Common Stock (cont.) To determine its cost of new common stock, r n , Duchess Corporation has estimated that on average, new shares can be sold for $50. The $3-per-share underpricing is due to the competitive nature of the market. A second cost associated with a new issue is flotation costs of $2.50 per share that would be paid to issue and sell the new shares. The total underpricing and flotation costs per share are therefore $5.50. r n = ($4.00/$44.50) + 0.05 = 0.09 + 0.05 = 0.140, or 14.0 %

19. Weighted Average Cost of Capital The weighted average cost of capital (WACC), r a , reflects the expected average future cost of capital over the long run; found by weighting the cost of each specific type of capital by its proportion in the firm ’ s capital structure. r a = ( w i  r i ) + ( w p  r p ) + ( w s  r r or n ) where w i = proportion of long-term debt in capital structure w p = proportion of preferred stock in capital structure w s = proportion of common stock equity in capital structure w i + w p + w s = 1.0

20. Weighted Average Cost of Capital (cont.) In earlier examples, we found the costs of the various types of capital for Duchess Corporation to be as follows: Cost of debt, r i = 6.0% Cost of preferred stock, r p = 10.6% Cost of retained earnings, r r = 13.0% Cost of new common stock, r n = 14.0% The company uses the following weights in calculating its weighted average cost of capital: Long-term debt = 40% Preferred stock = 10% Common stock equity = 50%

21. Calculation of the Weighted Average Cost of Capital for Duchess Corporation Source of Financing Weight (1) Cost (2) Weighted Cost (3) = [ (1) (2)] Long term debt 0.4 6.0% 2.4% Preferred stock 0.1 10.6% 1.1% Common stock equity 0.5 13.0% 6.5% Totals 1.00 WACC = 10% Source of Financing Weight (1) Cost (2) Long term debt 0.4 6.0% 2.4% Preferred stock 0.1 10.6% 1.1% Common stock equity 0.5 13.0% 6.5% Totals 1.00 WACC = 10%

22. Marginal Cost and Investment Decisions Weighted Marginal Cost of Capital (WMCC) WMCC– the firm’s weighted average cost of capital (WACC) associated with its next dollar of total new financing. How to calculate WMCC? 1. Calculate break points, which reflect the level of total new financing at which the cost of one of the financing component arises. BP j = AF j / W j Where: BP j = break-point for financing source j AF j = amt of funds available from financing source j at a given cost W j = capital structure weight (stated in decimal form) for financing sources

23. How to calculate WMCC …..? 2. Calculate WACC, for a level of total new financing between break points. First, we find the WACC for a level of total new financing between Zero and the first break point. Second, we find the WACC for a level of total new financing between the first and second break points, and so on. 3. Together, the data computed above can be used to prepare a weighted marginal cost of capital schedule . This graph relates the firm’s weighted average cost of capital to the level of total new financing

24. Marginal Cost and Investment Decisions.. example Problem: When Duchess Corp. exhausts its $300,000 of available retained earnings (at rr =13%), it must use the more expensive new common stock financing (at rn=14%) to meet its common stock equity needs. In addition, the firm expects that it can borrow only $400,000 of debt at the 6 % costs; additional debt will have an after-tax cost ( ri ) of 8.4%. Analysis: 2 break points therefore exists: (1) when the $300,000 of retained earnings costing 13% is exhausted, (2) when the $400,000 of a long-term debt costing 6 % is exhausted. Using the formula, BP common equity = $300,000/ 0.5 = $600,000 BP long-term debt = $400,000/ 0.4 = $1,000,000

25. Marginal Cost and Investment Decisions. Example Range of Total New financing $000 0 - 600 $000 600 - 1000 $000 1,000 + Source Weight MCC 1 MCC 2 MCC 3 Debt 0.4 6% 6% 8.4% Preference shares 0.1 10.6% 10.6% 10.6% Common Equity 0.5 13% 14% 14% WMCC 10% 10.5% 11.4%

26. Marginal Cost and Investment Decisions Investment Opportunities Schedule (IOS) IOS – is a ranking of investment possibilities from best (higher return) to worst (lower return). The first project will have the highest return, the next project the second highest, and so on . Using the WMCC and IOS to Make Financing/Investment Decisions As long as a project’s IRR > weighted marginal cost of new financing, the firm should accept the project The return will decrease with the acceptance of more projects, and the WMCC will increase because greater amounts of financing will be required. Decision Rule: Accept projects up to the point at which the marginal return on an investment equals its weighted marginal cost of capital. Beyond this point, its investment return will be less than its capital cost .

27. Example 2

28. Example 2 continued Required; Find the breaking Points in the Marginal Cost Schedule. Calculate the Marginal Cost of Capital in the interval between each break in the MCC schedule.   Construct a well labelled graph, showing the Marginal Cost of Capital (MCC) and the Investment Opportunities Schedule (IOS) Which projects should Bunky Ltd accept? Justify your answer .   What is the Weighted Average Cost of Capital for the capital budget you are advocating for in part (d)? Compute the NPV of project B. Assume uniform cash flows and a life of 6 years

29. Example 2 continued

30. Example 2 continued

31. Example 2 cont.…….

32. G raph , showing the Marginal Cost of Capital (MCC) and the Investment Opportunities Schedule (IOS)