HB 307 1st Edition Lecture 17The Purpose of the Cost of Capital - Cost of capital can be defined as the average rate paid for the use of capital funds - Use as the ‘hurdle rate’, or benchmark for projects o Compare this to IRR o Discount cash flows at this rate to find NPV - If a project cannot earn above this return, it is not worthwhile Capital Components - Components of a firm’s capital o Debt – borrowed money o Common equity – ownership interest o Preferred Stock – cross between debt and equity - Capital structure is the mix of the three components Capital Structure - Target capital structure o Mix of components that management considers optimal and strives to maintain - Raising money to the proportions of the capital structure o An exact capital structure can’t be maintained o If interest rates are low, a firm might issue more debto Increases the weight of debt relative to equity o Next time need more capital, issue equity to bring back into balance Returns of Investments and the Costs of Capital Components - Investors provide capital to companies by purchasing their securities - Returns to investors represent costs to firms in which investments are made- Since equity is riskier than debt, generally the COST for equity is higher than that of debt(or preferred stock), thus cost to firm is higherThe Weighted Average Calculation - Firm’s WACC is average of the costs of the separate sources weighted by the proportion of each source used These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.WACC = * Re + * Rd * (1 – Tc)- Re = cost of equity- Rd = cost of debt- E = market value of the firm’s equity- D = market value of the firm’s debt- V = E + D- E/V = percentage of financing that is equity- D/V = percentage of financing that is debt-Tc = corporate tax rateCapital Structure and Cost- Book versus market value - Book values reflect the cost of capital already spent - Market value estimates the cost of capital to be raised in the near future o Market values are appropriate because new projects are generally funded with newly-raised equity Calculating the WACC- Step 1: Develop a market-based capital structure - Step 2: Adjust the market returns on the securities underlying the capital components toreflect the company’s true component costs of capital- Step 3: Put the values obtained in Steps 1 and 2 together to determine the WACC- Developing market-value based capital structureso Involves determining % each source of capital makes up of firm’s overall capital structure based on market valuesCalculating Component Costs of Capital - Flotation costs- administrative fees and commissions incurred in the process of issuring and selling securities o Investment banks who help raise capital are paid this amounto CCOC = k / (1-f) o K=return on security o F= flotation costThe Cost of Debt- The actual cost of debt is the true cost for the borrower as a result of the tax deductibility of interest payments- Cost of debt is the market return on debt net of taxeso K(d) x (1 – tax rate) The Cost of Preferred Stock - Cost of preferred stock is the investor’s return adjusted to flotation costs o Preferred stockholder’s return is the dividend received divided by the current price of the stocko Adjusting this for a fact that a firm will only net the portion of the issuing price after flotation costs (F) results ino D(p) / (1 –f)P(p) or k(p) / (1-f) The Cost of Common Equity - Debt and preferred stock offer investors known stream of payments so calculating returns are easy - Cost of equity is imprecise because of the uncertainty of future cash flows o Market return has to be estimated o CAPM, Gordon Model, and risk premiums- Equity sources include stock sales and retained earnings, which have different costsThe Cost of Retained Earnings- RE is not free to company because they represent reinvested earnings for stockholders- RE represent money stockholders could have spent if it had been paid out as dividends o Deserve a return on retained earningso Market return on new shares is a starting point for estimating REo No adjustments are neededEstimating Cost of Retained Earnings – Gordon Model - Original formula for Gordon (constant growth) Model for stock valuation- K = (D1 / P0) + g Estimating Cost of Retained Earnings – Risk Premium Approach - Possible to estimate the return on a firm’s equity by adding 3 to 5 % points to the marketreturn on its debt - K(e) = k(d) + equity risk premium Cost of New Common Stock - Firms often need to raise more equity than that generated by retained earnings - Accomplish this by issuing new common stock- Equity from the new stock is just equity from RE, with the exception that raising it involves incurring flotation costs- Market Return estimates for RE must be adjusted for flotation costs to determine the cost for issuing new common stock - Easiest to do with Gordon Model because price of stock appears in that equationMarginal Cost of Capital (MCC) - Firm’s WACC is not independent of amount of capital raised - WACC typically rises as the firm raises more capital- The Marginal Cost of Capital (MCC) is graph of the WACC showing abrupt increases as larger amounts of capital are raised in the planning period The Break in MCC When Retained Earnings Run Out - Breaks in the MCC occur when a cheap source of financing is used up - First increase in MCC occurs when firm runs out of RE and starts raising external equity by selling stock - Locating the Breako First breakpoint is found by dividing the amount of RE available by the fractional proportion of equity in the capital