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Introduction: Capital Structure and Cost of Debt

Video Transcript:

"Hello everyone. Welcome to Corporate Finance Series: What is your Corporate Cost of Capital? My name is Joseph Ori. I am the Executive Managing Director of Paramount Capital Corporation. We are a corporate finance and real estate advisory firm based in the bay area of California. This is a presentation on what is your corporate cost of capital? I have a 36 slide presentation here and it's broken down into three modules. If you just follow along we will learn how to calculate your cost of capital.

Let's go to slide one. Again, I am Joe Ori. There is my contact information. My e-mail and website if you have any concerns or questions. Again, the title of this presentation is What is your Corporate Cost of Capital? Moving on to slide number two, this presentation is broken down into three modules that are approximately twenty minutes each. Participants can view the entire presentation at once or each module or in whatever format you prefer. That's up to your decision.

Let's look at slide number three. Our executive summary. A firm's capital structure or capitalization includes the amount of long term debt, preferred stock and common stock on a balance sheet. These are typically the three types of capital you will find on a lot of companies. Most companies don't have a preferred stock, but most have at least long term debt and common stock. The second point there is that the firm needs to know what the cost of is each of the components of its capital structures. Remember, the cost to the company of its debt, its preferred stock and its common stock is their return to the investor in each of those securities. The third point there on slide thee is a firm has five primary sources of capital. All firms need capital in order to invest and grow and there are five primary sources from the cheapest and easiest to the most expensive and difficult to raise. The last point on slide three is the weighted average cost of capital is the weighted cost of a firm's debt, preferred stock and common stock. Later in the presentation we will go through an actual example for our hypothetical company, the Acme Corporation and calculate its average weighted cost of capital.

Moving on to slide number four, let's talk about the cost of debt. The cost of debt... The formula is the yield on the debt Y, times one minus the tax rate. The cost of preferred stock is the dividend on the preferred stock divided by the price of the preferred. The cost of the common stock is calculated using one of two models. The dividend discount model (DDM) or the capital asset pricing model (CAP). Either one can be used to calculate the cost of common stock. The second point there on slide four is the weighted average cost of capital is used as a discount rate to evaluate all of the firm's investments. All firms make investments. They have to make investments in property, plant and equipment. It might acquire other firms. They might expand their business. All of those investments have to earn a return greater than their weighted average cost of capital. A firm, once it knows what its weighted average cost of capital should accept all investments that return are greater than the weighted average cost of capital. If the firm is making investments earning a return above its cost of capital, it will increase its value and wealth, stock price and therefore shareholder wealth.

Moving on to slide number five. In slide number five, the first point is that a firm can adjust its capital structure to lower its weighted average cost of capital. It can do this by adding more debt into the capital structure. Debt is cheaper than equity. Long term debt has a cheaper cost than issuing common stock equity. Why is debt cheaper? You have to pay it back. You usually have a loan agreement promissory note. You have an interest rate. You have a certain term. You have a payment schedule. A lot of times the lender may have some type of collateral. All of those items make debt cheaper than equity. Common stock is more expensive than debt, therefore if you add more debt in your capital structure, you will lower your weighted average cost of capital.

Let's take an example. Let's say you have a company that has 20% debt and 80% equity and their cost of capital is 12%. If that company increases its debt from 20% to 50% and now has 50% debt and 50% equity, its cost of capital may come down from 12% to let's say, 10.5%. However, if the company increases its debt from 20% to 80%, where has 80% debt and 20% equity, its cost of capital won't decrease. It will increase to 17 or 18% or some higher percentage. That is because the company would be considered over leveraged, too much debt and potential bankruptcy risk. As it said in the 3rd point there on slide five, too much debt may increase the weighted average cost of capital due to bankruptcy concerns.

The last item on slide five is that large diversified firms may have divisional weighted average cost of capital. Apple, as an example is a great company. It has a lot of divisions. It has the iMac division, the iPad division, the iPhone division, the iTunes division... Apple has a corporate composite cost of capital, but also has cost of capital for each of those divisions. We'll discuss later in the presentation when to use those divisional weighted cost of capital as opposed to the firms composite cost of capital.

Moving on to slide number six. On slide number six, let's talk about the sources of corporate capital. Firms need capital to reinvest and grow their businesses and this capital can come from five sources. These are listed in order of the cheapest and easiest to the most expensive and hardest to obtain. The cheapest and best source of capital for any company is its retained earnings or the profit and cash flow that is generated internally by the company. Any company that can generate a high net income and a high cash flow can potentially never have to go outside to raise debt or additional common stock equity and fund everything internally. This is very rare. Only a few companies can do this. Apple is one example. Google is another one. Any time you can use your retained earnings and internal cash flow as your source of capital, the better because you don't have to go out and borrow money and incur fees and costs. Have those additional sources of capital on your balance sheet and this will lead to a very low weighted average cost of capital.

The second cheapest source of capital are short term bank loans. Every company has a banking relationship or should have. They typically have a revolving line of credit or a term loan which they can get on a phone call or a moment's notice. Bank loans can be taken down or a revolving line of credit usually within hours, if not a day or so. So bank loans are the second easiest and cheapest forms of capital for a company.

Moving on to slide number seven. The third source of capital on slide seven for companies is long term debt. Long term debt is more expensive than a bank loan; however, the interest rate is usually fixed and it has longer terms as a five, seven or ten years. Most companies have long term debt. Some have multiple issues. So long term debt is the third most expensive capital for a company. Again, the interest is higher than a bank loan and its longer term and usually at a fixed rate. Most bank loan, term loans are at floating interest rates over liber or the prime rate. The second point there. The fourth type of corporate capital is preferred stock. Preferred stock is a hybrid security. It is part debt and part common stock. The dividend on the preferred is typically higher than the interest on long-
term debt. Preferred stock is typically issued at $25 a share. You don't own the company if you invest in the preferred stock, only the common stock holders do. Preferred stock is somewhat common. Not all companies have it. There are a lot of investors that like preferred stocks. Banks, hedge funds, a lot of mutual funds. So preferred stocks is the fourth type of security that a company can issue to raise capital.

The last and most expensive and hardest to issue security is common stock. It's the most expensive source of capital. If you're doing an IPO, less than a billion dollars, it typically will cost you 10% of the offering. Seven percent of that goes to the underwriting syndicate. Three percent goes to fees costs, travel, printing, etc. It usually takes the longest time to fund. An IPO usually takes about six months to close. If you're doing a secondary offering post IPO, it normally takes you probably 35, 45 or 60 days to do a common stock offering. The fee will be somewhat less, but in general, common stock is the most expensive source of capital and it also dilutes all of the other shareholders. The more common stock you issue, the lower the percentage interest of everybody who is a common share holder. Most companies do not like to list common stock unless they have to and when companies do issue secondary offerings of common stock, it is a signal to the market that the common stock is highly priced. Companies are not going to issue common stock when their stock is in the toilet or very low at a discounted, cheap price. If you see a company coming out while reading the Wall Street Journal that XYZ Company is issuing ten million share of common stock in a secondary offering, that should immediately tell you that they believe internally that the stock is at a very high price and they want to take advantage of that by issuing stock at the highest price possible.

OK, let's move on to slide eight. In slide eight, let's talk about the firm's capital structure. A firm's capital structure or capitalization includes the amount of long term debt, preferred stock and common stock, raised from investors to pursue growth and investment opportunities. That's a firm's capitalization. If somebody asks you what's your capitalization of your company, that would be how much of each of these you have in your capital structure. Debt, preferred stock and common stock. The second bullet point there is that all firms have common stock, common equity and may have long term debt and or preferred stock. The third point is that the cost of each of these components of the capital structure is key to calculating a firm's weighted average cost of capital. Each of these items, debt, common stock and preferred stock has a cost to the company and that cost is the return to the investors providing that capital. The initial step in calculating a firm's weighted average cost of capital is to determine the cost of each of the components in the capital structure, multiply it by the weight in the capital structure and then come up with the weighted average cost of capital.

Let's move on to slide nine. On slide nine, let's look at the formula for calculating the weighted average cost of capital. This may look a little confusing, but we'll break it down into pieces and then with our hypothetical company, the Acme Corporation, we'll calculate an actual weighted average cost of capital. The formula is the weight of the debt times the yield of the debt times one minus the tax rate. That's the cost of debt, plus the weight of the preferred, times the return of the preferred, plus the weight of the common times the weight of the common stock. That is the technical formula for calculating the weighted average cost of capital.

We, as I said, are going to calculate it for our hypothetical company, Acme Corporation, but we're going to use more of a long format and show you how to do it by the balance sheet way. Showing each part of the capital structure, times the cost times the weight and then coming up with the weighted average cost of capital.

Let's first look at the cost of debt. The weight of the debt times the yield of the debt times one minus the tax rate is the yield on the debt times one minus the tax rate times the weight in the capital structure. The preferred stock... The last bullet point there is the yield on the preferred stock times the weight in the capital structure.

Moving on to slide ten, the weight of the common times the return on the common is the cost of the common stock using either the dividend discount model or the capital asset pricing model times the weight in the capital structure. Again, the cost of the common is the cost of the company. Their return is the return to the investor. They mean the same thing. Each one is the side of a coin. The last point on slide ten is the weighted cost of each component is added together to obtain the weighted average cost of capital. We will go through an example with Acme Corporation to calculate that.

Moving on to slide eleven. Beginning on slide eleven, the first bullet point... Affirms weighted average cost of capital is the return that investors should expect when investing in the firm's common stock. A firm that earns a weighted average cost of capital or has a weighted average cost of capital of 15%... That is the minimum return that you as an investor in the common stock of that company should expect to earn. That assumes that the firm with that 15% cost of capital is investing in projects that are earning a return above that 15% weighted average cost of capital [inaudible 16:22].

The last point on slide eleven is that the most profitable and successful firms earn returns on investments well in excess of their weighted average cost of capital. For example, Apple, Google, Visa, MasterCard, Walgreens and a number of companies. These are all Berkshire Hathaway, Warren Buffet's company... These are all companies that are very successful and have earned returns well in excess of their weighted average cost of capital, therefore their firms have grown. Their stock price has grown, their wealth has grown and they are considered some of the most successful companies in corporate America.

Moving on to slide twelve. Let's talk about the cost of debt and how to calculate it. As we said previously, the cost of debt is the yield, not the interest rate of the debt minus one times the tax rate. The yield is used because that is the current and future cost of debt. All debt has an interest or coupon rate. That is not is what's used in this calculation for weighted average cost of capital. You need to use the current yield on the debt. The price of the debt changes with changes in interest rates. So if a company issues debt at 5% and market rates are higher, your debt is going to trade at a discount. If market rates are lower than a coupon rate, your debt will trade at a premium. Therefore, you have to calculate the yield on that debt. The yield, in the last bullet point there, is calculated using a time value money rate function found on Microsoft Excel or a financial calculator like the HP 12C and we have an example coming up in the next couple of slides of how to calculate the yield on the debt.

So let's move to slide number thirteen. Here is an example to calculate the cost of debt. All debt is issued in $1000 par values. If you buy debt... No matter what you pay for it. If you buy it at a premium or a discount, or even at par for $1000 and hold it to maturity, you always get your $1000 back. So the inputs if you're using one of the financial functions on Microsoft Excel or a calculator, the future value would be $1000. The present value would be the current market price of the debt. That you would also have to calculate using Excel or a calculator. The PMT is the payment. That would be the semi-annual interest payment on the debt. Remember, corporate debt, the interest is paid semi-annually. Twice a year on January 1st and July 1st. End is the remaining term of the debt and I or Rate you saw for the yield on the debt.

So let's take a quick example in the second point there on slide thirteen. Let's say you have debt with a par value of $1 thousand. It's currently priced at a small discount of $980. It has a coupon of 4.5%. That's the interest rate. Therefore, the annual interest payments would be 4.5% of
$1000 or $45. The semiannual payment would be half of that or $22.50. There is ten years remaining and if you put all of that data into your calculator, you will come up with a yield on this debt of 4.75%. That yield is the return or interest rate that will be used in the cost of debt formula.

Let's move on to the next slide, slide fourteen. So once that yield is determined... That 4.75%, it is multiplied by one minus the corporate tax rate and why do they do this? Because the interest on debt is tax deductible and therefore the after tax yield is required. So the 4.5% times one minus the tax rate, that would be the cost of debt for calculating the weighted average cost of capital."

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2 QuestionsLesson Questions and Answers

Member's Profile

Since the retained earnings belong to the common shareholders, wouldn't the cost of retained earnings be equal to the cost of equity?

Member's Profile

than the WACC, then shareholders don't need the return of RE as dividends. W. Buffets, Berkshire Hathaway is a great example. The company has never paid a dividend but has generated a compound annual return of 19% for over 45 yrs.

Course Syllabus
Module 1
Module 2
  12:05Cost of Common Stock
Module 3
  23:39WACC: Calculation, Factors, and Other Comments
Continuous Play
  56:26Calculating Your Corporate Cost of Capital: Corporate Finance Series
SUPPORTING MATERIALS
  PDFSlides: Cost of Capital
  PDFCost of Capital Glossary/Index
REVIEW & TEST
  quizREVIEW QUESTIONS
 examFINAL EXAM