31-07-2013, 02:35 PM
The Cost of Capital
Cost of Capital.ppt (Size: 283 KB / Downloads: 48)
What is the “Cost” of Capital?
When we talk about the “cost” of capital, we are talking about the required rate of return on invested funds
It is also referred to as a “hurdle” rate because this is the minimum acceptable rate of return
Any investment which does not cover the firm’s cost of funds will reduce shareholder wealth (just as if you borrowed money at 10% to make an investment which earned 7% would reduce your wealth)
The Appropriate Hurdle Rate: An Example
The managers of Rocky Mountain Motors are considering the purchase of a new tract of land which will be held for one year. The purchase price of the land is $10,000. RMM’s capital structure is currently made up of 40% debt, 10% preferred stock, and 50% common equity. This capital structure is considered to be optimal, so any new funds will need to be raised in the same proportions.
Before making the decision, RMM’s managers must determine the appropriate require rate of return. What minimum rate of return will simultaneously satisfy all of the firm’s capital providers?
The Weighted Average Cost of Capital
We now need a general way to determine the minimum required return
Recall that 40% of funds were from debt. Therefore, 40% of the required return must go to satisfy the debtholders. Similarly, 10% should go to preferred shareholders, and 50% to common shareholders
This is a weighted-average, which can be calculated as:
Calculating RMM’s WACC
Using the numbers from the RMM example, we can calculate RMM’s Weighted-Average Cost of Capital (WACC) as follows:
Market-value Weights
The problem with book-value weights is that the book values are historical, not current, values
The market recalculates the values of each type of capital on a continuous basis. Therefore, market values are more appropriate
Calculation of market-value weights is very similar to the calculation of the book-value weights
The main difference is that we need to first calculate the total market value (price times quantity) of each type of capital
The Costs of Capital
As we have seen, a given firm may have more than one provider of capital, each with its own required return
In addition to determining the weights in the calculation of the WACC, we must determine the individual costs of capital
To do this, we simply solve the valuation equations for the required rates of return
A Note on Flotation Costs
The amount of flotation costs are generally quite low for debt and preferred stock (often 1% or less of the face value)
For common stock, flotation costs can be as high as 25% for small issues, for larger issue they will be much lower
Note that flotation costs will always be given, but they may be given as a dollar amount, or as a percentage of the selling price