Cost of Capital Components - Business Finance - ثاني ثانوي

Link digitop 回我回 8.1 Cost of Capital Components Key Terms www.en.edu.sa Cost of capital Cost of preferred stock Cost of capital Also called required rate of return this is the cat required by lenders and investors who are letting the company use their money Cost of debt Cost of equity Cost of common stock Flotation costs When a company uses the money of others for its business activities, stockholders and creditors are paid for the use of these funds. Cost of capital, also called the required rate of return, is the rate required by lenders and investors who are letting the company use their money. The three main sources of money used by a company are: 1. debt; 2. preferred stock (a type of equity); and 3. common stock (another type of equity), Caux of debt The rate of retum required by.creditors 8.1a Cost of Debt Borrowing is a common practice among organizations. Bonds, loans, and other types of debt are major funding sources. Cost of debt is the rate of return required by creditors. This percentage is the rate that lenders expect to receive when allowing someone to use their money. Common benefits associated with using debt include: The company is using the money of others, allowing the business to keep its funds available for other uses. The risk for creditors is lower since the borrower is legally obliged to repay the debt so they are more likely to get their money back compared to other types of financial backing. ⚫ The cost of capital is lower than other funding sources because of the lower risk for lenders (creditors). • Interest payments on debt are tax deductible as a business expense. PL 320 Business Finance .

The after-tax cost of debt (k,) depends on the interest rate (/), and the tax rate (t). This can be expressed as: k-(1-t) EXAMPLE If the interest rate is 7.6% and the tax rate is 35%, the after-tax cost of debt is: 0.076 (1-0.35)=0.0494-4.94% What are some of the advantages of a company using debt to fund their activities?

332 Business Finance N You Try It A 10% cost of debt with a 20% tax rate would result in an after-tax cost of capital of In addition to the tax rate, the cost of debt for a company is also influenced by these factors: ⚫ The current cost of borrowing. A company may have outstanding debt that was issued in the past. Due to changing economic conditions, the interest rate on that debt is probably higher or lower than current rates. In determining the current cost of the debt, the current interest rate is used. . The length of the borrowing term. Short-term debt will usually have a lower interest rate than long-term debt. If a company issues long-term debt, the rate is usually higher than short-term financing due to the uncertainty over time in the future flowever, the use of long-term debt avoids the risk associated with refinancing short-term debt. . The riskiness of the firm. The risk is related to the nature of the business (business risk) and to the use of debt (financial risk). The more the firm uses debt financing, the greater the potential will be for it to fail to meet its debt obligations. This increase in the risk of default means that as the firm's use of financial leverage increases, the interest rate on borrowed money will increase. This is illustrated by the line k in Figure 8.2. Initially, the cost of debt may be stable, as the firm uses more debt without increasing risk for the creditors. However, as the use of debt increases, the cost of debt starts to rise because creditors demand more interest due to an increased risk of loss.

* Debt/Total Assets (%) K-(1-0 FIGURE B.2 Cost of Debt 8.1b Cost of Preferred Stock The required rate of return for stockholders is not as easily determined as it is for creditors. The cost of debt is usually set by the rate charged for borrowing funds. In contrast, cost of equity is the required return of the owners in a company. This amount is the percentage company owners expect to earn based on the money they have invested in the company. Two types of equity are used by corporations. 1. preferred stock; and 2. common stock. The value of preferred stock depends on the dividend and the yield required to prompt investors to buy the shares. The valuation of preferred stock can be expressed as: The required retum company Owners expect to satn based on the money they have invested in the company D₁ P. is the price of the preferred stock, D, is the dividend paid by the preferred stock, and k, is the return required by investors. This equation may be rearranged to isolate the yield or the firm's cost of preferred stock with these two steps: 1. Pxk, D. 2. K₁ = D₁ وزارة التعليم CHAPTERS Cost of Capital 323

لبدر Cast of preferred stock The relationship between the dividend from dividend paying shares in a firm and the market price As a result, the cost of preferred stock is the relationship between the dividend from dividend paying shares in a firm and the market price. EXAMPLE If the preferred stock pays a SAR 1.00 dividend and sells for SAR 12, the cost of the preferred stock to the firm is: SAR 1.00 SAR 12:00 0.0833 = 8.33% The 8.33% is the cost of capital for preferred stock in this situation. For a company, the cost of capital for preferred stock is higher than the cost of debt. This difference is the result of interest on debt being tax deductible; the interest is tax deductible while the preferred dividend payments are not. You Try It What would be the cost of preferred stock for a situation with a market price of SAR 78 and o dividend of SAR 6? Cad of comm The return required by investors to buy the shares of ownership in a firm, which is viewed as an opportunity cost 8.1c Cost of Common Stock The cost of common stock is the return required by investors to buy the shares of ownership in a firm, which is viewed as an opportunity cost. This cost of common equity is an opportunity cost, it is the return that investors could earn on comparable, alternative uses for their money. This cost applies both to existing shares and to new shares issued by the firm. Since the cost of common stock is an opportunity cost, there is no identifiable expense such as interest that the financial manager may use to determine the cost of these funds. However, the financial manager knows that the cost of common stock exceeds the cost of debt. 324 Business Finance

No tax advantage is associated with equity because dividends are paid in after-tax SAR (that is, dividends are not tax deductible), while interest is paid in before-tax SAR (that is, interest is a tax-deductible expense). In addition, common stock represents ownership and, therefore, is a riskier security than a debt obligation. Although the firm is legally obligated to pay interest and meet the terms of the debt agreement, there is no legal obligation for the firm to pay dividends. To determine the opportunity cost for the cost of capital for common stock, three methods are often used: 1. With equity riskier than debt for the investor, an estimate for the cost of equity could start with the interest rate paid to the debtholders and add a risk premium. This method can be noted as follows: k = i + Risk premium In this notation, k, is the cost of equity and is the interest rate for new debt. The risk premium is then added to the interest rate. Although the financial manager knows the interest rate, the amount of the risk premium is unsure. Selecting the rate for the risk premium could be an informed estimate based on various economic, company, and market factors. 2. A second approach to determine the cost of equity is the capital asset pricing model (CAPM). As discussed in Chapter 6, CAPM is used to determine the return on equity as follows: k₁ =+ (-)B With this method, the cost of equity depends on the risk-free rate of interest (r) plus a risk premium. The risk premium depends on: ⚫ the difference between the return on the market as a whole (r.) and the risk-free rate; and ⚫ the firm's beta coefficient, which measures the systematic risk associated with the firm. This required return is the return necessary to convince investors to buy the stock, so it may be viewed as the firm's cost of equity, CAPM is usually viewed as more valid than using the interest rate and adding a risk premium since it more precisely specifies the risk premium associated with investing in the stock. وزارة التعليم 2024-1889 CHAPTERS Cost of Capital 325

Why is the cost of common stock considered to be an opportunity cost? P326Business Finance A 3. A third approach defines the cost of equity based on an investor's expected return. This is the expected dividend yield plus expected growth. D. represents the current dividend, while g is the expected growth rate, which is estimated by managers based on recent trends and future expectations. For example, a dividend of SAR 5 with a 10% growth rate would result in an expected dividend of SAR 5.5. With this dividend growth-rate model, the return on common stock (r) can be expressed as. r = Dividend yield + Growth rate r = D₁(1+g) P g As with the CAPM approach, the financial manager has to make this model operational. Although the current dividend and the price of the stock are known, estimates must be made for the future capital gains.

Each of these three approaches have some basic similarities. The interest rate plus risk premium method and the CAPM method are comparable. However, the CAPM specifies more clearly the risk premium in terms of the return on a risk-free security, the return on the market, and the systematic risk associated with the individual firm. The CAPM method and the expected return method are identical if it is assumed that financial markets are in equilibrium. If that assumption holds, the required return found using the CAPM would also be the investors' expected return determined by using the expected dividend yield plus the expected capital gain. For example, if the expected return exceeded the required return, investors would drive up the price of the stock, causing the expected return to fall. If the expected return were less than the required return, the opposite would occur. Investors would seek to sell the shares, which would drive down their price and increase the yield. These changes will cease when the market is in equilibrium and the required return is equal to the expected return. The same argument may be expressed in terms of a stock's valuation and its price. If the price of the stock is less than the valuation, investors bid up the price. If the price exceeds the valuation, investors seek to sell, which drives down the price. The incentive for stock prices to cease changing occurs when the price and the valuation are equal. Thus, if the equity markets are in equilibrium, a stock's price must equal its valuation, and the required return equals the expected return. If the equity markets are in equilibrium, the stock's price may be substituted for its value in the dividend-growth model (V=P): P D₁(1+9) ke-9 By rearranging terms, the required return is: وزارة التعليم Do(1+g) ke-9 = P D₁(1 + g) ke +9 P CHAPTER & Cost of Capital 327

Expenses associated with selling new stock In this form, the required return is the sum of the dividend yield plus the capital gain. This is identical to the investor's return and may be used as the cost of common equity. This equation expresses the cost of equity under the assumption that the firm does not have to issue new shares. The cost of equity is the cost of retained earnings. If a firm were to issue additional shares, it would receive an amount less than the market price of the stock because of flotation costs, which are the expenses associated with selling new stock. To adjust for this expense, the flotation costs (F) must be subtracted from the price of the stock to obtain the net proceeds to the firm. This cost of new shares (k..) is expressed as: P 328 Business Finance kn= Do(1+g) P-F +9 The greater the flotation costs, the smaller the amount obtained from the sale of each new share will be, resulting in a higher cost of the equity. Risk partially depends both on the nature of the business (business risk) and the financial decisions of management (financial risk). The relationship between financial risk and the cost of equity is illustrated in Figure 8.3, which relates the cost of equity (k) to the firm's use of financial leverage (debt). The same relationship between the cost of debt and the firm's use of financial leverage was shown in Figure 8.2. Both the cost of equity and the cost of debt may be initially stable, but eventually starts to rise as the firm uses more financial leverage and becomes riskier.

EXAMPLE A firm's earings are growing at 7%. The common stock is currently paying SAR 0.935 a share, and this dividend will grow annually at 7% so that the year's dividends will be SAR 1=SAR 0,935 (1+0.07). If the common stock is selling for SAR 25, the firm's cost of common stock is: SAR 0.935 (1+0.07) k₁ = +0.07 SAR 25 SAR 1 k₂ = + 0.07 SAR 25 = 0.04 +0.07 0.11 = 11% This tells management that investors currently require an 11% return on the stock investment. That return consists of a 4% dividend yield and the 7% growth. Failure on the part of management to achieve this return for the common stockholders will result in a decline in the price of the common stock If the firm has exhausted its retained earnings and must issue new stock, the cost of common stock must rise to cover the flotation costs. If these costs are SAR 1 a share, the firm nets SAR 24 per share, and the cost of equity is: SAR 0.935 (1+0.07) + 0.07 SAR 25-1 1 -Kne = +0.07 24 = 0.0417+0.07 = 11.17% The cost of equity is now higher. The firm must earn 11.17% to cover the flotation costs and investors' required return. Flotation costs are a cash outflow that occurs when new securities are issued, which raises the cost of a new issue of securities. وزارة التعليم CHAPTERS Cost of Capital 329

FIGURE 9.3 Cast of Equity K = P 3.30 Business Finance Debi/Total Assets (6) 011+9+ +9 P You Try It Calculate the risk premium using CAPM with these amounts: bela coefficient 1.15, risk-free rate 4%, average market rute 8%. Exercises Choose the correct answer. 1. Dividends paid on preferred stock are tax deductible. True/False 2. The return required by investors viewed as an opportunity cost refers to the a. cost of common stock. b. cost of debt. c. cost of preferred stock. d. average weighted cost.