Sunday, October 16, 2011

The Cost of Capital

CFA Level 1 - Corporate Finance

The following sections discuss the cost of capital in terms of its components, calculations, and company internal targets. Readers should know the costs that make up the weighted cost of capital (WACC).
Interpreting the Cost of Capital
Given the importance of capital budgeting, a company should use the weighted average of the costs of the various types of capital it may use in financing its operations.

A company uses debt, common equity and preferred equity to fund new projects, typically in large sums. In the long run, companies typically adhere to target weights for each of the sources of funding. When a capital budgeting decision is being made, it is important to keep in mind how the capital structure may be affected.

Cost Components
A company's weighted average cost of capital (WACC) is comprised of the following costs:

1.Cost of debt
2.Cost of preferred stock
3.Cost of retained earnings
4.Cost of external equity

1. Cost of Debt   In the WACC calculation, the after-tax cost of debt is used. Using the after-tax cost takes into account the tax savings from the tax-deductibility of interest.
The after-tax cost of debt can be calculated as follows:

Formula 11.1

After-tax cost of debt = kd (1-t)

Look Out!
It is important to note that kd represents thecost to issue new debt, not the firm's existing debt.

Example: Cost of Debt
Newco plans to issue debt at a 7% interest rate. Newco's total (both federal and state) tax rate is 40%. What is Newco's cost of debt?
 kd (1-t) = 7% (1-0.40) = 4.2%

2.     Cost of Preferred Stock
Cost of preferred stock (kps) can be calculated as follows:

Formula 11.2

kps = Dps/Pnet where: Dps=preferred dividends and Pnet = net issuing price

Example: Cost of preferred stock
Assume Newco's preferred stock pays a dividend of $2 per share and it sells for $100 per share. If the cost to Newco to issue new shares is 4%, what is Newco's cost of preferred stock?
kps = Dps/Pnet = $2/$100(1-0.04) = 2.1%

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