KOSZT I STRUKTURA KAPITAU

2008

Kevin Campbell, University of Stirling, November 2005

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

Kevin Campbell, University of Stirling, November 2005

Cost of Capital

The cost of capital represents the overall cost of financing to the firm The cost of capital is normally the relevant discount rate to use in analyzing an investment The overall cost of capital is a weighted average of the various sources: WACC = Weighted Average Cost of Capital WACC = After-tax cost x weights

Kevin Campbell, University of Stirling, November 2005

Cost of Debt

The cost of debt to the firm is the effective yield to maturity (or interest rate) paid to its bondholders Since interest is tax deductible to the firm, the actual cost of debt is less than the yield to maturity: After-tax cost of debt = yield x (1 - tax rate) The cost of debt should also be adjusted for flotation costs (associated with issuing new bonds)
Kevin Campbell, University of Stirling, November 2005

Example: Tax effects of financing with debt

EBIT - interest expense EBT - taxes (34%) EAT

with stock 400,000 0 400,000 (136,000) 264,000

with debt 400,000 (50,000) 350,000 (119,000) 231,000

Now, suppose the firm pays $50,000 in dividends to the shareholders

Kevin Campbell, University of Stirling, November 2005

Example: Tax effects of financing with debt

with stock EBIT 400,000 - interest expense 0 EBT 400,000 - taxes (34%) (136,000) EAT 264,000 - dividends (50,000) Retained earnings 214,000
Kevin Campbell, University of Stirling, November 2005

with debt 400,000 (50,000) 350,000 (119,000) 231,000 0 231,000

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Cost of Debt
After-tax cost of Debt

=
=

Before-tax cost of Debt

Tax Savings

33,000
OR

50,000

17,000

33,000

50,000 ( 1 - .34)

Or, if we want to look at percentage costs:

Kevin Campbell, University of Stirling, November 2005

Cost of Debt
After-tax % cost of = Debt Before-tax % cost of Debt x

Marginal - tax rate

Kd .066

= =

kd (1 - T) .10 (1 - .34)
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Kevin Campbell, University of Stirling, November 2005

EXAMPLE: Cost of Debt

Prescott Corporation issues a $1,000 par, 20 year bond paying the market rate of 10%. Coupons are annual. The bond will sell for par since it pays the market rate, but flotation costs amount to $50 per bond. What is the pre-tax and after-tax cost of debt for Prescott Corporation?
Kevin Campbell, University of Stirling, November 2005

EXAMPLE: Cost of Debt

Pre-tax cost of debt:

950 = 100(PVIFA 20, Kd) + 1000(PVIF 20, Kd) using a financial calculator: So a 10% bond Kd = 10.61%

After-tax cost of debt:

Kd Kd Kd = = = Kd (1 - T) .1061 (1 - .34) .07 = 7%
Kevin Campbell, University of Stirling, November 2005

costs the firm only 7% (with flotation costs) because interest is tax deductible

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Cost of New Preferred Stock

Preferred stock: has a fixed dividend (similar to debt) has no maturity date dividends are not tax deductible and are expected to be perpetual or infinite Cost of preferred stock = dividend price - flotation cost

Kevin Campbell, University of Stirling, November 2005

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Cost of Preferred stock: Example

Baker Corporation has preferred stock that sells for $100 per share and pays an annual dividend of $10.50. If the flotation costs are $4 per share, what is the cost of new preferred stock?
KP $10.50 .1094 10.94% $100 - 4

Kevin Campbell, University of Stirling, November 2005

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Cost of Equity: Retained Earnings

Why is there a cost for retained earnings? Earnings can be reinvested or paid out as dividends Investors could buy other securities, and earn a return. Thus, there is an opportunity cost if earnings are retained

Kevin Campbell, University of Stirling, November 2005

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Cost of Equity: Retained Earnings

Common stock equity is available through retained earnings (R/E) or by issuing new common stock: Common equity = R/E + New common stock

Kevin Campbell, University of Stirling, November 2005

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Cost of Equity: New Common Stock

The cost of new common stock is higher than the cost of retained earnings because of flotation costs selling and distribution costs (such as sales commissions) for the new securities

Kevin Campbell, University of Stirling, November 2005

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Cost of Equity

There are a number of methods used to determine the cost of equity We will focus on two
Dividend growth Model CAPM

Kevin Campbell, University of Stirling, November 2005

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The Dividend Growth Model Approach

Estimating the cost of equity: the dividend growth model approach According to the constant growth (Gordon) model, D1 P0 = RE - g Rearranging RE = P0 D1 +g

Kevin Campbell, University of Stirling, November 2005

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Example: Estimating the Dividend Growth Rate

Percentage Change -

Year 1990

Dividend $4.00

Dollar Change -

1991
1992 1993 1994

4.40
4.75 5.25 5.65

$0.40
0.35 0.50 0.40

10.00%
7.95 10.53 7.62

Average Growth Rate (10.00 + 7.95 + 10.53 + 7.62)/4 = 9.025%

Kevin Campbell, University of Stirling, November 2005

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Dividend Growth Model

This model has drawbacks:

Some firms concentrate on growth and do not pay dividends at all, or only irregularly Growth rates may also be hard to estimate Also this model doesnt adjust for market risk
Therefore many financial managers prefer the capital asset pricing model (CAPM) - or security market line (SML) - approach for estimating the cost of equity
Kevin Campbell, University of Stirling, November 2005

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Capital Asset Pricing Model (CAPM)

kj Rf ( Rm Rf )
Cost of capital Risk-free return Co-variance of returns against the portfolio (departure from the average)
B < 1, security is safer than WIG average B > 1, security is riskier than WIG average

Average rate of return on common stocks (WIG)

Kevin Campbell, University of Stirling, November 2005

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The Security Market Line (SML)

Required rate of return Percent 20.0 18.0 16.0 14.0 12.0 10.0 Rf 8.0 5.5 0.5 1.0 1.5 2.0 Market risk premium SML = Rf + (Km Rf)

Beta (risk)
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Kevin Campbell, University of Stirling, November 2005

Finding the Required Return on Common Stock using the Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) can be used to estimate the required return on individual stocks. The formula: K j R f j (K m R f ) where Kj Rf = = = Required return on stock j Risk-free rate of return (usually current rate on Treasury Bill). Beta coefficient for stock j represents risk of the stock

Km

Return in market as measured by some proxy portfolio (index)

Suppose that Baker has the following values: = 5.5% Rf j = 1.0 Km = 12%

Kevin Campbell, University of Stirling, November 2005

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Finding the Required Return on Common Stock using the Capital Asset Pricing Model
Then, using the CAPM we would get a required return of
K j 5.5 1.0 ( 12 - 5.5) 12%

Kevin Campbell, University of Stirling, November 2005

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CAPM/SML approach

Advantage: Evaluates risk, applicable to firms that dont pay dividends Disadvantage: Need to estimate

Beta the risk premium (usually based on past data,

not future projections) use an appropriate risk free rate of interest

Kevin Campbell, University of Stirling, November 2005

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Estimation of Beta: Measuring Market Risk

Market Portfolio - Portfolio of all assets in the economy In practice a broad stock market index, such as the WIG, is used to represent the market Beta - sensitivity of a stocks return to the return on the market portfolio

Kevin Campbell, University of Stirling, November 2005

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Estimation of Beta

Theoretically, the calculation of beta is straightforward: Cov( Ri , RM ) iM 2 Problems Var ( RM ) M

1. Betas may vary over time. 2. The sample size may be inadequate. 3. Betas are influenced by changing financial leverage and business risk.

Solutions
Problems 1 and 2 (above) can be moderated by more sophisticated statistical techniques. Problem 3 can be lessened by adjusting for changes in business and financial risk. Look at average beta estimates of comparable firms in the industry.

Kevin Campbell, University of Stirling, November 2005

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Stability of Beta

Most analysts argue that betas are generally stable for firms remaining in the same industry Thats not to say that a firms beta cant change

Changes in product line Changes in technology Deregulation Changes in financial leverage

Kevin Campbell, University of Stirling, November 2005

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What is the appropriate risk-free rate?

Use the yield on a long-term bond if you are analyzing cash flows from a long-term investment
For short-term investments, it is entirely appropriate to use the yield on short-term government securities Use the nominal risk-free rate if you discount nominal cash flows and real risk-free rate if you discount real cash flows

Kevin Campbell, University of Stirling, November 2005

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Survey evidence: What do you use for the risk-free rate?

Corporations
90-day T-bill (4%) 3-7 year Treasuries (7%)

Financial Advisors
90-day T-bill (10%) 5-10 year Treasuries (10%)

10-year Treasuries (33%)

20-year Treasuries (4%) 10-30 year Treasuries (33%) 10-years or 90-day; depends (4%)

10-30 year Treasuries (30%)

30-year Treasuries (40%) N/A (10%)

N/A (15%)

Source: Bruner et. al. (1998)

Kevin Campbell, University of Stirling, November 2005

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Weighted Average Cost of Capital (WACC)

WACC weights the cost of equity and the cost of debt by the percentage of each used in a firms capital structure WACC=(E/ V) x RE + (D/ V) x RD x (1-TC)

(E/V)= Equity % of total value (D/V)=Debt % of total value (1-Tc)=After-tax % or reciprocal of corp tax rate Tc. The after-tax rate must be considered because interest on corporate debt is deductible

Kevin Campbell, University of Stirling, November 2005

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WACC Illustration
ABC Corp has 1.4 million shares common valued at $20 per share =$28 million. Debt has face value of $5 million and trades at 93% of face ($4.65 million) in the market. Total market value of both equity + debt thus =$32.65 million. Equity % = .8576 and Debt % = .1424
Risk free rate is 4%, risk premium=7% and ABCs =.74 Return on equity per SML : RE = 4% + (7% x .74)=9.18%

Tax rate is 40%

Current yield on market debt is 11%

Kevin Campbell, University of Stirling, November 2005

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WACC Illustration
WACC = (E/V) x RE + (D/V) x RD x (1-Tc) = .8576 x .0918 + (.1424 x .11 x .60) = .088126 or 8.81%

Kevin Campbell, University of Stirling, November 2005

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Final notes on WACC

WACC should be based on market rates and valuation, not on book values of debt or equity Book values may not reflect the current marketplace WACC will reflect what a firm needs to earn on a new investment. But the new investment should also reflect a risk level similar to the firms Beta used to calculate the firms RE.

In the case of ABC Co., the relatively low WACC of 8.81% reflects ABCs =.74. A riskier investment should reflect a higher interest rate.
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Kevin Campbell, University of Stirling, November 2005

Final notes on WACC

The WACC is not constant It changes in accordance with the risk of the company and with the floatation costs of new capital

Kevin Campbell, University of Stirling, November 2005

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Marginal cost of capital and investment projects

Percent 16.0 14.0

12.0
10.0 8.0 6.0

A B C 10.41%

10.77% E
F

11.23%

Kmc Marginal cost of capital

4.0 2.0 0.0 10 15 19

39 50 70 Amount of capital ($ millions)

Kevin Campbell, University of Stirling, November 2005

85

95
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The End .

KAPITA - bogactwo zebrane uprzednio w celu podjcia dalszej produkcji (F. Quesnay, XVIII) wszelki wynik procesu produkcyjnego, ktry przeznaczony jest do pniejszego wykorzystania w procesie produkcyjnym (MCKenzzie, Nardelli,1991) caoksztat zaangaowanych w przedsibiorstwie wewntrznych i zewntrznych, wasnych i obcych, terminowych i nieterminowych zasobw (bilans) STRUKTURA KAPITAU proporcja udziau kapitau wasnego i obcego w finansowaniu dziaalnoci przedsibiorstwa relacja wartoci zaduenia dugoterminowego do kapitaw wasnych przedsibiorstwa struktura finansowania struktura kapitau = zobowizania biece ramy statycznego kompromisu, w ktrym przedsibiorstwo ustala docelow wielko wskanika zaduenia i stopniowo zblia si do jego osignicia.

Kevin Campbell, University of Stirling, November 2005

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