Chapter 11 The Cost of Capital Copyright ©2003 South-Western/Thomson Learning Introduction • This chapter discusses the concept of the cost of capital and develops approaches used to measure it. • Weighted average cost of capital (WACC) • Risk vs. required return trade-off • Individual components Cost of Capital • Determined in the capital markets • Depends on the risk associated with the firm’s activities • What the firm must pay for capital • The return required by investors • Minimum rate of return required on new investments Equal to the equilibrium rate of return demanded by investors in the capital markets for securities of that degree of risk Notation • • • • • rf denotes riskless rate of return. kd denotes pretax cost of debt. ki denotes after-tax cost of debt. kp denotes cost of preferred stock. ke denotes cost of internal common equity. • ke’ denotes cost of external common equity. Notation • ka denotes weighted (marginal) cost of capital. • p0 denotes the current market price of a security. • pnet denotes the net proceeds to the firm from the sale of a security. • pf denotes market value of a firm’s preferred stock. Notation • E denotes market value of a firm’s common equity. • B denotes market value of a firm’s debt in its capital structure. • rm denotes expected return on the “market” portfolio. • denotes the beta (systematic risk) of a company’s stock. Weighted Average Cost of Capital • The weighted average cost of capital is the discount rate used when computing the net present value (NPV) of a project of average risk. • Similarly, the weighted average cost of capital is the hurdle rate used in conjunction with the internal rate of return (IRR) approach to project evaluation (for a project of average risk). Weighted Average Cost of Capital • Thus, the appropriate after-tax cost of capital figure to be used in capital budgeting not only is based on the next (marginal) capital to be raised, but also is weighted by the proportions of the capital components in the firm’s longrange target capital structure. Therefore, this figure is called the weighted average cost of capital (WACC). Weighted Average Cost of Capital (WACC): ka • The general expression for calculating the WACC as follows: E B ka ( )(ke ) ( )(kd )(1 T ) E B Pf E B Pf Pf ( )(kp ) E B Pf Weighted Average Cost of Capital (WACC): ka • In the absence of preferred stock in a firm’s capital structure, the calculation of the WACC can be simplified to: E B ka ( )(ke ) ( )(kd )(1 T ) EB EB WACC: Example • Firm A has a target capital structure consisting of 47 percent common equity, 51 percent debt, and 2 percent preferred stock. Firm A plans to finance future capital investments in these proportions. All common equity is expected to be derived internally from additions to retained earnings. WACC: Example • The marginal cost of internal common equity has been estimated to be 10.4 percent using the dividend valuation approach. The marginal cost of preferred stock is 8.1 percent and the pretax marginal cost of debt is 8 percent. The marginal tax rate is 40 percent. WACC: Example • Using these figures, the WACC for Firm A can be computed as follows: ka = 0.47*10.4% + 0.51*8.0%*(1 0.4) + 0.02*8.1% = 7.5% This is the rate that Firm A should use to evaluate investment projects of average risk over the coming year. Required return = rf + Risk premium • rf = risk-free rate • The risk-free rate of return has two components: – real rate of return determined by supply and demand – a premium for the effects of inflation Required return = rf + Risk premium • Components of the risk premium (Ch. 5) – Business risk is associated with the amount of operating leverage. – Financial risk is associated with the use of financial leverage. – Marketability risk refers to the ability to quickly buy and sell a company’s security without a significant loss of value. – Interest rate risk arises from changes in interest rates. – Seniority risk is due to the priority of a security’s claim on assets. Relative Costs of Capital • Figure 11.1 illustrates the general riskreturn trade-off between investors’ required rates of return and various sources of funds. Relative Costs of Capital • If capital markets are to clear (that is, supply equals demand), the firm must offer returns consistent with investor requirements. • In other words, the cost of capital to the firm is equal to the equilibrium rate of return demanded by investors in the capital markets for securities with that degree of risk. Relative Costs of Capital • Suppose, for example, that a firm offers a security for sale in the capital markets at a return that is less than investors generally require. Obviously, not enough buyers will come forth. Unless the firm increases the return (by dropping the price, raising the interest or dividend rate, and so on), the securities will remain unsold, and the firm will not be able to raise its capital. Marginal Costs • Firms calculate their cost of capital in order to determine a discount rate to use for evaluating proposed capital expenditure projects. • Recall that the purpose of capital expenditure analysis is to determine which proposed projects the firm should actually undertake. Marginal Costs • Therefore, it is logical that the capital whose cost is measured and compared with the expected benefits from the proposed projects should be the next or marginal capital the firm raises. • As we saw in Chapter 8, the capital budgeting process involves an extension of the marginal analysis principle from economics. Marginal Costs • The marginal revenue (internal rate of return) from a project is compared with the marginal cost of funds needed to finance the project. • The marginal cost of funds is the cost of the next increments of capital raised by the firm. Hence, the costs of the various capital funding components (debt, preferred stock, and common equity) must be their marginal costs. Marginal Costs • Historic average capital costs are not relevant for making new (marginal) resource allocation decisions. Cost of Debt • The cost of debt capital to the firm is the rate of return required by a firm’s creditors. Cost of Debt • For a debt issue, this rate of return, kd, equates the present value of all expected future receipts—interest, I, and principal repayment, M—with the net proceeds, pnet, of the debt security: n I M Pnet t n (1 k ) (1 k ) t 1 d d Pnet I (PVIFA kd ,n ) M (PVIFkd ,n ) Cost of Debt • The pre-tax cost of debt, kd, is calculated in the same way as the yield to maturity, shown in Chapter 6. The only difference in the calculation is that when making yield-to-maturity calculations, the price of the bond is the current market price. When computing the pretax cost of debt to a company, the price of the bond is the net proceeds the company receives after considering all issuance costs. Cost of Debt • Interest payments made to investors are deductible from the firm’s taxable income. Therefore, the after-tax cost of debt, ki, is computed by multiplying the pre-tax cost of debt, kd, by 1 minus the firm’s marginal tax rate, T: ki = kd(1 – T) – The tax benefits of interest deductibility are available only to firms that are making profits. – For a firm losing money, the after-tax cost, ki, is the same as the pretax cost, kd. Cost of Debt: Example • Assume that KMI sells $100 million of 20-year 7.8 percent coupon rate bonds. The net proceeds to KMI after issuance costs are $980 for each $1,000 bond. KMI’s pretax cost, kd, of this debt offering can be calculated as follows: 980 $78(PVIFA kd ,20 ) $1, 000(PVIFkd ,20 ) Cost of Debt: Example • The calculation of kd can be done either by trial and error using Tables IV and II or with the aid of a financial calculator. – By trial and error, try 8 percent: $980 = $78(9.818) + $1,000(0.215) – 20 → N -980 → PV 78 → PMT 1000 → FV Compute i% (= 8.00) Cost of Debt: Example • Assuming a 40 percent marginal tax rate, the after-tax cost of debt for KMI is: ki = kd(1 – T) = 8%(1 – 0.4) = 4.8% Cost of Preferred Stock • The cost of preferred stock to the firm is the rate of return required by investors on preferred stock issued by the company. Cost of Preferred Stock • The cost of preferred stock, kp, can be derived as follows: P0 Dp kp kp Dp P0 kp Dp Pnet where Pnet is the proceeds from the sale of the stock after subtracting issuance costs. Cost of Preferred Stock: Example • Suppose KMI has just issued 3 million shares of a preferred stock that pay an annual dividend of $4.05. The preferred stock was sold to the public at a price of $52 per share. With issuance costs of $2 per share, the marginal cost of preferred stock is calculated as follows: $4.05 kp 0.081 or 8.1% $52 $2 Cost of Preferred Stock • Because payments by the firm to preferred stockholders are in the form of dividends, they are not tax deductible; therefore, the after-tax cost of preferred stock is equal to the pretax cost. Cost of Preferred Stock • An increasing number of preferred stock issues are callable, have a sinking fund redemption provision, or have a fixed maturity. In these cases, the computation of the cost of preferred stock financing is similar to that for bond. Cost of Preferred Stock: Example • Progress Energy plans an offering of $50 par value preferred stock that will pay a $5.00 dividend per year. The preferred stock is expected to yield Progress Energy net proceeds of $46.40 per share after all issue costs. The preferred stock must be retired at its par value in 15 years. Cost of Preferred Stock: Example • The cost of this preferred stock issue can be computed by solving for kp in the following valuation model: Pnet $46.40 $5(PVIFA kp ,15 ) $50(PVIFkp ,15 ) Cost of Preferred Stock: Example • 15 → N -46.40 → PV 5 → PMT 50 → FV Compute i% (= 11%) Cost of Internal Equity Capital • The cost of equity capital to the firm is the equilibrium rate of return required by the firm’s common stock investors. Firms raise equity capital in two primary ways: – Internally, through retained earnings – Externally, through the sale of new common stock Cost of Internal Equity Capital • The cost of internal equity is not zero. When funds are generated through the earnings of the firm, either managers can pay out these funds as dividends to common stockholders, or the funds can be retained and reinvested in the firm. Cost of Internal Equity Capital • If the funds were paid out to stockholders, they could reinvest the funds elsewhere to earn an appropriate return, given the risk of the investment. Cost of Internal Equity Capital • Therefore, if managers decide to retain earnings and reinvest them in the firm, there must be investment opportunities in the firm offering a return equivalent to the returns available to common stockholders, on a risk-adjusted basis, in alternative investments. Cost of Internal Equity Capital • The cost of internal equity to the firm is less than the cost of new common stock because the sale of new stock requires the payment of issuance costs. st of Internal Equity Capital: Dividend luation Model Approach • The general dividend valuation model (or the dividend capitalization model) for common stock valuation is as follows: Dt P0 t t 1 (1 ke ) where P0 is the stock’s present value or current market price; Dt, the dividend received in period t; and ke, the return required by investors. st of Internal Equity Capital: Dividend luation Model Approach • The above equation shows that in efficient capital markets, ke, the required return and thus the cost of equity capital, equates the present value of all expected future dividends with the current market price of the stock. st of Internal Equity Capital: Dividend luation Model Approach • In principle, the cost of equity capital can be calculated by solving for ke. • In practice, however, the expected future dividends are not known and cannot be estimated with the same degree of confidence as preferred stock dividends and debt interest. As such, the general form of the dividend valuation model is not directly useful in calculating the cost of equity capital. st of Internal Equity Capital: Dividend luation Model Approach • If the firm’s future per-share dividends are expected to grow each period perpetually at a constant rate, g, the dividend valuation model can be written as follows: D1 P0 ke g where D1 = D0(1 + g) and D0 is the current period dividend (t = 0). Note that ke must be greater than g. st of Internal Equity Capital: Dividend luation Model Approach • As discussed in Chapter 7, the constant growth valuation model assumes that a firm’s earnings, dividends, and stock price will grow at rate g. Thus, g equates to the yearly price appreciation (capital gain). But the total return to stockholders, ke, is composed of both the price appreciation and the dividend yield. Therefore, g cannot be greater than or equal to ke because it is only one of two components making up k . st of Internal Equity Capital: Dividend luation Model Approach • Assuming that dividends are expected to grow perpetually at a rate g per year, the cost of equity can be calculated as follows: D1 ke g P0 st of Internal Equity Capital: Dividend luation Model Approach - Example • Suppose KMI’s common stock is currently selling for $56 a share. Its present dividend, D0, is $0.20 a share, and the expected long-term earnings and dividend growth rate is 10 percent. The cost of internal equity capital, ke, is calculated as follows: $0.20(1 0.10) ke 0.10 0.104 or 10.4% $56 st of Internal Equity Capital: onconstant Dividend Growth Model • The dividend valuation model can also be used to compute the cost of equity for common stocks expected to pay dividends that grow at variable rates in the future. An approach similar to the nonconstant growth dividend valuation model illustrated in Chapter 7 can be used. st of Internal Equity Capital: onconstant Dividend Growth Model • For example, Avtec Corporation is a rapidly growing producer of microcircuit boards used in the aerospace industry. Its stock is currently selling for $10.95 per share. Current dividends, D0, are $1.00 per share and are expected to grow at a rate of 10 percent per year over the next four years and 6 percent annually thereafter. st of Internal Equity Capital: onconstant Dividend Growth Model • Avtec’s cost of internal equity, ke, can be found as follows: $1.10 $1.10(1 0.1)1 $1.10(1 0.1) 2 $10.95 1 2 (1 ke ) (1 ke ) (1 ke )3 $1.10(1 0.1)3 1 $1.55 4 4 (1 ke ) (1 ke ) ke 0.06 $10.95 $1.10(PVIFke ,1 ) $1.21(PVIFke ,2 ) $1.33(PVIFke ,3 ) $1.55 $1.46(PVIFke ,4 ) (PVIFke ,4 ) ke 0.06 Note that the last term in this expression, $1.55/(ke – 0.06), is equal to the expected stock price at the st of Internal Equity Capital: onconstant Dividend Growth Model • The valuation expression above must be solved for ke, the cost of equity capital, using a trial-and-error procedure. A trial value of 17 percent for ke yields the following: $10.95 = $1.10(0.855) + $1.21(0.731) + $1.33(0.624) + $1.46(0.534) + 0.354[$1.55/(0.17 0.06)] = $10.95 Thus, Avtec’s cost of equity is 17%. Cost of Internal Equity Capital: CAPM Approach • Recall from Chapter 5 that the security market line is defined as follows: kj = rf + j(rm – rf) – – – – – kj = the required rate of return on any security j rf = the expected risk-free rate j = the beta (systematic risk) measure for security j rm = the expected return on the market portfolio. The value (rm – rf) equals the market risk premium (the slope of the SML), or the risk premium applicable to a stock of average (beta = 1.0) risk. Cost of Internal Equity Capital: CAPM Approach - Example • Suppose KMI’s beta is 0.70 and the return of the market portfolio is 12.1%. If short-term Treasury bills are yielding 3.0 percent, KMI’s cost of equity capital may be computed using the short-term SML as follows: ke = rf + j(rm – rf) = 3.0% + 0.7(12.1% – 3.0%) = 9.4% Cost of Internal Equity Capital: CAPM Approach • Recall from Chapter 5 that the beta measure of risk considers only the systematic risk or market risk of a stock. Poorly diversified investors may be more interested in total risk than in systematic risk. When this is true, the CAPM may understate returns required by those investors. Cost of Internal Equity Capital: Non-Dividend-Paying Stocks • For stocks that do not pay dividends, the dividend capitalization model is obviously an inappropriate valuation model and therefore cannot be used to determine an accurate cost of equity capital. • Investors in non-dividend-paying stocks expect to sell the stock in the future at a higher price than the present price, realizing a capital gain. Cost of Internal Equity Capital: Non-Dividend-Paying Stocks • Investors’ expectations about the future price are incorporated into the following valuation model: Pt P0 t (1 ke ) where Pt is the expected stock price at time t. Cost of Internal Equity Capital: Non-Dividend-Paying Stocks • In principle, a firm could use this valuation model to determine its cost of equity capital. In practice, however, this would be difficult to do, because the company probably has no way of confidently determining the Pt expectations of investors. Cost of Internal Equity Capital: Non-Dividend-Paying Stocks • Instead, the cost of equity capital for non-dividend-paying stocks normally is determined either by using the Capital Asset Pricing Model, the risk premium on debt approach, or by estimating ke for comparable dividend-paying stocks in their industry. Cost of External Equity Capital • The cost of external equity is greater than the cost of internal equity for the following reasons: – Issuance (flotation) costs associated with new shares are usually high enough that they cannot realistically be ignored. Cost of External Equity Capital – The selling price of the new shares to the public is normally set less than the market price of the stock before the announcement of the new issue. Before any announcement, the current market price of a stock usually represents an equilibrium between supply and demand. If supply is increased (all other things being equal), the new equilibrium price will be lower. Cost of External Equity Capital • When a firm’s future dividend payments are expected to grow at a constant rate of g per period forever, the cost of external equity, ke’, is defined as follows: D1 k g Pnet ' e where Pnet is the net proceeds to the firm on a per-share basis. Cost of External Equity Capital: Example • Suppose NICOR pays a current annual dividend of $1.68 per share. Its current stock price is $39 per share. The consensus forecast from security analysis is that earnings and dividend will grow at an annual rate of 6.5 percent per annum for the foreseeable future. Cost of External Equity Capital: Example • The cost of internal equity capital for NICOR using a constant growth dividend valuation model is: $1.68(1 0.065) ke 0.065 0.111 or 11.1% $39 Cost of External Equity Capital: Example • The cost of external equity capital, assuming that new shares of stock could be sold to net the company $37 per share, is: D1 k g Pnet ' e $1.68(1 0.065) 0.065 $37 0.113 or 11.3% Growth Rate Information • Institutional Brokers Estimate System – http://www.ibes.com/ • Zacks Earnings Estimates – http://www.zacks.com/ • Thomson Financial First Call Service – http://www.firstcall.com/index.shtml • Dividend growth model – http://www.finplan.com/invest/divgrowmo d.htm CAPM • Check out this Web site to see how the CAPM is used to calculate a firm’s cost of equity: http://www.ibboston.com/ Divisional Costs of Capital • Some divisions of a company have higher or lower systematic risk. The discount rates for these divisions should be higher or lower than the discount rate for the firm as a whole. • Each division could have its own beta and discount rate. • Divisional costs of capital reflect both the differential risks and the differential normal debt ratios for each division. Weighted (Marginal) Cost of Capital Schedule • Suppose the Major Foods Corporation is developing its capital expenditure plans for the coming year. The company’s schedule of potential capital expenditure projects for next year is as follows: Weighted (Marginal) Cost of Capital Schedule Project A B C D E F Amount (in Millions of Dollars) $4.0 8.0 6.0 5.0 8.0 4.0 Internal Rate of Return 13.8% 13.5 12.5 12.0 11.0 10.0 Weighted (Marginal) Cost of Capital Schedule • The projects are closely related to the company’s present business and have the same degree of risk as its existing assets. • The firm’s current capital structure (as well as its targeted future capital structure) consists of 40 percent debt, 10 percent preferred stock, and 50 percent common equity in the capital structure. Weighted (Marginal) Cost of Capital Schedule • Table 11.3 shows the current balance sheet for Major Foods. TABLE 11.3 Balance Sheet for Major Foods (in Millions of Dollars Assets Current assets Fixed assets Total assets Liabilities and Equity $100 Current liabilities $50 30 Long-term debt 32 (40%) $130 Preferred stock 8 (10%) Common equity 40 (50%) Total liabilities and equity $130 Weighted (Marginal) Cost of Capital Schedule • Major Foods can raise up to $5 million in debt funds at a pre-tax cost of 9 percent; debt amounts exceeding $5 million will cost 10 percent. • Preferred stock can be sold at an aftertax cost of 10 percent. • Major Foods’ marginal tax rate is 40 percent. Weighted (Marginal) Cost of Capital Schedule • Major Foods expects to generate $10 million of retained earnings over the coming year. Its present dividend rate, D0, is $2 per share. The firm’s common stock is now selling at $25 per share, and new common stock can be sold to net the firm $24 per share. Weighted (Marginal) Cost of Capital Schedule • Over the past several years, Major Foods’ earnings and dividends have grown at an average of 7 percent per year, and this growth rate is expected to continue for the foreseeable future. The company’s dividend payout ratio has been, and is expected to remain, more or less constant. Weighted (Marginal) Cost of Capital Schedule • Given this information, Major Foods’ weighted (marginal) cost of capital can be calculated for the coming year as shown in the following several slides: Weighted (Marginal) Cost of Capital Schedule • Step 1: Calculate the cost of capital for each individual component—the cost of debt, the cost of preferred stock, and the cost of equity. Weighted (Marginal) Cost of Capital Schedule • Cost of debt: – Ki = kd(1 T) = 9.0*0.6 = 5.4% for the first $5 million of debt – Ki = kd(1 T) = 10.0*0.6 = 6.0% for debt exceeding $5 million of debt • Cost of preferred stock: kp = 10% (given) Weighted (Marginal) Cost of Capital Schedule • Cost of common equity: – Internal (for amounts of retained earnings up to $10 million): ke = [D0(1 + g)/P0] + g = [$2(1.07)/$25] + 0.07 = 0.156 or 15.6% Weighted (Marginal) Cost of Capital Schedule • Cost of common equity: – External (for amounts of new common stock greater than $10 million): ke’ = [D0(1 + g)/Pnet] + g = [$2(1.07)/$24] + 0.07 = 0.159 or 15.9% Weighted (Marginal) Cost of Capital Schedule • Step 2: Compute the weighted (marginal) cost of capital for each increment of capital raised. Weighted (Marginal) Cost of Capital Schedule • Major Foods should raise funds in proportion to its target capital structure from its lowest cost sources first. In this case, these sources are retained earnings (15.6 percent after-tax cost), preferred stock (10 percent after-tax cost), and the first $5 million in debt (5.4 percent after-tax cost). Weighted (Marginal) Cost of Capital Schedule • When these sources are exhausted, the company should consider using the higher cost sources—external equity (15.9 percent after-tax cost) and additional debt (6.0 percent after-tax cost)—together with preferred stock (10 percent after-tax cost). Weighted (Marginal) Cost of Capital Schedule • How much total financing through combining retained earnings, preferred stock, and debt can be done before $5 million in low-cost debt is exhausted and Major must acquire additional debt funds at the higher cost? Weighted (Marginal) Cost of Capital Schedule • Because we know that the target capital structure consists of 40 percent debt, the total financing, X, that this will support is equal to the amount of low-cost debt available divided by debt fraction in the capital structure: X = (Amount of low-cost debt available) (Debt fraction of capital structure) = ($5 million) 0.40 = $12.5 million Weighted (Marginal) Cost of Capital Schedule This $12.5 million level represents a break point in the marginal cost of capital schedule. Break points delineate the levels of financing where the weighted cost of capital increases due to an increase in the cost of one component source of capital. Weighted (Marginal) Cost of Capital Schedule • Break points can be determined by dividing the amount of funds available from each financing source at a fixed cost by the target capital structure proportion for that financing source. • Thus, we saw in the Major Foods example that the $5 million of debt, with an after-tax cost of 5.4 percent, would support total financing of $12.5 million. Weighted (Marginal) Cost of Capital Schedule • Beyond $12.5 million in total financing, the weighted (marginal) cost of capital will rise because higher-cost debt (6.0 percent) must now be used. • Of this $12.5 million in total financing, $5 million (40 percent of the total) will be debt, $1.25 million (10 percent of the total) will be preferred stock, and $6.25 million (50 percent of the total) will be retained earnings. Weighted (Marginal) Cost of Capital Schedule • The cost of this first block of funds is calculated as follows: Ka = 0.50*15.6% + 0.40*5.4% + 0.10*10% = 10.96% Weighted (Marginal) Cost of Capital Schedule • The amount of available retained earnings also determines a break point. The $10 million of retained earnings will support total financing of $20 million ($10 million/0.5). Therefore, a new break point occurs at a total financing level of $20 million. Beyond that point, the weighted cost of capital increases due to the higher cost (15.9 percent) of external equity. Weighted (Marginal) Cost of Capital Schedule • Thus, the second block of financing totals $7.5 million ($20 million equity break point minus $12.5 million debt financing break point). This $7.5 million block of funds represents the size of the second lowest-cost block of funds. Weighted (Marginal) Cost of Capital Schedule • Of this $7.5 million in financing, $3.75 million (= $7.5 million*50%) will be retained earnings, $0.75 million (= $7.5 million*10%) will be preferred stock, and $3 million (= $7.5 million*40%) will be debt. Weighted (Marginal) Cost of Capital Schedule • The cost of this second block of funds will be as follows: Ka = 0.50*15.6% + 0.40*6.0% + 0.10*10% = 11.20% Weighted (Marginal) Cost of Capital Schedule • Beyond the second block, all additional funds raised will be with high-cost debt, new common stock, and preferred stock. The weighted cost of these funds is as follows: Ka = 0.50*15.9% + 0.40*6.0% + 0.10*10% = 11.35% Weighted (Marginal) Cost of Capital Schedule • The weighted (marginal) cost of capital schedule now can be used to determine the optimal capital budget for Major Foods. This procedure is illustrated in the next section. Determining the Optimal Capital Budget • The optimal capital budget can be determined by comparing the expected project returns to the company’s marginal cost of capital schedule. This is accomplished by first plotting the returns expected from the proposed capital expenditure projects against the cumulative funds required. The resulting graph is called an investment opportunity curve. Determining the Optimal Capital Budget • Next, the previously calculated ka for the three capital “packages” are combined to determine the company’s marginal cost of capital curve. The optimal capital budget is indicated by the point at which the investment opportunity curve and the marginal cost of capital curve intersect, as shown in Figure 11.4. Optimal Capital Budget % A B C MCC D E F IRR $ Optimal capital budget contains all projects for which the expected return lies above the MCC Optimal Capital Budget • Specifically, the Major Foods Corporation’s optimal capital budget totals $23 million and includes Projects A, B, C, and D. Projects E and F are excluded, because their returns are expected to be below the 11.35 percent cost of funds. Acceptance of Projects E and F would result in a decrease in the firm’s value. In principle, the optimal capital budget maximizes the value of the firm. Depreciation • Is a major source of funds • Is equal to the firm’s weighted cost of capital based on R/E and the lowest cost of debt • Availability of funds from depreciation shifts the MCC to the right by the amount of depreciation. The Cost of Capital for Multinational Firms • Some host countries offer preferential financing terms. • Multinationals can shop the world for the lowest capital costs. • Raise majority of equity in home country • Raise substantial amount of debt in countries where they maintain significant operations – Is a hedge against exchange rate risk – May insulate the firm from expropriation Small Firms • Have a difficult time attracting capital • Issuance costs are high (greater than 20% of issue) • Often issue two classes of stock – One class sold to outsiders paying a higher dividend. – Second class held by founders with greater voting power. • Limited sources of debt Sources of Debt for Small Firms • Owner’s own funds • Private placement • Loans from friends • Venture capital • Loans from financial institutions • SBA loans • Commercial finance company loans firms • Leasing companies • Creative financing – Warrants – Convertible debt