PowerPoint to accompany Chapter 11 The Cost Of Capital 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 Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition 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 Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Specific Sources Of Capital  Focus is on long term sources of funds available  Four basic sources: Debt Preference Shares Ordinary Shares Retained Earnings Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition 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 Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Before Tax Cost Of Debt  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] $1,000  N d I n rd  N d  $1,000 Where: I = Annual interest in dollars Nd = Net proceeds from the sale of debt (bond) n = Number of years to the bond’s maturity Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Before Tax Cost Of Debt 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:  Financial Calculator: n = 20, PV = 960, PMT = -90, FV = 1,000 i = 9.542 Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Before Tax Cost Of Debt  Calculation Method Continued:  Formula: Trial and error  Approximation Method: I  $1,000  N d n rd  N d  $1,000 $90  $1,000  $960 20 rd $960  $1,000 rd = 0.0094 or 9.4% Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition After Tax Cost Of Capital  Abbreviated as ri  Calculated by: ri rd (1  T ) [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: ri = 0.0094 x (1 – 0.30) ri = 0.00658 or 6.58% Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Cost Of Preference Share Capital  Abbreviated as rp  Calculated by: rp  Dp [Equation 11.3] Np Where: Dp = Annual preference dividend Np = Net proceeds from the sale of preference shares Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Finding The Cost Of Ordinary Share Equity Capital  Two techniques: Constant Growth Valuation (Gordon) Model Calculated by: [ErsquaDtio1 n1g1.6] P0 Where: P0 = Value of one ordinary share D1 = Per share dividend expected at the end of year Rs = Cost of ordinary share capital g = Constant rate of growth of dividends Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Finding The Cost Of Ordinary Share Equity Capital Capital Asset Pricing Model (CAPM) Calculated by: [EquarstionRF11[.b7](rm  RF )]  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 Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Finding The Cost Of Ordinary Share Equity Capital Cost Of Retained Earnings:  Abbreviated as rr  Is the same as the cost of an equivalent fully subscribed issue of additional equity Therefore: rr = rs [Equation 11.8]  No adjustment is required for flotation costs Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Finding The Cost Of Ordinary Share Equity Capital Cost Of New Issues Of Ordinary Share Equity:  Abbreviated as rn  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: rn [EqDu1atiogn 11.9] Nn Where: Nn = Net proceeds from the sale of new shares Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Weighted Average Cost Of Capital  Abbreviated as  Reflects the expected average future cost of funds over the long run  Calculated by: = (ri x wi) + (rp x wp) + (rr or n x ws) [Equation 11.10] Where: wi = Proportion of long term debt in the capital structure wp = Proportion of preference share capital in the capital structure ws = Proportion of ordinary share equity in the capital structure Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition Weighted Average Cost Of Capital Duchess Limited has calculated the costs of the various types of capital to be: The company uses the following weights in calculating WACC: Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition 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 Page 488 Assuming an unchanged risk level, the firm should accept all projects that earn a return greater than or equal to 10.38% Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition ... 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, ... Finding The Cost Of Ordinary Share Equity Capital Cost Of Retained Earnings:  Abbreviated as rr  Is the same as the cost of an equivalent fully subscribed issue of additional equity Therefore:... Average Cost Of Capital Duchess Limited has calculated the costs of the various types of capital to be: The company uses the following weights in calculating WACC: Copyright © 2011