Published On:Friday, 23 December 2011
Posted by Muhammad Atif Saeed
The Cost of Capital
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 CapitalGiven 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 ComponentsA company's weighted average cost of capital (WACC) is comprised of the following costs:1.Cost of debt2.Cost of preferred stock3.Cost of retained earnings4.Cost of external equity
Cost of retained earnings (ks) is the return stockholders require on the company's common stock.
There are three methods one can use to derive the cost of retained earnings:a) Capital-asset-pricing-model (CAPM) approachb) Bond-yield-plus-premium approach c) Discounted cash flow approach
a)CAPM Approach To calculate the cost of capital using the CAPM approach, you must first estimate the risk-free rate (rf), which is typically the U.S. Treasury bond rate or the 30-day Treasury-bill rate as well as the expected rate of return on the market (rm).
The next step is to estimate the company's beta (bi), which is an estimate of the stock's risk. Inputting these assumptions into the CAPM equation, you can then calculate the cost of retained earnings.
Formula
Example: CAPM approachFor Newco, assume rf = 4%, rm = 15% and bi = 1.1. What is the cost of retained earnings for Newco using the CAPM approach?
Answer:ks = rf + bi (rm - rf) = 4% + 1.1(15%-4%) = 16.1%
b) Bond-Yield-Plus-Premium ApproachThis is a simple, ad hoc approach to estimating the cost of retained earnings. Simply take the interest rate of the firm's long-term debt and add a risk premium (typically three to five percentage points):
Formula
Example: bond-yield-plus-premium approachThe interest rate on Newco's long-term debt is 7% and our risk premium is 4%. What is the cost of retained earnings for Newco using the bond-yield-plus-premium approach?
Answer: ks = 7% + 4% = 11%
c) Discounted Cash Flow ApproachAlso known as the "dividend yield plus growth approach". Using the dividend-growth model, you can rearrange the terms as follows to determine ks.
Formula
Typically, you must also estimate g, which can be calculated as follows:
Formula
Example: discounted cash flow approach Assume Newco's stock is selling for $40; its expected return on equity (ROE) is 10%, next year's dividend is $2 and the company expects to pay out 30% of its earnings. What is the cost of retained earnings for Newco using the discounted cash flow approach?
Answer: g must first be calculated: g = (1-0.3)(0.10) = 7.0%
ks = 2/40 + 0.07 = 0.12 or 12%
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 ComponentsA company's weighted average cost of capital (WACC) is comprised of the following costs:1.Cost of debt2.Cost of preferred stock3.Cost of retained earnings4.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
| 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?
Answer:
kd (1-t) = 7% (1-0.40) = 4.2%
Cost of Retained Earnings:
2. Cost of Preferred StockCost of preferred stock (kps) can be calculated as follows:
FormulaExample: Cost of preferred stockAssume 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
where:Dps = preferred dividendsPnet = net issuing price
Answer:kps = Dps/Pnet = $2/$100(1-0.04) = 2.1%
Cost of retained earnings (ks) is the return stockholders require on the company's common stock.
There are three methods one can use to derive the cost of retained earnings:a) Capital-asset-pricing-model (CAPM) approachb) Bond-yield-plus-premium approach c) Discounted cash flow approach
a)CAPM Approach To calculate the cost of capital using the CAPM approach, you must first estimate the risk-free rate (rf), which is typically the U.S. Treasury bond rate or the 30-day Treasury-bill rate as well as the expected rate of return on the market (rm).
The next step is to estimate the company's beta (bi), which is an estimate of the stock's risk. Inputting these assumptions into the CAPM equation, you can then calculate the cost of retained earnings.
Formula
 |
Example: CAPM approachFor Newco, assume rf = 4%, rm = 15% and bi = 1.1. What is the cost of retained earnings for Newco using the CAPM approach?
Answer:ks = rf + bi (rm - rf) = 4% + 1.1(15%-4%) = 16.1%
b) Bond-Yield-Plus-Premium ApproachThis is a simple, ad hoc approach to estimating the cost of retained earnings. Simply take the interest rate of the firm's long-term debt and add a risk premium (typically three to five percentage points):
Formula
| ks = long-term bond yield + risk premium |
Example: bond-yield-plus-premium approachThe interest rate on Newco's long-term debt is 7% and our risk premium is 4%. What is the cost of retained earnings for Newco using the bond-yield-plus-premium approach?
Answer: ks = 7% + 4% = 11%
c) Discounted Cash Flow ApproachAlso known as the "dividend yield plus growth approach". Using the dividend-growth model, you can rearrange the terms as follows to determine ks.
Formula
| ks = D1 + g; P0 where:D1 = next year's dividendg = firm's constant growth rateP0 = price |
Formula
| g = (retention rate)(ROE) = (1-payout rate)(ROE) |
Answer: g must first be calculated: g = (1-0.3)(0.10) = 7.0%
ks = 2/40 + 0.07 = 0.12 or 12%
| Exam Tips and Tricks Of the three approaches to determine the cost of retained earnings, be most familiar with the CAPM approach and the dividend-yield-plus-growth approach |
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Posted by Muhammad Atif Saeed on 12:52. Filed under Corporate Finance, feature, Financial Management . You can follow any responses to this entry through the RSS 2.0. Feel free to leave a response
