Lecture 6 - Cost of Capital

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What Types of Long-termCapital do Firms Use?

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What Types of Long-termCapital do Firms Use?

Long-term debtPreferred stockCommon equity

� Capital components are sources of funding that come frominvestors.

� Accounts payable, accruals, and deferred taxes are not sourcesof funding that come from investors, so they are not included inthe calculation of the cost of capital.

� We do adjust for these items when calculating the cash flows ofa project, but not when calculating the cost of capital.

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Before-tax vs. After-tax Capital Costs

� Tax effects associated with financing can beincorporated either in capital budgeting cash flowsor in cost of capital.

� Most firms incorporate tax effects in the cost ofcapital. Therefore, focus on after-tax costs.

� Only cost of debt is affected.

Historical (Embedded) Costs vs. New (Marginal) Costs

The cost of capital is used primarily to makedecisions which involve raising and investing newcapital. So, we should focus on marginal costs.

Lecture 6 - Cost of Capital

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Cost of Debt

� Method 1: Ask an investment banker what the coupon rate would be on new debt.

� Method 2: Find the bond rating for the company and use the yield on other bonds with a similar rating.

� Method 3: Find the yield on the company’s debt, if it has any.

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Component Cost of Debt

� Assume firm can borrow at 11%

� Interest is tax deductible, so the after tax (AT) cost of debt is:� rd AT = rd BT(1 - T)� rd AT = 11%(1 - 0.40) = 11%(.60)=6.6%.

� Use nominal rate.

� Flotation costs small, so ignore.

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Let PP = $100; DPS = 10% of Par;Par = $100; F = $2.50.

Use this formula:

rps =Dps

Pn

=0.1($100)

$100 - $2.50

=$10

$97.50= 0.103 = 10.3%

Cost of Preferred Stock

(Where Pnet = Pp – F)

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Time Line of Preferred

2.50 2.502.50

0 1 2 �rps=?

-100

...

$97.50 =DQrps

=$2.50

rps

rps =$2.50$97.50 = 2.56%; rps(Nom) = 2.56%(4) = 10.3%

Flotation costs for preferred are significant, 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 Less Risky to Investors than Debt?

� More risky; company not required to paypreferred dividend.

� However, firms want to pay preferreddividend. Otherwise, (1) cannot paycommon dividend, (2) difficult to raiseadditional funds, and (3) preferredstockholders may gain control of firm.

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Why is Yield on PreferredLower than rd?

� Corporations own most preferred stock,because 70% of preferred dividends arenontaxable to corporations.

� Therefore, preferred often has a lowerB-T yield than the B-T yield on debt.

� The A-T yield to investors and A-T cost tothe issuer are higher on preferred than ondebt, which is consistent with the higherrisk of preferred.

Example:

rps = 10.3% rd = 10% T = 40%

rps, AT = rps - rps (1 - 0.7)(T)

= 10.3% - 10.3%(0.3)(0.4) = 9.06%

rd, AT = 10% - 10%(0.4) = 6.60%A-T Risk Premium on Preferred = 2.46%

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What are the Two Ways that Companies Can Raise Common Equity?

� Directly, by issuing new shares of common stock.

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

Why is There a Cost for Reinvested Earnings?� Earnings can be reinvested or paid out as dividends.

� Investors could buy other securities, earn a return. Thus, there is an opportunity cost if earnings are reinvested.

� Opportunity cost: The return stockholders could earn on alternative investments of equal risk.

� 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.

Lecture 6 - Cost of Capital

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Why is Issuing Common Equity Not So Common?

� Flotation Costs can be high

� Investors perceive issuing equity as anegative sign. Why? It may signal thecurrent stock price is too high? Explain.

� What about supply and demand?

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Three Ways to Determine the Cost of Equity, rs:

1. CAPM: rs = rRF + (rM - rRF)bi

= rRF + (RPM)bi

2. DCF: rs = D1/P0 + g.

3. Own-Bond-Yield-Plus-RiskPremium:

rs = rd + Bond RP.

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CAPM Cost of Equity

rs = rRF + (rM - rRF )b

= 8.0% + (6.0%)1.1 = 14.6%.

http://studio4learning.tv/business/finance/cost/cost-of-issuing-common-stock

Assume rRF = 8%, RPM = 6%, b = 1.1.

Remember RPM = rM – rRF)

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Issues in Using CAPM

� Most analysts use the rate on a long-term (10 to 20years) government bond as an estimate of rRF. Fora current estimate, go to www.bloomberg.com,select “Bonds” from the section on the left underthe heading “Market Data.” Most analysts havehistorically used rate of 5% to 6.5% for the marketrisk premium (RPM). What about now?

� Estimates of beta vary, and estimates are “noisy”(they have a wide confidence interval).

� For an estimate of beta, go to:

http://www.moneychimp.com/articles/valuation/capm.htm

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Advantages and Disadvantages of CAPM

� Advantages�Explicitly adjusts for systematic risk�Applicable to all companies, as long as we can

compute beta

� Disadvantages�Have to estimate the expected market risk

premium, which does vary over time�Have to estimate beta, which also varies over

time�We are relying on the past to predict the

future, which is not always reliable

Constant Growth Model Once Again

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0s

DP

r g=

−g = constant perpetual growth rate of dividend

D1 = expected dividend = D0 (1 + g)

Constant Growth Model: Example

D0 = $2.24 g = 7% rs = 14.5%

0

$ 2 .2 4 (1 .0 7 )$ 2 .4 0 / .0 7 5 $ 3 2 .0 0

.1 4 5 .0 7P

+= = =−

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Discounted Cash Flow (DCF) Approach(dividend-yield-plus-growth-rate)

Let D0 = $2.24; P0 = $32; g = 7%.

1

0s

DP

r g=

−

rs =D1

P0+ g =

D0(1+g)P0

+ g

= $2.24(1.07)$32

+ 0.07

= 0.075 + 0.07= 14.5%

Solving for rs yields:1

0s

Dr g

P= +

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Estimating the Growth Rate

� Use the historical growth rate if you believe the future will be like the past.

� Obtain analysts’ estimates: Value Line, Zack’s, Yahoo.Finance.

� Use the earnings retention model, illustrated on next slide.

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Earnings Retention Model

� Suppose the company has been earning 15% on equity (ROE = 15%) and retaining 35% (dividend payout = 65%), and this situation is expected to continue.

� What’s the expected future g?

� Retention growth rate:

g = ROE(Retention rate)

g = (15%)(0.35) = 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?

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The Own-Bond-Yield-Plus-Risk-Premium Method

� rs = rd + RP

� rs = 11.0% + 3.7% = 14.7%

� This RP ≠≠≠≠ CAPM RPM.

� Produces ballpark estimate of rs. Useful check.

Let rd = 11%, RP = 3.7%.

What’s a Reasonable Final Estimate of rs?

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Determining the Weights for the WACC

� The weights are the percentages of the firm that willbe financed by each component.

� If possible, always use the target weights for thepercentages of the firm that will be financed with thevarious types of capital.

� If you don’t know the targets, it is better to estimatethe weights using current market values thancurrent book values.

� If you don’t know the market value of debt, then it isusually reasonable to use the book values of debt,especially if the debt is short-term.

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Estimating Weights

� 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.

� Vce = $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)

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

� wce = $150/$250 = 0.6

� wps = $25/$250 = 0.1

� wd = $75/$250 = 0.3

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What’s the WACC?

WACC = wdrd(1 - T) + wpsrps + wcers

Remember:

� wce = $150/$250 = 0.6

� wps = $25/$250 = 0.1

� wd = $75/$250 = 0.3

WACC = 0.3(11%)(0.6) + 0.1(10.3%) + 0.6(14.6)

WACC = 1.98% + 01.03% + 8.76% � 11.8%.

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What Factors Influence a Company’s WACC?

� Market conditions, especially interest rates and tax rates.

� The firm’s capital structure and dividend policy.

� The firm’s investment policy. Firms with riskier projectsgenerally have a higher WACC.

Is the firm’s WACC correct for each division?

� NO! The composite WACC reflects the risk of an average project undertaken by the firm.

� Different divisions may have different risks. The division’s WACC should be adjusted to reflect the division’s risk and capital structure.

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Real World WACCs

Company WACC

General Electric (GE) 12.5

Coca-Cola (KO) 12.3

Intel (INTC) 12.2

Motorola (MOT) 11.7

Wal-Mart (WMT) 11.0

Walt Disney (DIS) 9.3

AT&T (T) 9.2

Exxon Mobil (XOM) 8.2

H.J. Heinz (HNZ) 7.8

BellSouth (BLS) 7.4

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The Risk-Adjusted Divisional Cost of Capital

� Estimate the cost of capital that the division would have if it were a stand-alone firm.

� This requires estimating the division’s beta, cost of debt, and capital structure.

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1. Pure play. Find several publicly traded companies exclusively in project’s business.Use average of their betas as proxy for project’s beta.Hard to find such companies.

2. Accounting beta. Run regression between project’s ROA and S&P index ROA.Accounting betas are correlated (0.5 – 0.6) with market betas.But normally can’t get data on new projects’ ROAs before the capital budgeting decision has been made

Methods for Estimating Beta for a Division or a Project

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Divisional Cost of Capital Using CAPM

� Target debt ratio = 10%.

� rd = 12%.

� rRF = 7%.

� Tax rate = 40%.

� betaDivision = 1.7.

� Market risk premium = 6%.

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Divisional Cost of Capital Using CAPM

Division’s required return on equity:

rs = rRF + (rM – rRF)bDiv.

rs = 7% + (6%)1.7 = 17.2%.

WACCDiv. = wd rd(1 – T) + wc rs

= 0.1(12%)(0.6) + 0.9(17.2%)= 16.2%.

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Division’s WACC vs. Firm’s Overall WACC?

� Division WACC = 16.2% versus company WACC = 11.8%.

� “Typical” projects within this division would be accepted if their returns are above 16.2%.

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

Divisional Risk and the Cost of Capital

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What are the Three Types of Project Risk?

Stand-alone Risk - The risk associated with asingle operating unit of a company or asset.

Corporate risk

Market risk

� Stand-alone risk is easiest to calculate.

� Market risk is theoretically best in most situations.

� However, creditors, customers, suppliers, andemployees are more affected by corporate risk.

� Therefore, corporate risk is also relevant.

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Costs 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 stock price.

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Cost of New Common Equity(With Flotation Costs)

re =D0(1 + g)

P0(1 - F)+ g

= $4.19(1.05)

$50(1 – 0.15)+ 5.0%

= $4.40$42.50

+ 5.0% = 15.4%

Let P0=$50, D0=$4.19, g=5%, and F=15%.

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Cost of New 30-Year Debt (With Flotation Costs)

:

� Solve for rd:�N = 30�PV = 1000(1-.02) = 980�PMT = (.10)(1000)(1-.4) = 60�FV = 1000

� Solving for rd = 6.15%

Par=$1,000, Coupon=10% paid annually, and F=2%.

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Comments About 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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Four Mistakes to Avoid

1. When estimating the cost of debt, don’t use thecoupon rate on existing debt. Use the currentinterest rate on new debt.

2. When estimating the risk premium for the CAPMapproach, don’t subtract the current long-term T-bond rate from the historical average return oncommon stocks.

For example, if the historical rM has beenabout 12.2% and inflation drives the current rRFup to 10%, the current market risk premium isnot 12.2% - 10% = 2.2%!

(More...)

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3. Don’t use book weights to estimate the weights forthe capital structure.

Use the target capital structure to determine theweights.

If you don’t know the target weights, then usethe current market value of equity, and never thebook value of equity.

If you don’t know the market value of debt, thenthe book value of debt often is a reasonableapproximation, especially for short-term debt.

(More...)

Four Mistakes to Avoid

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4. Always remember that capital components aresources of funding that come from investors.

Accounts payable, accruals, and deferredtaxes are not sources of funding that comefrom investors, so they are not included in thecalculation of the WACC.

We do adjust for these items when calculatingthe cash flows of the project, but not whencalculating the WACC.

Four Mistakes to Avoid

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Lecture 6 - Cost of Capital

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