,CHAPTER 10 The Cost of Capital,Cost of capital components Accounting for flotation costs WACC Adjusting cost of capital for risk Estimating project risk,What types of capital do firms use?,Debt Preferred stock Common equity: Retained earnings New common stock,Should we focus on before-tax or after-tax capital costs?,Should we focus on historical (embedded) costs or new (marginal) costs?,A 15-year, 12% semiannual bond sells for $1,153.72. Whats kd?,60,60 + 1,000,60,0,1,2,30,i = ?,30 -1153.72 60 1000 5.0% x 2 = kd = 10%,-1,153.72,.,INPUTS,OUTPUT,Component Cost of Debt,Interest is tax deductible, so kd AT = kd BT(1 T) = 10%(1 0.40) = 6%. Use nominal rate. Flotation costs small. Ignore.,Whats the cost of preferred stock? Pp = $111.10; 10%Q; Par = $100.,Use this formula:,Picture of Preferred Stock,2.50,2.50,0,1,2,kp = ?,-111.1,.,2.50,$111.10 = = . kPer = = 2.25%; kp(Nom) = 2.25%(4) = 9%.,DQ kPer,$2.50 kPer,$2.50 $111.10,Note:,Preferred dividends are not tax deductible, so no tax adjustment. Just kp. Nominal kp is used. Our calculation ignores flotation costs.,Is preferred stock more or less risky to investors than debt?,More risky; company not required to pay preferred dividend. However, firms try to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, (3) preferred stockholders may gain control of firm.,Why is yield on preferred lower than kd?,Corporations own most preferred stock, because 70% of preferred dividends are nontaxable to corporations. Therefore, preferred often has a lower B-T yield than the B-T yield on debt. The A-T yield to an investor, and the A-T cost to the issuer, are higher on preferred than on debt. Consistent with higher risk of preferred.,Example:,kp = 9% kd = 10% T = 40%,kp, AT = kp kp (1 0.7)(T),= 9% 9%(0.3)(0.4) = 7.92%.,kd, AT = 10% 10%(0.4) = 6.00%.,A-T Risk Premium on Preferred = 1.92%.,Why is there a cost for retained earnings?,Earnings can be reinvested or paid out as dividends. Investors could buy other securities, earn a return. Thus, there is an opportunity cost if earnings are retained.,Opportunity cost: The return stockholders could earn on alternative investments of equal risk. They could buy similar stocks and earn ks, or company could repurchase its own stock and earn ks. So, ks is the cost of retained earnings.,Three ways to determine cost of common equity, ks:,1. CAPM: ks = kRF + (kM kRF)b. 2. DCF: ks = D1/P0 + g. 3. Own-Bond-Yield-Plus-Risk Premium: ks = kd + RP.,Whats the cost of common equity based on the CAPM? kRF = 7%, RPM = 6%, b = 1.2.,ks = kRF + (kM kRF )b.,= 7.0% + (6.0%)1.2 = 14.2%.,Whats the DCF cost of common equity, ks? Given: D0 = $4.19; P0 = $50; g = 5%.,D1 P0,D0(1 + g) P0,$4.19(1.05) $50,ks = + g = + g = + 0.05 = 0.088 + 0.05 = 13.8%.,Suppose the company has been earning 15% on equity (ROE = 15%) and retaining 35% (dividend payout = 65%), and this situation is expected to continue. Whats the expected future g?,Retention growth rate: g = (1 Payout)(ROE) = 0.35(15%) = 5.25%. Here (1 Payout) = Fraction retained. Close to g = 5% given earlier. Think of bank account paying 10% with payout = 100%, payout = 0%, and payout = 50%. Whats g?,Could DCF methodology be applied if g is not constant?,YES, nonconstant g stocks are expected to have constant g at some point, generally in 5 to 10 years. But calculations get complicated.,Find ks using the own-bond-yield-plus-risk-premium method. (kd = 10%, RP = 4%.),This RP CAPM RP. Produces ballpark estimate of ks. Useful check.,ks = kd + RP = 10.0% + 4.0% = 14.0%,Whats a reasonable final estimate of ks?,Method Estimate CAPM 14.2% DCF 13.8% kd + RP 14.0% Average 14.0%,1. When a company issues new common stock they also have to pay flotation costs to the underwriter. 2. Issuing new common stock may send a negative signal to the capital markets, which may depress stock price.,Why is the cost of retained earnings cheaper than the cost of issuing new common stock?,Two approaches that can be used to account for flotation costs:,Include the flotation costs as part of the projects up-front cost. This reduces the projects estimated return. Adjust the cost of capital to include flotation costs. This is most commonly done by incorporating flotation costs in the DCF model.,New common, F = 15%:,Comments about flotation costs:,Flotation costs depend on the risk of the firm and the type of capital being raised. The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small. We will frequently ignore flotation costs when calculating the WACC.,Whats the firms WACC (ignoring flotation costs)?,WACC = wdkd(1 T) + wpkp + wcks = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1%.,What factors influe