Financial Management 2-uum
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- Pages: 48
Ch. 12
Cost of Capital
2002, Prentice Hall, Inc.
Where we’ve been... • Basic Skills: (Time value of money, Financial Statements) • Investments: (Stocks, Bonds, Risk and Return) • Corporate Finance: (The Investment Decision - Capital Budgeting)
Assets Current assets Fixed assets
Liabilities & Equity Current Liabilities Long-term debt Preferred Stock Common Equity
The investment decision
Assets Current assets Fixed assets
Liabilities & Equity Current Liabilities Long-term debt Preferred Stock Common Equity
Where we’re going... • Corporate Finance: (The Financing Decision) Cost of capital Leverage Capital Structure Dividends
Assets Current assets Fixed assets
Liabilities & Equity Current Liabilities Long-term debt Preferred Stock Common Equity
The financing decision
Assets Current assets Fixed assets
Liabilities & Equity Current Liabilities Long-term debt Preferred Stock Common Equity
Assets Current assets
Liabilities & Equity Current Liabilities
Long-term debt Preferred Stock Common Equity
Assets Current assets
}
Long-term debt
Liabilities & Equity Current Liabilities
Capital Structure
Preferred Stock Common Equity
Ch. 12 - Cost of Capital • For Investors, the rate of return on a security is a benefit of investing. • Create an opportunity to invest more in company • For Financial Managers, that same rate of return is a cost of raising funds that are needed to operate the firm. • In other words, the cost of raising funds is the firm’s cost of capital.
Cost of Capital vs Required Rate of Return • The cost is different because of : • 1) Flotation Cost - transaction cost of issuing a new shares. - firms need to invest in order to produced high required rate of return compare than investors needs. 2) Taxes - interest expense on borrowing is tax deductible. - cost of debt is less than required rate of return
How can the firm raise capital? • • • •
Bonds Preferred Stock Common Stock Each of these offers a rate of return to investors. • This return is a cost to the firm. • “Cost of capital” actually refers to the weighted cost of capital - a weighted average cost of financing sources.
Cost of Debt
Cost of Debt For the issuing firm, the cost of debt is: • the rate of return required by investors, • adjusted for flotation costs (any costs associated with issuing new bonds), and • adjusted for taxes.
Example: Tax effects of financing with debt EBIT - interest expense EBT - taxes (34%) EAT
with stock 400,000 0 400,000 (136,000) 264,000
with debt 400,000 (50,000) 350,000 (119,000) 231,000
Example: Tax effects of financing with debt EBIT - interest expense EBT - taxes (34%) EAT
with stock 400,000 0 400,000 (136,000) 264,000
with debt 400,000 (50,000) 350,000 (119,000) 231,000
• Now, suppose the firm pays $50,000 in dividends to the stockholders.
Example: Tax effects of financing with debt with stock with debt EBIT 400,000 400,000 - interest expense 0 (50,000) EBT 400,000 350,000 - taxes (34%) (136,000) (119,000) EAT 264,000 231,000 - dividends (50,000) 0 Retained earnings 214,000 231,000
After-tax % cost of Debt
=
Before-tax % cost of Debt
x
1
Marginal - tax rate
After-tax % cost of Debt
Kd
=
Before-tax % cost of Debt
=
x
1
Marginal - tax rate
kd (1 - T)
After-tax % cost of Debt
=
Before-tax % cost of Debt
Kd .066
= =
x
1
Marginal - tax rate
kd (1 - T) .10 (1 - .34)
Example: Cost of Debt • Prescott Corporation issues a $1,000 par, 20 year bond paying the market rate of 10%. Coupons are semiannual. The bond will sell for par since it pays the market rate, but flotation costs amount to $50 per bond. • What is the pre-tax and after-tax cost of debt for Prescott Corporation?
• Pre-tax cost of debt: (using TVM) P/Y = 2 N = 40 PMT = -50 FV = -1000 PV = 950 solve: I = 10.61% = kd • After-tax cost of debt: Kd = kd (1 - T) Kd = .1061 (1 - .34) Kd = .07 = 7%
• Pre-tax cost of debt: (using TVM) P/Y = 2 N = 40 PMT = -50 FV = -1000 So, a 10% bond PV = 950 costs the firm solve: I = 10.61% = kd only 7% (with • After-tax cost of debt: flotation costs) Kd = kd (1 - T) since the interest Kd = .1061 (1 - .34) is tax deductible. Kd = .07 = 7%
Cost of Preferred Stock • Finding the cost of preferred stock is similar to finding the rate of return, (from Chapter 8) except that we have to consider the flotation costs associated with issuing preferred stock.
Cost of Preferred Stock • Recall:
Cost of Preferred Stock • Recall: kp =
D Po
=
Dividend Price
Cost of Preferred Stock • Recall: kp =
D Po
=
Dividend Price
• From the firm’s point of view:
Cost of Preferred Stock • Recall: kp =
D Po
=
Dividend Price
• From the firm’s point of view: kp =
D NPo
=
Dividend Net Price
Cost of Preferred Stock • Recall: kp =
D Po
=
Dividend Price
• From the firm’s point of view: kp =
D NPo
=
NPo = price - flotation costs!
Dividend Net Price
Example: Cost of Preferred • If Prescott Corporation issues preferred stock, it will pay a dividend of $8 per year and should be valued at $75 per share. If flotation costs amount to $1 per share, what is the cost of preferred stock for Prescott?
Cost of Preferred Stock
Cost of Preferred Stock D kp = NPo
Dividend =Net Price
Cost of Preferred Stock D kp = NPo
=
8.00 74.00
=
=
Dividend Net Price
Cost of Preferred Stock D kp = NPo
=
8.00 74.00
=
Dividend Net Price
=
10.81%
Cost of Common Stock • There are 2 sources of Common Equity: 1) Internal common equity (retained earnings), and 2) External common equity (new common stock issue) Do these 2 sources have the same cost?
Cost of Internal Equity • Since the stockholders own the firm’s retained earnings, the cost is simply the stockholders’ required rate of return. • Why? • If managers are investing stockholders’ funds, stockholders will expect to earn an acceptable rate of return.
Cost of Internal Equity
Cost of Internal Equity 1) Dividend Growth Model
Cost of Internal Equity 1) Dividend Growth Model kc =
D1 +g Po
Cost of Internal Equity 1) Dividend Growth Model kc =
D1 +g Po
2) Capital Asset Pricing Model (CAPM)
Cost of Internal Equity 1) Dividend Growth Model kc =
D1 +g Po
2) Capital Asset Pricing Model (CAPM)
kj = krf +
β (k - k ) j
m
rf
Cost of External Equity
Cost of External Equity Dividend Growth Model
Cost of External Equity Dividend Growth Model
D1 knc = NPo + g
Cost of External Equity Dividend Growth Model
D1 knc = NPo + g Net proceeds to the firm after flotation costs!
Weighted Cost of Capital • The weighted cost of capital is just the weighted average cost of all of the financing sources.
Weighted Cost of Capital
Source debt preferred common
Cost 6% 10% 16%
Capital Structure 20% 10% 70%
Weighted Cost of Capital (20% debt, 10% preferred, 70% common)
• Weighted cost of capital = .20 (6%) + .10 (10%) + .70 (16%) = 13.4%
Cost of Capital
2002, Prentice Hall, Inc.
Where we’ve been... • Basic Skills: (Time value of money, Financial Statements) • Investments: (Stocks, Bonds, Risk and Return) • Corporate Finance: (The Investment Decision - Capital Budgeting)
Assets Current assets Fixed assets
Liabilities & Equity Current Liabilities Long-term debt Preferred Stock Common Equity
The investment decision
Assets Current assets Fixed assets
Liabilities & Equity Current Liabilities Long-term debt Preferred Stock Common Equity
Where we’re going... • Corporate Finance: (The Financing Decision) Cost of capital Leverage Capital Structure Dividends
Assets Current assets Fixed assets
Liabilities & Equity Current Liabilities Long-term debt Preferred Stock Common Equity
The financing decision
Assets Current assets Fixed assets
Liabilities & Equity Current Liabilities Long-term debt Preferred Stock Common Equity
Assets Current assets
Liabilities & Equity Current Liabilities
Long-term debt Preferred Stock Common Equity
Assets Current assets
}
Long-term debt
Liabilities & Equity Current Liabilities
Capital Structure
Preferred Stock Common Equity
Ch. 12 - Cost of Capital • For Investors, the rate of return on a security is a benefit of investing. • Create an opportunity to invest more in company • For Financial Managers, that same rate of return is a cost of raising funds that are needed to operate the firm. • In other words, the cost of raising funds is the firm’s cost of capital.
Cost of Capital vs Required Rate of Return • The cost is different because of : • 1) Flotation Cost - transaction cost of issuing a new shares. - firms need to invest in order to produced high required rate of return compare than investors needs. 2) Taxes - interest expense on borrowing is tax deductible. - cost of debt is less than required rate of return
How can the firm raise capital? • • • •
Bonds Preferred Stock Common Stock Each of these offers a rate of return to investors. • This return is a cost to the firm. • “Cost of capital” actually refers to the weighted cost of capital - a weighted average cost of financing sources.
Cost of Debt
Cost of Debt For the issuing firm, the cost of debt is: • the rate of return required by investors, • adjusted for flotation costs (any costs associated with issuing new bonds), and • adjusted for taxes.
Example: Tax effects of financing with debt EBIT - interest expense EBT - taxes (34%) EAT
with stock 400,000 0 400,000 (136,000) 264,000
with debt 400,000 (50,000) 350,000 (119,000) 231,000
Example: Tax effects of financing with debt EBIT - interest expense EBT - taxes (34%) EAT
with stock 400,000 0 400,000 (136,000) 264,000
with debt 400,000 (50,000) 350,000 (119,000) 231,000
• Now, suppose the firm pays $50,000 in dividends to the stockholders.
Example: Tax effects of financing with debt with stock with debt EBIT 400,000 400,000 - interest expense 0 (50,000) EBT 400,000 350,000 - taxes (34%) (136,000) (119,000) EAT 264,000 231,000 - dividends (50,000) 0 Retained earnings 214,000 231,000
After-tax % cost of Debt
=
Before-tax % cost of Debt
x
1
Marginal - tax rate
After-tax % cost of Debt
Kd
=
Before-tax % cost of Debt
=
x
1
Marginal - tax rate
kd (1 - T)
After-tax % cost of Debt
=
Before-tax % cost of Debt
Kd .066
= =
x
1
Marginal - tax rate
kd (1 - T) .10 (1 - .34)
Example: Cost of Debt • Prescott Corporation issues a $1,000 par, 20 year bond paying the market rate of 10%. Coupons are semiannual. The bond will sell for par since it pays the market rate, but flotation costs amount to $50 per bond. • What is the pre-tax and after-tax cost of debt for Prescott Corporation?
• Pre-tax cost of debt: (using TVM) P/Y = 2 N = 40 PMT = -50 FV = -1000 PV = 950 solve: I = 10.61% = kd • After-tax cost of debt: Kd = kd (1 - T) Kd = .1061 (1 - .34) Kd = .07 = 7%
• Pre-tax cost of debt: (using TVM) P/Y = 2 N = 40 PMT = -50 FV = -1000 So, a 10% bond PV = 950 costs the firm solve: I = 10.61% = kd only 7% (with • After-tax cost of debt: flotation costs) Kd = kd (1 - T) since the interest Kd = .1061 (1 - .34) is tax deductible. Kd = .07 = 7%
Cost of Preferred Stock • Finding the cost of preferred stock is similar to finding the rate of return, (from Chapter 8) except that we have to consider the flotation costs associated with issuing preferred stock.
Cost of Preferred Stock • Recall:
Cost of Preferred Stock • Recall: kp =
D Po
=
Dividend Price
Cost of Preferred Stock • Recall: kp =
D Po
=
Dividend Price
• From the firm’s point of view:
Cost of Preferred Stock • Recall: kp =
D Po
=
Dividend Price
• From the firm’s point of view: kp =
D NPo
=
Dividend Net Price
Cost of Preferred Stock • Recall: kp =
D Po
=
Dividend Price
• From the firm’s point of view: kp =
D NPo
=
NPo = price - flotation costs!
Dividend Net Price
Example: Cost of Preferred • If Prescott Corporation issues preferred stock, it will pay a dividend of $8 per year and should be valued at $75 per share. If flotation costs amount to $1 per share, what is the cost of preferred stock for Prescott?
Cost of Preferred Stock
Cost of Preferred Stock D kp = NPo
Dividend =Net Price
Cost of Preferred Stock D kp = NPo
=
8.00 74.00
=
=
Dividend Net Price
Cost of Preferred Stock D kp = NPo
=
8.00 74.00
=
Dividend Net Price
=
10.81%
Cost of Common Stock • There are 2 sources of Common Equity: 1) Internal common equity (retained earnings), and 2) External common equity (new common stock issue) Do these 2 sources have the same cost?
Cost of Internal Equity • Since the stockholders own the firm’s retained earnings, the cost is simply the stockholders’ required rate of return. • Why? • If managers are investing stockholders’ funds, stockholders will expect to earn an acceptable rate of return.
Cost of Internal Equity
Cost of Internal Equity 1) Dividend Growth Model
Cost of Internal Equity 1) Dividend Growth Model kc =
D1 +g Po
Cost of Internal Equity 1) Dividend Growth Model kc =
D1 +g Po
2) Capital Asset Pricing Model (CAPM)
Cost of Internal Equity 1) Dividend Growth Model kc =
D1 +g Po
2) Capital Asset Pricing Model (CAPM)
kj = krf +
β (k - k ) j
m
rf
Cost of External Equity
Cost of External Equity Dividend Growth Model
Cost of External Equity Dividend Growth Model
D1 knc = NPo + g
Cost of External Equity Dividend Growth Model
D1 knc = NPo + g Net proceeds to the firm after flotation costs!
Weighted Cost of Capital • The weighted cost of capital is just the weighted average cost of all of the financing sources.
Weighted Cost of Capital
Source debt preferred common
Cost 6% 10% 16%
Capital Structure 20% 10% 70%
Weighted Cost of Capital (20% debt, 10% preferred, 70% common)
• Weighted cost of capital = .20 (6%) + .10 (10%) + .70 (16%) = 13.4%
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