CORPORATE FINANCE Meeting XI Cost of Capital Chapter Outline • • • • • Cost of Capital Cost of Debt Cost of Preferred Stock Cost of Common Equity: – Retained Earnings – New Common Stock Optimum Capital Structure 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 use in analyzing an investment The overall cost of capital is a weighted average of the various sources: – WACC = Weighted Average Cost of Capital – WACC = After-tax cost x weights Table Eg. Cost of capital–Baker Corporation (1) Cost (2) (3) (aftertax) Weights Cost 30% 2.12% 10 1.09 Weighted Debt . . . . . . . . . . Kd 7.05% Preferred stock . . . . Kp 10.94 Common equity (retained earnings) . . . Ke 12.00 Weighted average cost of capital . . . . . Ka 60 7.20 10.41% 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) Cost of New Preferred Stock 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 Preferred—an Example Baker Corporation has preferred stock that sells for $100 per share and pays an annual dividend of $10.50. If the flotation costs are $4 per share, what is the cost of new preferred stock? KP $10.50 .1094 10.94% $100 - 4 Cost of Common Equity: Retained Earnings Common stock equity is available through retained earnings (R/E) or by issuing new common stock: – Common equity = R/E + New common stock 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 (this is the opportunity cost) Cost of Common Equity: New Common Stock 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 Finding the Required Return on Common Stock using the Capital Asset Pricing Model The Capital Asset Pricing Model (CAPM) is a formula that we can use to estimate the required return on individual stocks. Here is the formula: K j R f j K m R f (11 - 5) where Kj = Required return on stock j Rf j = = Risk-free rate of return (usually current rate on Treasury Bill). Beta coefficient for stock j—represents risk of the stock Km = Return in market as measured by some proxy portfolio (index) Suppose that Baker has the following values: R = 5.5% j f = 1.0 Km = 12% Then, using the would get a required return for Baker of 12CAPM K j 5.5 1.0 - 5.5 we 12% . Cost of Retained Earnings The cost of Retained Earnings can be estimated using equations from the prior chapter. Suppose that Baker Corporation will pay an annual dividend at the end of the year of $2 per share. The price of the stock today is $40 and dividends are expected to grow at 7% per year. Then: Ke D1 $2 g 7% 12% . P0 $40 Cost of NEW common stock The cost of NEW common stock can be estimated using equations from the prior chapter. Suppose that Baker Corporation will pay an annual dividend at the end of the year of $2 per share. The price of the stock today is $40 and dividends are expected to grow at 7% per year. New flotation costs will be $4 per share. Then: Ke D1 $2 g 7% 12.6% . P0 F $40 - $4 Optimum Capital Structure The optimal (best) situation is associated with the minimum overall cost of capital: Optimum capital structure means the lowest WACC Optimal Capital Structure usually occurs with 3050% debt in a firm’s capital structure—but this can vary widely among firms and industries WACC is also referred to as the required rate of return or the discount rate Debt is usually cheaper than equity, but its costs rise as we add increasing amounts of debt. As we begin to add debt, the cost of equity may initially drop (reflecting the advantages of lower-cost debt to shareholders), but will eventually rise as debt adds more risk for shareholders. Figure (next slide) shows how we find an optimal WACC. Figure Cost of capital curve Cost of equity Cost of capital (percent) Weighted average cost of captial U-shaped Cost of debt Minimum point for cost of capital 0 40 Debt-assets mix (percent) 80 Capital Acquisition and Investment Decision Making Figure (next slide) shows a theoretical costof-capital curve at three different points in time. As we move from time period t to time period t+2, falling interest rates and rising stock prices cause a downward shift. The graph illustrates two basic points: (1)The firm wants to keep its debt-to-equity ratio between x and y along the bottom axis at all times because this is the lowest area on each of the three curves. (2)The firm would like to finance its long-term needs at time period t+2 rather than the other two time periods because overall costs are lowest during this time frame. Cost of Capital in the Capital Budgeting Decision Assume that Baker Corporation is considering making an investment in eight projects and the returns and costs are shown in Table (next slide) Table Investment projects available to the Baker Corporation Projects A . . . . B. . . . C. . . . D. . . . E. . . . F. . . . G. . . . H. . . . Expected Returns 16.00% 14.00 13.50 11.80 10.65 9.50 8.60 7.00 Cost ($ millions) $10 5 4 20 11 20 15 10 $95 million Figure Cost of capital and investment projects for the Baker Corporation Percent 14.0 12.0 10.0 8.0 16.0 A B C 10.41% D E F 4.0 2.0 0.0 - G H 6.0 10 15 19 39 50 70 Amount of capital ($ millions) 85 Ka Weighted average cost of capital 95 The Marginal Cost of Capital Let us make the following assumptions about Baker The weights will remain constant at their current level of 60% equity and 30% debt. 2. Once current retained earnings ($23.4 million) are exhausted, equity must be sold at a cost of 12.6% (due to flotation costs). 3. The firm can raise up to $15 million of debt at 7.05%. Above that amount, debt will cost 7.56%. 1. Baker will have the following break points: Point where equity cost rises: $23.4 million / .6 = $39 million Point where debt cost rises: $15 million / .3 = $50 million Baker faces these conditions: • • • First $39 million – Cost of debt = 7.05% – Cost of preferred = 10.94% – Cost of equity = 12% From $39 million to $50 million – Cost of debt = 7.05% – Cost of preferred = 10.94% – Cost of equity = 12.6% Above $50 million – Cost of debt = 8.60% – Cost of preferred = 10.94% – Cost of equity = 12.6% Table Cost of capital for different amounts of financing First $39 Million A/T Cost Debt . . . . Preferred. . Common equity *. . Kd 7.05% Kp 10.94 Ke 12.00 Next $11 Million Weighted Wts. Cost .30 .10 .60 A/T Cost Wts. 2.12% 1.09 Debt . . . Kd 7.05% .30 Preferred . Kp 10.94 .10 2.12% 1.09 7.20 Common equity † . . Kn 12.60 7.56 Ka = 10.41% *Retained earnings. Weighted Cost .60 Kmc = †New common stock. 10.77% Table Cost of capital for increasing amounts of financing Over $50 Million Cost (aftertax) Debt (higher cost) Kd Preferred stock Kp Common equity (new common stock) Kn 8.60% Weights Weighted Cost .30 2.58% 10.94 .10 1.09 12.60 .60 7.56 11.23% Kmc = Table Marginal cost of capital and Baker Corporation projects Percent 14.0 12.0 10.0 8.0 16.0 A B 10.77% C 11.23% Kmc Marginal cost of capital 10.41% D E F 4.0 2.0 0.0 - G H 6.0 10 15 19 39 50 70 Amount of capital ($ millions) 85 95 Capital Asset Pricing Model We begin with observations about how a company, Parts Associates, Inc. (PAI) has performed, compared to the market, over a period of time. Table Performance of PAI and the market Rate of Return on Stock Year 1 . . . . . . . . . . . . PAI Market 12.0% 10.0% 2 . . . . . . . . . . . . 16.0 18.0 3. . . . . . . . . . . . 20.0 16.0 4 . . . . . . . . . . . . 16.0 10.0 5 . . . . . . . . . . . . 6.0 8.0 Mean return Standard deviation 14.0% 4.73% 12.4% 3.87% The Security Market Line By making some assumptions about markets and investor risk preferences, we can move from the regression results to the Security Market Line (SML) The equation for the SML is the CAPM. Figure The security market line (SML) Required rates of return Percent 20.0 K2 18.0 SML = Rf + (Km – Rf) 16.0 14.0 K1 12.0 K.5 Rf 6.5 % market risk premium 10.0 8.0 5.5 0.5 1.0 1.5 2.0 Beta (risk) We can observe how the relation between risk and return changes when basic parameters of the CAPM change The line shifts up as the risk-free rate increases. The line becomes steeper as beta rises (as investors become more risk averse) Figure The security market line and changing interest rates SML1 Required rates of return (percent) 20.0 SML0 18.0 16.0 14.0 Rf increased 2% 12.0 10.0 Rf1 7.5 Rf0 5.5 0.5 1.0 1.5 2.0 Beta (risk) Figure The security market line and changing investor expectations Required rates of return (percent) SML1 22.0 More risk aversion 20.0 18.0 SML0 16.0 14.0 12.0 10.0 8.0 5.5 Rf 0.5 1.0 1.5 2.0 Beta (risk) CORPORATE FINANCE End of Slides