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Cost of Capital

Chapter 1414-#1Chapter OutlineThe Cost of Capital OverviewThe Cost of EquityThe Cost of DebtThe Cost of Preferred StockThe Weighted Average Cost of Capital (WACC)Flotation Costs relative to WACC

14-#Why the Cost of Capital Is ImportantWe know that the return earned on assets depends on the risk of those assets

The return to an investor is the same as the cost to the company

14-#3Why the Cost of Capital Is ImportantThe cost of capital provides us with an indication of how the market views the risk of firms assets

4. Knowing the cost of capital can also help determine the required return for capital budgeting projects14-#4The Cost of EquityThere are two major methods for determining the cost of equity:

Dividend growth model (aka: the Gordon Model)

2. SML, or the CAPM14-#The Dividend Growth Model (The Gordon Model)Start with the dividend growth model formula and rearrange to solve for RE

14-#6Dividend Growth Model ExampleSuppose that your company is expected to pay a dividend of $1.50 per share next year.

There has been a steady growth in dividends of 5.1% per year and the market expects that to continue. The current price is $25.

What is the cost of equity?

14-#Example: Estimating the Dividend Growth RateOne method for estimating the growth rate is to use the historical average:

YearDividendPercent Change20051.2320061.30(1.30 1.23) / 1.23 = 5.69%20071.36(1.36 1.30) / 1.30 = 4.62%20081.43(1.43 1.36) / 1.36 = 5.15%20091.50(1.50 1.43) / 1.43 = 4.90%

Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.087%14-#8Advantages and Disadvantages of the Dividend Growth ModelAdvantage:

Easy to understand and useDisadvantages:Only applicable to companies currently paying dividendsNot applicable if dividends arent growing at a reasonably constant rateExtremely sensitive to the estimated growth rate an increase in g of 1% increases the cost of equity by 1%Does not explicitly consider risk14-#9The SML ApproachUse the following information to compute our cost of equity:

Risk-free rate, Rf

Market risk premium, E(RM) Rf

Systematic risk of asset,

14-#10Example - SMLSuppose your company has:

an equity beta of .58

the current risk-free rate is 6.1%

the expected market risk premium is 8.6%What is the cost of equity using the SML valuation technique?RE = 6.1 + .58(8.6) = 11.1%14-#11How Did We Do?Since we came up with similar numbers using both the dividend growth model (11.1%) and the SML approach (11.1%), we should feel good about our estimate!

14-#Advantages and Disadvantages of SMLAdvantages:Explicitly adjusts for systematic riskApplicable to all companies, as long as we can estimate betaDisadvantages:Have to estimate the expected market risk premium, which does vary over timeHave to estimate beta, which also varies over timeHave to use the past to predict the future, which is not always reliable14-#13Example Cost of EquityOur company has a beta of 1.5.

The market risk premium is expected to be 9%, and the current risk-free rate is 6%.

We have used analysts estimates to determine that the market believes our dividends will grow at 6% per year and our last dividend was $2.

Our stock is currently selling for $15.65. What is our cost of equity using the SML?RE = 6% + 1.5(9%) = 19.5%14-#Example Cost of EquityOur company has a beta of 1.5.

The market risk premium is expected to be 9%, and the current risk-free rate is 6%.

We have used analysts estimates to determine that the market believes our dividends will grow at 6% per year and our last dividend was $2.

Our stock is currently selling for $15.65. What is our cost of equity using the DGM?RE= [2(1.06) / 15.65] + .06 = 19.55%14-#15Cost of DebtThe cost of debt is the required return on our companys debt

We usually focus on the cost of long-term debt or bonds (as opposed to short-term debt like notes payable)

14-#16Cost of DebtThe required return is best estimated by computing the yield-to-maturity on the existing long-term debt (the YTM).

14-#17Example: Cost of Debt: computing the YTMSuppose we have a corporate bond issue currently outstanding that has 25 years left to maturity.

The coupon rate is 9%, and coupons are paid semiannually.

The bond is currently selling at 90.872% of Par. What is the cost of debt?YTM = 10%

14-#Cost of Preferred StockPreferred stock is a perpetuity, so we take the perpetuity formula:P0 = D_ RpsRps = D_ P0and then rearrange the terms to solve for RP14-#Example: Cost of Preferred StockYour company has preferred stock that has an annual dividend of $3.00

The current price is $25What is the cost of preferred stock?RP = 3/25 = 12%14-#Capital Structure WeightsTo compute the WACC, we first need the weights of each source of funds: namely debt, preferred stock and equity

14-#Capital Structure WeightsLets simplify with an example of just debt and equity.

We often use the market value of both debt and equity

14-#Capital Structure ValuationDebts Market Value = (# of outstanding bonds ) x (the market price of one bond)

Equitys Market Value = (# shares of outstanding common stock) x (the market price of one share of common stock)

14-#23Capital Structure ValuationA firms market value is simply the added value of both the debt and the equity:

V = D + E

14-#24Capital Structure WeightsWD = D/VThis is the % financed with debt

WE = E/VThis is the % financed with equityWD + WE = 1

Remember D/E = (D/V)/(E/V)If D/E = 1.5, thenD/V = ?E/V = ?14-#25Student Alert!The capital structure weights must always add up to 100%WD + WPS + WE = 100%If no preferred stocks, then WPS =0, hence, WD + WE = 100%14-#Example: Capital Structure WeightsSuppose you have a market value of equity equal to $500 million and a market value of debt equal to $475 million.What are the capital structure weights?V = $500 million + $475 million = $975 millionwE = E/V = 500 / 975 = .5128 = 51.28%wD = D/V = 475 / 975 = .4872 = 48.72%14-#Taxes and the WACCWait a minute!

Debt and Equity are not equal in the eyes of the firm.

Debt gets a tax advantage and Equity does not.

14-#28Taxes and the WACCInterest expense reduces our tax liability

This reduction in taxes reduces our cost of debtThus, our real cost of debt is actually the AFTER-TAX cost of debt or After-tax cost of debt = RD(1-TC)14-#Taxes and the WACCOur new equation for the WACC is:WACC = WDRD(1-TC) +WE RE + WPs RPsThis is one of the most powerful relationships in finance.If no Preferred shares, then WACC = WDRD(1-TC) +WE RE14-#30Putting All the Pieces Together WACC ExampleEquity Information:50 million shares$80 per shareBeta = 1.15Market risk premium = 9%Risk-free rate = 5%Debt Information:Outstanding debt in the form of bonds with a face value = $1 bn.Current quote = 110Coupon rate = 9%,Semiannual coupons15 years to maturityThe firms tax rate is 40%14-#31WACC Example2. What is the cost of equity (using the CAPM)?RE = 5% + 1.15(9%) = 15.35%1. What is the cost of debt? AT-Cost of Debt?If YTM (RD ) = 7.85% After-tax cost of debt = RD(1 TC)= 7.854%(1 - .40) = 4.712%14-#32WACC Example3. What are the capital structure weights?VDebt = 1 billion ($1.10) = $1.1 billionVEquity = 50 million ($80) = $4 billionValue of the Firm = 4 + 1.1 = $5.1 billion14-#WACC Example (Plug and Chug)4. Compute the Weighted Average Cost of Capital (the WACC)WACC = 0.2157 x (4.712%) + 0.7843 (15.35%) = 13.06%WACC = WDRD(1-TC) + WE RE14-#Flotation CostsFlotation costs are the fees paid to issue stocks or bonds

While the required return for a project depends on the risk, it should not depend upon how the money is raised

However, the cost of issuing new securities should not just be ignored either14-#Flotation CostsHowever, the cost of issuing new securities should not just be ignored either.

The Basic Approach:Compute the weighted average flotation cost (fA)

2. Use the target weights because the firm will issue securities in these percentages over the long term14-#Flotation Costs: An NPV ExampleYour company is considering a project that will cost $1 million.

The project will generate after-tax cash flows of $250,000 per year for 7 years.

The WACC is 15%, and the firms target D/E ratio is .6

The flotation cost for equity is 5%, and the flotation cost for debt is 3%. 14-#Flotation Costs: An NPV ExampleWhat is the NPV for the project before adjusting for flotation costs?WACC = 15%

PV of future cash flows = $1,040,105

NPV = 1,040,105 - 1,000,000 = $ 40,105

14-#Flotation Costs: An NPV ExampleWhat is the NPV for the project after adjusting for flotation costs?fA = (.375)(3%) + (.625)(5%) = 4.25%

PV of future cash flows = 1,040,105

NPV = 1,040,105 - 1,000,000/(1-.0425) = $ -4,281

The project would have a positive NPV of $40,105 without considering flotation costs

Once we consider the cost of issuing new securities, the NPV becomes a negative $4,281!14-#Formulas

Cost of Equity (Dividend Growth Model)Cost of Equity (CAPM)14-#Formulas (continued)Rps = D_ P0After-tax cost of debt = RD(1-TC)Cost of Preferred Stock

Cost of Debt (approximationWACC = WDRD(1-TC) +WE RE + WPs RPs14-#

Key Concepts and SkillsBe able to compute a firms cost of equity using the CAPM and the Dividend Growth model

Be able to compute a firms after-tax cost of debt

14-#

Key Concepts and SkillsKnow how to compute the WACC of a firm

Identify the consequences to the WACC of considering floatation costs14-#There are two ways to compute the cost of equity: DGM and CAPM.2. The relevant cost of debt to a firm is the after-tax cost.3. Capital structure determines the weights of debt, preferred stock and equity used by the firm.The WACC determines the discount rate to be used for capital budgeting purposes for NPV, IRR .5. All projects may not have the identical risk classification and we may need to adjust the WACC accordingly.What are the most important topics of this chapter?

14-#44Q2 FEx:Par1000Price908.72n25CR9%rB9.81%

YTM=10.00%

Sheet17.85%

Input DataCost1,000,000CFFA250,000WACC15.0%D/E60.0%fe5.0%fd3.0%

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Sheet3

Sheet17.85%Cost1,000,000CFFA250,000WACC15.0%D/E60.0%fe5.0%fd3.0%NPV=40,104.933D/E=0.6D/V =0.375E/V =0.625fA=4.250%

Sheet2

Sheet3