Chapter 10: The Cost of Capital Managerial Finance
Because of flotation costs, dollars raised by selling new stock must
"work harder" than dollars raised by retaining earnings. Moreover, because no flotation costs are involved, retained earnings cost less than new stock. Therefore, firms should utilize retained earnings to the greatest extent possible. However, if a firm has more good investment opportunities than can be financed with retained earnings plus the debt and preferred stock supported by those retained earnings, it may need to issue new common stock. The total amount of capital that can be raised before new stock must be issued is defined as the retained earnings breakpoint
WAAC=
(% of debt)(After-tax cost of debt) + (% of preferred stock)(cost of preferred stock) + (% of common equity)(Cost of common equity) The after-tax cost of debt has a tax adjustment factor (1-T)
A firm can directly affect its cost of capital in three primary ways:
(1) by changing its capital structure, (2) by changing its dividend payout ratio, and (3) by altering its capital budgeting decision rules to accept projects with more or less risk than projects previously undertaken.
New common equity is raised in two ways:
(1) by retaining some of the current year's earnings and (2) by issuing new common stock.
rs= Bond yield
+ risk premium
Costs of capital for projects of differing risk
: We touched briefly on the fact that different projects can differ in risk and thus in their required rates of return. However, it is difficult to measure a project's risk (hence, to adjust the cost of capital for capital budgeting projects with different risks).
weighted average cost of capital, WACC
A weighted average of the component costs of debt, preferred stock, and common equity.
Retained earnings breakpoint =
Addition to retained earnings for the year/ equity fraction
Flotation cost adjustment =
Adjusted DCF cost - Pure DCF cost
Which has payment priority- preferred stock or bonds?
Bonds!
How would the book and market values of stock typically compare?
Book value of debt approximately equals market value of debt Book value of stock < market value of stock
How can we estimate the cost of debt for bonds?
Calculate the yield to maturity and use that as an estimate of cost.
Why do we focus just on long-term borrowing and not include short-term?
Capital budgeting projects are long-term in nature, so financing generally matches our investment term.
R-hat s =
D1/P0 + growth rate as projected by security analysts
P0=
D1/rs-g
What risk are treasuries considered to be free from?
Default risk
The optimal capital structure is the one where the percentages of debt, preferred stock, and common equity minimize the firm's value. True or false?
False
The second approach involves adjusting the cost of capital rather than increasing the project's investment cost. If the firm plans to continue using the capital in the future, as is generally true for equity, this second approach theoretically will be better. The adjustment process is based on the following logic
If there are flotation costs, the issuing firm receives only a portion of the capital provided by investors, with the remainder going to the underwriter. To provide investors with their required rate of return on the capital they contributed, each dollar the firm actually receives must "work harder"; that is, each dollar must earn a higher rate of return than the investors' required rate of return. For example, suppose investors require a 13.7% return on their investment, but flotation costs represent 10% of the funds raised. Therefore, the firm actually keeps and invests only 90% of the amount that investors supplied. In that case, the firm must earn about 14.3% on the available funds in order to provide investors with a 13.7% return on their investment. This higher rate of return is the flotation-adjusted cost of equity.
Capital structure weights
In this chapter, we took as given the target capital structure and used it to calculate the WACC.
What is the implied life of most preferred stock?
Infinite, but not in all cases, and most is callable.
Should we use marginal or average tax rate?
Interest expense lowers our taxes, which lowers our financing cost.
Why do we have (1-tax rate)?
Interest expense lowers our taxes, which lowers our financing cost.
After-tax cost of debt =
Interest rate on new debt - Tax savings (Before-tax cost of debt)(1-Tax rate)
Cost of capital is the rate of return suppliers of capital demand to invest in the firm. If the expected return from investment is not high enough, what will investors do?
Investors will go elsewhere.
There are several types of long-term debt that the firm may have available:
Issue bonds, bank loans, loan from officer.
Most preferred stock is callable- what does this mean?
Issuer can buy it back (whether seller wants to sell or not) under certain conditions.
There are four major sources of long-term capital at the firm's disposal:
Long-term debt, preferred stock, common stock, retained earnings.
What if management has a target capital structure?
Might make sense to use target weights instead.
Capital components
One of the types of capital used by firms to raise funds.
Privately owned firms
Our discussion of the cost of equity focused on publicly owned corporations, and we have concentrated on the rate of return required by public stockholders. However, there is a serious question about how to measure the cost of equity for a firm whose stock is not traded. Tax issues are also especially important in these cases. As a general rule, the same principles of cost of capital estimation apply to both privately held and publicly owned firms, but the problems of obtaining input data are somewhat different.
Why is it called preferred stock?
Preferred dividends get priority over dividend payments to common shareholders.
If we can assume that a firm's dividends will grow at a constant rate, we can use discounted cash flow model.
Price 0 = Dividend / (return stock- growth) OR return stock = (Dividend 1 (1+ growth)/ Price 0) + Growth AKA "Cost of equity" Dividend 1 is the next annual dividend
Treasuries do have big risk. What is that?
Purchasing power risk
The Capital Asset Pricing Model (CAPM) calculates required returns for assets based on their Betas.
Required return = risk free rate + beta(Required market return - risk free rate) The market risk premium is also (required market return - risk free rate) This equation is also called the security market line
If preferred stock has no maturity, then this is simply a perpetuity from a cash flow perspective.
Return preferred = preferred dividend / price of preferred stock This is also known as "Cost of Preferred." This is the "price" we pay in % each year for issuing preferred stock. Why don't we have (1-Tax rate) here? Preferred dividends, unlike interest paid on bonds, are not tax deductible.
Cost of equity can also be estimated using the historical risk premium for the company's stock versus their bonds.
Return stock = bond yield + risk premium
retained earnings breakpoint
The amount of capital raised beyond which new common stock must be issued.
Flotation cost
The amount that must be added to rs to account for flotation costs to find re.
flotation cost adjustment
The amount that must be added to rs to account for flotation costs to find re.
What is the correct measurement for the cost of capital?
The cost of capital is a % cost. All of the costs that go into the cost of capital are % costs, too.
cost of new common stock, re
The cost of external equity; based on the cost of retained earnings, but increased for flotation costs necessary to issue new common stock.
The before-tax cost of debt, rd
The interest rate the firm must pay on new debt.
Depreciation-generated funds
The largest single source of capital for many firms is depreciation, yet we have not discussed how the cost of this capital is determined. In brief, depreciation cash flows can either be reinvested or returned to investors (stockholders and creditors). The cost of depreciation-generated funds is thus an opportunity cost, and it is approximately equal to the WACC from retained earnings, preferred stock, and debt. Therefore, we can ignore it in our estimate of the WACC.
Target capital structure
The mix of debt, preferred stock, and common equity the firm plans to raise to fund its future projects.
cost of preferred stock, rp
The rate of return investors require on the firm's preferred stock; rp is calculated as the preferred dividend, Dp, divided by the current price, Pp.
cost of retained earnings, rs
The rate of return required by stockholders on a firm's common stock.
The after-tax cost of debt, rd(1-T)
The relevant cost of new debt, taking into account the tax-deductibility of interest; used to calculate the WACC. Should be used to calculate the weighted average cost of capital.
Barlett Co. has two divisions. Its risky division, Division R, has a WACC = 12%, while its safer division, Division S, has a WACC = 8%. Since the two divisions are the same size, the company's composite WACC is 10%. A Division S project has a 9% expected return. Since this project's return exceeds the division's WACC, the company should accept the project even though its return is less than the company's composite WACC. True or false?
True
The cost of depreciation-generated funds is approximately equal to the WACC calculated from retained earnings, preferred stock, and debt. True or false?
True
The investor-supplied items—debt, preferred stock, and common equity—are called capital components. Increases in assets must be financed by increases in these capital components. True or false?
True
The target capital structure is the mix of debt, preferred stock, and common equity the firm plans to raise to fund its future projects. True or false?
True
What class of securities is our proxy for the risk-free asset?
U.S. Treasuries
Retained earnings are earnings that are reinvested back into the firm,
Ultimately, whose money is the firm's earnings? Shareholders What are the two main things the firm can do with its earnings? 1. Pay dividend (or buy back stock) or 2. Reinvest- retained earnings. Should the firm assign a cost to retained earnings? Yes
What if our debt is not publicly traded?
Use bond ratings to estimate cost by comparing to other publicly-traded debt.
Measurement problems
We cannot overemphasize the practical difficulties encountered when estimating the cost of equity. It is very difficult to obtain good input data for the CAPM, for g in the formula r-hat s = D1/P0 + g, and for the risk premium in the formula rs= Bond yield + risk premium. As a result, we can never be sure of the accuracy of our estimated cost of capital.
Common equity (owners' investment) may come from two main sources:
What do we issue when we take on additional owners? Common stock What do we call it when we reinvest earnings back into the firm? Retained earnings
Should we use the current or historical cost of debt?
What new debt costs (currently) is what is relevant.
With net present value, we find the present value of all of a firm's cash flows and
add them up.
The risk-free rate is what we would earn on an
asset that is free from default risk.
Each project's hurdle rate should reflect the risk of the project, not the risk
associated with the firm's average project as reflected in its composite WACC. Empirical studies do indicate that firms consider the risks of individual projects, but the studies also indicate that most firms regard most projects as having about the same risk as the firm's average existing assets. Therefore, the WACC is used to evaluate most projects, but if a project has especially high or low risk, the WACC will be adjusted up or down to account for the risk differential.
Missing a bond interest payment could lead to
bankruptcy, but missing a stock dividend payment is not as serious
The cost of capital relates to financing of
big dollar, long-term projects and investments. Property, plant, and equipment decisions are examples.
The target proportions of debt (wd), preferred stock (wp), and common equity (wc), along with the costs of those components, are used to
calculate the firm's weighted average cost of capital, WACC.
The investor-supplied items—debt, preferred stock, and common equity—are called
capital components. Increases in assets must be financed by increases in these capital components. The cost of each component is called its component cost.
Companies generally use an investment banker when they issue new
common stock and sometimes when they issue preferred stock or bonds. In return for a fee, investment bankers help the company structure the terms, set a price for the issue, and sell the issue to investors. The bankers' fees are called flotation costs, and the total cost of the capital raised is the investors' required return plus the flotation cost.
We need to assign a cost to equity capital as part of calculating a firms weighted average cost of capital. There are 3 primary techniques for estimating that cost:
constant growth, bond yield + risk premium, and CAPM
The firm's capital budgeting decisions can also affect its
cost of capital. When we estimate the firm's cost of capital, we use as the starting point the required rates of return on its outstanding stock and bonds. These cost rates reflect the riskiness of the firm's existing assets. Therefore, we have been implicitly assuming that new capital will be invested in assets that have the same risk as existing assets. This assumption is generally correct, as most firms do invest in assets similar to ones they currently operate. However, if the firm decides to invest in an entirely new and risky line of business, its component costs of debt and equity (and thus its WACC) will increase.
Projects should be accepted if and only if their estimated returns exceed their
costs of capital. Thus, the cost of capital is a "hurdle rate"—a project's expected rate of return must "jump the hurdle" for it to be accepted. Moreover, investors require higher returns on riskier investments. Consequently, companies that are raising capital to take on risky projects will have higher costs of capital than companies that are investing in safer projects.
Components of capital are
debt, preferred stock, and common equity
For companies that are expected to remain in business indefinitely, the cash flows are the
dividends; on the other hand, if investors expect the firm to be acquired by some other company or to be liquidated, the cash flows will be dividends for some number of years plus a price at the horizon date when the firm is expected to be acquired or liquidated.
If project earns less than cost of capital, then the value of the stock will go
down in value
The cost of capital is the rate of return a firm must
earn on its investments to maintain the market value of its stock. The cost of capital is an average % cost of funds that the firm uses to finance its capital expansion.
Security analysts regularly forecast growth rates for
earnings and dividends, looking at such factors as projected sales, profit margins, and competition.
The company can choose to finance its assets with
either debt or equity
Preferred stock is a hybrid security, of sorts. Preferred stock generally pays a
fixed dividend, similar to bond interest payments. But, failure to pay these dividends is not a bankruptcy event, because this is stock, not debt.
The Cost of Capital for a firm is not
fixed. It will change over time due to internal and external forces. Companies may estimate a new Cost of Capital each year as part of the capital budgeting process.
The three most important factors that the firm cannot directly control are
interest rates in the economy, the general level of stock prices, and tax rates.
When calculating the WACC, our concern is with capital that must be provided by investors—
interest-bearing debt, preferred stock, and common equity. Accounts payable and accruals, which arise spontaneously when capital budgeting projects are undertaken, are not included as part of investor-supplied capital because they do not come directly from investors.
Weighted Average Cost of Capital (WACC) is calculation is based on the costs of
its components. WAAC= (Weight debt %)(After-tax cost of debt)(1-marginal tax rate)+ (Weight preferred)(Cost of preferred) + (Weight common equity)(Cost of common equity) WAAC "weights" are based on the total $ value of capital invested. We use % weights.
The investor who buys a bond is
lending money
With debt, the company borrows money. They could take out a
loan or issue bonds.
If interest rates in the economy rise, the cost of debt increases because the firm
must pay bondholders more when it borrows. Similarly, if stock prices in general decline, pulling the firm's stock price down, its cost of equity will rise. Also, because tax rates are used in the calculation of the component cost of debt, they have an important effect on the firm's cost of capital. Taxes also affect the cost of capital in other less apparent ways. For example, when tax rates on dividends and capital gains were lowered relative to rates on interest income, stocks became relatively more attractive than debt; consequently, the cost of equity and WACC declined.
It is important to emphasize that the cost of debt is the interest rate on
new debt, not outstanding debt. We are interested in the cost of new debt because our primary concern with the cost of capital is its use in capital budgeting decisions. For example, would a new machine earn a return greater than the cost of the capital needed to acquire the machine? The rate at which the firm has borrowed in the past is irrelevant when answering this question because we need to know the cost of new capital. For these reasons, the yield to maturity on outstanding debt (which reflects current market conditions) is a better measure of the cost of debt than the coupon rate.
Whereas debt and preferred stocks are contractual obligations whose costs are clearly stated within the contracts, stocks have
no comparable stated cost rate.
With equity, the company issues stock, taking on investors who become part
owners of the firm.
A share of common stock represents
ownership interest in a company. Shareholders own a proportion of the firm based on the number of shares they own.
Dividends are distributions to shareholders. We generally think of cash dividends, but they could also be additional shares of stock or other consideration. The firm is not obligated to
pay dividends until they have been declared.
Bondholders are compensated by interest payments
preferred stockholders, by preferred dividends. But the net earnings remaining after paying interest and preferred dividends belong to the common stockholders, and these earnings serve to compensate them for the use of their capital. The managers, who work for the stockholders, can either pay out earnings in the form of dividends or retain earnings for reinvestment in the business. When managers make this decision, they should recognize that there is an opportunity cost involved—stockholders could have received the earnings as dividends and invested this money in other stocks, in bonds, in real estate, or in anything else. Therefore, the firm needs to earn at least as much on any earnings retained as the stockholders could earn on alternative investments of comparable risk.
However, if the company's past growth has been abnormally high or low due to a unique situation or because of general economic fluctuations, investors will not
project historical growth rates into the future. In this case, which applies to Allied, g must be obtained in some other manner.
Cost of capital is also called the "hurdle rate" because
projects need to clear this rate to be accepted. Used to calculate project Net Present Value (NPV). Compared to project Internal Rate of Return (IRR).
Some have argued that retained earnings should be "free" because they
represent money that is "left over" after dividends are paid. Although it is true that no direct costs are associated with retained earnings, this capital still has a cost, an opportunity cost. The firm's after-tax earnings belong to its stockholders.
Dividend policy affects the amount of
retained earnings available to the firm and thus the need to sell new stock and incur flotation costs. This suggests that the higher the dividend payout ratio, the smaller the addition to retained earnings, the higher the cost of equity, and therefore the higher the firm's WACC will be. However, investors may prefer dividends to retained earnings, in which case reducing dividends might lead to an increase in both rs and re.
Use T-Bonds as our
risk-free rate
Component cost of preferred stock =
rp = Dp/Pp
The market value of equity is the number of
shares of stock outstanding multiplied by the current stock price.
The $ values used in finding weights should be the current market values rather
than book values (if possible).
Bonds are debt instruments where issuer has borrowed with the promise to repay
the lender with interest.
Capital structure impacts a firm's cost of capital. So far we have assumed that Allied has a given target capital structure, and we used the target weights to calculate its WACC. However, if the firm changes its target capital structure,
the weights used to calculate the WACC will change. Other things held constant, an increase in the target debt ratio tends to lower the WACC (and vice versa if the debt ratio is lowered) because the after-tax cost of debt is lower than the cost of equity. However, other things are not likely to remain constant. An increase in the use of debt will increase the riskiness of both the debt and the equity, and these increases in component costs might more than offset the effects of the changes in the weights and raise the WACC.
One approach to handling flotation costs, found as the sum of the flotation costs for the debt, preferred, and common stock used to finance the project, is to add
this sum to the initial investment cost. Because the investment cost is increased, the project's expected rate of return is reduced. For example, consider a 1-year project with an initial cost (not including flotation costs) of $100 million. After 1 year, the project is expected to produce an inflow of $115 million. Therefore, its expected rate of return is $115/$100 - 1 = 0.15 = 15.0%.
Investors expect to receive a dividend yield, D1/P0 , plus a capital gain, g, for a total expected return of r-hat s; in equilibrium, this expected return is also equa
to the required return, rs. This method of estimating the cost of equity is called the discounted cash flow, or DCF, method. Henceforth, we will assume that equilibrium exists, which permits us to use the terms rs and r-hat s interchangeably.
