FIN3403 STUDY GUIDE EXAM 4 CHAPTERS 14 16 17 3 Chapter 14 COST OF CAPITAL The cost of capital is important to financial mangers because it REPRESENTS the estimated cost of the funding that firms use to finance most of their investments in real assets It is the required rate of return associated with most projects that the firm will consider undertaking It is important to understand that we are talking about the cost of new funding for investment purposes RECALL the internal Rate of Return must EXCEED the Required Rate of Return on the project for it to be acceptable similarly when the projected cash flows of the project are discounted to the present using the required rate of return on the project as the discount rate and summed they must exceed 0 for the project to be acceptable Companies get their cost of capital from multiple sources 1 Equity Retained earnings Common stock 2 Preferred stock 3 Debt W Weight R Required Return t Tax rate Issuing corporate bonds Steps involved in estimating a Firm s Cost of Capital 1 Estimate the after tax cost of the long term financing sources used by the firm equity debt and possibly preferred stock 2 Determine the weight to be applied to each source of financing used the of the total capital structure that each source represents 3 Calculate the Weighted Average Cost of Capital WACC as WACC WDRD BT 1 t WERE WPRP WDRD AT WERE WPRP D Debt E Equity P Preferred Stock RBT Before tax has to be adjusted to its after tax equivalent because interest payments are TAX DEDCUTIBLE Market value of Debt of shares Face vale market value OR bonds price per bond Market Value of Preferred Price per share of shares Market Value of Equity Price of shares FINDING THE REUIRED RETURNS Different Approaches for Estimating a Firm s Cost of Equity The cost of equity is DIFFICULT to estimate accurately why RECALL relationship between the markets Required Rate of Return on the stock and the risk of the stock In essence the RRR on the stock is the firms cost of equity T is not easy to precisely estimate the Risk Premium on a stock and hence the RRR Therefore a precise estimate of a firms cost of equity is difficult to generate 1 Constant Growth Dividend Valuation Model Approach This approach should ONLY be used for stock that are characterized by the expectation the eps and dps will grow at a relatively CONSTANT rate for an indefinite period of time Po D1 r g Re is the same are r in this equation so RE D1 P0 g D1 estimated dividend yield Po estimated LT growth rate If D1 is not given replace the numerator with Do 1 g Just Paid Means Do 2 CAPM Approach RECALL CAPM holds that the RE on a security depends only upon the systematic risk non diversifiable risk of a security RE Rf RRRM Rf i or RE Rf RPMarket i 3 Equity Risk Premium Approach not in text Formula Logic of approach RE YTM on the debt Equity risk premium Equity of firm is riskier than debt from the perspective of INVESTORS Therefore the firms before tax cost of debt provides a base from which to start when estimating the cost of equity AT present some firms have long term debt cost in the 4 5 range while others which are much RISKIER might have a long term debt cost in excess of 10 or even 15 Thus differences n risk across firms are reflected to some extent in difference in cost of debt for the firms How large the equity risk premium should be a question that mist be answered when using this approach Somewhere in the range of 4 6 percent would seem reasonable Also the equity risk premium would not necessarily ne the same for all firms Estimating the After Tax Cost of Debt General Procedure 1 Calculate the YTM on the firms outstanding long term debt and then adjust for the tax deductibility of interest payments The YTM represents the firm s current before tax cost of debt Debt pays interest which is tax deductible in other word interest creates a TAX SHIELD Formal RD AT RD BT 1 t YTM on LT Debt 1 t Using debt gives a firm a tax shelter HIGHER interest means LOWER taxable income at the expense of additional risk Debt is also known as financial leverage using leverage can be very good thing for the stockholder of the company Increase the proportion of debt will tend to decrease WACC Estimating the Cots of Preferred Stock Formula RP D P0 D Divided and P current price The payment of preferred stock is constant and has no maturity and it does NOT increase in value when firm value increase Determining the Weights to Apply to Each Source of Financing 1 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 2 For outsiders that are unaware of managements 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 Market value of each source of shares or bonds outstanding X Market price per security Formula WD MVD MVTOTAL WP MVP MVTOTAL WE MVE MVTOTAL MV total MVD MVP MVE Sum W should 1 00 MV shares bonds Market price 3 An Alternative method for estimating the weights would be to use Book Value for Debt and Equity from the balance sheet This Approach can product estimated that weights differ substantially from those obtained using market values because of the large difference that often exist between book values and market values for equity Whenever possible market values not book values should be used in estimating weights as market values are used in estimating the cost of each source of financing Other conceptual Issues pertaining to the Cost of Capital 1 Flotation Costs and the Weighted Average Cost of Capital Flotation costs arise when a firm issues new securities for the purpose of raising funds These refer to the fees paid investment bankers who help the firm raise capital For new equity these costs can be substantial ranging from 3 to 10 of the gross proceeds The percentage fees are lower for preferred stock and bond issues Question of Concern How should flotation costs be treated for capital budgeting purposes When a firm must sell new debt and or equity securities to finance a project the total floatation costs incurred should be added to the initial outlay associated with the investment and then the NPV should be computed as before Some adjust the estimated cost of the various
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