Contemporary Engineering Economics, 4 th edition, © 2007 Cost of Capital Lecture No. 61 Chapter 15...
-
Upload
chrystal-gibbs -
Category
Documents
-
view
215 -
download
0
Transcript of Contemporary Engineering Economics, 4 th edition, © 2007 Cost of Capital Lecture No. 61 Chapter 15...
Contemporary Engineering Economics, 4th edition, © 2007
Cost of Capital
Lecture No. 61Chapter 15Contemporary Engineering EconomicsCopyright © 2006
Contemporary Engineering Economics, 4th edition, © 2007
Cost of Capital (k)
Cost of Equity (ie) – Opportunity cost associated with using shareholders’ capital
Cost of Debt (id) – Cost associated with borrowing capital from creditors
Cost of Capital (k) – Weighted average of ie and id
Cost of Equity
Cost of Debt
Cos
t of
Cap
ital
Contemporary Engineering Economics, 4th edition, © 2007
Cost of Equity (ie)
Cost of Retained Earnings (kr)
Cost of issuing New Common Stock(ke)
Cost of Preferred Stock (kp)
Cost of equity: weighted average of kr ke, and kp
Contemporary Engineering Economics, 4th edition, © 2007
i c c k c c k
c c ke r e r c e e
p e p
( / ) ( / )
( / )Where Cr = amount of equity financed from retained earnings, Cc = amount of equity financed from issuing new stock, Cp = amount of equity financed from issuing preferred stock, and Ce = Cr + Cc + Cp
Calculating the Cost of Equity based on Financing Sources
Contemporary Engineering Economics, 4th edition, © 2007
Calculating the Cost of Equity
Issuing New Common Stock
kD
P fge
c
1
0 1( )
Cost of Preferred Stock
kD
P fpc
*
*( )1
Cost of Equity
i c c k c c k
c c ke r e r c e e
p e p
( / ) ( / )
( / )
kD
Pgr 1
0
Cost of Retained Earnings
Where cr = amount of equity financed from retained earnings,cc = amount of equity financed from issuing new stock,cp = amount of equity financed fromissuing preferred stock, andce = cr + cc + cp
Contemporary Engineering Economics, 4th edition, © 2007
Example 15.4 Determining the Cost of Equity – Alpha Corporation
Source Amount Fraction of Total Equity
Retained earnings
$1 million 0.167
New common stock
$4 million 0.666
Preferred stock
$1 million 0.167
Contemporary Engineering Economics, 4th edition, © 2007
Cost of retained earnings: With D1= $5, g = 8%, and P0= $40
Cost of new common stock: With D1= $5, g = 8%, and fc= 12.4%
Cost of preferred stock: With D*= $9, P*= 95, and fc= 0.06
kr 5
400 08 205%. .
ke [ / ( . )] . .5 40 1 0124 0 08 22 27%
kp 9 95 1 0 06 10 08%/ ( . ) .
Cost of equity:
ie
( . )( . ) ( . )( . ) ( . )( . )
.
0167 0 205 0 666 0 2227 0167 01008
19 96%
Solution:
Contemporary Engineering Economics, 4th edition, © 2007
Cost of Debt (id)
( / ) (1 ) ( / ) (1 )d s d s m b d b mi c c k t c c k t
where the amount of the term loan,
the amount of bond financing,
the before-tax interest rate on the term loan,
the before-tax interest rate on the bond,
the firm's marginal tax rate,
s
b
s
b
m
c
c
k
k
t
and
d s bc c c
Contemporary Engineering Economics, 4th edition, © 2007
Example 15.6 Determining the Cost of Debt
Given: Sources of debt financing, tax rate = 38%
Find: A/T cost of debt
Source Amount Fraction Interest
Rate
Flotation
Cost
Term loan $1.33 million
0.333 12% per year
Bonds $2.67 million
0.667 10% per year
6%
Contemporary Engineering Economics, 4th edition, © 2007
Solution
A/T Cost of Issuing Bond (kb):
A/T Cost of Debt:
$940 $100( / , , 20) $1,000( / , , 20)
10.74%b b
b
P A k P F k
k
(0.333)(0.12)(1 0.38) (0.667)(0.1074)(1 0.38)
6.92%di
Contemporary Engineering Economics, 4th edition, © 2007
The Weighted A/T Cost of Capital
d d e ei c i ck
V V
cd= Total debt capital(such as bonds) in dollars,ce=Total equity capital in dollars,V = cd+ ce,
ie= Average equity interest rate per period considering all equity sources,id = After-tax average borrowing interest rate per period considering all debt sources, andk = Tax-adjusted weighted-average cost of capital.
Contemporary Engineering Economics, 4th edition, © 2007
Process of Calculating the Cost of Capital
Contemporary Engineering Economics, 4th edition, © 2007
Marginal Cost of Capital
• Given: Cd = $4 million, Ce = $6 million, V= $10 millions, id= 6.92%, ie=19.96%• Find: k
k
0 0692 4
10
01996 6
1014 74%
. ( ) . ( )
.
Comments: This 14.74% would be the marginal cost of capital that a company with this financial structure would expect to pay to raise $10 million.
Contemporary Engineering Economics, 4th edition, © 2007
Summary
• Methods of financing: 1. Equity financing uses retained earnings
or funds raised from an issuance of stock to finance a capital investment.
2. Debt financing uses money raised through loans or by an issuance of bonds to finance a capital investment.
• Companies do not simply borrow all funds to finance projects. Well-managed firms usually establish a target capital structure and strive to maintain the debt ratio when individual projects are financed.
Contemporary Engineering Economics, 4th edition, © 2007
The cost of the capital formula is a composite index reflecting the cost of funds raised from different sources. The formula is
The marginal cost of capital is defined as the cost of obtaining another dollar of new capital. The marginal cost rises as more and more capital is raised during a given period.
, where d d e ed e
i c i ck V c c
V V