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Chapter11: CALCULATING THE COST OF CAPITAL

Chapter Opener

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<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077323483/student/cor82256_icon04.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>  Learning Goals

LG1 Grasp the basic intuition behind calculating the cost of capital and its relationship to the investor’s required return.

LG2 Use the weighted-average cost of capital (WACC) formula to calculate a project’s cost of capital.

LG3 Debate the firm’s choices in estimating the appropriate capital component costs of equity, preferred stock, and debt.

LG4 Calculate and justify appropriate weights used for WACC projections.

LG5 Clarify which parts of a firmwide WACC can be used in calculating a project-specific WACC and which parts do not apply.

LG6 Note the trade-offs implicit in using either a firmwide WACC or a divisional cost of capital approach.

LG7 Differentiate between the objective and subjective approaches to computing a divisional cost of capital.

LG8 Denote the impact that flotation costs have on capital budgeting decisions and adjust the WACC to reflect flotation costs.

In the previous two chapters, we discussed investors’ required return given a particular risk profile. In this chapter, we examine the question from the firm’s point of view: How much must the firm pay to finance its operations and expansions using debt and equity sources? Firms use a combination of debt and equity sources to fund their operations, projects, and any expansions they may undertake. In Chapter 14, we’ll explore the factors that managers consider as they choose the optimal capital structure mix. For now, we’ll assume that management has chosen the optimal mix for us, and that it’s our job to implement it.

As we’ve seen in previous chapters, investors face different kinds of risks associated with debt, preferred stock, and equity. As a result, their required rates of return for each debt or equity source differ as well. So as the firm uses a combination of different financing sources, we must calculate the investors’ average required rate of return. Since firms seldom use equal amounts of debt and equity capital sources, we will need to calculate a weighted average, with weights based on the proportion of debt and equity capital used.

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viewpoints

Business Application

MP3 Devices, Inc. is about to launch a new project to create and market a combination MP3 player/video projector. The new project will be funded with 40 percent debt, 10 percent preferred stock, and 50 percent common stock. MP3 Devices currently has 10 million shares of common stock outstanding, selling at $18.75 per share, and expects to pay an annual dividend of $1.35 one year from now, after which future dividends are expected to grow at a constant 6 percent rate. MP3’s debt consists of 20-year, 10-percent annual coupon bonds with a face value of $150 million and a market value of $165 million. The company’s capital mix also includes 100,000 shares of 10 percent preferred stock selling at par. If MP3 Devices faces a marginal tax rate of 34 percent, what weighted- average cost of capital should it to use as it evaluates this project? (See solution on p. 376)

Personal Application

Mackenzie is currently finishing up her B.S. degree and is considering going back to grad school for a master’s. She currently has $17,125 in student loans carrying an 8 percent interest rate from her B.S. and estimates that she will need to take out an additional $29,000 in student loans (at the same interest rate) to make it through the master’s program she’d like to attend. The IRS allows taxpayers with student loans to deduct the interest on those loans, but only up to a maximum amount of $2,500 per year. Assuming that Mackenzie will face a marginal personal tax rate of 25 percent when she graduates, what will be the average after-tax interest rate that she will be paying on the student loans immediately after she graduates with her master’s? (See solution on p. 376)

A practice test can be found on the Online Learning Center at www.mhhe.com/can1e   <a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077323483/student/OLCv2_LOGO.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

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One important point about the component costsThe individual costs of each type of capital—bonds, preferred stock, and common stock. to be used in the firm’s computation of the average required rate of return is that dividends paid to either common or preferred stockholders are not tax deductible. Thus paying a certain interest rate to either costs the firm that same interest rate. On the other hand, interest paid to debt holders is tax deductible, implying that the firm’s effective after-tax out-of-pocket interest cost will be equal to the interest rate paid on debt multiplied by one minus the firm’s relevant tax rate.

For example, if a firm pays a 10 percent coupon on $1 million in debt while it is subject to a 35 percent tax rate, then each coupon payment will be equal to .10 × $1,000,000 = $100,000, but that $100,000 in interest, being tax deductible, will reduce the firm’s tax bill by .35 × $100,000 = $35,000. So paying $100,000 in interest saves the firm $35,000 in taxes, making the effective after-tax cost of debt equal to $100,000 − $35,000 = $65,000 and the effective after-tax interest rate equal to 10% × (1 − 35%) = 6.5%.

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