ch. 9 -13ed cost of capitalmaster

8/12/2019 Ch. 9 -13ed Cost of CapitalMaster

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CHAPTER 9

Cost of Capital

Topics in Chapter Cost of capital components

Preferred stock

Common equity

Factors that affect WACC

Adjusting cost of capital for risk

COST OF CAPITAL

Why? Key to understanding cost

of raising $

Risk Financing costs

Discount Rate

Business Application

Min Req’d return neededon Project

Reflects blended costs ofraising capital

Relevant “i ”

Discount rate used to

determine Project’s NPVor to disct FCFs by

Hurdle rate

Value = + + +FCF1 FCF2 FCF∞

(1 + WACC)1 (1 + WACC)∞ (1 + WACC)2

Free cash flow(FCF)

Market interest rates

Firm’s business risk Market risk aversion

Firm’s debt/equity mix Cost of debt

Cost of equity

Weighted average

cost of capital(WACC)

Net operatingprofit after taxes

Required investmentsin operating capital

Determinants of Intrinsic Value:The Weighted Average Cost of Capital

What types of long-term

capital do firms use? Long-term debt

Preferred stock

Common equity

Capital Components Cap. components are sources of funding that

come from investors.

A/P, accruals, and deferred taxes are notsources of funding that come from investors,& not included in the calculation of the cost ofcapital.

These items are adjusted for when calculatingproject cash flows, not when calculating thecost of capital.

Before-tax vs. After-tax Capital

Costs Tax effects associated with financing

can be incorporated either in capital

budgeting cash flows or in cost ofcapital.

Most firms incorporate tax effects in thecost of capital. Therefore, focus onafter-tax costs.

Only cost of debt is affected.

Historical (Embedded) Costs

vs. New (Marginal) Costs The cost of capital is used primarily to

make decisions which involve raising

and investing new capital. So, focus onmarginal (incremental) costs.

COST of CAPITALRaising $ & its Costs

Cost of Borrowing

Interest Rate

Equity

Internal

External

Common Stock

Prfd Stock

Cost of Capital

Raising $ & its Costs Debt & Equity

Cost Return

Int. pd. Int. recd.

Divids pd. Divids Recd

Weighted Average Cost of

Capital (WACC) WACC: Blended cost or raising capital

considering mix of debt & equity

WACC = (Wt of Debt)(After-tax cost ofDebt) + Wt of Eqty)(Cost of Eqty) +(Wt of Prfd)(Cost of Prfd)

Cost of Equity Know: = P0 = D1 / (rs –g)

So then: rs = D1 /P0 + g

Cost of Equity Cost of External Equity: Function of Dvids,

growth, & net proceeds after adjusting for

flotation costs

Cost of Internal Equity: Function of opp.

Costs of divids not pd out but retained in firmto grow internally (no flot. req’d)

Cost of Preferred Stock r = D1 /P0 + g

g= 0, so cost of prfd = function of

divids pd. & flot cost to issue

Determining Cost of Debt

Method 1: Ask an investment bankerwhat coupon rate would be on new

debt. Method 2: Find bond rating for the

company and use yield on similarlyrated bonds.

Method 3: Find yield on the company’sexisting debt.

Current vs. Historical Cost ofDebt

For cost of debt, don’t use coupon rateon existing debt, which represents cost

of past debt. Use the current interest rate on new

debt (think YTM).

(More…)

A 15-year, 13.25% semiannual bond sellsfor $1,250. Tax = 40%. 60,000 Bonds

o/s. What’s rd?

-66.25 <66.25 + 1,000>-66.25

0 1 2 30rd = ?

1,250.00...

30 1250 -66.25 -1000

5.0% x 2 = rd = 10%

N I/YR PV FVPMTINPUTS

OUTPUT

Component Cost of Debt

Interest is tax deductible, so the aftertax (AT) cost of debt is:

rd AT = rd BT(1 – T)

rd AT = 10%(1 – 0.40) = 6%.

Use nominal rate.

Flotation costs small, so ignore.

Cost of preferred stock: Pps = $125;10.26% Div; Par = $100; F = 8.8%

r ps =Dps

Pps (1 – F)=

.0126($100)

$125.00(1 – 0.088)

= $10.26

$114.= 0.090 = 9.0%

Time Line of Preferred

10.26 10.2610.26

0 1 2 ∞ rps = ?

-114....

$114.00 =DQ

=$10.26

rPer =

$10.26

$114.00= 9%

Flotation costs for preferred aresignificant, so are reflected. Use net

price. Preferred dividends are not deductible,

so no tax adjustment. Just rps.

Nominal rps is used.

Is preferred stock more or lessrisky to investors than debt?

More risky; company not required topay preferred dividend.

However, firms want to pay preferreddividend. Otherwise, (1) cannot paycommon dividend, (2) difficult to raise

additional funds, and (3) preferredstockholders may gain control of firm.

Why is yield on preferredlower than r

Corporations own most preferred stock,because 70% of prfd divids nontaxable to

corps. T/4, prfd often has a lower

B-T yield than the B-T yield on debt.

The A-T yield to investors and A-T cost to theissuer are higher on prfd than on debt, whichis consistent w/ higher risk of prfd.

Example:rps

= 9%, rd = 10%, T = 40%

rps, AT = rps – rps(1 – 0.7)(T)

= 9% – 9%(0.3)(0.4) = 7.92%

rd, AT = 10% – 10%(0.4) = 6.00%

A-T Risk Premium on Preferred = 1.92%

What are the two ways thatcompanies can raise common equity?

Directly, by issuing new shares ofcommon stock.

Indirectly, by reinvesting earnings thatare not paid out as dividends (i.e.,retaining earnings).

Why is there a cost forreinvested earnings?

Earnings can be reinvested or paid outas dividends.

Investors could buy other securities,earning a return.

Thus, there is an opportunity cost if

earnings are reinvested.

Three ways to determinethe cost of equity, r

1. CAPM: rs = rRF + (rM – rRF)b

= rRF + (RPM)b.2. DCF: rs = D1 /P0 + g.

3. Own-Bond-Yield-Plus-Judgmental-Risk Premium: rs = rd + Bond RP.

Equity Cost Components

Risk free = 5.6%

Mrkt Risk Prem = 6%

Beta = 1.2

Div today = $3.12

Price today = $50

Growth = 5.8%

Cost of Debt = 10%

Risk prem = 3.2%

3,000,000 shs outstanding30

CAPM Cost of Equity: rRF = 5.6%,RP

M = 6%, b = 1.2

rs = r

RF + (RP

= 5.6% + (6.0%)1.2 = 12.8%.

Issues in Using CAPM

Most analysts use the rate on along-term (10 to 20 years)

government bond as an estimateof rRF.

Can use Bloomberg.com to obtain

US Treasuries Quotes

(More…)

Issues in Using CAPM(Continued)

Most analysts use a rate of 3.5% to6% for the market risk premium

(RPM) Estimates of beta vary, and

estimates are “noisy” (they have a

wide confidence interval).

DCF Cost of Equity, rs:D

0 = $3.12; P

0 = $50; g = 5.8%

+ g =D0(1 + g)

= $3.12(1.058)

+ 0.058

= 6.6% + 5.8%

= 12.4%

Estimating the Growth Rate

Use historical growth rate if believefuture be like past.

Obtain analysts’ estimates: Value Line,Zacks, Yahoo!Finance.

Use earnings retention model.

Earnings Retention Model

Suppose company has been earning15% on equity (ROE = 15%) and

been paying out 62% of its earnings. If expected to continue as is, what’s

the expected future g?

Earnings Retention Model(Continued)

Growth from earnings retention model:g = (Retention rate)(ROE)

g = (1 – Payout rate)(ROE)g = (1 – 0.62)(15%) = 5.7%.

Close to g = 5.8% given earlier.

Could DCF methodology beapplied if g is not constant?

YES, nonconstant g stocks areexpected to have constant g at some

point, generally in 5 to 10 years.

The Own-Bond-Yield-Plus-Judgmental-Risk-Premium Method: r

= 10%, RP = 3.2%

rs = rd + Judgmental risk premium

rs = 10.0% + 3.2% = 13.2%

This over-own-bond-judgmental-riskpremium CAPM equity risk premium,

RPM. Produces ballpark estimate of rs.

Useful check.

Final estimate of rs?

Method Estimate

CAPM 12.8%

DCF 12.4%

Bond Yld + risk prem 13.2%

Average 12.8%

Determining Weights for WACC

Wts are % of firm’s capital to befinanced by each component.

If possible, always use the target wtsfor % financed by each type ofcapital.

Estimating Weights for theCapital Structure

If don’t know targets, better to estimatewts using current market values than

current book values. If don’t know MV of debt, then

reasonable to use BV of debt, especially

if S/T debt.

(More…)

Estimating Weights(Continued)

Suppose the common stock price is $50with 3 million shares outstanding; the

firm has 200,000 shs of preferred stocktrading at $125; and 60,000 bondsoutstanding trading at quoted price of

125% of par.

(More…)

Vs = $50(3 million) = $150 million.

Vps = $25 million.

Vd = $75 million.

Total value = $150 + $25 + $75= $250 million.

ws = $150/$250 = 0.6

wps = $25/$250 = 0.1

wd = $75/$250 = 0.3

Target wts for this co. are same as these MV

wts, but often MV wts temporarily deviatefrom targets due to changes in stock prices.

What factors influence acompany’s WACC?

Uncontrollable factors:

Market conditions, especially interest rates.

The market risk premium. Tax rates.

Controllable factors:

Capital structure policy.

Dividend policy.

Investment policy. Firms with riskier projectsgenerally have higher financing costs.

Should firm-wide WACC beused for each of its divisions?

NO! Composite WACC reflects risk ofan average project undertaken by the

firm. Different divisions may have different

risks. Division’s WACC should be

adjusted to reflect division’s risk andcap structure.

The Risk-Adjusted DivisionalCost of Capital

Estimate cost of capital divisionwould have if it were a stand-alone

firm. This requires estimating division’s

beta, cost of debt, and capital

structure.

Pure Play Method for EstimatingBeta for a Division or a Project

Find several publicly traded companiesexclusively in project’s business.

Use average of their betas as proxy forproject’s beta.

Hard to find such companies.

Accounting Beta Method forEstimating Beta

Run regression between project’sROA and S&P Index ROA.

Accounting betas correlated (0.5 – 0.6) with market betas.

But normally can’t get data on new

projects’ ROAs before capitalbudgeting decision made.

Divisional Cost of CapitalUsing CAPM

Target debt ratio = 10%.

rd = 12%.

rRF = 5.6%.

Tax rate = 40%.

betaDivision

= 1.7.

Market risk premium = 6%.

l C f C l

Divisional Cost of CapitalUsing CAPM (Continued)

Division’s required return on equity:

rs = rRF + (rM – rRF)bDiv.

rs = 5.6% + (6%)1.7 = 15.8%.

WACCDiv. = wd rd(1 – T) + wsrs

= 0.1(12%)(0.6) + 0.9(15.8%)= 14.94% ≈ 14.9%

Division’s WACC vs. Firm’s OverallWACC?

Division WACC = 14.9% versuscompany WACC = 10.4%.

“Typical” projects within this divisionwould be accepted if its returns above14.9%.

Wh h h f

What are the three types ofproject risk?

Stand-alone risk

Corporate risk

Market risk

How is each type of risk used?

Stand-alone risk easiest to calculate.

Market risk theoretically best in most

situations. However, creditors, customers,

suppliers, and employees are moreaffected by corporate risk.

Therefore, corporate risk is alsorelevant.

A Project-Specific, Risk-AdjustedCost of Capital

Start by calculating a divisional cost ofcapital.

Use judgment to scale up or down thecost of capital for an individual projectrelative to the divisional cost of capital.

C t f I i N C

Costs of Issuing New CommonStock

When a company issues new commonstock they also have to pay flotation

costs to the underwriter. Issuing new common stock may send a

negative signal to the capital markets,

which may depress stock price.

Cost of New Common Equity: P0 = $50,D0 = $3.12, g = 5.8%, and F = 15%

D0(1 + g)

P0(1 – F)

=$3.12(1.058)

$50(1 – 0.15)

+ 5.8%

= $3.30

$42.50+ 5.8% = 13.6%

Cost of New 30-Year Debt: Par = $1,000,Coupon = 10% paid annually, and F = 2%

Using a financial calculator:

N = 30

PV = 1,000(1 – 0.02) = 980 PMT = -(0.10)(1,000)(1 – 0.4) = -60

FV = -1,000

Solving for I/YR: 6.15%

C t b t fl t ti

Comments about flotationcosts:

Flot costs depend on risk of firm & type ofcapital being raised.

Flot costs highest for common equity.However, most firms issue equityinfrequently, the per-project cost is fairlysmall.

We will frequently ignore flotation costs whencalculating the WACC.

Four Mistakes to Avoid

Current vs. historical cost of debt

Mixing current and historical measures

to estimate the market risk premium Book weights vs. Market Weights

Incorrect cost of capital components

(More…)

C t Hi t i l C t f

Current vs. Historical Cost ofDebt

When estimating the cost of debt, don’tuse the coupon rate on existing debt,

which represents the cost of past debt. Use the current interest rate on new

(More…)

E ti ti th M k t Ri k

Estimating the Market RiskPremium

When estimating the risk premium for theCAPM approach, don’t subtract the current

long-term T-bond rate from the historicalaverage return on common stocks.

For example, if the historical rM has beenabout 12.2% and inflation drives the current

rRF up to 10%, the current market riskpremium is not 12.2% – 10% = 2.2%!

(More…)

Estimating Weights

Use target cap structure to determine wts.

If don’t know target wts, use MV of equity.

If don’t know MV of debt, then use BV ofdebt.

(More…)

Capital components are sources offunding that come from investors.

Accounts payable, accruals, and deferredtaxes are not sources of funding that come

from investors, so they are not included inthe calculation of the WACC.

We do adjust for these items whencalculating project cash flows, but not when

calculating the WACC.

ch. 9 -13ed cost of capitalmaster

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