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The Cost of Capital

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

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Topics Covered
Geothermals Cost of Capital
Weighted Average Cost of Capital (WACC)
Capital Structure
Required Rates of Return
Big Oils WACC
Interpreting WACC
Flotation Costs
Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

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Cost of Capital
Cost of Capital - The return the firms
investors could expect to earn if they
invested in securities with comparable
degrees of risk.
Capital Structure - The firms mix of long
term financing and equity financing.

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

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Cost of Capital
Example - Geothermal Inc. has the following
structure. Given that geothermal pays 8% for debt
and 14% for equity, what is the Company Cost of
Capital?

Market Value Debt $194 30%


Market Value Equity $453 70%
Market Value Assets $647 100%
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Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

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Cost of Capital
Example - Geothermal Inc. has the following
structure. Given that geothermal pays 8% for debt
and 14% for equity, what is the Company Cost of
Capital?

Portfolio Return = (.3x8%) + (.7x14%) = 12.2%

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

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Cost of Capital
Example - Geothermal Inc. has the following
structure. Given that geothermal pays 8% for debt
and 14% for equity, what is the Company Cost of
Capital? Portfolio Return = (.3x8%) + (.7x14%) = 12.2%
Interest is tax deductible. Given a 35% tax rate, debt only
costs us 5.2% (i.e. 8 % x .65).

WACC = (.3x5.2%) + (.7x14%) = 11.4%


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Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

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WACC
Weighted Average Cost of Capital (WACC) The expected rate of return on a portfolio of
all the firms securities.
Company cost of capital = Weighted average of debt
and equity returns.

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Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

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WACC
Three Steps to Calculating Cost of Capital
1. Calculate the value of each security as a
proportion of the firms market value.
2. Determine the required rate of return on
each security.
3. Calculate a weighted average of these
required returns.

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

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WACC
Taxes are an important consideration in the
company cost of capital because interest payments
are deducted from income before tax is calculated.

After - tax cost of debt = pretax cost x (1 - tax rate)


= rdebt x (1 - Tc)

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

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WACC
Example - Executive Fruit has
issued debt, preferred stock and
common stock. The market
value of these securities are
$4mil, $2mil, and $6mil,
respectively. The required
returns are 6%, 12%, and 18%,
respectively.
Q: Determine the WACC for
Executive Fruit, Inc.
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Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

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WACC
Example - continued
Step 1
Firm Value = 4 + 2 + 6 = $12 mil
Step 2
Required returns are given
Step 3

WACC =

4
12

] (

x(1-.35).06 +

2
12

) (

x.12 +

6
12

=.123 or 12.3%
Irwin/McGraw Hill

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Measuring Capital Structure


In estimating WACC, do not use the Book
Value of securities.
In estimating WACC, use the Market Value
of the securities.
Book Values often do not represent the true
market value of a firms securities.

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

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Measuring Capital Structure


Market Value of Bonds - PV of all coupons
and par value discounted at the current
interest rate.
Market Value of Equity - Market price per
share multiplied by the number of
outstanding shares.

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

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Required Rates of Return


Bonds

rd = YTM

Common Stock

re = CAPM
= rf + B(rm - rf )
Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

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Required Rates of Return


Dividend Discount Model Cost of Equity
Perpetuity Growth Model =

Div1
P0 =
re - g
solve for re

Irwin/McGraw Hill

Div1
re =
+ g
P0
Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

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Required Rates of Return


Expected Return on Preferred Stock
Price of Preferred Stock =

P0 =

Div1
rpreferred

solve for preferred


rpreferred

Irwin/McGraw Hill

Div1
=
P0

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

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Flotation Costs
The cost of implementing any financing
decision must be incorporated into the cash
flows of the project being evaluated.
Only the incremental costs of financing
should be included.
This is sometimes called Adjusted Present
Value.

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

Problems

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Q1) Cost of Debt. Micro Spinoffs, Inc., issued


20-year debt a year ago at par value with a coupon
rate of 8 percent, paid annually. Today, the debt is
selling at $1,050. If the firms tax bracket is 35
percent, what is its after-tax cost of debt?
Q2) Cost of Preferred Stock. Micro Spinoffs also
has preferred stock outstanding. The stock pays a
dividend of $4 per share, and the stock sells for
$40. What is the cost of preferred stock?
Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

Problems

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Q3) Calculating WACC. Suppose Micro Spinoffss cost of


equity is 12 percent. What is its WACC if equity is 50 percent,
preferred stock is 20 percent, and debt is 30 percent of total
capital?
Q4) Calculating WACC. Reactive Industries has the following
capital structure. Its corporate tax rate is 35 percent. What is its
WACC?

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

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Problems

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

Problems

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Q5 Calculating WACC. Find the WACC of


William Tell Computers. The total book value of
the firms equity is $10 million; book value per
share is $20. The stock sells for a price of $30 per
share, and the cost of equity is 15 percent. The
firms bonds have a par value of $5 million and
sell at a price of 110 percent of par. The yield to
maturity on the bonds is 9 percent, and the firms
tax rate is 40 percent.
Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

Problems

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Long street communications Inc (LCI) has the following capital


structure, which it considers to be optimal:
Debt = 25%
Preferred Stocks = 15%
Common stocks = 60%
LCIs net income expected this year is $ 17,142.86, its established
dividend payout ratio is 30 percent, its tax rate is 40 percent and
investors expect earning and dividends to grow at a constant rate of
9 percent in the future. LCI paid a dividend of $ 3.60 per share last
year and its stock currently sells at a price of $ 60 per share.
Treasury bonds yield 11 percent and average stock beta has a 14
percent expected rate of return and LCIs beta is 1.51. These terms
will apply to new offerings:
Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

Problems
Common: New common stock would have a
floating cost of 10 percent.
Preferred: New preferred could be sold to the
public at a price of $ 100 per share with the
dividend of $11, Floating cost of $ 5 would be
incurred.
Debt: New debt could be sold at an interest rate of
12 percent.
Find the component cost debt, preferred stock,
retained earnings and new common stocks?
What is the WACC?
Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights

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