Chapter 11 the cost of capital

• Calculate cost of ordinary share capital, convert to cost of new ordinary shares and cost of retained earnings.. Calculating The Cost Of Already Issued Preference Capital[Equation 11

Learning Goals:

• Understand the cost of capital and the specific

sources of capital associated with the cost of capital.

• Determine the cost of debt and preference share

capital.

• Calculate cost of ordinary share capital, convert to

cost of new ordinary shares and cost of retained

earnings.

• Find the weighted average cost of capital and discuss the alternative weighting schemes available.

 Describe the procedures used to determine break

points and the weighted marginal cost of capital.

 Explain the weighted marginal cost of capital and its use with the investment opportunities schedule to

make financing/investment decisions.

The Cost Of Capital

 The rate of return a firm must earn on its project investments to maintain the market value of its

shares and attract investors.

 Is affected by a variety of economic and firm

factors.

 Is estimated at a given point in time.

 Reflects the expected average future cost of funds over the long run based on available information.

 Should reflect the interrelatedness of financing

activities.

Specific Sources Of Capital

 Focus is on long term sources of funds available.

 Four basic sources:

1 Debt

2 Preference Shares

3 Ordinary Shares

4 Retained Earnings

The Cost Of Long Term Debt

 The after tax cost today of raising long term funds through borrowing.

 Assumes funds are raised through the issuance and sale or long term bonds or debentures.

 Net Proceeds: The funds actually received from the

sale of a security.

 Flotation Costs: The costs of issuing and selling a

security Flotation costs consist of two components:

• Underwriting costs

Administrative costs

 Calculation: Involves calculating the internal rate of return of the

bond cash flows

 Approximation: For a bond with a $1,000 par value the before tax

cost of debt can be approximated by:

[Equation 11.1]

Where:

I = Annual interest in dollars

N d = Net proceeds from the sale of debt (bond)

n = Number of years to the bond’s maturity

Before Tax Cost Of Debt

2

000 ,

1

$

000 ,

r

Duchess Limited, a major hardware manufacturer, is

contemplating selling $10 million worth of 20 year, 9% coupon bonds, each with a face value of $1,000 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 The flotation costs paid to the

investment banker are 2% of the face value of the bond.

 Calculation Method Continued:

1

$ 960

$ 20

960

$ 000 ,

1

$ 90

1

$

000 ,

r

After Tax Cost Of Capital

 Abbreviated as r i.

 Calculated by:

[Equation 11.2]

Where:

T = Applicable tax rate

Duchess Limited has a 30% tax rate Using the 9.4% before tax cost of debt previously calculated

we can calculate the after tax cost of debt:

r i = 0.0094 x (1 – 0.30)

r i = 0.00658 or 6.58%

) 1

( T r

r i  d  

Cost Of Preference Share

D p = Annual preference dividend

N p = Net proceeds from the sale of preference shares

p

p p

N D

r 

Duchess Limited is considering the issue of 12% preference shares with an issue price of $100 per share The costs of issuing and marketing the

shares, the flotation costs, are expected to be $4 per share.

N D

r 

Calculating The Cost Of Already Issued Preference Capital

[Equation 11.4]

Where:

P = Market value of preference share capital

If the market value of Duchess Limited’s previously

issued share capital is $10 million and the preference

dividend payable is $1.2 million, the cost of preference

share capital is:

$10,000,000

P D

Cost Of Ordinary Share Equity Capital

 Abbreviated as r s

 The rate at which investors discount the

expected dividends of the firm to determine its

year 1

g = Constant rate of growth of dividends

Finding The Cost Of Ordinary Share Equity Capital

g P

D

rs  

01

2 Capital Asset Pricing Model (CAPM)

Calculated by:

[Equation 11.7]

 Despite the fact that it does not directly address

risk, the constant growth model is more commonly used in practice due to its ease of calculation,

availability of data and ease of adjustment for

flotation costs when calculating the cost of new

ordinary share capital.

Finding The Cost Of Ordinary Share Equity Capital

Cost Of Retained Earnings:

 Abbreviated as r r

 Is the same as the cost of an equivalent fully

subscribed issue of additional equity Therefore:

r r = r s [Equation 11.8]

 No adjustment is required for flotation costs.

Finding The Cost Of Ordinary Share Equity Capital

Cost Of New Issues Of Ordinary Share Equity:

 Abbreviated as r n

 Is calculated net of underpricing and flotation costs.

 Will always be greater than the cost of existing

issues/retained earnings, and the greatest long term financing cost option.

 Calculated using the constant growth model:

[Equation 11.9]

Where:

N = Net proceeds from the sale of new shares.

Finding The Cost Of Ordinary Share Equity Capital

g N

D r

n

Weighted Average Cost Of

structure

structure.

Duchess Limited has calculated the costs of the various types of capital to be:

The company uses the following weights in

calculating WACC:

Weighted Average Cost Of

Capital

Because the firm expects to have a sizeable amount of retained earnings available ($300,000), it plans to use its cost of retained earnings as the cost of ordinary share capital.

Assuming an unchanged risk level, the firm should

accept all projects that earn a return greater than or

equal to 10.38%.

Weighted Average Cost Of

Capital

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Weighted Marginal Cost Of

Capital

 The firm’s WACC associated with its next dollar of total new financing.

 Is an increasing function of the level of total new financing.

 The ‘break point’ is the level of total new financing at

which the cost of one of the financing components rises causing the WMCC to rise.

 Break Point can be calculated by:

BP j = Af j [Equation 11.17]

w j

Where:

BP j = Break point for financing source j

Af j = Amount of funds available from financing source j at a given cost

w j = Capital structure weight

for financing source j

Weighted Marginal Cost Of

Capital

Weighted Marginal Cost Of

Capital

Weighted Marginal Cost Of

Capital Schedule

 Reflects the firm’s WACC for each level of total new financing between each set of break points.

Page 497

Weighted Marginal Cost Of

Investment Opportunity

Using WMCC & IOS For

Decision Making

 The firm should accept projects up to the point at which the marginal return on its investment

equals its weighted marginal cost of capital.

 The point of intersection between the WACC & IOS defines the firm’s optimal capital budget

 Due to capital rationing there is generally a gap between the optimal capital budget and the firm’s actual level of financing/investment.