operation. Third, managers tend to engage in a great deal of speculation regarding the budgeted cash flows resulting from their requests, resulting in inaccurate discounted cash flow projections. Since many requests involve unverifiable cash flow estimates, it is impossible to discern which projects are better than others.
A greater reliance on throughput accounting concepts eliminates most of these problems. In particular, the priority for funding should be placed squarely on any projects that can improve the capacity of the constrained resource, based on a comparison of the incremental additional throughput created with the incremental operating expenses and investment incurred.
Nonetheless, many companies have a long tradition of using discounted cash flows to determine which capital requests are to be accepted. If so, then at least include constraint analysis in the overall approval process, which may skew some funding allocations in favor of bottleneck operations that require additional capacity.
Another issue is the cost of acquiring debt, and how this cost should be factored into the overall cost of debt calculation. When obtaining debt, there are usually extra fees involved, which may include placement or brokerage fees, documentation fees, or the price of a bank audit. In the case of a private placement, the company may set a fixed percentage interest payment on the debt, but find that prospective borrowers will not purchase the debt instruments unless they can do so at a discount, thereby effectively increasing the interest rate they will earn on the debt. In both cases, the company is receiving less cash than initially expected, but must still pay out the same amount of interest expense. In effect, this raises the cost of the debt. To carry forward the example in Exhibit 2.4 to Exhibit 2.5, we assume that the interest payments are the same, but that brokerage fees were $25,000 and that the debt was sold at a 2 percent discount. The result is an increase in the actual interest rate.
The cost of preferred stock is treated differently from debt, because under the tax laws, interest payments are treated as dividends instead of interest expense, which means that these payments are not tax deductible. This is a key issue, for it greatly increases the cost of funds for any company using preferred stock as a funding source.
By way of comparison, if a company has a choice between issuing debt or preferred stock at the same rate, the difference in cost will be the tax savings on the debt. In the following example, a company issues $1,000,000 of debt and $1,000,000 of preferred stock, both at 9 percent interest rate, with an assumed 35 percent tax rate.
Debt cost¼Principal ðInterest rate ð1tax rateÞÞ Debt cost¼$1;000;000 ð9% ð1:35ÞÞ
$58;500¼$1;000;000 ð9%:65Þ
Exhibit 2.5 Calculating the Interest Cost of Debt, Net of Taxes, Fees, and Discounts ðInterest expenseÞ ð1Tax rateÞ
---¼Net after-tax interest expense ðAmount of debtÞ ðFeesÞ ðDiscount on sale of debtÞ
Or;
ð95;000 ð10:35Þ
---¼Net after-tax interest expense
$1;000;000$25;000$20;000
$61;750
---¼6:466%
$955;000
If the same information is used to calculate the cost of payments using preferred stock, we have the following result:
Preferred stock interest cost¼PrincipalInterest rate Preferred stock interest cost¼$1;000;0009%
$90;000¼$1;000;0009%
2-9 How Do I Calculate the Cost of Capital? 55
The final component of the cost of capital is common stock. The usual method for developing its cost is the capital asset pricing model (CAPM). The CAPM essentially derives the cost of capital by determining the relative risk of holding the stock of a specific company as compared with a mix of all stocks in the market. This risk is composed of three elements:
1. The return that any investor can expect from a risk-free investment. This is usually defined as the return on a U.S. government security.
2. The return from a set of securities considered to have an average level of risk. This can be the average return on a largemarket basketof stocks, such as the Standard & Poor’s 500, the Dow Jones Industrials, or some other large cluster of stocks.
3. The company’s beta, which defines the amount by which a specific stock’s returns vary from the returns of stocks with an average risk level. This information is provided by several of the major investment services, such as Value Line. A beta of 1.0 means that a specific stock is exactly as risky as the average stock, while a beta of 0.8 would represent a lower level of risk and a beta of 1.4 would be higher.
When combined, this information yields the baseline return to be expected on any investment (the risk-free return), plus an added return that is based on the level of risk that an investor is assuming by purchasing a specific stock.
The calculation of the equity cost of capital using the CAPM methodology is relatively simple, once one has accumulated all the components of the equation. For example, if the risk-free cost of capital is 5 percent, the return on the Dow Jones Industrials is 12 percent, and ABC Company’s beta is 1.5, the cost of equity for ABC Company would be:
Cost of equity capital¼Risk-free returnþBetaðAverage stock returnrisk-free returnÞ
Cost of equity capital¼5%þ1:5ð12%5%Þ Cost of equity capital¼5%þ1:57%
Cost of equity capital¼5%þ10:5%
Cost of equity capital¼15:5%
Now that we have derived the costs of debt, preferred stock, and common stock, we can assemble all three costs into a weighted cost of capital. The following example shows the method by which the weighted cost of capital of the Canary Corporation is calculated.
The chief financial officer of the Canary Corporation, Mr. Birdsong, is interested in determining the company’s weighted cost of capital. There are two debt offerings on the books. The first is $1,000,000 that was sold below par value, which garnered
$980,000 in cash proceeds. The company must pay interest of 8.5 percent on this debt.
The second is for $3,000,000 and was sold at par, but included legal fees of $25,000.
The interest rate on this debt is 10 percent. There is also $2,500,000 of preferred stock on the books, which requires annual interest (or dividend) payments amounting to 9 percent of the amount contributed to the company by investors. Finally, there is
$4,000,000 of common stock on the books. The risk-free rate of interest, as defined by the return on current U.S. government securities, is 6 percent, while the return expected from a typical market basket of related stocks is 12 percent. The company’s beta is 1.2, and it currently pays income taxes at a marginal rate of 35 percent. What is the Canary Company’s weighted cost of capital?
The method we will use is to separately compile the percentage cost of each form of funding, and then calculate the weighted cost of capital, based on the amount of funding and percentage cost of each of the above forms of funding. We begin with the first debt item, which was $1,000,000 of debt that was sold for $20,000 less than par value, at 8.5 percent debt. The marginal income tax rate is 35 percent. The calculation is as follows.
ððInterest expenseÞ ð1tax rateÞÞ Amount of debt Net after-tax interest percent¼---
ðAmount of debtÞ ðDiscount on sale of debtÞ ðð8:5%Þ ð1:35ÞÞ $1;000;000
Net after-tax interest percent¼---
$1;000;000$20;000
Net after-tax interest percent¼5:638%
We employ the same method for the second debt instrument, for which there is
$3,000,000 of debt that was sold at par: $25,000 in legal fees were incurred to place the debt, which pays 10 percent interest. The marginal income tax rate remains at 35 percent. The calculation is as follows:
ððInterest expenseÞ ð1tax rateÞÞ Amount of debt Net after-tax interest percent¼---
ðAmount of debtÞ ðDiscount on sale of debtÞ ðð10%Þ ð1:35ÞÞ $3;000;000
Net after-tax interest percent¼---
$3;000;000$25;000
Net after-tax interest percent¼7:091%
We now calculate the cost of the preferred stock. As noted above, there is
$2,500,000 of preferred stock on the books, with an interest rate of 9 percent.
The marginal corporate income tax does not apply, since the interest payments are treated like dividends, and are not deductible. The calculation is the simplest of all, for the answer is 9 percent, since there is no income tax to confuse the issue.
2-9 How Do I Calculate the Cost of Capital? 57
To arrive at the cost of equity capital, we take from the example a return on risk- free securities of 6 percent, a return of 12 percent that is expected from a typical market basket of related stocks, and a beta of 1.2. We then enter this information into the following formula to arrive at the cost of equity capital:
Cost of equity capital¼Risk-free returnþBetaðAverage stock returnrisk-free returnÞ
Cost of equity capital¼6%þ1:2ð12%6%Þ Cost of equity capital¼13:2%
Now that we know the cost of each type of funding, it is a simple matter to construct a table such as the one shown in Exhibit 2.6 that lists the amount of each type of fund- ing and its related cost, which we can quickly sum to arrive at a weighted cost of capital.
When combined into the weighted average calculation shown in Exhibit 2.6, we see that the weighted cost of capital is 9.75 percent. Though there is some considerably less expensive debt on the books, the majority of the funding is comprised of more expensive common and preferred stock, which drives up the overall cost of capital.