Chp. 10: The Cost of Capital

What are the two approaches that can be used to adjust for flotation costs?

1. Add this sum to the initial investment cost 2. Adjusting the cost of capital rather than increasing the project's investment cost

Identify some problem areas in the cost analysis.

1. Depreciation-generated funds. 2. Privately owned firms. 3. Measurement problems. 4. Costs of capital for projects of differing risk. 5. Capital structure weights

Name 3 factors that affect the cost of capital and that are beyond the firm's control

1. Interest rates in the economy 2. The general level of stock prices 3. Tax rates

What 3 approaches are used to estimate the cost of common equity? which one is most commonly used in practice?

1. The CAPM approach, commonly used one. 2. Bond-yield-plus-risk-premium approach. 3. Dividend-yield-plus-growth-rate, or discounted cash flow (DCF), approach

Why is the cost of capital sometimes referred to as a "hurdle rate"?

A project's expected rate of return must "jump the hurdle" for it to be accepted

When calculating WACC, what capital is excluded and why?

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.

Why must a cost be assigned to retained earnings?

Although it is true that no direct costs are associated with retained earnings, this capital still has an opportunity cost

What are 3 factors under that firm's control that can affect its cost of capital?

By changing 1. capital structure, 2. dividend payout ratio, 3. altering its capital budgeting decision rules

When calculating a company's WACC, should book value, market value, or target weights be used?

Current market value of the company's debt and equity

Identify the firm's 3 major capital structure components

Debt (Wd), preferred stock (Wp), and common equity (Wc)

How should firms evaluate projects with different risks?

Each projects 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

Identify some potential problems with the CAPM

If a firm's stockholders are not well diversified, they may be concerned with stand-alone risk rather than just market risk. in that case, the firm's true investment risk would not be measured by its beta and the CAPM estimate would understate the correct value of Rs. Even if the CAPM theory is valid, it is hard to obtain accurate estimates of the required inputs

Suppose interest rates in the economy increase. How would such a change affect the costs of both debt and common equity based on the CAPM?

If interest rates increase, the cost of debt increases because the firm must pay bondholders more when it borrows.

Which of the two components of the DCF formula, the dividend yield or the growth rate, do you think is more difficult to estimate?

It is easy to calculate the dividend yield; but because stock prices fluctuate, the yield varies from day to day, which leads to fluctuations in the DCF cost of equity. It is difficult to calculate the growth rate because if past growth rates in earnings and dividends have been relatively stable, and if investors expect a continuation of past trends, g may be based on te firm's historic growth rate. however, if the company's past growth has been abnormally high or low due to unique situation or because of general economic fluctuations, investors will not project historical growth rates into the future.

Is a tax adjustment made to the cost of preferred stock?

No tax adjustments are made when calculating Rp because preferred dividends, unlike interest on debt, are not tax deductible, so no tax savings are associated with preferred stock

Capital Components

One of the types of capital used by firms to raise funds

Why is the relevant cost of debt the interest rate on new debt, not that on already outstanding, or old debt?

Our primary concern with the cost of capital is its use in capital budgeting decisions. The rate at which the firm borrowed in the past is irrelevant because we need to know the cost of new capital.

Retained earnings breakpoint

The amount of capital raised beyond which new common stock must be issued

Flotation cost adjustment

The amount that must be added to Rs to account for flotation costs to find Re

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

Before-tax cost of debt, Rd

The interest rate the firm must pay on new debt

Target Capital Structure

The mix of debt, preferred stock, and common equity the firm plans to raise to fund its future projects

Flotation costs, F

The percentage cost of issuing

Cost of preferred stock, Rp

The rate of return 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

After-tax cost of debt, Rd(1-T)

The relevant cost of new debt, taking into account the tax deductibility of interest

Equation for WACC

WdRd(1-T) + WpRp + WcRs

Why is the after-tax cost of debt rather than the before-tax cost used to calculate the WACC?

We are interested in maximizing the value of the firm's stock and the stock price depends on after-tax cash flows

WACC

Weighted Average Cost of Capital: a weighted average of the components costs of debt, preferred stock, and common equity

Flotation Cost

bankers fee

Why might there be two different component costs for common equity? Which one is generally relevant, and for what type of firm is the second one likely to be relevant?

internal equity Rs, and external equity Re. internal equity is more relevant because external equity reflects the cost of issuing new stocks so it is rarely relevant except for very young, rapidly growing firms