6 - 1The Cost of Capitaln Cost of Capital Componentsl Debtl Preferredl Common Equityn WACC6 - 2What types of long-term capital do firms use?nLong-term debtnPreferred stocknCommon equity6 - 3Capital components are sources of funding that come from investors.Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the cost of capital.We do adjust for these items when calculating the cash flows of a project, but not when calculating the cost of capital.6 - 4Should we focus on before-tax or after-tax capital costs?nTax effects associated with financing can be incorporated either in capital budgeting cash flows or in cost of capital.nMost firms incorporate tax effects in the cost of capital.Therefore, focus on after-tax costs.nOnly cost of debt is affected.6 - 5Should we focus on historical (embedded) costs or new (marginal) costs?The cost of capital is used primarily to make decisions which involve raising and investing newcapital.So, we should focus on marginal costs.6 - 6Cost of Debtn Method 1: Ask an investment banker what the coupon rate would be on new debt.n Method 2: Find the bond rating for the company and use the yield on other bonds with a similar rating.n Method 3: Find the yield on the companys debt, if it has any.6 - 7Component Cost of Debtn Interest is tax deductible, so the after tax (AT) cost of debt is:rd AT= rd BT(1 - T)= 10%(1 - 0.40) = 6%.n Use nominal rate.n Flotation costs small, so ignore.6 - 8Whats the cost of preferred stock?PP= $113.10; 10%Q; Par = $100; F = $2.( )%. 0 . 9 090 . 010 . 111 $10 $00 . 2 $ 10 . 113 $100 $ 1 . 0= = ==npspsPDr =Use this formula:6 - 9Picture of Preferred2.50 2.500 1 2rps=?-111.1...2.50.50 . 2 $10 . 111 $Per PerQr rD= =%. 9 ) 4 %( 25 . 2 %; 25 . 210 . 111 $50 . 2 $) (= = = =Nom ps Perr r6 - 10Note:n Flotation costs for preferred are significant, so are reflected.Use net price.n Preferred dividends are not deductible, so no tax adjustment.J ust rps.n Nominal rpsis used.6 - 11Is preferred stock more or less risky to investors than debt?n More risky; company not required to pay preferred dividend.n However, firms want to pay preferred dividend.Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, and (3) preferred stockholders may gain control of firm.6 - 12Why is yield on preferred lower than rd?n Corporations own most preferred stock, because 70% of preferred dividends are nontaxable to corporations.n Therefore, preferred often has a lower B-T yield than the B-T yield on debt.n The A-T yield to investors and A-T cost to the issuer are higher on preferred than on debt, which is consistent with the higher risk of preferred.6 - 13Example: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%6 - 14n Directly, by issuing new shares of common stock.n Indirectly, by reinvesting earnings that are not paid out as dividends (i.e., retaining earnings).What are the two ways that companies can raise common equity?6 - 15n Earnings can be reinvested or paid out as dividends.n Investors could buy other securities, earn a return.n Thus, there is an opportunity cost if earnings are reinvested.Why is there a cost for reinvested earnings?6 - 16n Opportunity cost:The return stockholders could earn on alternative investments of equal risk.n They could buy similar stocks and earn rs, or company could repurchase its own stock and earn rs.So, rs, is the cost of reinvested earnings and it is the cost of equity.6 - 17Three ways to determine the cost of equity, rs:1. CAPM:rs= rRF+ (rM- rRF)b= rRF+ (RPM)b.2. DCF:rs= D1/P0+ g.3. Own-Bond-Yield-Plus-Risk Premium:rs= rd+ RP.6 - 18Whats the cost of equity based on the CAPM?rRF= 7%, RPM= 6%, b = 1.2.rs=rRF+(rM- rRF )b.=7.0% +(6.0%)1.2=14.2%.6 - 19Issues in Using CAPMn Most analysts use the rate on a long-term (10 to 20 years) government bond as an estimate of rRF.For a current estimate, go to www.bloomberg.com, select U.S. Treasuries from the section on the left under the heading Market.More6 - 20Issues in Using CAPM (Continued)n Most analysts use a rate of 5% to 6.5% for the market risk premium (RPM)n Estimates of beta vary, and estimates are noisy (they have a wide confidence interval).For an estimate of beta, go to www.bloomberg.comand enter the ticker symbol for STOCK QUOTES.6 - 21Whats the DCF cost of equity, rs?Given:D0= $4.19;P0= $50; g = 5%.( )gP g DgPDrs++= + =00011( )= += +=$4. .$50.. ..19 1050050088 005138%.6 - 22Estimating the Growth Raten Use the historical growth rate if you believe the future will be like the past.n Obtain analysts estimates: Google Finance, Bloomberg, Yahoo! Finance.n Use the earnings retention model, illustrated on next slide.6 - 23Suppose the company has been earning 15% on equity (ROE =15%) and retaining 35% (dividend payout = 65%), and this situation is expected to continue.Whats the expected future g?6 - 24Retention growth rate:g = ROE(Retention rate) g = 0.35(15%) = 5.25%.This is close to g = 5% given earlier.Think of bank account paying 15% with retention ratio = 0.What is g of account balance?If retention ratio is 100%, what is g?6 - 25Could DCF methodology be appliedif g is not constant?n YES, nonconstant g stocks are expected to have constant g at some point, generally in 5 to 10 years.6 - 26Find rsusing the own-bond-yield-plus-risk-premium method. (rd= 10%, RP = 4%.)n This RP CAPM RPM.n Produces ballpark estimate of rs.Useful check.rs= rd+ RP= 10.0% + 4.0% = 14.0%6 - 27Whats a reasonable final estimateof rs?Method EstimateCAPM 14.2%DCF 13.8%rd+ RP 14.0%Average 14.0%6 - 28Determining the Weights for the WACCn The weights are the percentages of the firm that will be financed by each component.n If possible, always use the target weights for the percentages of the firm that will be financed with the various types of capital. 6 - 29Estimating Weights for theCapital Structuren If you dont know the targets, it is better to estimate the weights using current market values than current book values.n If you dont know the market value of debt, then it is usually reasonable to use the book values of debt, especially if the debt is short-term.(More...)6 - 30Estimating Weights (Continued)n Suppose the stock price is $50, there are 3 million shares of stock, the firm has $25 million of preferred stock, and $75 million of debt.(More...)6 - 31n Vce= $50 (3 million) = $150 million.n Vps= $25 million.n Vd= $75 million.n Total value = $150 + $25 + $75 = $250 million.n wce= $150/$250 = 0.6n wps= $25/$250 = 0.1n wd= $75/$250 = 0.36 - 32Whats the WACC?WACC =wdrd(1 - T) +wpsrps+wcers=0.3(10%)(0.6) +0.1(9%) +0.6(14%)=1.8% +0.9% +8.4% =11.1%.6 - 33WACC Estimates for Some Large U. S. CorporationsCompany WACCGeneral Electric (GE) 12.5Coca-Cola (KO) 12.3Intel (INTC) 12.2Motorola (MOT) 11.7Wal-Mart (WMT) 11.0Walt Disney (DIS) 9.3AT&T (T) 9.2Exxon Mobil (XOM) 8.2H.J . Heinz (HNZ) 7.8BellSouth (BLS) 7.46 - 34What factors influence a companys WACC?n Market conditions, especially interest rates and tax rates.n The firms capital structure and dividend policy.n The firms investment policy.Firms with riskier projects generally have a higher WACC.6 - 35Should the company use the composite WACC as the hurdle rate for each of its divisions?n NO!The composite WACC reflects the risk of an average project undertaken by the firm.n Different divisions may have different risks.The divisions WACC should be adjusted to reflect the divisions risk and capital structure.6 - 36n Estimate the cost of capital that the division would have if it were a stand-alone firm.n This requires estimating the divisions beta, cost of debt, and capital structure.What procedures are used to determine the risk-adjusted cost of capital for a particular division?6 - 37Methods for Estimating Beta for a Division or a Project1. Pure play.Find several publicly traded companies exclusively in projects business.Use average of their betas as proxy for projects beta.Hard to find such companies.6 - 382. Consolidated method: Use the same beta as the rest of firm. Simple and time-saving approach, although can be an inaccurate assessment of project risk.3. Accounting beta: No longer popular and may result in widely misleading calculations.6 - 39Find the divisions market risk and cost of capital based on the CAPM, given these inputs:n Target debt ratio = 10%.n rd= 12%.n rRF= 7%.n Tax rate = 40%.n betaDivision= 1.7.n Market risk premium = 6%.6 - 40n Beta = 1.7, so division has more market risk than average.n Divisions required return on equity:rs= rRF+ (rM rRF)bDiv.= 7% + (6%)1.7 = 17.2%.WACCDiv.= wdrd(1 T) + wcrs= 0.1(12%)(0.6) + 0.9(17.2%)= 16.2%.6 - 41How does the divisions WACC compare with the firms overall WACC?n Division WACC = 16.2% versus company WACC = 11.1%.n Typical projects within this division would be accepted if their returns are above 16.2%.6 - 42Divisional Risk and the Cost of Capital R ate of R eturn (%) WA C CR ejecti on R egi on A c ceptanc e R egion R is k LBA H WAC C H WAC C L WAC C A 0R is kL R is kAR i s kH 6 - 43What are the three types of project risk?n Stand-alone riskn Corporate riskn Market risk6 - 44How is each type of risk used?n Stand-alone risk is easiest to calculate.n Market risk is theoretically best in most situations.n However, creditors, customers, suppliers, and employees are more affected by corporate risk.n Therefore, corporate risk is also relevant.6 - 45A Project-Specific, Risk-AdjustedCost of Capitaln Start by calculating a divisional cost of capital.n Estimate the risk of the project using the techniques in Chapter 8.n Use judgment to scale up or down the cost of capital for an individual project relative to the divisional cost of capital.6 - 461. When a company issues new common stock they also have to pay flotation costs to the underwriter.2. Issuing new common stock may send a negative signal to the capital markets, which may depress stock price.Why is the cost of internal equity from reinvested earnings cheaper than the cost of issuing new common stock? 6 - 47Estimate the cost of new common equity: P0=$50, D0=$4.19, g=5%, and F=15%.gF Pg Dre++=) 1 () 1 (00( )( )%. 4 . 15 % 0 . 550 . 42 $40 . 4 $% 0 . 515 . 0 1 50 $05 . 1 19 . 4 $= + =+=6 - 48Estimate the cost of new 30-year debt: Par=$1,000, Coupon=10%paid annually, and F=2%.n Using a financial calculator:l N = 30l PV = 1000(1-.02) = 980l PMT = -(.10)(1000)(1-.4) = -60l FV = -1000n Solving for I: 6.15%6 - 49Comments about flotation costs:n Flotation costs depend on the risk of the firm and the type of capital being raised.n The flotation costs are highest for common equity.However, since most firms issue equity infrequently, the per-project cost is fairly small.n We will frequently ignore flotation costs when calculating the WACC.6 - 50Four Mistakes to Avoid1. When estimating the cost of debt, dont use the coupon rate on existing debt. Use the current interest rate on new debt.2. When estimating the risk premium for the CAPM approach, dont subtract the current long-term T-bond rate from the historical average return on common stocks.(More ...)6 - 51For example, if the historical rMhas been about 12.7% and inflation drives the current rRFup to 10%, the current market risk premium is not 12.7% - 10% = 2.7%!(More ...)6 - 523. Dont use book weights to estimate the weights for the capital structure.Use the target capital structure to determine the weights.If you dont know the target weights, then use the current market value of equity, and never the book value of equity. If you dont know the market value of debt, then the book value of debt often is a reasonable approximation, especially for short-term debt. (More...)6 - 534. Always remember that capital components are sources of funding that come from investors.Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the WACC.We do adjust for these items when calculating the cash flows of the project, but not when calculating the WACC.