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Rushen Chahal
CHAPTER 12
Cost of Capital
CHAPTER ORIENTATION
In Chapters 7 and 8 we considered the valuation of debt and equity instruments. The concepts advanced there serve as a foundation for determining the required rate of return for the firm and for specific investment projects. The objective in this chapter is to determine the required rate of return to be used in evaluating investment projects.
CHAPTER OUTLINE
I. The concept of the cost of capital A. Defining the cost of capital: 1. 2. B. The rate that must be earned in order to satisfy the required rate of return The rate of return on investments at which the price of a firm's common stock will remain unchanged.
Investors required rate of return is not the same as the firms cost of capital due to 1. 2. Taxes: Interest payments on debt are tax deductible to the firm. Flotation costs: Firms incur expenses when issuing securities that reduce the proceeds to the firm. Each type of capital used by the firm (debt, preferred stock, and common stock) should be incorporated into the cost of capital, with the relative importance of a particular source being based on the percentage of the financing provided by each source of capital. Using the cost of a single source of capital as the hurdle rate is tempting to management, particularly when an investment is financed entirely by debt. However, doing so is a mistake in logic and can cause problems.
C.
Financial Policy 1.
2.
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$I t (1 + k d ) = = = = =
t
$M (1 + k d ) n
the market price of the debt, less flotation costs, the dollar interest paid to the investor each period, the maturity value of the debt before-tax cost of the debt (before-tax required rate of return on debt) the number of periods to maturity.
The after-tax cost of debt equals: kd (1 - T) where T = corporate tax rate 2. Cost of preferred stock (required rate of return on preferred stock), kps, equals the dividend yield based upon the net price (market price less flotation costs), or D dividend kps = = net price NPps 3. Cost of Common Stock. There are two measurement techniques to obtain the required rate of return on common stock. a. b. 4. dividend-growth model capital asset pricing model Cost of internally generated common equity, kcs kcs = kcs = dividend in year1 annual growth + in dividends market price D1 + g Pcs
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It is important to notice that the major difference between the equations presented here and the equations from Chapters 7 and 8 is that the firm must recognize the flotation costs incurred in issuing the security.
B.
Selection of weights. The individual costs of capital will be different for each source of capital in the firm's capital structure. To use the cost of capital in investment analyses, we must compute a weighted, or overall, cost of capital. 1. It will be assumed that the company's current financial mix resulting from the financing of previous investments is relatively stable and that these weights will closely approximate future financing patterns. In computing weights, we could use either the current market values of the firm's securities or the book values as shown in the balance sheet. Since we will be issuing new securities at their current market value, and not at book (historical) values, we should use the market value of the securities in calculating our weights.
2.
III.
PepsiCo approach to weighted average cost of capital A. PepsiCo calculates the divisional cost of capital for its snack, beverage and restaurant organizations by first finding peer-group firms for each division and using their average betas, after adjusting for differences in financial leverage, to compute the division's cost of equity. They also use accounting betas in estimating the cost of equity. They then compute the cost of debt for each division. Finally, they calculate a weighted cost of capital for each division.
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E/(D+E)= D/(D+E)= C.
Calculating the Cost of Equity Based on capital asset pricing model: kcs where: kcs krf km = = = = the cost of common stock the risk-free rate beta, measure of the stock's systematic risk the expected rate of return on the market = krf + (km - krf)
Betas for each division are estimated by calculating an average unlevered beta from a group of divisional peers. The average beta for each division's peer group is unlevered and then relevered using that division's target debt-to-equity ratio. D. Calculating the Cost of Debt The after-tax cost of debt is equal to: kd (1 - T) where: kd T = = before-tax cost of debt marginal tax rate
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B.
C.
(2)
12-3. All types of capital, including debt, preferred stock, and common stock, should be incorporated into the cost of capital computation, with the relative importance of a particular source being based upon the percentage of financing to be provided.
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b.
c.
12-6
In general, the relative costs of various sources of capital reflect the riskness of the source to the investor. For example, for a given firm, we would expect debt securities to be less risky than preferred stock which is less risky than common stock. Consequently, debt would demand a lower required return than the firms preferred stock, which is lower than the required rate of return for common stock.
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t =1
10
b.
kncs
= =
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= = d. kps =
= = e.
12-2A. a. After tax cost of debt = = = b. kncs kncs c. $1,150(.90) $1,035 Rate = kd(1 - T) 8%(1 - 0.34) 5.28% D1 + g NPcs $1.05(1 + 0.05) + 0.05 $25(1 0.09) $1,035 = = 9.85%
= = =
t =1
20
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After tax cost of debt After tax cost of debt d. kps kps e. kcs kcs =
12-3A.
kncs
kncs
58
t =1
$1,000 (1 + k d )15 Value $914.13 839.27 $74.86 .0882 = 7.23% = 7.69% = 8.82%
kd
12-5A.
kps
D NPps
n
12-6A.
NPd
t =1 15
$945
t =1
Since the net price on the bonds, $945, is less than the $1,000 par value, the beforetax cost of the debt must be greater than the 12 percent coupon interest rate ($120 $1,000). Rate 12% kd% 13% Value $1,000.00 945.00 _______ $ 55.00 kd = 935.44 $ 64.56 Value $1,000.00
$55.00 .12 + .01 = .1285 = 12.85% $64.56 = kd(1 - T) = 12.85%(1 - .34) = 8.48% 59
= =
12-9A.If the firm pays out 50 percent of its earnings in dividends, its recent earnings must have been $8 ($4 dividend divided by .5). Thus, earnings increased from $5 to $8 in five years. Using Appendix C and looking for a table value of .625 ($5/$8), the annual growth rate is approximately ten percent. a. Cost of internal common stock (kcs): kcs = D1 P + g cs $4(1 + .10) $4.40 + .10 = + .10 $58 $58 .1759 = 17.59%
= = b.
Cost of external common (new common) stock, kncs kncs = D1 NP + g cs $4.40 + .10 $58(1 0.08) $4.40 + .10 $53.36
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$1,000 (1 + 0.09)10
$140(6.418) + $1000(.422) $1,320.52 $1,320.52(1 - 0.105) $1,181.87 $500,000 = 423.06 424 Bonds $1,181.87
c.
Number of Bonds
d.
t =1
$140 (1 + k d )
t
kd
After tax cost of debt = 10.92%(1 - 0.34) = 7.21% 12-11A. a. 1. Price (Pd) = =
10 t =1
$100 (1 + 0.09) t
$1,000 (1 + 0.09)10
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62
t =1
$100 (1 + k d )
t
There is a very slight decrease in the cost of debt because the flotation costs associated with the higher coupon bond are higher ($138.65 in flotation costs for the 14 percent coupon bond versus $111.70 for the 10 percent coupon bond).
12-12A. Source Common Stock Preferred Stock Debt Capital Structure 40% 10% 50% After-tax cost of capital 18% 10% 8% x (1-.35) kwacc = Weighted cost 7.2% 1.0% 2.6% 10.8%
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t =1
15
D1 NP + g cs $2.25 + .05 $30(1 0.05) .129 = 12.9% Capital Structure 60% 40% After-tax cost of capital 4.48% 12.9% kwacc = Weighted cost 2.69% 5.16% 7.85%
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t =1
10
kd After tax cost of debt Cost of preferred stock (kps) kps = = = Cost of common stock, kncs kncs =
$88.84 0.06 + (0.01) = .069 = 6.9% $96.84 6.9 %(1 - 0.30) = 4.8%
.091 = 9.1%
D1 NP + g cs $3(1 + .10) + .10 $55 $5 .166 = 16.6% Weight .33 .17 .50 1.00 65 After-tax cost of capital 4.8% 9.1% 16.6% kwacc = Weighted Cost 1.6% 1.5% 8.3% 11.4%
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= NPd
t
t =1
$80 (1 + k d )
kd
Cost of Internal Common Equity: kcs = D1 + g Pcs $2.50(1 + 0.06) + 0.06 $35 .1357 = 13.57%
= =
Weighted Cost of Capital (kwacc) is calculated as follows: Bonds Preferred Stock Common Stock Weights .38 .15 .47 1.00 67 Costs 6.28% 8.83% 13.57% Weighted Costs 2.39% 1.32% 6.38% kwacc = 10.09%
= = = = = = = = =
the cost of preferred stock. the cost of internally generated common funds the cost of new common stock. the growth rate. the before-tax cost of debt. the marginal tax rate. dollar dividend per share, where Do is the most recently paid dividend and D1 is the forthcoming dividend. the value (present value) of a security. the value of a security less any flotation costs incurred in issuing the security
t =1
$120 (1 + k d ) Value
kd
$1.18 .11 + .01 = .1102 = 11.02% $58.68 = = kd(1 - T) 11.02%(1 - .34) = 7.27%
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= = c. kcs =
= = d. kps =
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$1,125(.90) $1,012.50
t =1
20
$1,000 $130 20 + (1 + k d ) (1 + k d ) t Value $1,074.97 1,012.50 $ 62.47 Value $1,074.97 1,000.00 $ 74.97
For:
= = = D NPps
.1283 = 12.83%
8.47%
= =
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kncs 12-4B.
$845.50 = the net price (value less flotation costs). $80 (1 + k d ) Value $847.48 845.50 $1.98
t
For:
kd
12-6B.
NPd $950
= =
$I t (1 + k d ) $130 (1 + k d ) t
t
t =1 15
+ +
$M (1 + k d ) n $1,000 (1 + k d )15
t =1
Since the net price on the bonds, $950, is less than the $1,000 par value, the beforetax cost of the debt must be greater than the 13 percent coupon interest rate ($130 $1,000). Rate 13% kd% 14% Value $1,000.00 950.00 $ 50.00 kd = Value $1,000.00 938.46 $ 61.54
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Cost of preferred stock (kps) = = = D Dividend = NPps Net Price 13% x$100 $13 = $97 $97 13.40% D1 + g Pcs $0.80(1 + 0.16) + 0.16 $22.50
12-8B.
kcs
= =
= .2012 = 20.12% 12-9B. If the firm pays out 50 percent of its earnings in dividends, its recent earnings must have been $9 ($4.50 dividend divided by .5). Thus, earnings increased from $5 to $9 in five years. Using Appendix C and looking for a table value of .556 ($5/$9), the annual growth rate is approximately twelve percent. a. Cost of internal common stock (kcs): kcs = = = = b. D1 P + g cs $4.50(1 + .12) + .12 $60 $5.04 + .12 $60 .204 = 20.4%
Cost of external common (new common) stock, kncs kncs = D1 NP + g cs $5.04 + .12 $60(1 0.09)
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$1,000 (1 + 0.10)10
$150(6.145) + $1000(.386) $1,307.75 $1,307.75(1 - 0.115) $1,157.36 = = $600,000 $1,157.36 518.4 519 bonds
d.
Cost of debt: $1,157.36 Rate For 12% kd% 13% $ 12.14 kd = = 10 $150 $1,000 t + t = 1 (1 + k d ) (1 + k d )10 Value $1,169.50 1,157.36 1,108.90 $ 60.60 Value $1,169.50
Price (Pd)
= =
t=
10
$100 (1 + 0.10) t
$1,000 (1 + 0.10)10
$100 (1 + k d ) t
For:
kd
b,There is a very slight decrease in the cost of debt because the flotation costs associated with the higher coupon bond are higher (flotation costs are $150.39 for the 15 percent coupon bond versus $115 for the 10 percent coupon bond) 12-12B. Bias Corporation - Weighted Cost of Capital Capital Structure $1,100 250 3,700 $5,050 Weights 0.2178 0.0495 0.7327 1.0000 Individual Costs 6.0% 13.5% 19.0% Weighted Costs 1.31% 0.67% 13.92% 15.90%
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t =1
semi-annual kd annual kd After tax cost of debt Cost of common stock, kncs kncs =
= = =
$151.6 0.03 + (0.01) = .0365 = 3.65% $231.60 3.65% x 2 = 7.3% 7.3%(1 - 0.34) = 4.8%
D1 NP + g cs $2.00 + .08 $80(1 0.10) .108 = 10.8% Capital Structure 60% 40% After-tax cost of capital 10.8% 4.8% kwacc = Weighted cost 6.48% 1.92% 8.4%
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t =1
For:
kd
After tax cost of debt = 10.4 % x (1 - 0.34) = 6.07% Cost of preferred stock (kps) kps = = = Cost of common stock, kncs kncs = D1 NP + g cs $2(1 + .08) + .08 $50(1 .10) .128 = 12.8% Weight .50 .10 .40 1.00 77 After-tax cost of capital Weighted Cost 6.07% 3.04% 8.3% 12.8% kwacc = .83% 5.12% 8.99% D Dividend = NPps Net Price $2.50 $2.50 = $35 $5 $30 .083 = 8.3%
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