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TOWSON FIN 331 - The Cost of Capital

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Chapter10. The Cost of Capital (Funding, Financing)* Basic Definitions- Marginal cost of raising extra one $! (the minimum rate of return (e.g., 8.6%) on the last one $ to generate from the project to satisfy every investor (creditors, equity investors (=shareholders), preferred stock investors, etc, since they would not invest if the firm fails to provide what they are seeking at minimum) - Here, we try to determine the cost of capital. A low cost of funding is good!* The cash flows an investor faces and the cash flows from a firm’s (an issuer’s) perspective are a kind of mirror image; -Po followed by C1, C2, C3, - - - versus PoN followed by -C1, -C2, -C3, - - -.The cash flow at 0 may be different due to PoN = Po – FC, FC=Flotation Cost. Note that investors determine the projected ROI (return on investment) for various security investment from the security projected cash flows: YTM (or YTC depending on whether it is likely to be called for a callable bond), Projected Total Return on Stock ( ^rs¿ DCF ¿ , Projected Total Return on Preferred Stock (^rp).* Where are the money from (how to finance/fund)? - Look at the Right Hand Side of the B/S - Here, we are mainly focusing on the long-term financing (forget about current liabilities)- Different funding sources: Equity: Internal (using R/Es) & External (issuing new common stock shares)Debt: Bonds (and long-term loans. We mainly talk about bonds in this class. Why?)Preferred Stock Capital structure,  What is optimal capital structure? e.g., 40%, 50%, 10%. This is a Fin439 topic, Here, the capital structure is given in terms of % numbers or $ amounts (=> we need to get % structure)* To raise capital, what do you need to do?- Need to offer each group of investors (E, D, P), what they seek! => How can you find out what they are asking for? 1) a survey?, 2) each group’s required rate of return from Chapters 7, 8, and 9.- Take into consideration extra costs & benefits (flotation costs, tax benefits, etc) - E.g., Try to raise $10m for a new project, Given the capital structure above, and the cost of Equity (10%), Debt (7%), Pref Stock (8%) => WA(M)CC = .4*10% + .5*7% + .1*8% = 8.3% Real Life Example using Apples:US: VA (5¢) with a limited qty of 30 apples, unlimited quantity of WA (6¢) China: (4¢) with a 40% quota (=> wus, wch ?)Note: For US apples, always buy VA apples whenever possible! Why? 1) When buying 10 appliesHow many from US (6)? how many from China (4)? How many from VA(6)?Total Cost = 46¢ = 6*5¢ + 4*4¢ Average Cost = 4.6¢ = TC/total# Marginal Cost when you buy the 11th = TC11 – TC10 = 50.6 – 46 = 4.6¢ or = wus*MCus + wch*MCch = .6*5¢ + .4*4¢ = 4.6¢ (60% of the one last apple from the US, actually from VA, 40% from China)Note: AC = MC2) When do I need to switch from VA to WA?When the total # of apples from the US becomes 30, or the TOTAL # of apples becomes X, where(.6)X = 30 => Backfigure X=?3) At 250 applesWhere are the apples from? Since 250*0.6 = 150 US applies and 100 from China.Among the US apples, 30 from VA (buy out all the VA apples), 120 WATC = 1270¢ or $12.70 = 30*5¢ + 120*6¢ + 100*4¢ AC = 5.08¢ = ?MC = TC251 – TC250 or = .6*6¢ + .4*4¢ =5.2¢ (from 250 to 251 apples, US applies are only from WA)4) WA(M)CC schedule by looking at MCs,In terms of US apples, the MC increases when we buy out all VA applies as we have to start buying more expensive WA apples. The break point is at 30 US apples.In terms of TOTAL # of apples. The break point is at 50 total number of applies.=> Now, in terms of Equity (Internal and External) and Debt?* Cost of Debt (bonds) - Reviewing: Cash flow stream from an investor’s perspective{- Po, C, C, C, - - - , C, C+F}, n periods=> YTM (return (yield) on the bond)=> Ex: Po = $1,025, FV=1,000, coupon rate=8%, semi-annual, 20 years?(-1025 PV, 40 PMT, 1000 FV, 40 N, CPT i/Y=YTM=3.88%*2=7.76%) - How about the cash flow stream from issuer (firm)’s perspective?- Cash inflows and outflows are switched- Instead of Po, (Po – FC)=PoN will be used, where FC=flotation cost=> {PoN , -C, -C, -C, - - - , -C, -C-FV}Aside) For the flotation costs and the interest (coupon) payments, the issuer canenjoy TAX benefits. How much? (C+F/n)*t, where t is the tax rate - - -=> HERE, compute YTM before tax, rd from the cash flows { }(Using a financial calculator, PoN PV, -C PMT, -F FV, n (number of periods) N, CPT i/Y). Then compute ra = rd *(1-T) to determine the after-tax cost of debt.=> Ex above: FC is a 4% of Po, PoN =1025*(1-0.04)=$984, so {984, -40, - - , -40-1000}(rd = 8.16%, and ra = 5.30% based on t=35%Aside) The cost of funding increases with a FC (compare 7.76% vs. 8.16%) as the firm needs to work harder to make up for the increased FC. * Cost of Equity (=cost of common stock)=How much the firm has to deliver to shareholders to make them happy (delivering what they are askingfor, required rate of return). The flotation cost can be considered, if exists.- Internal Equity Financing using retained earnings. No floatation costs.There are two approaches, one is using the DCF (discount cash flow) = DDM (discount dividend model), the other one is CAPMDCF(=DDM): In this case, rs = ^rsEx1: Po = $23.06, D1 = $1.25, g=8.3%, rs = 13.7%CAPM: Ex2: Risk free rate is 5.6%, Expect Market Return (rm)=10.6%, Beta=1.48  rs = 5.6% + (10.6% - 5.6%)*1.48 = 5.6% + 5%*1.48 = 13% Note that the market risk premium = rM – rf = 5% and the cost of equity can be different depending on the approach used ~ investment analysis is ART+ Science- External Equity Financing by issuing new common equity shares (basically, we use DCF approach. However, we need to use PoN because of the FC), re = D1/PoN + gEx3: The same as Ex1 except the FC is 10% of the share price. PoN = 23.06*(1-0.1)=$20.75re = 1.25/20.75 + 0.083 = 14.3%* Cost of Preferred Stock rp = Dp /PoN Ex: Dp = $10, Po = $100 with the FC is 2.5% of the preferred stock price. rp = 10/97.5 = 10.3% Note: unlike debt (bond) financing, no tax benefits for equity and preferred stock financing for dividend payments and flotation costs.* The Financing (Capital, Funding) Structure before the Break Point and after - What causes the break point? Using more expensive External Equity Financing when you switch from Internal Equity Financing (using retained earnings) to External Equity Financing - Where is the Break Point? In terms of Equity Financing Amount? When you use up all the retained earnings. - Where is the Break


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TOWSON FIN 331 - The Cost of Capital

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