CHAPTER 10 The Cost of CapitalWhat types of capital do firms use?Should we focus on before-tax or after-tax capital costs?Should we focus on historical (embedded) costs or new (marginal) costs?A 15-year, 12% semiannual bond sells for $1,153.72. What’s kd?Component Cost of DebtWhat’s the cost of preferred stock? Pp = $111.10; 10%Q; Par = $100.Picture of Preferred StockNote:Is preferred stock more or less risky to investors than debt?Why is yield on preferred lower than kd?Example:Why is there a cost for retained earnings?Slide 14Three ways to determine cost of common equity, ks:What’s the cost of common equity based on the CAPM? kRF = 7%, RPM = 6%, b = 1.2.What’s the DCF cost of common equity, ks? Given: D0 = $4.19; P0 = $50; g = 5%.Suppose the company has been earning 15% on equity (ROE = 15%) and retaining 35% (dividend payout = 65%), and this situation is expected to continue. What’s the expected future g?Retention growth rate: g = (1 – Payout)(ROE) = 0.35(15%) = 5.25%. Here (1 – Payout) = Fraction retained. Close to g = 5% given earlier. Think of bank account paying 10% with payout = 100%, payout = 0%, and payout = 50%. What’s g?Could DCF methodology be applied if g is not constant?Find ks using the own-bond-yield-plus-risk-premium method. (kd = 10%, RP = 4%.)What’s a reasonable final estimate of ks?Why is the cost of retained earnings cheaper than the cost of issuing new common stock?Two approaches that can be used to account for flotation costs:Slide 25Comments about flotation costs:What’s the firm’s WACC (ignoring flotation costs)?What factors influence a company’s composite WACC?WACC Estimates for Some Large U. S. Corporations, Nov. 1999Should the company use the composite WACC as the hurdle rate for each of its projects?Risk and the Cost of CapitalSlide 32What are the three types of project risk?How is each type of risk used?What procedures are used to determine the risk-adjusted cost of capital for a particular project or division?Methods for Estimating a Project’s BetaSlide 37Find the division’s market risk and cost of capital based on the CAPM, given these inputs:Slide 39How does the division’s market risk compare with the firm’s overall market risk?10 - 1Copyright © 2001 by Harcourt, Inc. All rights reserved.CHAPTER 10The Cost of CapitalCost of capital componentsAccounting for flotation costsWACCAdjusting cost of capital for riskEstimating project risk10 - 2Copyright © 2001 by Harcourt, Inc. All rights reserved.What types of capital do firms use?DebtPreferred stockCommon equity: Retained earnings New common stock10 - 3Copyright © 2001 by Harcourt, Inc. All rights reserved.Stockholders focus on A-T CFs.Therefore, we should focus on A-T capital costs, i.e., use A-T costs in WACC. Only kd needs adjustment.Should we focus on before-tax or after-tax capital costs?10 - 4Copyright © 2001 by Harcourt, Inc. All rights reserved.The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on today’s marginal costs (for WACC).Should we focus on historical (embedded) costs or new (marginal) costs?10 - 5Copyright © 2001 by Harcourt, Inc. All rights reserved.A 15-year, 12% semiannual bond sells for $1,153.72. What’s kd? 60 60 + 1,000600 1 2 30i = ?30 -1153.72 60 1000 5.0% x 2 = kd = 10% N I/YR PV FVPMT-1,153.72...INPUTSOUTPUT10 - 6Copyright © 2001 by Harcourt, Inc. All rights reserved.Component Cost of DebtInterest is tax deductible, sokd AT = kd BT(1 – T) = 10%(1 – 0.40) = 6%.Use nominal rate.Flotation costs small.Ignore.10 - 7Copyright © 2001 by Harcourt, Inc. All rights reserved.What’s the cost of preferred stock? Pp = $111.10; 10%Q; Par = $100.Use this formula:%.0.9090.010.111$10$PDkppp10 - 8Copyright © 2001 by Harcourt, Inc. All rights reserved.Picture of Preferred Stock2.50 2.500 1 2kp = ?-111.1...2.50$111.10 = = .kPer = = 2.25%; kp(Nom) = 2.25%(4) = 9%.DQkPer$2.50kPer$2.50$111.1010 - 9Copyright © 2001 by Harcourt, Inc. All rights reserved.Note:Preferred dividends are not tax deductible, so no tax adjustment. Just kp.Nominal kp is used.Our calculation ignores flotation costs.10 - 10Copyright © 2001 by Harcourt, Inc. All rights reserved.Is 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.10 - 11Copyright © 2001 by Harcourt, Inc. All rights reserved.Why is yield on preferred lower than kd?Corporations own most preferred stock, because 70% of preferred dividends are nontaxable to corporations.Therefore, preferred 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 than on debt. Consistent with higher risk of preferred.10 - 12Copyright © 2001 by Harcourt, Inc. All rights reserved.Example:kp = 9% kd = 10% T = 40%kp, AT = kp – kp (1 – 0.7)(T)= 9% – 9%(0.3)(0.4) = 7.92%.kd, AT = 10% – 10%(0.4) = 6.00%. A-T Risk Premium on Preferred = 1.92%.10 - 13Copyright © 2001 by Harcourt, Inc. All rights reserved.Why is there a cost for retained earnings?Earnings can be reinvested or paid out as dividends.Investors could buy other securities, earn a return.Thus, there is an opportunity cost if earnings are retained.10 - 14Copyright © 2001 by Harcourt, Inc. All rights reserved.Opportunity cost: The return stockholders could earn on alternative investments of equal risk.They could buy similar stocks and earn ks, or company could repurchase its own stock and earn ks. So, ks is the cost of retained earnings.10 - 15Copyright © 2001 by Harcourt, Inc. All rights reserved.Three ways to determine cost of common equity, ks: 1. CAPM: ks = kRF + (kM – kRF)b.2. DCF: ks = D1/P0 + g.3. Own-Bond-Yield-Plus-Risk Premium: ks = kd + RP.10 - 16Copyright © 2001 by Harcourt, Inc. All rights reserved.What’s the cost of common equity based on the CAPM?kRF = 7%, RPM = 6%, b = 1.2.ks = kRF + (kM – kRF )b.= 7.0% + (6.0%)1.2 = 14.2%.10 - 17Copyright © 2001 by Harcourt, Inc. All rights reserved.What’s the DCF cost of commonequity, ks? Given: D0 = $4.19;P0 = $50; g = 5%.D1P0D0(1 +