FIN3403 Exam 4 Conceptual Review Chapter 14 Cost of Capital The Cost of Capital is important to Financial Managers because it represents the hurdle rate for most investment proposals to be deemed acceptable Steps involved in estimating a firm s Cost of Capital o Estimate the after tax cost of the long term financing sources used by the firm debt equity preferred stock o Determine the weight to be applied to each source of financing used o Calculate the weighted average cost of capital the portion of a firm s assets that are purchased using debt Weight of debt financing Cost of debt When evaluating the use of debt in the capital structure some issues do arise the yield to maturity of a bond o Using debt gives a firm a tax shelter Higher interest means lower taxable income at the expense of additional risk o Debt is also known as financial leverage Using leverage can be a very good thing for the stockholders of the company o We are interested in the marginal debt that is newly issued debt not the interest rate the firm pays on currently outstanding debt The rate at which the firm has borrowed in the past is irrelevant The cost of debt helps determine the interest that a firm will pay out which is why it is multiplied by 1 t to solve for WACC Because we need a term to place the before tax cost of debt on an after tax basis by issuing new preferred stock not all firms use preferred stock the portion of a firm s assets that are purchased Weight of preferred stock Preferred stock dividends are usually the same from year to year Meaning Weight of equity they produce a perpetuity stream of cash flows new common stock and or by additions to retained earnings Cost of equity capital the return that stockholders require for a company the portion of a firm s assets that are purchased by issuing o can be raised from 2 different sources with 2 different costs RE internal equity or CS external equity o The cost of using RE is less than the cost of issuing new equity because there isn t any need to involve an investment banker therefore the cost of RE does not include a factor for flotation costs but the cost of CS may include such a term The cost of equity is difficult to estimate because it is not easy to precisely estimate the Risk Premium on a stock and hence to RRR which on a stock is the firm s cost of equity Interest rates and tax rates are external factors that influence a firm s WACC Capital structure policy and dividend policy are internal factors that affect a firm s WACC but can be controlled by the firm unlike external factors Equity of a firm is riskier than debt from the perspective of investors Therefore the firm s before tax cost of debt provides a base from which to start when estimating the cost of equity Differences in risk across firms is reflected to some extent in differences in the cost of debt for the firms The management of a firm will often specify a target capital structure the desired mix of long term financing sources that the firm desires to use in its capital structure If this is available the weights can be used as specified For outsiders that are unaware of management s target capital structure the weights can be determined by calculating the market value of the firm s long term debt preferred stock and common stock respectively and then figuring out what each source represents of the total value Flotation costs the cost incurred by a public traded company when it issues new securities These refer to the fees paid to investment bankers who help the firm raise capital o For new equity these costs can be substantial ranging from 3 to 10 of the gross proceeds o For debt and preferred stock it s quite a bit less 1 2 A firm s WACC would be somewhat higher if flotation costs are accounted for Flotation costs lead to a reduction in a proposal s NPV if they are incorporated into the analysis The WACC is the correct discount rate to use in capital budgeting when the project being evaluated had approximately the same risk as the average risk associated with the firms existing assets o This is because when the after tax costs of debt preferred stock and equity are estimated these costs reflect the riskiness of the firm s existing assets Thus if a firm is evaluating a project that is either considerably less or more risky than average riskiness of the firm s existing assets it would be incorrect to use the WACC as the discount rate for such proposals For projects deemed riskier than average the RRR should be set higher than the firm s WACC and vice versa for projects of less than average risk Intuitively investor s RRR will be higher lower for projects with greater less risk The cost of capital depends on the riskiness of a firm as a whole o A firm may have some division with more or less risk than average The firm may consider new projects with more or less risk than average Chapter 16 Capital Structure The target capital structure for a firm is the set of debt preferred stock and common stock that a firm plans on using in order to raise capital This target usually changes as conditions change within the firm The policy influencing capital structure decisions is an exchange between risk and returns For example If a firm uses more debt than capital structure this use of debt will increase the risk for investors but will also generate higher returns on the equity There fore the target capital structure may become the optimal capital structure if the firm finds the right combination of risk and return that will maximize the firm s stock price and thus maximize shareholder wealth Does the capital structure employed by a firm have an affect on shareholder s wealth o If the market value of a firm and the WACC change as the Debt Equity change than YES the capital structure decision is relevant because it impacts shareholder s wealth On the other hand if the WACC and the market value of the firm do not change as the Debt Equity changes then capital structure decisions are unimportant The effect of using financial leverage debt financing on the remaining shareholders o It increases the risk of the SH s claims because using financial leverage leads to greater variability in EPS and the ROE for the SH s o It generally increases the SH s expected rate of return as measured by expected EPS or the expected ROE Factors influencing decisions concerning the capital structure include business risk tax position flexibility financially and the aggressiveness of the manager Business Risk
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