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Transcript of Ch. 9 -13ed Cost of CapitalMaster
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CHAPTER 9
Cost of Capital
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Topics in Chapter Cost of capital components
Debt
Preferred stock
Common equity
WACC
Factors that affect WACC
Adjusting cost of capital for risk
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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
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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
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What types of long-term
capital do firms use? Long-term debt
Preferred stock
Common equity
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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.
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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.
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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.
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COST of CAPITALRaising $ & its Costs
Debt
Cost of Borrowing
Interest Rate
Equity
Internal
RE
External
Common Stock
Prfd Stock
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Cost of Capital
Raising $ & its Costs Debt & Equity
Cost Return
Int. pd. Int. recd.
Divids pd. Divids Recd
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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)
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Cost of Equity Know: = P0 = D1 / (rs –g)
So then: rs = D1 /P0 + g
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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)
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Cost of Preferred Stock r = D1 /P0 + g
g= 0, so cost of prfd = function of
divids pd. & flot cost to issue
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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.
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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…)
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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
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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.
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Cost of preferred stock: Pps = $125;10.26% Div; Par = $100; F = 8.8%
Use :
r ps =Dps
Pps (1 – F)=
.0126($100)
$125.00(1 – 0.088)
= $10.26
$114.= 0.090 = 9.0%
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Time Line of Preferred
10.26 10.2610.26
0 1 2 ∞ rps = ?
-114....
$114.00 =DQ
rPer
=$10.26
rPer
rPer =
$10.26
$114.00= 9%
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Note:
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.
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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.
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Why is yield on preferredlower than r
d?
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.
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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%
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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).
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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.
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Three ways to determinethe cost of equity, r
s:
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.
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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
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CAPM Cost of Equity: rRF = 5.6%,RP
M = 6%, b = 1.2
rs = r
RF + (RP
M)b
= 5.6% + (6.0%)1.2 = 12.8%.
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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…)
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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).
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DCF Cost of Equity, rs:D
0 = $3.12; P
0 = $50; g = 5.8%
rs
=D1
P0
+ g =D0(1 + g)
P0
+ g
= $3.12(1.058)
$50
+ 0.058
= 6.6% + 5.8%
= 12.4%
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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.
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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?
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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.
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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.
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The Own-Bond-Yield-Plus-Judgmental-Risk-Premium Method: r
d
= 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.
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Final estimate of rs?
Method Estimate
CAPM 12.8%
DCF 12.4%
Bond Yld + risk prem 13.2%
Average 12.8%
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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.
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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…)
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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…)
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Estimating Weights(Continued)
Vs = $50(3 million) = $150 million.
Vps = $25 million.
Vd = $75 million.
Total value = $150 + $25 + $75= $250 million.
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Estimating Weights(Continued)
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.
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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.
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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.
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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.
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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.
f
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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.
l f l
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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
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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%
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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
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What are the three types ofproject risk?
Stand-alone risk
Corporate risk
Market risk
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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.
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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.
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C t f I i N C
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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.
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Cost of New Common Equity: P0 = $50,D0 = $3.12, g = 5.8%, and F = 15%
re =
D0(1 + g)
P0(1 – F)
+ g
=$3.12(1.058)
$50(1 – 0.15)
+ 5.8%
= $3.30
$42.50+ 5.8% = 13.6%
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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
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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.
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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
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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
debt.
(More…)
E ti ti th M k t Ri k
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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…)
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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…)
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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.