FIN 3403 LECTURE NOTES COST OF CAPITAL LEVERAGE CAPITAL BUDGETING R DIGGLE JR CFA University of Central Florida FINANCIAL INSTRUMENTS LEC NOTES PP 32 33 MONEY MKT 1 T BILLS FED FUNDS COMML PAPER CDS MMMFs EURODOLLARS COMML CREDIT CAPITAL MKT 1 YR TREAS NOTES BONDS FED AGENCY BONDS MUNY BONDS CORP BONDS MTGS LEASES PFD STOCK COMMON STOCK RESIDUAL EQUITY PRIMARY SECONDARY MARKETS PRIMARY NEW ISSUE IPO OR SECONDARY PROSPECTUS OR INDENTURE REQUIRED FOR CORP SECURITIES OFFERING MEMO NEEDED FOR MUNY BONDS MUTUAL FUNDS ARE PRIMARY SECONDARY TRADING IN EXISTING SECURITIES ON EXCHANGES OR OTC MARKETS DIFFERENCE BETWEEN NYSE ASE AND NASDAQ COST OF CAPITAL CONCEPTS FIN 3403 DIGGLE UNIVERSITY OF CENTRAL FLORIDA COST OF CAPITAL DEFINED TEXT CH 12 LEC NOTES PP 20 21 CAPITAL GOODS ARE LONG TERM INVESTMENTS 1 YEAR CAPITAL MARKET INSTRUMENTS FOR CORPORATIONS ARE LT DEBT PREFERRED STOCK COMMON STOCK Cost of Capital is the OPPORTUNITY COST or HURDLE RATE of using funds for new projects COC CONCEPTS COST OF CAPITAL IS AN IMPORTANT FIRST STEP IN CAPITAL BUDGETING CAPITAL COSTS ARE BASED ON MARKET COSTS OF FINANCING SOURCES ALL CAPITAL COSTS ARE COMPUTED USING AFTER TAX COSTS SINCE INTEREST IS DEDUCTIBLE COST OF DEBT IS Kd 1t where t Corp FIT rate COC CONCEPTS CONTD THE COST OF PREFERRED STOCK IS Kps Dps P0 WHERE D preferred dividend P market price of preferred IN YEAR 0 COST OF COMMON STOCK Equity IS Kcs also called Ks D1 g P0 WHERE D1 common stock dividend next year and P0 is common price now AND g is the estimated EPS growth rate COC CONCEPTS CONTD Cost of NEWLY issued common stock is Ke D1 g P0 1 F Where F flotation costs of new equity Secondary offering PREFERRED AND COMMON STOCK ARE AFTER TAX COSTS COST OF DEBT MUST BE ADJUSTED BY 1 T for the corporate income tax rate WACC The average cost of capital for a corporation is the WEIGHTED cost of 3 external capital sources LT debt Pfd stock and common stock on an AFTER TAX basis WACC or weighted average cost of capital is therefore based on the firm s capital structure SEE Table 12 6 on p 444 USUALLY cost of L T debt is the lowest cost source of funds KINDS OF DEBT CORPORATIONS MAY ISSUE MANY BONDS BOND TYPES FIRST MORTGAGE BONDS collateralized 2ND MTG BONDS DEBENTURES UNSECURED LT DEBT CORPORATIONS MAY ISSUE SEVERAL SERIES OF BONDS WITHIN EACH CLASS EACH NEW ISSUE IS SUBORDINATED TO EARLIER ISSUES PRIORITY OF CLAIM PYRAMID CORPORATE LIABILITIES HAVE A DEFINED PRIORITY OF CLAIM TO INCOME AND ASSETS IN EVENT OF LIQUIDATION BANKRUPTCY CREDITORS INCLUDING THE IRS 1st Mortgage bonds 2nd mortgage bonds Preferred stock Common Stock RESIDUAL EQUITY CORPORATE DEBT CHARACTERISTICS ALL interest on debt is deductible Corporate bonds are 1000 par which is value at maturity or redemption The stated interest rate or COUPON rate is fixed for life of bond BONDS are issues with an initial maturity of 10 years usually to a maximul of 30 years NOTES are issues with an initial maturity of 110 years BONDS NOTES are sold by INDENTURE PREFERRED STOCK CHARACTERISTICS PREFERRED STOCK HAS NO MATURITY IT IS LIKE AN UNLIMITED MATURITTY BOND PREFERRED STOCK PAYS A FIXED DIVIDEND PAR CAN BE ANY AMOUNT PREFERRED STOCK DIVIDENDS ARE NOT DEDUCTIBLE TO THE ISSUING CORPORATION INTERCORPORATE DIVIDEND EXCLUSION COMMON STOCK CHARACTERISTICS COMMON STOCK IS OWNERSHIP CAPITAL OR EQUITY PAR CAN BE ANY AMOUNT AND IS MEANINGLESS COMMON STOCK DIVIDENDS are discretionary THE BOARD DECLARES THE COMMON DIVIDEND QUARTERLY BASED ON PROFITS EXCESS PROFIT AFTER COM DIVDS IS ADDED TO RETAINED EARNINGS QUARTERLY LOWEST PRIORITY OF CLAIM COMMON STOCK CHARACTERISTICS contd High growth companies often do NOT pay a dividend preferring to REINVEST profits back in the business Reinvested earnings are called retained earnings The price of common stock rises with profits per share called Earnings per Share or E P S High growth companies often have high Price Earnings or P E ratios COMMON STOCK CHARACTERISTICS contd THE COST OF COMMON STOCK IS USUALLY THE HIGHEST SOURCE OF EXTERNAL CAPITAL THIS COST IS RELATED TO THE P E RATIO however D1 g P0 EXAMPLE D0 1 00 g 12 P0 30 D1 1 00 x 1 g 1 12 COMMON STOCK CHARACTERISTICS contd COST OF EXISTING EQUITY IN EXAMPLE IS 1 12 30 1 12 12 50 12 3 73 12 15 73 ASSUME THE PRICE RISES TO 50 2 24 12 14 24 COMMON STOCK CHARACTERISTICS contd EXTERNAL EQUITY OR COMMON STOCK IS USUALLY THE HIGHEST COST SOURCE OF EXTERNAL FINANCING SAY A COMPANY PAYS NO DIVIDEND AT ALL BUT IS GROWING AT 20 D1 g Ks P0 Ks 20 since D1 P0 is zero COST OF NEW EQUITY Secondary offering D1 g P0 1 F Where F floatation cost of a new equity underwriting EXAMPLE D1 1 12 P0 30 g 10 F 7 Ks 1 12 30 93 1 12 27 9 10 10 4 01 10 14 01 Why would a CFO NOT use all debt financing ADVANTAGES Debt is cheaper Cost is fixed Interest is deductible Debt can be refinanced if rates decline This is called REFUNDING and must be spelled out in the indenture DISADVANTAGES Non payment of ANY coupon on ANY debt issue will trigger Ch 11 filing by bond trustee Debt costs are a function of prevailing interest rates at time of issue for bonds of similar type quality WACC CALCULATION SEE TEXT P 444 WE WILL USE BOOK VALUE OF ASSETS not market MULTIPLY percent weight of each component by AFTER tax cost of capital of each component Notice in example that WACC 12 7 and the common stock component cost is the highest This is typical What if bonds were 60 of capital cost and equity was 35 WACC CALCULATION CONTD 60 X 7 4 20 5 X 13 0 65 35 X 16 5 60 WACC 10 45 WE LOWERED WACC BY 2 25 What could be wrong with this INCREASED USE OF DEBT DECREASES WACC BUT INCREASES RISK THIS IS CALLED FINANCIAL LEVERAGE which is covered in FIN 402 HOW IS WACC USED IN CORPORATE FINANCE WACC is the HURDLE RATE for capital budgeting decisions If company A has a WACC of 12 ALL new investments must return at least 12 for the firm to have a positive ROI If company B has a higher WACC of 15 it must seek investments with a minimum return of 15 WACC therefore influences the ability of a company to compete effectively CAPM CAPITAL ASSET PRICING MODEL SEE LEC NOTES P 20 21 and text P 4412 CAP M is an ALTERNATIVE way of measuring capital costs Kcs Krf B Km Krf see p 452 CAPM APPROACH Risk free rate Treasury yield curve PLUS risk premium Estimated market return Km less Krf TIMES Beta or volatility HOW CAN YOU ACCURATELY ESTIMATE Km ALTERNATIVE METHOD SEE LECTURE NOTES RISK FREE RATE Krf Risk premium reflecting business risk interest rate risk etc X Beta E cost of capital using