chapter 9 - the cost of capital

Cost of Capital

• Represents the firm’s cost of financing and is the minimum rate of return that a project must earn to increase the firm’s value

Basic Concept

Capital

• A firm’s long-term sources of financing, which include both debt and equity

Capital Structure

• The mix of debt and equity financing that a firm employs

Weighted Average Cost of Capital (WACC)

• A weighted average of a firm’s cost of debt and equity financing, where the weights reflect the percentage of each type of financing used by the firm

Sources of Long-Term Capital

• Long-term capital for firms derives from four basic sources: long-term debt, preferred stock, common stock, and retained earnings

• Not every firm will use all of these financing sources

Cost of Long-Term Debt

• The financing cost associated with new funds raised through long-term borrowing

Net Proceeds

Net Proceeds

• The funds actually received by the firm from the sale of a security

Floatation Costs

• The total costs of issuing and selling a security

Before-Tax Cost of Debt

• The before-tax cost of debt is the rate of return the firm must pay on new borrowing

• Using Market Quotations

  • A relatively quick method for finding the before-tax cost of debt is to observe the yield to maturity (YTM) on the firm’s existing bonds or bonds of similar risk issued by other companies

• Calculating the Cost

  • Managers can calculate the cost of debt associated with a particular bond issue by calculating the bond’s YTM

After-Tax Cost of Debt

• The interest payments paid to bondholders are tax deductible for the firm, so the interest expense on debt reduces the firm’s taxable income

Cost of Preferred Stock

Preferred Stock Dividends

• When companies issue preferred shares, the shares usually pay a fixed dividend and have fixed par value

Finding the Cost of Common Stock Equity

Cost of Common Stock Equity

• The costs associated with using common stock equity financing

• The cost of common stock equity is equal to the required return on the firm’s common stock in the absence of flotation costs

• The cost of common stock equity is the same as the cost of retained earnings, but the cost of issuing new common equity is higher

Comparing the Constant-Growth and CAPM Techniques

• The CAPM technique differs from the constant-growth valuation model in that it directly considers the firm’s risk, as reflected by beta, in determining the required return on common stock equity

• The constant-growth model doesn’t look at risk directly; it uses an indirect approach to infer what return shareholders expect based upon the price they are willing to pay for the stock today, given estimates of the firm’s future dividends

Cost of Required Earnings

• The cost of retained earnings is equal to the required return on a firm’s common stock

Capital Structure Weights

Market Value Weights

• Weights that use market values to measure the proportion of each type of capital in the firm’s financial structure

• In calculating a firm’s WACC, market value weights should be used rather than book or par values

Target Capital Structure

• The mix of debt and equity financing that a firm desires over the long term

• The target capital structure should reflect the optimal mix of debt and equity for a particular firm