Managerial Finance

The Cost of Capital

Dr. Said El Salmy

Money has a cost: Like anything with value, there is a price to using money. The price is the users (firm) cost and the owners (investor) return.

The use of money has to produce to the user, as a minimum, enough return to meet the cost demanded by the owner. The cost of the money to the user is the Rate of Return required by the owner. Projects ability to pay for the cost of the investment, i.e. projects ability to produce investors required minimum rate of return, is the principle criteria of project evaluation and selection in the capital budgeting process. Investors decision to invest or not, and to choose between different types of investment, depends on the expected return of each type of investment.

What is Capital Budgeting? If a firm is financed entirely with equity funds, in that case the cost of capital is the companys required return on equity. This is the easy situation, which is not always the case as firms are financed with a mixture of owned money (equity) and borrowed money (debt).

The decisions to accept or to reject projects (fixed assets) for investment are Capital Budgeting decisions.

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 Determining the cost of the capital to be invested in the project and, naturally, determining the source of the capital, is the first step in the capital budgeting process. The cost of capital is the discount (interest) rate used to discount cash flows in discounted cash flow analysis. The discounted cash flow analysis is the basic tool in capital budgeting. The firms cost of capital is the weighted average of the costs of the individual capital components in the capital mixture.

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Capital Components and their Costs: Capital components are the types of long-term sources of funds corporations utilize to finance assets acquisition and other types of capital expenditures included in the capital budget.

Capital components are: 1. Debt: a. Long-term bank loans b. Bonds 2. Equity: a. Retained earnings (internal equity) b. Common stock (external equity) c. Preferred stock What is a Stock? 1- Common Stock: A common stock represents a proportional share of ownership in a company. By owning stock, the shareholder becomes a part owner of a business. Shareholders own a part of the assets of the company and a part of the stream of cash those assets generate. As the company acquires more assets and the stream of cash it generates gets larger, the value of the company increases. This increase in the value of the company is what drives up the value of the stock of that company. Because they own a part of the company, shareholders get one vote per share of stock to elect the board of directors. 2- Preferred Stock: Preferred stocks are a hybrid between common stock and bonds. They usually have a fixed dividend and carry no voting rights. They have priority over common stocks in the case of bankruptcy and with regard to dividends. They technically have an unlimited life, but often are redeemable.
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 Most preferred stocks are cumulative, meaning that dividends will accrue even if they are suspended and not actually paid. Once the dividends are resumed, and before common dividends can be paid, preferred shareholders must be paid their accrued dividends. Preferred stocks are a more expensive form of capitalization as they pay dividends, which are paid from the after-tax profits, whereas bonds pay interest, which is paid from the before-tax income. Costs of capital components: The cost of debt, kd = Interest rate on debt before tax. The cost of debt, Kd(1-T) = Interest rate on debt after tax. The cost of preferred stock, Kps = Dividend on shares of preferred stock. The cost of equity from retained earnings (internal equity), Ks =Dividend on shares of common stock funded with retained earnings. The cost of equity from issuing new stock (external equity), Ke = Dividend on shares of common stock funded with new offerings of stock.

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The Weighted Average Cost of Capital (WACC) is the sum of the weighted average cost of each of the components in the firms capital mix. 1.The After-Tax Cost of Debt, Kd(1-T): Is the interest rate on new debt (Kd) less the tax savings from interest deduction. Example: If interest rate is10% and tax rate is 40%, then the after tax cost of debt Kd (1-T) = 10% (1- 0.40) = 6% 2. The Cost of Preferred Stock, Kps: Is the preferred stock dividend (Dps) divided by the net issuing price (Pn) for new issues of preferred stock after deducting the issuing costs (floatation costs). Kps = Dps Pn Example: - Preferred stock dividend LE10 per share. Stock selling price LE100 with LE2.50 floatation cost, then: Kps = 10 = 10.3% 97.50 3. The Cost of Retained Earnings Internal Equity, Ks: Is the rate of return on equity capital obtained from retained earnings.

By retaining the earnings in the firm (not paying them as dividends) the stockholders are deprived of earnings they could get from alternative forms of investment (the Opportunity Cost Principle). The firm should earn on its retained earnings at least as much as the shareholders could earn on alternative investments of comparable risk.

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 Approaches (methods) to estimate Ks: Determining the required return on stock from retained earnings (Ks) is difficult and has to be estimated. There are three approaches to estimate Ks, they are: a) The Capital Asset Pricing Model (CAPM) approach. b) The Bond-Yield-plus-Risk Premium approach. c) The Dividend-Yield-plus-Growth-Rate, or the Discounted Cash Flow (DCF) approach. a) The Capital Asset Pricing Model Approach: This approach is based on assessing the estimated riskiness of the investment, relative the average risk in the market.

It assumes that KS equals the rate of return of an average risk investment in the market as adjusted to a risk factor representative of the project considered for investment.

This representative risk factor is the market average risk adjusted upward or downward to reflect the projects riskiness. The CAPM approach is applied as follows: 1) Estimate a return on a risk-free investment (KRF) such as treasury bonds rate. 2) Estimate the beta coefficient (a measure of projects riskiness) for the project or the stock considered for investment. 3) Estimate (KM), being the expected rate of return on the market, or on an average stock or investment. 4) Calculate KS using the CAPM equation being: Ks = KRF + (KM KRF)bi. (Note that KM minus KRF gives the markets average risk factor).

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Example: If KRF = 8% and KM = 13% and bi = 0.7 then: Ks = 8% +(13%-8%)(0.7) = 8% + (5%)(0.7) = 8% + 3.5% = 11.5 %. If bi was 1.8 then: Ks = 8% +(13%-8%)(1.8) = 8% + (5%)(1.8) = 8% + 9% = 17%. Note that 5% is in fact the markets average risk factor. Investments (bi) adjusts this average risk up or down to produce a risk factor representative of this investment. Problems with the CAPM approach: - Possibility of understating the correct value of Ks due to inaccurate measuring of the firms true investment risk, or vice-versa. Difficulty of obtaining estimates of inputs.

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b) The Bond-Yield-plus-Risk Premium Approach. A subjective and ad hoc procedure. Calculated by adding a judgmental risk premium of 3% to 5% to the interest rate on the firms own long-term debt. Does not produce a precise cost of equity, but only an approximate one. Example: Company A is a strong company with 8% bonds while Company B is a risky company with 12% bonds. Then: Ks for Company A = 8% +4% = 12%. Ks for Company B =12% +4% = 16%. Since the 4% risk premium is arbitrary and judgmental, then the estimated value of Ks is also arbitrary and judgmental.

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c- The Dividend-Yield-plus-Growth Rate, or the Discounted Cash Flow (DCF) Approach: Ks = D1 Po +g

1)

Ks is the rate of rate required by the investor Ks is the rate of rate expected by the firm D1 is the expected dividend Po is the share price g is the expected growth rate

Investors expect to receive two things:

A dividend with the potential to increase, and 2) A capital gain, which is expressed in the growth rate in the shares value. The total of the two elements is represented in the expected return (Ks) which, in equilibrium, will equal the required return (ks). In this method of estimating the cost of equity the assumption is that we are in equilibrium and ks = ks. Example: A stock sells for LE23, next expected dividend is LE1.24, and Expected growth rate is 8%, then: ks & ks = 1.24 + 8% 23 = 5.4% +8% = 13.4% This 13.4% is the minimum rate of return that management must expect to earn from the new project(s) to justify retaining all or part of the earnings and reinvesting them in the business rather than paying them out to stockholders as dividends.

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 It is relatively easy to project or estimate dividend yield by reference to historic growth rate. It is more difficult to project growth rate g. If the companys past growth was abnormally high or low, g must be estimated by reference to security analysts forecasts. The illusion of the cost of retained earnings calculation: Unlike the cost of debt, which can be determined with a fair degree of certainty, the cost of retained earnings can only be estimated, and with much less certainty. Reasons are: 1. In the CAPM and the Bond Yield-Plus-Risk methods, cost is dependant on risk (bi) assessment, which could be biased and subjective. 2. In DCF method, cost is dependant on growth (g) estimation, which could be unrealistic.

In all three methods, therefore, the cost of retained earnings (Ks) can only be estimated.

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4. The Cost of Newly Issued Common Stock (external equity) Ke: Ke = D1 +g Po (1 F) The cost of newly issued common stock, Ke is higher than the cost of retained earnings, Ks because of the floatation costs, F; the percentage cost of issuing new common stock. Example: D1 = LE 1.24 F = 0.10 Po = LE 23 g =8% Then, Ke = LE1.24 + 8% = 1.24 + 8% = 6% + 8% = 14%. 23(1- 0.10) 20.70 To produce the required rate of return on investment, money raised by selling new stock must work harder than money raised by retaining earnings due to the cash flow lost in the floatation cost. If dividends are expected to grow at a constant rate, then, the following important formula is used to calculate the current price of the stock (Po): Po = D1 Ks - g The Weighted Average Cost of Capital, WACC: Firms capital structure includes varying portions of debt, preferred stock and common equity. Common equity comes either from retained earnings, or from new issuing of common stock. WACC is the average of the costs of these capital components, weighted by the percentage of each component to the total capital in the firms target (optimal) capital structure.

Target (optimal) capital structure is the mixture of debt, preferred stock and common equity at which the price of the firms stock is maximized.
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Example: A firms target capital situation is 45% debt, 2% preferred stock and 53% common equity (retained earnings plus common stock) and costs of capital components were as follows: 10% before tax cost of debt Kd 6% after-tax cost of debt Kd(1-T) 10.3% cost of preferred stock Kps 13.4% cost of common equity from retained earnings Ks 14.-% cost of common equity from sale of new stock Ke At 40% tax rate, and with all new equity coming from retained earnings, then WACC is calculated as follows: WACC = Wd Kd(1-T) + Wps Kps + Wce Ks = 0.45X(10%)(0.6) = 2.7 % Plus 0.02(10.3%) = 0.2 % Plus 0.53(13.4%) = 7.1 % 10.- %. If all new equity comes from sale of new stock, then WACC is calculated as follows: WACC = = Plus Plus Wd Kd(1-T) + Wps Kps + Wce Ke 0.45X(10%)(0.6) = 2.7 % 0.02(10.3%) = 0.2 % 0.53(14.-%) = 7.4 % 10.3 %

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Marginal Cost of Capital, MCC: Is the cost of obtaining one more pound of new capital. Is the weighted average cost of the last pound of new capital raised. MCC rises as more and more capital is raised during a given period. MCC Schedule: Is a graph that shows how WACC changes as more and more new capital is raised during a given year. Relates the firms weighted average cost of each pound of capital to the total amount of new capital raised.

Illustration of Marginal Cost of Capital: Using the information from Allied Food, the concept of MCC can be illustrated as follows: Allied Food target capital structure: - Long-term debt LE 754,000,000 45% - Preferred stock 40,000,000 2% - Common equity 896,000,000 53% Total capital LE1,690,000,000 100% Kps = 10.3% T = 40% Kd = 10% Kd (after tax) = 6% Ks = 13.4% Ke = 14% (1) WACC when new equity is from retained earnings:
Debt Pref. Stock C. equity Weight X Component cost Weighted cost 0.45 6% 2.7% 0.02 10.3% 0.2% 0.53 13.4% 7.1% 1.00 WACC 10.0%

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(2) WACC when new equity is from common stock:

Debt Pref. Stock C. equity Weight X Component cost 0.45 6% 0.02 10.3% 0.53 14% 1.00 WACC Weighted cost 2.7% 0.2% 7.4% 10.3%

Now, what happens when Allied wants to raise LE1,000,000 in new capital? For Allieds WACC to remain without increase, the new capital should be obtained from the same components of the existing capital and in the same proportions, i.e.: - LE 450,000 of debt at an after tax cost of 6%. - LE 20,000 of Preferred stock at cost of 10.3% - LE 530,000 of common equity coming either: a) From retained earnings at cost of 13.4%, or b) From new issue of common stock at cost of 14%.

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How much new capital can Allied raise before its WACC starts to increase? Or, where will a Break Point take place? Corporations cannot raise unlimited amounts of capital at a constant cost.

A Break Point represents the volume of new capital that can be raised before an increase in the firms WACC occurs. - In general, a break point (jump) will occur whenever the cost of one of the capital components rises.
Break point = total amount of lower-cost capital (type) Fraction of this type of capital in the capital structure How to determine where a Break Point will occur? Example: Allied wants to raise LE 1million in new capital at the target capital structure of 45% debt, 2% preferred stock and 53% common equity. How much capital can Allied raise at WACC 10% before it exhausts its retained earnings and is forced to sell new common stock that will raise WACC to 10.3%? Give information: - Expected year earnings LE 137.8 million - dividends at 45% of earnings LE 62.0 million - retained earnings LE 75.8 million Break Point RE = Retained earnings = 75.8 = LE 143 million Equity fraction 53% This means that Allied can raise new capital of up to LE143 million at WACC of 10%, provided that the new LE 143 million capital composition is as follows: 45% debt or LE 64.3 2% preferred stock or LE 2.9 53% retained earnings or LE 75.8 LE 143.-

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Using the MCC in Capital Budgeting: A Preview: The cost of capital is a key element in the capital budgeting process. Capital budgeting consists of the following five steps: 1. Identifying available investment opportunities (projects). 2. Estimating the future cash flow from each project. 3. Finding the total present value (PV) of each projects cash flow, discounted at the cost of the capital components used to finance the project. 4. Comparing each projects PV with its cost and accepting projects with cash flows PV exceeding their costs 5. Ranking the accepted projects for final selection in the order of the projects rates of return, i.e. draw up an investment opportunity schedule.

Investment Opportunity Schedule:

Project Cost Rate of Return A 50 MM 13.0% B 50 MM 12.5% C 80 MM 12.0% D 80 MM 10.2% Projects A,B and C all have expected rates of return which exceed the cost of the capital to be used to finance, but the expected rate of return from Project D is less than its cost of capital, therefore it should be rejected.

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The Corporate (Optimal) Cost of Capital: Is the point that reflects the marginal cost of capital to the corporation and, It is where WACC and MCC intersect on the investment opportunity schedule.

Problem Areas in Cost of Capital: Depreciation, a cost item not spent in cash, is an important source of capital. The cost of depreciation-generated funds is +/- the WACC in the interval when financing comes from retained earnings and lowcost debt.

Privately-Owned Firms: - Generally, stock not traded. - Same rules for publicly traded firms apply. - Data obtaining problems somewhat different. Small Businesses: - They are generally privately owned. - Estimating their cost of equity is somewhat difficult. Measurement Problems: - Inaccuracy of estimation the cost of capital due to practical difficulties in estimating the cost of equity. - Costs of capital for projects of different risking. - Capital structure weights, a major task in itself.

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Course: Finance Instructor: Dr. Said El Salmy Assignment on Lecture 3 The Cost of Capital A. Tick True or False for each of the following statements: 1. The component costs of capital are market-determined variables in as much as they are based on investors required returns. True False 2. The before-tax cost of debt, which is lower than the after-tax cost of debt, is used as the component cost of debt for purposes of developing the firms WACC. True False 3. In capital budgeting and cost of capital analysis, the firm should always consider retained earnings as the first source of capital, since this is a free source of funding to the firm. True False 4. The cost of capital should reflect the average cost of the various sources of long-term funds a firm uses to support its assets. True False B. Solve the following problem (exam type problem): Happy Dreams Hotels is planning an expansion project for its Red Sea resort, which will be funded 40% in a new common stock issuing, 10% in a new preferred stock issuing and 50% in a new bank loan. Available information as follows: New common stock price LE 45 per share. New preferred stock price LE 50 per share Last paid dividend LE 3 Preferred dividend LE 10 Company estimated growth rate 8% Interest rate on new debt 20% Return on risk-free investment 10% Tax rate 40% Bank floatation cost 2% 1. Calculate the cost of capital for each of the three sources of funds for the expansion project. 2. Calculate the weighted average cost of capital for the project. Answered assignment will be collected at the start of the next lecture. Late presentation of assignment will result in loss of credit points.

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