Chapter 11 The Cost of Capital Learning Objectives 1. Understand the different kinds of financing available to a company: debt financing, equity financing, and hybrid equity financing. 2. Understand the debt and equity components of the weighted average cost of capital (WACC) and explain the tax implications on debt financing and the adjustment to the WACC. 3. Calculate the weights of the components using book values or market values. 4. Explain how the WACC is used in capital budgeting models 5. Determine the beta of a project and its implications in capital budgeting problems. 6. Select optimal project combinations for a companys portfolio of acceptable potential projects.

11-2 2013 Pearson Education, Inc. All rights reserved. 11.1 The Cost of Capital: A Starting Point 3 broad sources of financing available or raising capital: debt, common stock (equity), and preferred stock (hybrid equity). Each has its own risk and return profile and therefore its own rate of return required by investors to provide funds to the firm. Figure 11.1 Component sources of capital. 11-3 2013 Pearson Education, Inc. All rights reserved.

11.1 The Cost of Capital: A Starting Point The weighted average cost of capital (WACC) is estimated by multiplying each component weight by the component cost and summing up the products. The WACC is essentially the minimum acceptable rate of return that the firm should earn on its investments of average risk, in order to be profitable. WACC discount rate for computing NPV IRR > WACC for acceptance of project. 11-4 2013 Pearson Education, Inc. All rights reserved. 11.1 The Cost of Capital: A Starting Point (continued) Example 1: Measuring weighted average cost of a mortgage

Jim wants to refinance his home by taking out a single mortgage and paying off all the other sub-prime and prime mortgages that he took on while the going was good. Listed below are the balances and rates owed on each of his outstanding home-equity loans and mortgages: Lender Balance First Cut-Throat Bank Rate $ 150,000 7.5% Second Considerate Bank $ 35,000 8.5% Third Pawn Mortgage Co.

$ 15,000 9.5% Below what rate would it make sense for Jim to consolidate all these loans and refinance the whole amount? 11-5 2013 Pearson Education, Inc. All rights reserved. 11.1 The Cost of Capital: A Starting Point (continued) Example 1 Answer Jims weighted average cost of borrowing = Proportion of each loan * Rate (10,000/200,000)*.075+(35,000/200,000) *.085+(15,000/200,000)*.095 (.75*.075) + (.175*.085) (+.075*.095) = .07825 or 7.825%

Jims average cost of financing his home is 7.825%. Any rate below 7.825% would be beneficial. 11-6 2013 Pearson Education, Inc. All rights reserved. 11.2 Components of the Weighted Average Cost of Capital To determine a firms WACC we need to know how to calculate: 1. the relative weights and 2. costs of the debt, preferred stock, and common stock of a firm. 11-7 2013 Pearson Education, Inc. All rights reserved.

11.2 (A) Debt Component The cost of debt (Rd) is the rate that firms have to pay when they borrow money from banks, finance companies, and other lenders. It is essentially measured by calculating the yield to maturity (YTM) on a firms outstanding bonds, as covered in Chapter 6. Although best solved for by using a financial calculator or spreadsheet, the YTM can also be figured out as follows: 11-8 2013 Pearson Education, Inc. All rights reserved. 11.2 (A) Debt Component (continued) YTM on outstanding bonds, indicates what investors require for lending the firm their

money in current market conditions. However, new debt would also require payment of transactions costs to investment bankers reducing the net proceeds to the issuer and raising the cost of debt. We must adjust the market price by the amount of commissions that would have to be paid when issuing new debt, and then calculate the YTM. 11-9 2013 Pearson Education, Inc. All rights reserved. 11.2 (A) Debt Component (continued) Example 2: Calculating the cost of debt Kelloggs wants to raise an additional $3,000,000 of debt as part of the capital that would be needed to expand their operations into the Morning Foods sector.

They were informed by their investment banking consultant that they would have to pay a commission of 3.5% of the selling price on new issues. Their CFO is in the process of estimating the corporations cost of debt for inclusion into the WACC equation. The company currently has an 8%, AA-rated, non-callable bond issue outstanding, which pays interest semi-annually, will mature in 17 years, has a $1000 face value, and is currently trading at $1075. Calculate the appropriate cost of debt for the firm. 11-10 2013 Pearson Education, Inc. All rights reserved. 11.2 (A) Debt Component (continued) Example 2 Answer First determine the net proceeds on each bond

= Selling price Commission =$1075-(.035*1075) = $1037.38 Using a financial calculator we enter: P/Y = C/Y = 2 Input 34 ? -1037.38 40 1000 Key N I/Y PV PMT FV Output 7.60% The appropriate cost of debt for Kelloggs is 7.6% 11-11 2013 Pearson Education, Inc. All rights reserved. 11.2 (B) Preferred Stock Component Preferred stock holders receive a constant dividend with no maturity point; The cost of preferred (Rp)can be estimated by dividing the annual dividend by the net

proceeds (after floatation cost) per share of preferred stock: Rp = Dp/Net price 11-12 2013 Pearson Education, Inc. All rights reserved. 11.2 (B) Preferred Stock Component (continued) Example 3: Cost of Preferred Stock Kelloggs will also be issuing new preferred stock worth $1 million. They will pay a dividend of $4 per share which has a market price of $40. The floatation cost on preferred will amount to $2 per share. What is their cost of preferred stock? Answer Net price on preferred stock = $38; Dividend on preferred = $4

Cost of preferred = Rp = $4/$38 = 10.53% 11-13 2013 Pearson Education, Inc. All rights reserved. 11.2 (C) Equity Component The cost of equity (Re) is essentially the rate of return that investors are demanding or expecting to make on money invested in a companys common stock. The cost of equity can be estimated by using either the SML approach (covered in Chapter 8) or the Dividend Growth Model (covered in Chapter 7). 11-14 2013 Pearson Education, Inc. All rights reserved.

11.2 (C) Equity Component (continued) The Security Market Line Approach: calculates the cost of equity as a function of the risk-free rate (rf) the market riskpremium [E(rm)-rf], and beta (i). That is, 11-15 2013 Pearson Education, Inc. All rights reserved. 11.2 (C) Equity Component (continued) Example 4: Calculating Cost of Equity with the SML equation Remember Kelloggs from the earlier 2 examples? Well, to reach their desired capital structure their CEO has decided to utilize all of their expected retained earnings in the coming

quarter. Kelloggs beta is estimated at 0.65 by Value Line. The risk-free rate is currently 4%, and the expected return on the market is 15%. How much should the CEO put down as one estimate of the companys cost of equity? Answer Re = rf + [E(rm)-rf]i Re=4%+[15%-4%]0.65 Re= 4%+7.15% = 11.15% 11-16 2013 Pearson Education, Inc. All rights reserved. 11.2 (C) Equity Component (continued) The Dividend Growth Approach to Re: The Gordon Model, introduced in Chapter 7, is used to calculate the price of a constant growth stock. However, with some algebraic manipulation it can be

transformed into Equation 11.6, which calculates the cost of equity, as shown below: where Div0 = last paid dividend per share; Po = Current market price per share; and g = constant growth rate of dividend. 11-17 2013 Pearson Education, Inc. All rights reserved. 11.2 (C) Equity Component (continued) For newly issued common stock, the price must be adjusted for floatation cost (commission paid to investment banker) as shown in Equation 11.7 below: where F is the floatation cost in percent.

11-18 2013 Pearson Education, Inc. All rights reserved. 11.2 (C) Equity Component (continued) Example 5: Applying the Dividend Growth Model to calculate Re Kelloggs common stock is trading at $45.57 and its dividends are expected to grow at a constant rate of 6%. The company paid a dividend last year of $2.27. If the company issues stock they will have to pay a floatation cost per share equal to 5% of selling price. Calculate Kelloggs cost of equity with and without floatation costs.

11-19 2013 Pearson Education, Inc. All rights reserved. 11.2 (C) Equity Component (continued) Example 5 Answer Cost of equity without floatation cost: Re = (Div0*(1+g)/Po) + g ($2.27*(1.06)/$45.57)+.0611.28% Cost of equity with floatation cost: Re = [$2.27*(1.06)/(45.57*(1-.05)]+.06 11.56% 11-20 2013 Pearson Education, Inc. All rights reserved. 11.2 (C) Equity Component (continued)

Depending on the availability of data, either of the two models, or both, can be used to estimate Re. With two values, the average can be used as the cost of equity. For example, in Kelloggs case we have (11.15%+11.28%)/211.22% (without floatation costs) or (11.15%+11.56%) /211.36%(with floatation costs) 11-21 2013 Pearson Education, Inc. All rights reserved. 11.2 (D) Retained Earnings Retained earnings does have a cost, i.e. the opportunity cost for the shareholders not being able to invest the money themselves. The cost of retained earnings can be calculated by

using either of the above two approaches, without including floatation cost. Also, since interest expenses are tax deductible, the cost of debt, must be adjusted for taxes, as shown below, prior to including it in the WACC calculation: After-tax cost of debt = Rd*(1-Tc) So if the YTM (with floatation cost) = 7.6%, and the companys marginal tax rate is 30%, the after-tax cost of debt7.6%*(1-3)5.32% 11-22 2013 Pearson Education, Inc. All rights reserved. 11.3 Weighting the Components: Book Value or Market Value? To calculate the WACC of a firm, each components cost is multiplied by its proportion in the capital mix and then

summed up. There are two ways to determine the proportion or weights of each capital component, using book value, or using market values. 11-23 2013 Pearson Education, Inc. All rights reserved. 11.3 (A) Book Value Book value weights can be determined by taking the balance sheet values for debt, preferred stock, and common stock, adding them up, and dividing each by the total. These weights, however, do not indicate the current proportion of each component. 11-24

2013 Pearson Education, Inc. All rights reserved. 11.3 (B) Adjusted Weighted Average Cost of Capital Equation 11.9 can be used to combine all the weights and component costs into a single average cost which can be used as the firms discount or hurdle rate: 11-25 2013 Pearson Education, Inc. All rights reserved. 11.3 (B) Adjusted Weighted Average Cost of Capital (continued) Example 6: Calculating Adjusted WACC Using the market value weights and the component costs determined earlier, calculate Kelloggs adjusted WACC.

Capital Component Weight After-tax Cost% Debt .38 7.6%*(1-.3) =5.32% Rd (1-Tc) Preferred Stock.14 10.53% Rp Common Stock .48 11.36%* Re *using average of SML and Div. Growth Model (with floatation cost) Answer WACC = .38*5.32% + .14*10.53%+.48*11.36% =2.02%+1.47%+5.45%=8.94% 11-26 2013 Pearson Education, Inc. All rights reserved. 11.3 (C) Market Value

Market value weights are determined by taking the current market prices of the firms outstanding securities and multiplying them by the number outstanding, to get the total value; and then dividing each by the total market value to get the proportion or weight of each If possible, market value weights should be used since they are a better representation of a companys current capital structure, which would be relevant for raising new capital. 11-27 2013 Pearson Education, Inc. All rights reserved. 11.3 (C) Market Value (continued) Example 7: Calculating capital component weights: Kelloggs CFO is in the process of determining the firms WACC and needs to figure out the weights of the various types of capital sources.

Accordingly, he starts by collecting information from the balance sheet and the capital markets, and makes up the Table shown below: Component Debt Preferred Stock Common Stock Balance Sheet Value $ 150,000,000 $ 45,000,000 $ 180,000,000 Number outstanding 150,000 1,500,000 4,500,000

What should he do next? 11-28 2013 Pearson Education, Inc. All rights reserved. Current Market Price $1,075 $40 $45.57 Market Value $161,250,000 $ 60,000,000 $205,065,000 11.3 (C) Market Value (continued) Example 7 Answer

1) Calculate the total book value and total market value of the capital 2) Divide each components book value and market value by their respective totals. Total Book Value = $375,000,000; Total Market Value = $426,315,000 Book Value Weights: Market Value Weights: Debt = $150m/$375m=40%; Debt = $161.25m/$426.32m=38% P/ S=$45m/$375m=12%; P/S = $60m/$426.32=14% C/S = $180m/$375m=48%; C/S= $205.07m/$426.32m=48% (Rounded to nearest whole number) He should use the market value weights as they represent a more current picture of the firms capital structure. 11-29 2013 Pearson Education, Inc. All rights reserved.

11.4 Using the Weighted Average Cost of Capital in a Budgeting Decision Once a firms WACC has been determined, it can be used either as the discount rate to calculate the NPV of the projects expected cash flow or as the hurdle rate which must be exceeded by the projects IRR. Table 11.1 presents the incremental cash flow of a $5 million project being considered by a firm whose WACC is 12%. Table 11.1 Incremental Cash Flow of a $5 Million Project 11-30 2013 Pearson Education, Inc. All rights reserved. 11.4 Using the Weighted Average Cost of Capital in a Budgeting Decision (continued)

Using a discount rate of 12%, the projects NPV would be determined as follows: Since the NPV > 0 this would be an acceptable project. Alternatively, the IRR could be determined using a financial calculator14.85% Again, since IRR>12%, this would be an acceptable project. 11-31 2013 Pearson Education, Inc. All rights reserved. 11.4 (A) Individual Weighted Average Cost of Capital for Individual Projects Using the WACC for evaluating projects assumes that the project is of average risk. If projects have varying risk levels, using the same discount rate could lead to incorrect

decisions. 11-32 2013 Pearson Education, Inc. All rights reserved. 11.4 (A) Individual Weighted Average Cost of Capital for Individual Projects Figure 11.3 Capital project decision model without considering risk. 4 projects, whose IRRs range from 8% to 11%, but the risk levels also go from lowmoderatehighvery high With a WACC of 9.5%, only Projects 3 and 4, with IRRs of 10% and 11% respectively would be accepted. However, Projects 1 and 2 could have been profitable lower risk

projects that are being rejected in favor of higher risk projects, merely because the risk levels have not been adequately adjusted for. 11-33 2013 Pearson Education, Inc. All rights reserved. 11.4 (A) Individual Weighted Average Cost of Capital for Individual Projects To adjust for risk, we would need to get individual project discount rates based on each projects beta. Using a risk-free rate of 3%; a market risk premium of 9%; a before-tax cost of 10%, a tax rate of 30%; equally-weighted debt and equity levels, and varying project betas we can compute each projects hurdle rate as follows: 11-34

2013 Pearson Education, Inc. All rights reserved. 11.4 (A) Individual Weighted Average Cost of Capital for Individual Projects Under the risk-adjusted approach, Project 1 (IRR=8%>7.7%) and Project 2 (IRR=9%>8.6%) should be accepted, while Project 3 (IRR=10%<10.4%) and Project 4 (IRR=11%<13.1%) should be rejected. Figure 11.4 Capital project decision model with risk. 11-35 2013 Pearson Education, Inc. All rights reserved.

11.5 Selecting Appropriate Betas for Projects It is important to adjust the discount rate used when evaluating projects of varying risk, based on their individual betas. However, since project betas are not easily available, it is more of an art than a science. There are two approaches generally used: 1. Pure play betas: i.e. matching the project with a company that has a similar single focus, and using that companys beta. 2. Subjective modification of the companys average beta: i.e. adjusting the beta up or down to reflect different levels of risk. 11-36 2013 Pearson Education, Inc. All rights reserved. 11.6 Constraints on Borrowing and

Selecting Projects for the Portfolio Capital constraints prevent firms from funding all potentially profitable projects that come their way. Capital rationing -- select projects based on their costs and expected profitability, within capital constraints. Rank order projects (descending order) based on NPV or IRRs along with their costs choose the combination which has the highest combined return or NPV while using up as much of the limited capital budget. 11-37 2013 Pearson Education, Inc. All rights reserved. 11.6 Constraints on Borrowing and Selecting Projects for the Portfolio (continued)

Example 8: Selecting Projects with Capital Constraints. The XYZ Companys managers are reviewing various projects that are being presented by unit managers for possible funding. They have an upper limit of $5,750,000 for this forthcoming year. The cost and NPV of each project has been estimated and is presented below. Which combination of projects would be best for them to invest in? 11-38 2013 Pearson Education, Inc. All rights reserved. 11.6 Constraints on Borrowing and Selecting Projects for the Portfolio (continued) Example 8 Answer

Project Cost NPV 1 2,000,000 500,000 2 2,250,000 400,000 3 1,750,000 300,000 4 750,000 100,000 5 500,000 50,000 1) Form combinations of projects by adding the costs to sum up as close to the $5,750,000 limit as possible. Sum up the NPVs as well. Comb Total Cost NPV

1,2,4,5 2m+2.25m+.75m+0.5m=$5.5m 1.5m 1,3,4,5 2m+1.75m+.75m+.5m=$5m 0.95m 2,3,4,5 2.25m+1.75m+.75m+.5m=$5.25m 0.85m 2) Select the combination which has the highest NPV i.e. Combination 1 including projects 1,2,4, and 5 with a total NPV of $1.5m. 11-39 2013 Pearson Education, Inc. All rights reserved. Additional Problems with Answers Problem 1 Cost of debt for a firm: You have been assigned the

task of estimating the after-tax cost of debt for a firm as part of the process in determining the firms cost of capital. After doing some checking, you find out that the firms original 20-year 9.5% coupon bonds (paid semiannually), currently have 14 years until they mature and are selling at a price of $1,100 each. You are also told that the investment bankers charge a commission of $25 per bond when new bonds are sold. If these bonds are the only debt outstanding for the firm, what is the after-tax cost of debt for this firm if the marginal tax rate for the firm is 34 percent? 11-40 2013 Pearson Education, Inc. All rights reserved. Additional Problems with Answers Problem 1 (Answer) Calculate the YTM on the currently outstanding bonds, after adjusting the price for the $25

commission. i.e. Net Proceeds = $1100-$25 $1075 Set P/Y=2 and C/Y = 2 Input 28 ? -1075 47.5 1000 Key N I/Y PVPMT FV Output 8.57% After-tax cost of debt = 8.57%(1-.34) 5.66% 11-41 2013 Pearson Education, Inc. All rights reserved. Additional Problems with Answers Problem 2 Cost of Equity for a firm: R.K. Boats Inc. is in the process of making some major investments for growth and is interested in calculating their cost of equity so as to be able to correctly estimate their

adjusted WACC. The firms common stock is currently trading for $43.25 and their annual dividend, which was paid last year, was $2.25, and should continue to grow at 6% per year. Moreover, the companys beta is 1.35, the risk-free rate is at 3%, and the market risk premium is 9%. Calculate a realistic estimate of RKBIs cost of equity. (Ignore floatation costs.) 11-42 2013 Pearson Education, Inc. All rights reserved. Additional Problems with Answers Problem 2 (Answer) Using the SML Approach: Rf =3%; Rm-Rf = 9%; = 1.35; Re=3%+(9%)*1.35 15.15% Using the Dividend Growth Model (constant growth)

P0 = $43.25; Do=$2.25; g=6%; ($2.25*(1.06)/$43.25)+.0611.51% A realistic estimate of RKBIs cost of equity = Average of the 2 estimates (15.15%+11.51%)/213.33% 11-43 2013 Pearson Education, Inc. All rights reserved. Additional Problems with Answers Problem 3 Calculating capital component weights: T.J. Enterprises is trying to determine the weights to be used in estimating their cost of capital. The firms current balance sheet and market information regarding the price and number of securities outstanding are listed below. TJ Enterprises Balance Sheet (in thousands)

Current Assets: $50,000 Current Liabilities: Long-Term Assets: $60,000 Long-Term Liabilities Bonds Payable $0 $48,000 Owners Equity Preferred Stock Common Stock Total Assets: 11-44

$110,000 2013 Pearson Education, Inc. All rights reserved. Total L & OE $15,000 $47,000 $110,000 Additional Problems with Answers Problem 3 (continued) Market Information Debt Preferred Stock Common Stock Outstanding 48,000 102,000 1,300,000

Market Price $850 $95.40 $40 Calculate the firms capital component weights using book values as well as market values. 11-45 2013 Pearson Education, Inc. All rights reserved. Additional Problems with Answers Problem 3 (Answer) Based on book values: Weight of Debt = $48,000/$110,000 43.64% Weight of P/S= $15,000/$110,000 13.64% Weight of C/S = $47,000/$110,00042.72% Based on market value:

Market value of Debt =$40,800,000 Market Value of P/S= $9,730,800 Market Value of C/S= $52,000,000 Total Market Value= $102,530,000 Weight of Debt = $40,800/$102,530 39.79% Weight of P/S= $9,730.8/$102,530 9.49% Weight of C/S = $52,000/$102,53050.72% 11-46 2013 Pearson Education, Inc. All rights reserved. Additional Problems with Answers Problem 4 Computing WACC: New Ideas Inc. currently has 30,000 of its 9% semiannual coupon bonds outstanding (Par value =1000). The bonds will mature in 15 years and are currently priced at $1,340 per bond.

The firm also has an issue of 1 million preferred shares outstanding with a market price of $11.00. The preferred shares offer an annual dividend of $1.20. New Ideas Inc. also has 2 million shares of common stock outstanding with a price of $30.00 per share. The firm is expected to pay a$3.20 common dividend one year from today, and that dividend is expected to increase by 7 percent per year forever. The firm typically pays floatation costs of 2% of the price on all newly issued securities. If the firm is subject to a 35 percent marginal tax rate, then what is the firms weighted average cost of capital? 11-47 2013 Pearson Education, Inc. All rights reserved. Additional Problems with Answers Problem 4 (Answer) 1) Determine the component costs Cost of Debt:

P=1340; F=2%; Net proceeds=P(1-F) Net proceeds = $1340*(1-.02)=$1273 Set P/Y=2 and C/Y = 2 Input 30 ? -1273 45 1000 Key N I/Y PV PMT FV Output 6.18% Before-tax Rd 6.18% 11-48 2013 Pearson Education, Inc. All rights reserved.

Additional Problems with Answers Problem 4 (Answer) (continued) Cost of preferred stock: Dp=$1.20; Pp=$11; F=2% Rp = Dp/Pp(1-F) $1.20/($11(.98)1.20/10.7811.13% Cost of common stock: Pc=$30; D1=$3.2; g=7%; F=2% Using the constant dividend growth model: Re = [D1/(P(1-F])+g[3.2/$30(.98)]+.0717.88% 11-49 2013 Pearson Education, Inc. All rights reserved. Additional Problems with Answers Problem 4 (Answer) (continued) 2) Determine the market value weights of the components:

Market value of bonds = $1340*30,000$40,200,000 Market value of P/S = $11*1,000,000 $11,000,000 Market value of C/S=$30*2,000,000 $60,000,000 Total Market value $111,200,000 Weight of debt = 40.2m/111.2m 36.15% Weight of P/S = 11m/111.2m 9.89% Weight of C/S = 60m/111.2m53.96% 11-50 2013 Pearson Education, Inc. All rights reserved. Additional Problems with Answers Problem 4 (Answer) (continued) 3) Calculate the adjusted WACC WACC = .5396*17.88% + .0989*11.13%

+.3615*6.18%*(1-.35) =9.65 +1.10%+1.45% 12.2% 11-51 2013 Pearson Education, Inc. All rights reserved. Additional Problems with Answers Problem 5 Capital Rationing: Quick Start Ventures, Incorporated is has received 6 excellent funding proposals, but is only able to fund up to $2,500,000 Project A: Cost $700,000, NPV $50,000 Project B: Cost $800,000, NPV $60,000 Project C: Cost $500,000, NPV $40,000 Project D: Cost $600,000, NPV $50,000 Project E: Cost $700,000, NPV $60,000 Project F: Cost $300,000, NPV $30,000

Which projects should Quick Start select? 11-52 2013 Pearson Education, Inc. All rights reserved. Additional Problems with Answers Problem 5 (Answer) 1) Compute the Profitability Index of the projects and rank order from highest to lowest PI: PI = (NPV + Cost)/Cost Project F E D C B A

11-53 Cost 300,000 700,000 600,000 500,000 800,000 700,000 2013 Pearson Education, Inc. All rights reserved. NPV 30,000 60,000 50,000 40,000 60,000 50,000

PI 1.10 1.09 1.08 1.08 1.08 1.07 Additional Problems with Answers Problem 5 (Answer) (continued) 2) Form combinations of projects going from highest to lowest PI until $2,500,000 is used up: Combinations F,E,D,B F, E, C,B E,D,C,A

F,E,B,A Cost 2,400,000 2,300,000 2,500,000 2,500,000 NPV 200,000 200,000 150,000 200,000 PI 1.0833 1.0870 1.0600 1.0800

Pick the combination which has the highest PI Projects F, E, C. and B. Together they cost $2,300,000 and will have an NPV of $200,000 with a PI of 1.087. 11-54 2013 Pearson Education, Inc. All rights reserved. Figure 11.2 11-55 2013 Pearson Education, Inc. All rights reserved. TABLE 11.2 Decision on Projects with and without Risk 11-56

2013 Pearson Education, Inc. All rights reserved.