The Cost of Capital
Management need to understand the cost of capital to select longterm investments after assessing their acceptability and relative rangkings.
Gitman & Zutter (2012:358) The cost of capital represents the firm’s cost of financing and is the minimum rate of return that a project must earn to increase firm value. A firm’s cost of capital is estimated at a given point in time and reflects the expected average future cost of funds over the long run.
A firm is currently faced with an investment opportunity. - Best project available today: Cost $100,000 Life 20 years IRR = 7% Cost of least-cost financing source available, Debt = 6% The firm undertakes the opportunity
Best project available 1 week later: Cost $100,000 Life 20 years IRR = 7% Cost of least-cost financing source available: Equity =14% The firm rejects the opportunity
Assuming that a 50-50 mix of debt and equity is targeted, the weighted average cost here would be 10%: (50% x 6%) + (50% x 14%)
Mengapa perhitungan “weighted average cost of capital” diperlukan? • Suatu pendekatan sederhana untuk evaluasi investasi • Evaluasi secara keseluruhan mengenai pengambilan keputusan suatu investasi agar dapat meningkatkan nilai perusahaan, dalam hal ini memilih projek yang memberikan return yang lebih besar daripada weighted average cost of financing (or WACC).
Long-term sources of funds the permanent financing: 1. long-term debt 2. Preferred stock 3. Common stock equity: Common stock and Retained earnings.
The Firm’s Capital Structure
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
Overall cost of capital: biaya modal rata-rata dari modal/dana jangka panjang yang digunakan perusahaan untuk mendanai/membiayai perusahaan.
Brealey, Myers & Marcus (2004:322) The company cost of capital is a weighted average of the returns demanded by debt and equity investors. The weighted average is the expected rate of return investors would demand on a portfolio of all the firm’s outstanding securities.
Mengapa penting: 1. Biaya modal akan menentukan penawaran dana kepada perusahaan 2. Biaya modal akan mempengaruhi struktur modal dan kebijakan dividen
WACC ditentukan oleh: 1. Biaya sumber dana secara individual 2. Bobot sumber dana dalam struktur modal
Biaya modal secara individual: 1. Biaya pinjaman jangka panjang 2. Biaya saham preferen 3. Biaya saham biasa: laba ditahan dan penerbitan saham baru.
The Cost of Long-Term Debt Dapat dihitung melalui salah satu cara: – Persamaan biaya /cost quotations – Menghitung biaya /Calculating the cost – Memperkirakan biaya/ Using/Approximating the cost
Cost of Debt Duchess Corporation, a major hardware manufacturer, is contemplating selling bonds with a par value of $ 1,000 of 20year, 9% coupon. The firm sell the bonds at $ 980. Flotation costs are 2% or $ 20. The net proceeds to the firm for each bond is therefore $ 960 ($ 980 - $ 20).
Persamaan biaya: Net proceeds dari penjualan obligasi sama dengan nilai per lembar nya, dan biaya sebelum pajak akan sama dengan tingkat bunga kupon
Menghitung biaya Dilakukan dengan menghitung internal rate of return (IRR),dengan cara: (a) trial and error, (b) kalkulator finansial, atau (c) spreadsheet.
Calculating the cost of debt before tax:
Approximating the cost of debt before tax:
Find the after-tax cost of debt for Duchess assuming it has a 40% tax rate: rd = 9.4% (1- 40%) = 5.6% This suggests that the after-tax cost of raising debt capital for Duchess is 5.6%.
The Cost of Preferred Stock Duchess Corporation is contemplating issuance of a 10% preferred stock that is expected to sell for its $87 per share par value. The cost of issuing and selling the stock expected to be $5 per share. rp = DP/Np = $8.70/$82 = 10.6%
The Cost of Common Stock • The cost of common stock equity is the rate at which investors discount the expected dividends of the firm to determine its share value. • Estimasi cost of common equity: the constant-growth valuation model, dan capital asset pricing model (CAPM).
• Using the constant-growth valuation (Gordon) model : rs = D1/Po + g
• Estimate the cost of common equity using the CAPM: r = R + b(r - R ) s
F
m
F
The constant-growth valuation (Gordon) model Duchess Corporation wishes to determine its cost of common stock equity. The market price of its common stock is $ 50 per share. The firm expects to pay dividend of $ 4 at the end of the coming year. The dividend paid out the outstanding stock over the past 6 years were as follows:
Year
Dividend
2012
$ 3.80
2011
$ 3.62
2010
$ 3.47
2009
$ 3.33
2008
$ 3.12
2007
$ 2.97
g = 5% P0 = $ 50 D1 = $ 4 Cost of common stock equity = 13%
• CAPM memperhitungkan risiko perusahaan yaitu beta, sedangkan The constant-growth valuation (Gordon) model tidak memperhitungkan risiko. • The constant-growth valuation (Gordon) model menggunakan harga pasar (P0) sebagai tingkat risk-return yang diharapkan.
• Cost of Retained Earnings (ke) – Constant-Growth Model For example, assume a firm has just paid a dividend of $2.50 per share, expects dividends to grow at 10% indefinitely, and is currently selling for $50.00 per share. D1 = $ 2.50 (1+ 10%) = $ 2.75 kS = ($2.75/$50.00) + 10% = 15.5%.
– Security Market Line Approach rs = rF + b(rM - rF). For example, if the 3-month T-bill rate is currently 5.0%, the market risk premium is 9%, and the firm’s beta is 1.20, the firm’s cost of retained earnings will be: rs = 5.0% + 1.2 (9.0%) = 15.8%.
• The previous example indicates that our estimate of the cost of retained earnings is somewhere between 15.5% and 15.8%. At this point, we could either choose one or the other estimate or average the two. • Using some managerial judgment and preferring to err on the high side, we will use 15.8% as our final estimate of the cost of retained earnings.
• Cost of New Issues of Common Stock (rn) rn = = D1/Nn + g Continuing with the previous example, how much would it cost the firm to raise new equity if flotation costs amount to $4.00 per share? rn = [$2.75/($50.00 - $4.00)] + 10% = 15.97% or 16%.
Capital Structure Weights • For example, assume the market value of the firm’s debt is $40 million, the market value of the firm’s preferred stock is $10 million, and the market value of the firm’s equity is $50 million.
• Dividing each component by the total of $100 million gives us market value weights of 40% debt, 10% preferred, and 50% common.
WACC = ka = wiki + wpkp + wskn The weights in the above equation are intended to represent a specific financing mix (where wi = % of debt, wp = % of preferred, and ws= % of common).
Using the costs previously calculated along with the market value weights, we may calculate the weighted average cost of capital as follows: WACC = 0.40(5.6%) + 0.10(10.6%) + 0.50(15.8%) = 11,2%
• This assumes the firm has sufficient retained earnings to fund any anticipated investment projects.
WACC • • • • • -
Cost of debt = 5,6% Cost of preferred stock = 10,6% Cost of retained earnings = 15,8% Cost of new common stock = 16% Source of capital: Long term debt 40% Preferred stock 10% Common stock equity 50%
Capital Structure Weights: • One method uses book values from the firm’s balance sheet. For example, to estimate the weight for debt, simply divide the book value of the firm’s longterm debt by the book value of its total assets.
• A second method uses the market values of the firm’s debt and equity. To find the market value proportion of debt, simply multiply the price of the firm’s bonds by the number outstanding. This is equal to the total market value of the firm’s debt.
Brealey, Myers & Marcus (2004:324) The cost of capital must be based on what investors are actually willing to pay for the company’s outstanding securities – that is, based on the securities’ market values.
