The Cost of Capital

According to solemn:
It is the minimum required rate of return by investors.
The firm must earn a minimum of rate of return to cover the cost
of generating funds to finance investments; otherwise, no one
will be willing to buy the firms bonds, preferred stoc!, and
common stoc!.
This point of reference, the firms required rate of return, is
called the C"#T "$ CA%ITA& .
The cost of capital is the required rate of return that a firm must
achieve in order to cover the cost of generating funds in the
mar!etplace. 'ased on their evaluations of the ris!iness of each
firm, investors will supply new funds to a firm only if it pays them
the required rate of return to compensate them for ta!ing the ris!
of investing in the firms bonds and stoc!s. If, indeed, the cost of
capital is the required rate of return that the firm must pay to
generate funds, it becomes a guideline for measuring the
profitabilities of different investments. (hen there are
differences in the degree of ris! between the firm and its
divisions, a ris!)ad*usted discount)rate approach should be used
to determine their profitability.
Case Studies in Corporate Finance
Cost of Capital Teaching Note
By Dr. Betty Simkins
Page 1 of 12
the annual report (www.reportgallery.com) and the 10-K report
(www.sec.gov/edgarhp.htm). The nputs for estmatng the mar!et value of
de"t and e#uty should "e avala"le n these sources. $ou can get a "eta
from the daly stoc!s we" ste (www.dalystoc!s.com). To get an e%tensve
rs! profle of a frm& vst the we" ste mantaned "y www.rs!vew.com.
'hat more nformaton& such as data on analyst coverage and vews of the
stoc!( Try )ac!s *nvestment +esearch (www.,achs.com). There are many
other we" stes on the *nternet wth a wealth of nformaton.
www.yahoo.com s -ust one place to start searchng for company nfo.
(hat impacts the cost of capital+
The Cost of Capital becomes a guideline for measuring the
profitabilities of different investments.
Another way to thin! of the cost of capital is as the opportunity
cost of funds, since this represents the opportunity cost for
investing in assets with the same ris! as the firm. (hen
investors are shopping for places in which to invest their funds,
they have an opportunity cost. The firm, given its ris!iness, must
strive to earn the investors opportunity cost. If the firm does not
achieve the return investors e,pect -i.e. the investors
opportunity cost., investors will not invest in the firms debt and
equity. As a result, the firms value -both their debt and equity.
will decline.
/emember that: The goal of the corporation is to ma,imi0e the
value of shareholders equity1
Case Studies in Corporate Finance
Cost of Capital Teaching Note
By Dr. Betty Simkins
Page 2 of 12
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(2I34T25 A62/A32 C"#T "$ CA%ITA&
-(ACC.
The firms (ACC is the cost of Capital for the firms mi,ture of
debt and stoc! in their capital structure.
(ACC 7 w
d
-cost of debt. 8 w
s
-cost of stoc!9/2. 8 w
p
-cost of
pf. stoc!.
#o now we need to calculate these to find the (ACC1
w
d
7 weight of debt -i.e. fraction of debt in the firms capital
structure.
w
s
7 weight of stoc!
w
p
7 weight of prefered stoc!
C"#T "$ 52'T -:
d
.
Case Studies in Corporate Finance
Cost of Capital Teaching Note
By Dr. Betty Simkins
Page ? of 12
w
d
w
s

w
p
Think of the firms capital
structure as a pie, that you
can slice into different shaped
pieces. The firm strives to
pick the eights of de!t and
e"uity #i.e. slice the pie$ to
minimi%e the cost of capital.
T&' F()*S C+,(T+-
ST).CT.)' (S T&'
*(/ 0F D'BT +ND
'1.(T2 .S'D T0
F(N+NC' T&'
B.S(N'SS.
(e use the after ta, cost of debt because interest payments
are ta, deductible for the firm.
:
d after ta,es
7 :
d
-; < ta, rate.
2=A>%&2
If the cost of debt for Cowboy 2nergy #ervices is ;?@ -effective
rate. and its ta, rate is A?@ then:
:
d after ta,es
7 :
d
-; < ta, rate.
7 ;? -; < ?.A. 7 B.? @
(e use the effective annual rate of debt based on current mar!et
conditions -i.e. yield to maturity on debt.. (e do not use
historical rates -i.e. interest rate when issued; the stated rate..
Cost of %referred #toc! -:p.
%referred #toc! has a higher return than bonds, but is less costly
than common stoc!. (4C+
In case of default, preferred stoc!holders get paid before
common stoc! holders. 4owever, in the case of ban!ruptcy, the
holders of preferred stoc! get paid only after short and long)term
debt holder claims are satisfied.
Case Studies in Corporate Finance
Cost of Capital Teaching Note
By Dr. Betty Simkins
Page @ of 12
%referred stoc! holders receive a fi,ed dividend and usually
cannot vote on the firms affairs.
preferred stoc! dividend
:
p
7 mar!et price of preferred stoc!
D"/ if issuing new preferred stoc!E
preferred stoc! dividend
:
p
7 mar!et price of preferred stoc! -; < flotation cost.
Fnli!e the situation with bonds, no ad*ustment is made for ta,es,
because preferred stoc! dividends are paid after a corporation
pays income ta,es. Consequently, a firm assumes the full
mar!et cost of financing by issuing preferred stoc!. In other
words, the firm cannot deduct dividends paid as an e,pense, li!e
they can for interest e,penses.
2,ample
If Cowboy 2nergy #ervices is issuing preferred stoc! at G;?? per
share, with a stated dividend of G;H, and a flotation cost of I@,
then:
preferred stoc! dividend
:
p
7 mar!et price of preferred stoc! -; < flotation cost.
G;H
7 G;?? -;)?.?I. 7 ;H.A @
Cost of 2quity -i.e. Common #toc! J /etained 2arnings.
The cost of equity is the rate of return that investors require to
ma!e an equity investment in a firm. Common stoc! does not
Case Studies in Corporate Finance
Cost of Capital Teaching Note
By Dr. Betty Simkins
Page A of 12
generate a ta, benefit as debt does because dividends are paid
after ta,es.
The cost of common stoc! is the highest. (hy+
/etained earnings are considered to have the same cost of
capital as new common stoc!. Their cost is calculated in the
same way, 2=C2%T that no ad*ustment is made for flotation
costs.
I (ays to Calculate
;. Fse CA%>
H. -3"/5"K >"52&. The constant dividend growth model <
same as 5C$ method
I. 'ond yield < plus < ris! premium
Case Studies in Corporate Finance
Cost of Capital Teaching Note
By Dr. Betty Simkins
Page B of 12
;. :
s
using CA%> -capital asset pricing model.
The CA%> is one of the most commonly used ways to determine
the cost of common stoc!. This LcostM is the discount rate for
valuing common stoc!s, and provides an estimate of the cost of
issuing common stoc!s.
:
s
7 :
rf
8 -:
m
) :
rf
.
(here: :
rf
is the ris! free rate
is the firms beta
:
m
is the return on the mar!et
2=A>%&2:
Cowboy 2nergy #ervices has a ' 7 ;.B. The ris! free rate on
T)bills is currently A@ and the mar!et return has averaged ;N@.
:
s
7 :
rf
8 -:
m
) :
rf
.
7 A 8 ;.B -;N < A. 7 H;.B @
$or information on estimating the cost of equity based on the
dividend growth model, or the bond)yield plus ris! premium, refer
to the bac!ground readings te,tboo!.
Case Studies in Corporate Finance
Cost of Capital Teaching Note
By Dr. Betty Simkins
Page C of 12
(ACC: %FTTIK3 IT A&& T"32T42/
/2CA&&:
(ACC 7 w
d
-cost of debt after ta,. 8 w
s
-cost of stoc!9/2. 8
w
p
-cost of %#.
2=A>%&2
Cowboy 2nergy #ervices maintains a mi, of A?@ debt, ;?@
preferred stoc!, and N?@ common stoc! in its capital structure.
The (ACC is:
(ACC 7 ?.A-B@. 8 ?.; -;H.A. 8 ?.N-H;.B.
7 H.A 8 ;.HA 8 ;?.O
7 ;A.A @
/eminder: /ead the article: L'est %racticesM in 2stimating the
Cost of Capital: #urvey and #ynthesis. It provides e,cellent
information on how some of the most financially sophisticated
companies and financial advisers estimate capital costs.
5etermining the (eights to be Fsed:
>y e,ample above gives you the weights to use in calculating
the (ACC. 4ow do you calculate the weights yourself+
The firms balance sheet shows the boo! values of the common
stoc!, preferred stoc!, and long)term bonds. Cou can use the
balance sheet figures to calculate boo! value weights, though it
is more practicable to wor! with mar!et weights. 'asically,
mar!et value weights represent current conditions and ta!e into
account the effects of changing mar!et conditions and the
Case Studies in Corporate Finance
Cost of Capital Teaching Note
By Dr. Betty Simkins
Page D of 12
current prices of each security. 'oo! value weights, however,
are based on accounting procedures that employ the par values
of the securities to calculate balance sheet values and represent
past conditions. The table on the ne,t page illustrates the
difference between boo! value and mar!et value weights and
demonstrates how they are calculated.
6A&F2 5"&&A/
A>"FK
T
(2I34T#
"/ @ "$
T"TA&
6A&F2
A##F>25
C"#T "$
CA%ITA&
-@.
'oo! 6alue
5ebt
H,??? bonds at par, or
G;???
H,???,??
?
A?.A ;?
%referred stoc!
A,N?? shares at G;?? par
value
AN?,??? P.; ;H
Common equity
N??,??? shares
outstanding at GN.?? par
value
H,N??,??
?
N?.N ;I.N
Total boo! value of capital A,PN?,??
?
;?? ;;.HA is
the (ACC
>ar!et 6alue
5ebt
H,??? bonds at GP??
current mar!et price
;,O??,??
?
I?.H ;?
%referred stoc!
A,N?? shares at GP?
current mar!et price
A?N,??? B.O ;H
Common equity
N??,??? shares
outstanding at GQN
current mar!et price
I,QN?,??
?
BI.? ;I.N
Case Studies in Corporate Finance
Cost of Capital Teaching Note
By Dr. Betty Simkins
Page E of 12
Total mar!et value of
capital
N,PNN,??
?
;?? (hat is the
(ACC+
Kote that the boo! values that appear on the balance sheet are
usually different from the mar!et values. Also, the price of
common stoc! is normally substantially higher than its boo!
value. This increases the weight of this capital component over
other capital structure components -such as preferred stoc! and
long)term debt.. The desirable practice is to employ mar!et
weights to compute the firms cost of capital. This rationale rests
on the fact that the cost of capital measures the cost of issuing
securities < stoc!s as well as bonds < to finance pro*ects, and
that these securities are issued at mar!et value, not at boo!
value.
Target weights can also be used. These weights indicate the
distribution of e,ternal financing that the firm believes will
produce optimal results. #ome corporate managers establish
these weights sub*ectively; others will use the best companies in
their industry as guidelines; and still others will loo! at the
financing mi, of companies with characteristics comparable to
those of their own firms. 3enerally spea!ing, target weights will
appro,imate mar!et weights. If they dont, the firm will attempt
to finance in such a way as to ma!e the mar!et weights move
closer to target weights.
4urdle rates:
4urdle rates are the required rate of return used in capital
budgeting. #imply put, hurdle rates are based on the firms
(ACC. To understand the concept of hurdle rates, I li!e to thin!
of it this way. A runner in trac! *umps over a hurdle. %ro*ects
the firm is considering must L*ump the hurdleM < or in other words
< e,ceed the firms borrowing costs -i.e. (ACC.. If the pro*ect
does not clear the hurdle, the firm will lose money on the pro*ect
if they invest in it < and decrease the value of the firm. The
Case Studies in Corporate Finance
Cost of Capital Teaching Note
By Dr. Betty Simkins
Page 10 of 12
hurdle rate is used by firms in capital budgeting analysis -one of
the ne,t topics we will be studying.. &arge companies, with
divisions that have different levels of ris!, may choose to have
divisional hurdle rates.
5ivisional hurdle rates are sometimes used because firms are not
internally homogeneous in terms of ris!. $inance theory and
practice tells us that investors require higher returns as ris!
increases. $or e,ample, do the following investment pro*ects
have the same level of ris!s+ 2ngineering pro*ects such as
highway construction, mar!et)e,pansion pro*ects into foreign
mar!ets, new)product introductions, 2)commerce startups, etc.
'rea!points -'%. in the (ACC:
'rea!points are defined as the total financing that can be done
before the firm is forced to sell new debt or equity capital. "nce
the firm reaches this brea!point, if they choose to raise
additional capital their (ACC increases.
$or e,ample, the formula for the retained earnings brea!point
below demonstrates how to calculate the point at which the
firms cost of equity financing will increase because they must
sell new common stoc!. -Kote: The formula for the '% for debt or
preferred stoc! is basically the same, by replacing retained
earnings for debt and using the weight of debt..

'%
/2
7 /etained earnings
(eight of equity
2,ample:
Cowboy 2nergy #ervices e,pects to have total earnings of
GOA?,??? for the year, and it has a policy of paying out half of its
earnings as dividends. Thus, the addition to retained earnings
will be GAH?,??? during the year. (e now want to !now how
much total new capital < debt, preferred and retained earnings <
Case Studies in Corporate Finance
Cost of Capital Teaching Note
By Dr. Betty Simkins
Page 11 of 12
can be raised before the GAH?,??? of retained earnings is
e,hausted and the company is forced to sell new common stoc!.
(e are see!ing the amount of capital which represents the total
financing that can be done before Cowboy 2nergy #ervices is
forced to sell new common stoc! to maintain their target weights
in their (ACC. &ets assume that Cowboy 2nergy #ervices
maintains a capital structure of B?@ equity, A?@ debt. Fsing the
formula above:
'%
/2
7 /etained earnings
(eight of equity
7 GAH?,???9?.B? 7 GQ??,???
Thus, Cowboy 2nergy #ervices can raise a total of GQ??,??? in
new financing, consisting of ?.B-GQ??,???. 7 GAH?,??? of retained
earnings and ?.A?-GQ??,???. 7 GHO?,??? of debt, without altering
its capital structure. The '%
/2
7 GQ??,??? is defined as the
retained earnings brea! point, or the amount of total capital at
which a brea!, or *ump, occurs in the marginal cost of capital.
Can there be other brea!s+ Ces, there can < depending on if
there is some point at which the firm must raise additional
capital at a higher cost.
Case Studies in Corporate Finance
Cost of Capital Teaching Note
By Dr. Betty Simkins
Page 12 of 12