Chapter 5, Cost of Capital PDF

Chapter Five Cost of capital By Lencho M. By Lencho M.(Msc)  5.1 Meaning of the Cost of capital  The cost of capital is the minimum rate of return that a firm must earn on its investments to compensate its investors for the use of their capital.  The cost of capital is t...

Chapter Five Cost of capital By Lencho M. By Lencho M.(Msc)  5.1 Meaning of the Cost of capital  The cost of capital is the minimum rate of return that a firm must earn on its investments to compensate its investors for the use of their capital.  The cost of capital is the rate of return that the enterprise must pay to satisfy the providers of funds.  If a firm’s actual rate of return exceeds its cost of capital, the value of the firm would increase.  If on the other hand, the cost of capital is not earned, the firm’s market value will decrease.  A company's investment decisions for new projects should always generate a return that exceeds the firm's cost of the capital used to finance the project. Otherwise, the project will not generate a return for investors. By Lencho M.(Msc) Component of Cost of Capital  Capital component is one of type of capital used by firms to raise money.  Are source of funding that comes from investor  Each type of capital contained the capital structure of a firm include: 1. Debt 2. Preferred stock 3. Common stock 4. Retained earnings By Lencho M.(Msc)  But Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors  Cost of capital relates to cost of new funds needed to finance the project, not the cost of funds raised in the past.  Generally the cost of capital should include the specific cost of each source of financing today not the historically based cost reflected by the existing financing on the firm's books. By Lencho M.(Msc)  A. Cost of debt  This is the minimum rate of return required by suppliers of debt.  Cost of debt is the after-tax cost today of raising long-term funds through borrowing.  Generally, debt is the cheapest source of finance to a firm  debt suppliers, generally, assume the lowest risk among all suppliers of capital. Since they assume the smallest risk, their return is the lowest.  debt suppliers receive interest payments before preferred and common dividends are paid.  Since interest is tax-deductible, the pretax rate should be adjusted. By Lencho M.(Msc)  The explicit cost of debt tends to be the least expensive of the other forms of financing sources for two reasons:  Bond holders have greater security than preferred or common stockholders  Interest is tax deductible  After-tax cost of debt (Ki) = interest rate - tax savings After-tax cost of debt = Kd(1-T) Wher: T=tax rate Kd = the before tax cost of debt, the interest rate net of floatation costs. By Lencho M.(Msc) Computing the cost of new bond issue involves three steps: i) Determine the net proceeds from the sale of each bond NPd = Pd – f Where: NPd = The net proceeds from the sale of each bond Pd = The market price of the bond f = Flotation costs, are the total cost of issuing and selling security ii) Compute the effective before tax cost of the bond using the following approximation formula: Pn − NPd I+ n Pn + NPd 2 Where: Kd = The effective before tax cost of debt I = Annual interest payment Pn = The par value of the bond iii) Compute the after-tax cost of debt Kdt = Kd (1 – t) Where: Kdt = the after-tax cost of debt and t = the marginal tax rate By Lencho M.(Msc) Example 1: Currently, Abyssinia Industrial Group is planning to sell 15-year, Br. 1,000 par-value bonds that carry a 12% annual coupon interest rate. As a result of lower current interest rates, Abyssinia bonds can be sold for Br. 1,010 each. Flotation costs of Br. 30 per bond will be incurred in the process of issuing the bonds. The firm’s marginal tax rate is 40%. Required: Calculate the after tax cost of Abyssinia’s new bond issue: Given: Pn = Br. 1,000; I = Br. 120 (Br. 1,000 x 12%); n = 15; Pd = Br. 1,010; f = Br. 30; t = 40%; Kdt =? Then apply the three steps: i) NPd = pd – f = Br. 1,010 – Br. 30 = Br. 980 Br.1,000 − Br.980 Br.120 + 15 = 12.26% ii) Kd = Br.1,000 + Br.980 2 iii) Kdt = 12.26% (1 – 40%) = 7.36% Therefore, the after – tax cost of Abyssinia’s new bond issue is 7.36%. That is, Abyssinia should be able to earn a minimum of 7.36% to satisfy bondholders. By Lencho M.(Msc) Example 2: Duchess Company is contemplating selling $10 million worth of 20 year, 9% annal coupon bonds, each with a par value of $ 1000. Since similar-risk bonds earn returns greater than 9%, the firm must sell the bonds for $980 to compensate for the lower coupon interest rate. Flotation costs paid to the investment banker are 2% of the par value of the bond (2% x 1000), or $20 tax rate is 40%. Required: compute the after tax cost of the bond. Given: I= 9% x 1000 = 90, n=20, T=40% i). Npd=980-20=960 90 + 1000-960 ii). Kd = 20 = 92 = 9.4% 1000+960 980 2 iii). After tax cost of debt= Kdt= 9.4% (1-0.4) = 5.6% By Lencho M.(Msc) B. Cost of preferred stock (Kp)  It a today's cost of using preferred stock to raise funds.  Tax adjustment is unnecessary Firms often pay dividend on preferred stock because if they fail to do so: a) they can not pay dividends on their common stock b) they will find it difficult to raise additional funds in the capital markets, and c) in some cases, preferred stockholders have the right to assume control of the firm. The cost of a new preferred stock issue can be computed by following two steps: i) Determine the net proceeds from the sale of each preferred stock. NPpf = Ppf – f ii) Kps = Dps NPpf Where: Dps= annual preferred dividend per share NPpf = net proceeds from the sale of the Ppf = Market price of the preferred stock By Lencho M.(Msc) Example 1  Duches Company is contemplating issuance of a l0% preferred stock that is expected to sell for its $87 per share par vale. The cost of issuing and selling the stock is expected to be $5 per share. What is he cost of the preferred stock? Dp= 10% x 87=8.7, f = 5 NPpf = Ppf – f = 87-5 = 82 Kps =8.7=10.8% 82  Compared with the 5.6% cost of debt, calculated above the cost of preferred stock is higher. This occurs because the dividends on preferred stock are not tax-deductible. By Lencho M.(Msc) Example 2: Sefa Computer Systems Company has just issued preferred stock. The stock has 12% annual dividend and Br. 100 par value and was sold at 102% of the par value. In addition, flotation costs of Br. 2.50 per share must be paid. Calculate the cost of the preferred stock. Solution:  Given: Pps = Br. 102 (Br. 100 x 102%); Dps = Br. 12 (Br 100 x 12%); f = Br. 2.50; Kps =? Then apply the two steps: i) NPpf = Br. 102 – Br. 2.50 = Br. 99.50 ii) Kps = Br. 12 =12.06% Br. 99.50  Therefore, Sefa Company should be able to earn a minimum of 12.06% on any investment financed by the new preferred stock issue. Otherwise, the firm’s value will decrease. By Lencho M.(Msc)  3. The cost of common stock ❑ The cost of common stock is the minimum rate of return that a firm must earn for its common stockholders in order to maintain the value of the firm.  Generally, common stock dividends are paid after interest and preferred dividends are paid.  As a result, common stock investors assume the maximum risk in corporate investment.  They compensate the maximum risk by requiring the highest return.  This highest return expected by common stockholders make common stock the most expensive source of capital. By Lencho M.(Msc) ❑ The cost of common stock can be computed using the constant growth valuation model. Ks = D1 + g Npo Where: Ks = the cost of new common stock issue D1 = the expected dividend payment at the end of the next year NPo = Net proceeds from the sale of each common stock g = the expected annual dividends growth rate  The net proceeds from the sale of each common stock (NPo) is computed as follows: NPo = Po – f Where: Po = the current market price of the common stock f = flotation costs By Lencho M.(Msc) Example: An issue of common stock is sold to investors for Br. 20 per share. The issuing corporation incurs a selling expense of Br. 1 per share. The current dividend is Br. 1.50 per share and it is expected to grow at 6% annual rate. Compute the specific cost of this common stock issue. Solution Given: Po = Br. 20; Do = Br. 1.50; g = 6%; f = Br. 1; Ks =? Then apply the two steps: i) NPo = Br. 20 – Br. 1 = Br. 19 ii) Ks = D1 + g = Br. 1.50 (1.06) + 0.06 = 14.37% Npo Br. 19 Therefore, the firm should be able to earn a minimum return of 14.37% on investments that are financed by the new common stock issue. D1 = Do (1+g), where Do is the most recent dividend. Similarly D2 = D1 (1+g) and so on. D1= the expected dividend at the end of next year. By Lencho M.(Msc) Cost of Retained Earnings  The firm should retain earnings only if it can earn at least as much as its stockholders could earn on alternative investments of equivalent risk.  This rate of return stockholders expect to earn on other investments of equivalent risk is the required rate return on common stock.  Estimating the cost of common equity is more difficult than estimating the cost of debt or preferred stock because there is no stated interest or dividend rate.  Since common stock dividends are paid from after-tax income, no tax adjustment is required By Lencho M.(Msc) Computing the cost of retained earnings involves just a single procedure of applying the following formula: Kr = D1 + g Po Where: Kr = the cost of retained earnings D1 = the expected dividends payment at the end of next year Po = the current market price of the firm’s common stock g = the expected annual dividend growth rate. By Lencho M.(Msc) Example: Zeila Auto Spare Parts Manufacturing Company expects to pay a common stock dividend of Br. 2.50 per share during the next 12 months. The firm’s current common stock price is Br. 50 per share and the expected dividend growth rate is 7%. A flotation cost of Br. 3 is involved to sale a share of common stock. Required: Compute the cost of retained earnings Solution Given: Po = Br. 50; D1 = Br. 2.50; g = 7%; Kr =? Then apply the formula: Kr = D1+ g = Br. 2.50 + 7% = 12% Po Br. 50 By Lencho M.(Msc) WEIGHTED AVERAGE COST OF CAPITAL  WACC is the weighted average of the individual costs of debt, preferred stock and common equity (common stock, and retained earnings)  It is also called the composite cost of capital.  The WACC is the weighted average cost of each new dollar of capital raised.  This reflects, on the average, the firm's cost of long- term financing WACC = (Wd x Kdt) + (Wps x Kps) + (Wce x Ks) Where: Wd= proportion of debt in capital structure Wps= proportion of preferred stock Wce; proportion of common stock equity (both common stock and retained earnings By Lencho M.(Msc)  Weights of the individual capital sources can be calculated based on their book value or market value.  Example.  Muna Tools Manufacturing Company’s financial manager wants to compute the firm’s weighted average cost of capital. The book and market values of the amounts as well as specific after-tax costs are shown in the following table for each source of capital. Source of capital Book value Market value Specific cost Debt Br. 1,050,000 Br. 1,000,000 5.3% Preferred stock 84,000 125,000 12.0 Common equity 966,000 1,375,000 16.0 Total Br. 2,100,000 Br. 2,500,000 Required: Calculate the firm’s weighted average cost of capital using: 1) book value weights 2) market value weights By Lencho M.(Msc) Solution: 1) Total book value = Br. 2,100,000 Wd = Br. 1,050,000 = 0.5; Wps = Br. 84,000__ = 0.04; Wce = Br. 966,000 = 0.46 Br. 2,100,000 Br. 2,100,000 Br. 2,100,000 WACC = WdKdt + WpsKps + WceKs = 0.5 (5.3%) + 0.04 (12.0%) + 0.46 (16.0%) = 2.65% + 0.48% + 7.36% = 10.49% The minimum rate of return on all projects should be 10.49%. Meaning, Muna should accept all projects so long as they earn a return greater than or equal to 10.49% 2) Total Market value = Br. 2,500,000 Wd = Br. 1,000,000 = 0.4; Wps = Br. 125,000 = 0.05; Wce = Br. 1,375,000 = 0.55 Br. 2,500,000 Br. 2,500,000 Br. 2,500,000 WACC = 0.4 (5.3%) + 0.05 (12.0%) + 0.55 (16.0%) = 2.12% + 0.60% + 8.80% = 11.52% If the market value weights are used, Muna should accept all projects with a minimum rate of return of 11.52% By Lencho M.(Msc)  The End of Chapter 5 Thank You!!! By Lencho M.(Msc)