CHAPTER 9 The Cost of CapitalWhat sources of long-term capital do firms use?Calculating the weighted average cost of capitalShould our analysis focus on before-tax or after-tax capital costs?Should our analysis focus on historical (embedded) costs or new (marginal) costs?How are the weights determined?Component cost of debtA 15-year, 12% semiannual coupon bond sells for $1,153.72. What is the cost of debt (kd)?Slide 9Component cost of preferred stockWhat is the cost of preferred stock?Slide 12Is preferred stock more or less risky to investors than debt?Why is the yield on preferred stock lower than debt?Illustrating the differences between A-T costs of debt and preferred stockComponent cost of equityWhy is there a cost for retained earnings?Three ways to determine the cost of common equity, ksIf the kRF = 7%, RPM = 6%, and the firm’s beta is 1.2, what’s the cost of common equity based upon the CAPM?If D0 = $4.19, P0 = $50, and g = 5%, what’s the cost of common equity based upon the DCF approach?What is the expected future growth rate?Can DCF methodology be applied if growth is not constant?If kd = 10% and RP = 4%, what is ks using the own-bond-yield-plus-risk-premium method?What is a reasonable final estimate of ks?Why is the cost of retained earnings cheaper than the cost of issuing new common stock?If issuing new common stock incurs a flotation cost of 15% of the proceeds, what is ke?Flotation costsIgnoring floatation costs, what is the firm’s WACC?What factors influence a company’s composite WACC?Should the company use the composite WACC as the hurdle rate for each of its projects?Risk and the Cost of CapitalWhat are the three types of project risk?How is each type of risk used?Problem areas in cost of capitalHow are risk-adjusted costs of capital determined for specific projects or divisions?Finding a divisional cost of capital: Using similar stand-alone firms to estimate a project’s cost of capitalCalculating a divisional cost of capital9-1CHAPTER 9The Cost of CapitalSources of capitalComponent costsWACCAdjusting for flotation costsAdjusting for risk9-2What sources of long-term capital do firms use?Long-Term CapitalLong-Term CapitalLong-Term DebtLong-Term DebtPreferred StockPreferred StockCommon StockCommon StockRetained EarningsRetained EarningsNew Common StockNew Common Stock9-3Calculating the weighted average cost of capitalWACC = wdkd(1-T) + wpkp + wcks The w’s refer to the firm’s capital structure weights.The k’s refer to the cost of each component.9-4Should our analysis focus on before-tax or after-tax capital costs?Stockholders focus on A-T CFs. Therefore, we should focus on A-T capital costs, i.e. use A-T costs of capital in WACC. Only kd needs adjustment, because interest is tax deductible.9-5Should our analysis focus on historical (embedded) costs or new (marginal) costs?The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on today’s marginal costs (for WACC).9-6How are the weights determined?WACC = wdkd(1-T) + wpkp + wcks Use accounting numbers or market value (book vs. market weights)?Use actual numbers or target capital structure?9-7Component cost of debt WACC = wdkd(1-T) + wpkp + wcks kd is the marginal cost of debt capital.The yield to maturity on outstanding L-T debt is often used as a measure of kd.Why tax-adjust, i.e. why kd(1-T)?9-8A 15-year, 12% semiannual coupon bond sells for $1,153.72. What is the cost of debt (kd)?Remember, the bond pays a semiannual coupon, so kd = 5.0% x 2 = 10%.INPUTSOUTPUTN I/YR PMTPV FV30560 1000-1153.729-9Component cost of debtInterest is tax deductible, so A-T kd = B-T kd (1-T) = 10% (1 - 0.40) = 6%Use nominal rate.Flotation costs are small, so ignore them.9-10Component cost of preferred stock WACC = wdkd(1-T) + wpkp + wcks kp is the marginal cost of preferred stock.The rate of return investors require on the firm’s preferred stock.9-11What is the cost of preferred stock?The cost of preferred stock can be solved by using this formula:kp = Dp / Pp = $10 / $111.10 = 9%9-12Component cost of preferred stockPreferred dividends are not tax-deductible, so no tax adjustments necessary. Just use kp.Nominal kp is used.Our calculation ignores possible flotation costs.9-13Is preferred stock more or less risky to investors than debt?More risky; company not required to pay preferred dividend.However, firms try to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, (3) preferred stockholders may gain control of firm.9-14Why is the yield on preferred stock lower than debt?Corporations own most preferred stock, because 70% of preferred dividends are nontaxable to corporations.Therefore, preferred stock often has a lower B-T yield than the B-T yield on debt.The A-T yield to an investor, and the A-T cost to the issuer, are higher on preferred stock than on debt. Consistent with higher risk of preferred stock.9-15Illustrating the differences between A-T costs of debt and preferred stockRecall, that the firm’s tax rate is 40%, and its before-tax costs of debt and preferred stock are kd = 10% and kp = 9%, respectively.A-T kp = kp – kp (1 – 0.7)(T) = 9% - 9% (0.3)(0.4) = 7.92%A-T kd = 10% - 10% (0.4) = 6.00%A-T Risk Premium on Preferred = 1.92%9-16Component cost of equity WACC = wdkd(1-T) + wpkp + wcks ks is the marginal cost of common equity using retained earnings.The rate of return investors require on the firm’s common equity using new equity is ke.9-17Why is there a cost for retained earnings?Earnings can be reinvested or paid out as dividends.Investors could buy other securities, earn a return.If earnings are retained, there is an opportunity cost (the return that stockholders could earn on alternative investments of equal risk).Investors could buy similar stocks and earn ks.Firm could repurchase its own stock and earn ks.Therefore, ks is the cost of retained earnings.9-18Three ways to determine the cost of common equity, ksCAPM: ks = kRF + (kM – kRF) βDCF: ks = D1 / P0 + gOwn-Bond-Yield-Plus-Risk Premium:ks = kd + RP9-19If the kRF = 7%, RPM = 6%, and the firm’s beta is 1.2, what’s the cost of common equity based upon the CAPM?ks = kRF + (kM – kRF) β = 7.0% + (6.0%)1.2 = 14.2%9-20If D0 = $4.19, P0 = $50, and g = 5%, what’s the cost of common equity based upon the