Cost of Capital Presented by: Coteng, Walter Malapitan, Jhe-anne Pagulayan, Jemaima Valdez, Jenya...
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Transcript of Cost of Capital Presented by: Coteng, Walter Malapitan, Jhe-anne Pagulayan, Jemaima Valdez, Jenya...
![Page 1: Cost of Capital Presented by: Coteng, Walter Malapitan, Jhe-anne Pagulayan, Jemaima Valdez, Jenya Dan.](https://reader035.fdocuments.net/reader035/viewer/2022062716/56649dbe5503460f94ab1338/html5/thumbnails/1.jpg)
Cost of Capital
Presented by:Coteng, Walter
Malapitan, Jhe-annePagulayan, JemaimaValdez, Jenya Dan
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What is the “Cost” of Capital?
Cost of Capital - The return the firm’s investors could expect to earn if they invested in securities with comparable degrees of risk.
Capital Structure - The firm’s mix of long term financing and equity financing.
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What sources of long-term capital do firms use?
Long-Term Capital
Long-Term Debt
Preferred Stock
Common Stock
Retained Earnings
New Common
Stock
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*Calculating the weighted average cost of capital:
WACC = wdrd(1-T) + wprp + wcrs
• The w’s refer to the firm’s capital structure weights.
• The r’s refer to the cost of each component.
Weighted Average Cost of Capital (WACC) - The expected rate of return on a portfolio of all the firm’s securities.
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Should our analysis focus on before-tax or after-tax capital costs?• Stockholders focus on A-T
cashflows. Therefore, we should focus on A-T capital costs, i.e. use A-T costs of capital in WACC. Only rd needs adjustment, because interest is tax deductible.
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Should our analysis focus on historical costs or new costs?
• The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on today’s marginal costs.
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How are the weights determined?
• In estimating WACC, do not use the Book Value of securities.
• In estimating WACC, use the Market Value of the securities.
• Book Values often do not represent the true market value of a firm’s securities.
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COST OF DEBT
– Before-Tax cost of Debt
(rd )
- The interest rate a firm must pay on its new debt.
- Yield to maturity (or yield to call if the debt is likely to be called) on their currently outstanding debt.
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Principal payment – Price of the bond
Annual interest payment + Number of years to
maturity 0.6 (Price of the bond) + 0.4 (Principal payment)
Yield to Maturity
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After –Tax cost of Debt - The relevant cost of
new debt, taking into account the tax deductibility of interest;
- It is used to calculate WACC.
After-Tax Cost of Debt= r d ( 1 – T )
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Example:• Assume that a company issues
bond at price of P940 with interest payments of P101.50 for 20 years and a maturity payment of P1,000. What is the Yield to maturity?
Annual interest payment + Number of years to maturity 0.6 (Price of the bond) + 0.4 (Principal payment)
Y' = $101. 50 + 1,000 - 940 20 .6 ($940) + .4 ($1,000) = $101.50 + 60 20 $564 + $400 Y’ = $101.50 + 3 = $104.50 = 10.84% $964 $964
Principal payment – Price of the bond
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Example:• L company can borrow at an
interest rate of 10% and its marginal federal-plus-state tax rate is 35%, its after-tax cost of debt will be…
After-tax cost of debt = rd (1-T)
= 10% (1-35%)
= 6.5%
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Cost of Preferred Stock, rp
WACC = wdrd(1-T) + wprp + wcrs
• rp is the marginal cost of preferred stock.
• The rate of return investors require on the firm’s preferred stock.
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What is the cost of preferred stock?
• The cost of preferred stock can be solved by using this formula:
rp = Dp / Pp
= $10 / $111.10 = 9%
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Example
• L Company issued P100 par value preferred stock 12 years ago. The stock provided a 9% yield at the time of issue. The preferred stock is now selling for P72. What is the current yield or cost of the preferred stock?
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Solution
rp = Dp/Pp
= ($100 x 9%)/ $72
= 12.5%
Where: rp – cost of preferred stock
Dp – annual dividend
Pp – current price
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Component cost of preferred stock
• Preferred dividends are not tax-deductible, so no tax adjustments necessary. Just use rp.
• Nominal rp is used.
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Is preferred stock more or less risky to investors than debt?• More risky; company not
required to pay preferred dividend.
• However, firms try to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, (3) preferred stockholders may gain control of firm.
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Why is the yield on preferred stock lower than debt?
• Corporations own most preferred stock, because 70% of preferred dividends are nontaxable to corporations.
• Therefore, preferred stock often has a lower B-T yield than the B-T yield on debt.
• The A-T yield to an investor, and the A-T cost to the issuer, are higher on preferred stock than on debt. Consistent with higher risk of preferred stock.
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Cost of Equity
WACC = wdrd(1-T) + wprp + wcrs
• rs is the marginal cost of common equity using retained earnings.
• The rate of return investors require on the firm’s common equity using new equity is re.
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Cost of Retained Earnings, rs
• Earnings can be reinvested or paid out as dividends.
• Investors could buy other securities, earn a return.
• If earnings are retained, there is an opportunity cost (the return that stockholders could earn on alternative investments of equal risk).
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The Capital Asset Pricing Model (CAPM) Approach
rs = rRF + (RPM) bi
= rRF + (rM - rRF) bi
where:
rs - required return on common stock
rRF - risk-free rate of return
bi - beta coefficient
rM - return in the market as measured by an approximate index
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Example: CAPM Approach
• If L company’s beta is 1.5, the risk-free rate is 10%, and the average return on the market is 13%, what will be its cost of common equity?
rs= rRF + (rM - rRF) bi
= 10% + (13% - 10%) 1.5
rs = 14.5%
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Bond-Yield-plus-Risk-Premium Approach
*risk premium estimate : 3%-5%.
rs= Bond yield + Risk premium
Example:If L’s bonds yield 13%, its cost of equity might be estimated as follows:
rs = 13% + 4%
= 17%
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Discounted-Yield-plus-Growth-Rate or
Discounted Cash Flow (DCF) Approach
rs = + gwhere:D1= dividend expected to be paid at the end of the yearP0 = current stock price
g = Constant growth rate in dividends
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Example: DCF Approach• L’s stock sells for P23.20, its next
expected dividend is P1.50, and analysis expect its growth rate to be 9.3%. Thus,
rs = + g
= + 9.3%= 6.47% + 9.3%
= 15.77%
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Averaging the Alternative Estimates
If management is highly confident of one method, it would probably use that method’s estimate. Otherwise, it might use an average of the three methods.
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Solving for the Average:
CAPM: rs = 14.5%
Bond-Yield-plus-Risk-Premium: rs= 17%
DCF: rs = 5.77%
Average = = 15.76%
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Why is the cost of retained earnings cheaper than the cost of issuing new common stock?
• When a company issues new common stock 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 the stock price.
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If issuing new common stock incurs a flotation cost of 15% of the proceeds, what is ke?
15.4%
5.0% $42.50$4.3995
5.0% 0.15)-$50(1
)$4.19(1.05
g F)-(1Pg)(1D
k0
0e
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Flotation costs
• Flotation costs depend on the risk of the firm and the type of capital being raised.
• The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small.
• We will frequently ignore flotation costs when calculating the WACC.
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What factors influence a company’s composite WACC?• Market conditions.
- Interest rates- Stock prices- Tax rates
• The firm’s capital structure and dividend policy.
• The firm’s investment policy. Firms with riskier projects generally have a higher WACC.
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Should the company use the composite WACC as the hurdle rate for each of its projects?
• NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the “hurdle rate” for a typical project with average risk.
• Different projects have different risks. The project’s WACC should be adjusted to reflect the project’s risk.
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Risk and the Cost of Capital
Rate of Return(%)
WACC
Rejection Region
Acceptance Region
Risk
L
B
A
H12.0
8.0
10.010.5
9.5
0 RiskL RiskA RiskH
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What are the three types of project risk?
• Stand-alone risk• Corporate risk• Market risk
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How is each type of risk used?
• Market risk is theoretically best in most situations.
• However, creditors, customers, suppliers, and employees are more affected by corporate risk.
• Therefore, corporate risk is also relevant.
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Problem areas in cost of capital
• Depreciation-generated funds
• Privately owned firms• Measurement problems• Adjusting costs of capital for
different risk• Capital structure weights
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How are risk-adjusted costs of capital determined for
specific projects or divisions?
• Subjective adjustments to the firm’s composite WACC.
• Attempt to estimate what the cost of capital would be if the project/division were a stand-alone firm. This requires estimating the project’s beta.
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Finding a divisional cost of capital:Using similar stand-alone firms to estimate a project’s cost of capital
• Comparison firms have the following characteristics:–Target capital structure consists
of 40% debt and 60% equity.– rd = 12%– rRF = 7%–RPM = 6%–βDIV = 1.7–Tax rate = 40%
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Calculating a divisional cost of capital
• Division’s required return on equity– rs = rRF + (rM – rRF)β
= 7% + (6%)1.7 = 17.2%
• Division’s weighted average cost of capital– WACC = wd rd ( 1 – T ) + wc rs
= 0.4 (12%)(0.6) + 0.6 (17.2%) =13.2%
• Typical projects in this division are acceptable if their returns exceed 13.2%.