Chapter 11Cost of CapitalChapter ObjectivesEconomic ValueEVA MeasurementShareholder Value-Based ManagementEVASlide 8Slide 9Discount RateRequired Rate of Return and Cost of CapitalSlide 12Financial PolicyWeighted Average Cost of CapitalFinancing InstrumentsCost of DebtCost of Preferred StockCommon EquityCost of Equity CapitalDividend Growth ModelSlide 21Issues with the Dividend Growth ModelCapital Asset Pricing ModelCapital Asset Pricing ModelIssues with the Capital Asset Pricing ModelSlide 26Slide 27PepsiCoSlide 29Cost of Capital and New InvestmentMarket Value Added MVAEconomic ProfitKmart ExampleSlide 34Incentive Based CompensationMultinational Firms and Interest RatesFisher Model and Domestic Interest RatesInternational or Foreign Rates and Fisher EffectInterest Rates and Currency Exchange RatesInterest Rates and Currency Exchange RatesChapter 11Chapter 11Cost of CapitalCost of CapitalChapter ObjectivesChapter ObjectivesCost of CapitalAfter-tax cost of debt, preferred stock and common stockWeighted average cost of capitalPepsiCo’s cost of capitalCost of capital and new investmentsEconomic profitEquivalent interest rates for different countriesEconomic ValueEconomic ValueCreated by earning a return greater than investors’ required returnDestroyed by earning a return less than they requireEVA MeasurementEVA MeasurementEncourages management to make business decisions that create economic value through improved operating efficiency, better asset utilization, and growth that generates returns which exceed the cost of capitalShareholder Value-Based Shareholder Value-Based ManagementManagementRewards the firm’s employees in ways that continually encourage them to seek out new ways to create shareholder valueEVAEVAEmphasis on EVA will more closely align the interests of employees and shareholdersCost of CapitalCost of CapitalLink between financing decisions and investment decisionsHurdle rate that must be achieved by an investment before it will increase shareholder wealthBasis for evaluating division or firm performanceCost of CapitalCost of CapitalAlso called:Hurdle rate for new investmentDiscount rateOpportunity cost of fundsRequired rate of returnDiscount RateDiscount RateInvestors’ required rate of return orMinimum rate of return necessary to attract an investor to purchase or hold a securityConsiders opportunity costRequired Rate of Return and Required Rate of Return and Cost of CapitalCost of CapitalCost of capital incorporates–Taxes or Tax Savings–Flotation CostsCost of CapitalCost of CapitalIf a firm sells new stock for $30.00 a share and incurs $5 in flotation costs, and the investors have a required rate of return of 12%, what is the cost of capital?.12 x30 = $3.603.60 / (30-5) = 14.40%Financial PolicyFinancial PolicyPolicies regarding the sources of finances a firm plans to use and the particular mix in which they will be used Governs the use of debt and equity financing. The particular mixture of debt and equity a firm utilizes impacts the firm’s cost of capital.Weighted Average Cost of Weighted Average Cost of CapitalCapitalCombined costs of all the sources of financing used by the firm. The weighted average of the after-tax costs of each of the sources of capital used by a firm to finance a project where the weights reflect the proportion of total financing from each source.Financing InstrumentsFinancing InstrumentsDebtPreferred StockCommon StockCost of DebtCost of DebtAfter tax cost of debt = kd(1-Tc)Before tax cost of capital less the effect of tax savingsExampleDebt at 9.75% and tax rate of 34%After-tax cost of debt = .0975(1-.34) = 6.435%Cost of Preferred StockCost of Preferred StockCost of preferred stock = Preferred Stock dividend/ Net proceeds per shareExample: Annual dividend $5, Stock price $65 and flotation costs of $1.50Cost = 5/(65 - 1.50) = 5/(63.50) = .07874or Cost of preferred stock = 7.874%Common EquityCommon EquitySources:–Retained Earnings–Sales of new sharesNo Flotation costs on retained earningsCost of Equity CapitalCost of Equity CapitalFirst estimate common stockholders’ required rate of return:Dividend Growth ModelCapital Asset Pricing ModelDividend Growth ModelDividend Growth ModelInvestors’ required rate of return:Kcs = D1/Pcs+ gDividends divided by price of stock; plus growth rateIssue new common stockKncs = D1/NPcs+ gDividends divided by net proceeds; plus growthDividend Growth ModelDividend Growth ModelExample: A company expects dividends this year to be $2.20, based upon the fact that $2 were paid last year. The firm expects dividends to grow 10% next year and into the foreseeable future. Stock is trading at $50 a share.Cost of retained earnings: Kcs = D1/Pcs+ g2.20/50 + .10 = 14.4%Cost of new stock:Kncs = D1/NPcs+ g2.20/(50-7.50) + .10 = 15.18%Issues with the Dividend Issues with the Dividend Growth ModelGrowth ModelSimplicityAssume constant growth rateEstimating rate of growthCapital Asset Pricing Model Capital Asset Pricing Model Combines:Risk Free rate krfSystematic risk or Beta (B)Market Risk Premium or Expected rate of return for market or average security less the risk free rate km – krfkc = krf + B(km – krf)Capital Asset Pricing ModelCapital Asset Pricing ModelExample:Beta is 1.4; Risk-free rate is 3.75%; Expected market rate is 12%.0375 + 1.4(.12 - .0375) = 15.3%Issues with the Capital Asset Issues with the Capital Asset Pricing ModelPricing ModelSimple/Easy to understandVariables available from public sourcesNo reliance upon dividends or growth rate assumptionsWeighted Average Cost of Weighted Average Cost of CapitalCapitalNeed cost of each of the sources of capital used and capital structure mixCapital Structure Mix –proportions of each source of financing used by the firmWACoC = (After tax cost of debt X proportion of debt financing) + (Cost of equity X proportion of equity financing)Weighted Average Cost of Weighted Average Cost of CapitalCapitalExample:A firm borrows money at 6% after taxes and pays 10% for equity. The company raises capital in equal proportions – 50/50WACoC = (.06 X .5) + (.1 X .5) = .08 or 8%PepsiCoPepsiCoCalculated divisional cost of capitalDifferent target ratios for debt/equity mix per divisionDifferent pretax cost of