10.4
Determination of the Cost of Equity Capital and the MARR
Solution (a) The after-tax net cash flow for interest on the $10,000 loan is an annual amount of 600(1 2 0.42) 5 $348 by Equation [10.6]. The loan repayment is $10,000 in year 10. PW is used to estimate a cost of debt capital of 3.48%. 0 5 10,000 2 348(P/A, i*,10) 2 10,000(P/F, i*,10) (b) The 6% annual interest on the $10,000 loan is not the WACC because 6% is paid only on the borrowed funds. Nor is 3.48% the WACC, since it is only the cost of debt capital. The cost of the $10,000 equity capital is needed to determine the WACC.
10.4 Determination of the Cost of Equity Capital and the MARR Equity capital is usually obtained from the following sources: Sale of preferred stock Sale of common stock Use of retained earnings Use of owner’s private capital The cost of each type of financing is estimated separately and entered into the WACC computation. A summary of one commonly accepted way to estimate each source’s cost of capital is presented here. One additional method for estimating the cost of equity capital via common stock is presented. There are no tax savings for equity capital, because dividends paid to stockholders and owners are not tax-deductible. Issuance of preferred stock carries with it a commitment to pay a stated dividend annually. The cost of capital is the stated dividend percentage, for example, 10%, or the dividend amount divided by the price of the stock. Preferred stock may be sold at a discount to speed the sale, in which case the actual proceeds from the stock should be used as the denominator. For example, if a 10% dividend preferred stock with a value of $200 is sold at a 5% discount for $190 per share, there is a cost of equity capital of ($20/$190) 3 100% 5 10.53%. Estimating the cost of equity capital for common stock is more involved. The dividends paid are not a true indication of what the stock issue will actually cost in the future. Usually a valuation of the common stock is used to estimate the cost. If Re is the cost of equity capital (in decimal form), Re 5 5
first-year dividend 1 expected dividend growth rate price of stock DV1 1 g P
[10.7]
The growth rate g is an estimate of the annual increase in returns that the shareholders receive. Stated another way, it is the compound growth rate on dividends that the company believes is required to attract stockholders. For example, assume a multinational corporation plans to raise capital through its U.S. subsidiary for a new plant in South America by selling $2,500,000 worth of common stock valued at $20 each. If a 5% or $1 dividend is planned for the first year and an appreciation of 4% per year is anticipated for future dividends, the cost of capital for this common stock issue from Equation [10.7] is 9%. 1—1 0.04 5 0.09 Re 5 — 20
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