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LONG -TERM

SHORT TERM MEDIUM TERM

The Cost of Capital

Sources of Long-Term Capital:


Long-Term Debt Preferred Equity Common Equity
Retained Earnings New Common Stock
COMPONENT COST

Cost of Capital
The cost of companys funds The expected return on a portfolio of all the companys existing securities May include cost of debt, cost of preferred stock, cost of RE, or cost of common stock

Weighted Average Cost of Capital


WACC = wdrd(1-T) + wprp + wcrs A weighted average of the component costs of debt, preferred stock, and common equity. The ws refer to the firms capital structure weights. The rs refer to the cost of each component.

Target (Optimal) Capital Structure


The percentages of debt, preferred stock, and common equity that will maximize the firms stock price and minimize WACC.

Before or After Tax Cost of Capital?


After Tax Cash Flows (amounts in the timeline) should be the focus, thus we must use the AfterTax Cost of Capital. Only rd needs adjustment, because interest is tax deductible. When a company pays interest, the actual cost is less than the expense.

WACC = wdrd(1-T) + wprp + wcrs or re

Focus: Historical (Embedded) or New (Marginal) Costs?


For WACC, we must focus on the marginal costs because we are dealing with the future. Cost of Capital is used primarily to make decisions involving raising new capital.

Determination of Weights
Book Value (Accounting Numbers) or Market Value?
MV reflects expectations of investors and closely reflects how a company has to raise new capital.

Actual Numbers or Target Capital Structure?

Book Value Weights


Source Long-term Debt Preferred Equity Common Equity Grand Totals Total Book Value $400,000 $100,000 $500,000 $1,000,000 % of Total ? ? ? ?

Illustration:
At present, Malady Companys balance sheet shows P1 million in short term debt, P1.4 million in long term debt, P0.6 million in preferred stock, and P2 million in common equity. Market values as determined should have been P1.8 million in short term debt, P1.5 million in long term debt, P0.4 million in preferred stock, and 1.3 million in common equity. Assume that before-tax cost of debt is 5%, cost of preferred stock is 8%, and cost of common equity is 10%. Further assume that tax rate is 40%. How much is the WACC?

Flotation Costs
Costs associated with the issuance of new securities, such as the fees paid for the services of an investment banker. Setting the price of the issue Selling the issue to the public They must be accounted for in the computation of WACC, though they are (unfortunately) frequently ignored. There may be flotation costs for debt, preferred stock, and new common stock, but not for retained earnings. Flotation costs are highest for the issuance of new common equity though per project cost is fairly small as firms issue equity infrequently. Flotation costs are often small and insignificant for the issuance of debt and preferred stock, hence they are often ignored in computation for the cost of debt and cost of preferred stock.

Component Cost of Debt


WACC = wdrd(1-T) + wprp + wcrs

rd is the marginal cost of debt capital. The yield to maturity on outstanding L-T debt is often used as a measure of rd. Flotation costs are usually small and are usually ignored.

Cost of Debt Sample Problem


A 15-year, 12% semiannual coupon bond sells for $1,153.72. What is the cost of debt (rd)?

(rd) Ignoring Flotation Costs


Herrington Companys 8 percent coupon rate, quarterly payment, $1,000 par value bond, which matures in 20 years, currently sells at a price of $686.86. The companys tax rate is 40 percent. What is the firms component cost of debt for purposes of calculating the WACC?

(rd) Including Flotation Costs


Herrington Companys 8 percent coupon rate, quarterly payment, $1,000 par value bond, which matures in 20 years, currently sells at a price of $686.86. The companys tax rate is 40 percent. If issuing the bond incurs a flotation cost of 20% of the proceeds, what is the firms component cost of debt for purposes of calculating the WACC?

Component Cost of Preferred Stock


WACC = wdrd(1-T) + wprp + wcrs
Preferred dividends are not tax deductible, so there are no tax adjustments. Nominal rp is used. Growth is not included as preferred stocks pay out fixed dividends. Flotation costs are usually small and are usually ignored. rp = Dp/Pp

Component Cost of Preferred Stock Sample Problem


Mayflower Company has a 10% cumulative and non-participating preferred stocks worth P10 million. The company has 80,000 shares outstanding. How much is the component cost of preferred stock?

Seatwork (rp) ignoring flotation costs


Yelena Company sells, at par, $200 preferred stock that pays a 15% annual dividend. Flotation costs are negligible. How much is the component cost of preferred stock?

Seatwork (rp) including flotation costs


Yelena Company sells, at par, $200 preferred stock that pays a 15% annual dividend. Flotation costs of 8% would be incurred. How much is the component cost of preferred stock?

Preferred Stock vs. Debt


Investors point of view: preferred stock is riskier
Preferred dividends are not required to be paid. When debt is due, creditors can demand for payment. Debt investors get paid first before preferred investors. Corporations, however want preferred stock as 70% of preferred dividends (USA) are tax exempt.

Firms try to pay dividends, because:


Firms cant pay common dividend if they dont pay off preferred dividends. Difficult to raise additional funds because less investors will be willing to buy stocks that dont pay dividends. Preferred shareholders may gain control of the firm (Convertible preferred shares)

B4 Tax Preferred Stock vs. B4 Tax Debt


Which before-tax yield is lower?
Before-tax yield on preferred stock often has a lower before-tax yield on debt, because of the 70% tax exemption on preferred dividends as far as corporate investors are concerned. The desirability of preferred stock as compared to debt (even though debt is less risky than preferred stock in terms of liquidity) renders a spike in its demand, hence, preferred stock pre-tax yield offered to investors would be lower than the pre-tax yield on debt.

After Tax Preferred Stock vs. After Tax Debt


Which after-tax yield is lower?
After-tax yield on debt has a lower yield after-tax yield on preferred stock, because cost of debt is tax deductible, while cost of preferred stock is not tax deductible. This is also consistent with higher risk of preferred stock as creditors have priority over preferred shareholders. In conclusion, the effect of tax exemption on preferred stock rendering it attractive to corporate investors, consequently leading to a lower pre-tax yield, is less than the effect of cost of debts tax deductibility. Thus the net effect is that after-tax yield on debt will be lower than after-tax yield on preferred stock.

Component 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 firms common equity using new equity is re.

Cost of Retained Earnings


A firm can choose to finance new projects using only internally generated funds (retained earnings). There is a cost of retained earnings because RE funds are not free as they belong to the shareholders, hence there is an opportunity cost:
Investors could buy similar stocks and earn rs. The firm could repurchase its own stock and earn rs.

Cost of Retained Earnings is exactly the same as the Cost of New Common Equity, except that there are no flotation costs.

3 ways to determine cost of common equity


Using Own Bond Yield Plus Risk Premium rs = rd + RP Using CAPM rs = rRF + (rM rRF)
Using DCF Method rs = D1 / P0 + g

Own Bond Yield Plus Risk Premium Method


Provides a ballpark estimate of rs The Risk Premium is NOT the RPM (Risk Premium of the Market) in the CAPM formula.

If rd = 10% and RP = 4%, what is rs using the own-bond-yield-plus-risk-premium method? ks = kd + RP ks = 10.0% + 4.0% = 14.0%

Using CAPM
If the rRF = 7%, MRP = 6%, and the firms beta is 1.2, whats the cost of common equity based upon the CAPM?

ks = kRF + (kM kRF) = 7.0% + (6.0%)1.2 = 14.2%

Using DCF (DDM & Constant Growth) Method (Cost of Retained Earnings)
If the most current dividend is $4.19, P0 = $50, and constant g = 5%, whats the cost of common equity based upon the DCF approach?

D1 = D0 (1+g) D1 = $4.19 (1 + .05) D1 = $4.3995


rs = D1 / P 0 + g = $4.3995 / $50 + 0.05 = 13.8%

What is a reasonable final estimate of rs?


Method CAPM DCF rd + RP Average Estimate 14.2% 13.8% 14.0% 14.0%

Using DCF (DDM & Constant Growth) Method (Cost of New Common Equity)
If the most current dividend is $4.19, P0 = $50, and constant g = 5%, and flotation costs is 15%, whats the cost of common equity based upon the DCF approach?

D1 = D0 (1+g) D1 = $4.19 (1 + .05) D1 = $4.3995


re = (D1 / P0 (1 F))+ g =( $4.3995 / ($50 x 0.85)) + 0.05 = 15.4%

Cost of RE vs Cost of New Common Equity


Cost of new common equity (re) is always higher than or equal to Cost of Retained Earnings (rs) because of the following reasons:
Flotation costs due to the underwriter is incurred when issuing new common equity. Issuing new common equity may send a negative signal to the capital markets which may depress stock price.

Should we use rs or re if the problem is silent?


If the firm has sufficient retained earnings to finance the common equity portion of new projects, then rs (Cost of Retained Earnings) must be used. If the firms retained earnings is not sufficient to finance the common equity portion of new projects, then re (Cost of New Common Equity) must be used. Retained Earnings Breakpoint is the amount of capital raised beyond which new common stock must be issued REBP = Addition to Retained Earnings / Equity Fraction

Illustration 1 RE Breakpoint
Maleficent Industries has determined that its optimal capital structure is 20% debt, 30% preferred equity, and 50% common equity. It wants to raise $50 million to fund a new project. Currently, it has $20 million in net income and the dividend payout ratio is 50%. How much is the REBP? Should Maleficent use retained earnings or should it issue new common equity?

Illustration 2 RE Breakpoint
SSS has a capital structure that consists of 20% equity and 80% debt. The company expects to report $3 million in net income this year, and 60% of the net income will be paid out as dividends. How large must the firms capital budget be this year without it having to issue any new common stock?

WACC Illustration 1(P 11-10 adapted)


Klose Outfitters Inc. has determined its optimal capital structure consists of 60% equity and 40% debt. Klose must raise additional capital to fund its upcoming expansion. The firm has $2 million in retained earnings that has a cost of 12 percent. Its investment bankers have informed the firm that it can issue an additional $6 million of new common stock at a cost of 15%. Furthermore, the firm can raise up to $2 million of debt at 10% and an additional $5 million at 12%. The firm has estimated that the proposed expansion will require an investment of $5.9 million. Assume that tax rate is 40%, what is the WACC for the funds Klose will be raising?

WACC Illustration 2
Anderson Company has four investment opportunities with the following costs (paid at t = 0) and expected returns: Project Cost Expected Return A 2,000 16.0% B 3,000 14.5 C 5,000 11.5 D 3,000 9.5 The company has a target capital structure that consists of 40 percent common equity, 40 percent debt, and 20 percent preferred stock. The company has $1,000 in retained earnings. The company expects its year-end dividend to be $3.00 per share. The dividend is expected to grow at a constant rate of 5 percent a year. The companys stock price is currently $42.75. If the company issues new common stock, the company will pay its investment bankers a 10 percent flotation cost. The company can issue corporate bonds with a yield to maturity of 10 percent. The company is in the 35% tax bracket. How large can the cost of preferred stock be (including flotation costs) and it still be profitable for the company to invest in all four projects?

WACC Illustration 3
Valerie Constructions CFO wants to estimate the companys WACC. She has collected the following information:

The company currently has 20-year bonds outstanding. The bonds have an 8.5 percent annual coupon, a face value of $1,000, and they currently sell for $945. The companys stock has a beta = 1.20. The market risk premium equals 5%. The risk-free rate is 6%. The company has outstanding preferred stock that pays a $2.00 annual dividend. The preferred stock sells for $25 a share. The companys tax rate is 40 percent. The companys capital structure consists of 40 percent long-term debt, 40 percent common equity, and 20 percent preferred stock.

REQUIRED: Compute for the after-tax cost of debt, after-tax cost of preferred stock, after-tax cost of common equity, and WACC

WACC Illustration 4
Gavan Corp. is a steel manufacturer that finances its operations with 40 percent debt, 10 percent preferred stock, and 50 percent equity. The interest rate on the companys debt is 11 percent. The preferred stock pays an annual dividend of $2 and sells for $20 a share. The companys common stock trades at $30 a share, and its current dividend of $2 a share is expected to grow at a constant rate of 8 percent per year. The flotation cost of external equity is 15 percent of the dollar amount issued, while the flotation cost on preferred stock is 10 percent. The company estimates that its WACC is 12.30 percent. Assume that the firm will not have enough retained earnings to fund the equity portion of its capital budget. What is the companys tax rate?

Composite COC or WACC


Reflects the risk of an average project undertaken by the firm. Represents the hurdle rate for a typical project with average risk Cannot be used as a hurdle rate for each project the firm wants to undertake Different projects have different risks. The projects WACC should be adjusted to reflect the projects risk.
RISK-ADJUSTED COST OF CAPITAL
The cost of capital appropriate for a given project, given the riskiness of that project. The greater the risk, the higher the cost of capital

Factors that influence a companys composite COC or WACC:


Market Conditions Level of Interest Rates (direct rel.) General Level of Stock Prices Tax Rates

Uncontrollable

Firms Capital Structure Firms Dividend Policy (RE level) Firms Capital Budgeting Decision Rules Controllable Firms Investment Policy Firms with riskier projects generally have a higher WACC

Risk-Adjusted Discount Rate (P 11-19)


Ziege Systems is considering the following independent projects for the next year. The company estimates that its WACC is currently 10%. The company adjusts for risk by adding 2 percentage points to the WACC for high-risk projects and subtracting 2 percentage points from the WACC for low-risk projects.
PROJECT A B C D E F G REQUIRED INVESTMENT $4 million $5 million $3 million $2 million $6 million $5 million $6 million RATE OF RETURN 14.0% 11.5% 9.5% 9.0% 12.5% 12.5% 7.0% RISK High High Low Average High Average Low

$3 million

11.5%

Low

Required:
Which projects should Ziege accept if it faces no capital constraints? If Ziege only has the ability to invest a total of $13 million, which projects should it accept, and what will the firms capital budget be for the next year? Suppose that Ziege can raise additional funds in order to increase its capital budget from the level determined in the previous question. However, for every $5 million of new capital raised by Ziege, the firms WACC is expected to increase by 1%. If Ziege proceeds to use the same method of risk adjustment, which projects will it accept, and how much in additional funds must be raised to complete its capital budget?

Required:
Ziege Systems is considering the following independent projects for the next year. The company estimates that its WACC is currently 10%. The company adjusts for risk by adding 2 percentage points to the WACC for high-risk projects and subtracting 2 percentage points from the WACC for low-risk projects. Which projects should Ziege accept if it faces no capital constraints? PROJECT A REQUIRED INVESTMENT $4 million RATE OF RETURN 14.0% RISK High

B
C D E F

$5 million
$3 million $2 million $6 million $5 million

11.5%
9.5% 9.0% 12.5% 12.5%

High
Low Average High Average

G
H

$6 million
$3 million

7.0%
11.5%

Low
Low

Required:
Ziege Systems is considering the following independent projects for the next year. The company estimates that its WACC is currently 10%. The company adjusts for risk by adding 2 percentage points to the WACC for high-risk projects and subtracting 2 percentage points from the WACC for low-risk projects. If Ziege only has the ability to invest a total of $13 million, which projects should it accept, and what will the firms capital budget be for the next year? PROJECT A REQUIRED INVESTMENT $4 million RATE OF RETURN 14.0% RISK High

B
C D E F

$5 million
$3 million $2 million $6 million $5 million

11.5%
9.5% 9.0% 12.5% 12.5%

High
Low Average High Average

G
H

$6 million
$3 million

7.0%
11.5%

Low
Low

Required:
Ziege Systems is considering the following independent projects for the next year. The company estimates that its WACC is currently 10%. The company adjusts for risk by adding 2 percentage points to the WACC for high-risk projects and subtracting 2 percentage points from the WACC for low-risk projects. Suppose that Ziege can raise additional funds in order to increase its capital budget from the level determined in the previous question. However, for every $5 million of new capital raised by Ziege, the firms WACC is expected to increase by 1%. If Ziege proceeds to use the same method of risk adjustment, which projects will it accept, and how much in additional funds must be raised to complete its capital budget?

PROJECT A

REQUIRED INVESTMENT $4 million

RATE OF RETURN 14.0%

RISK High

B
C D E F

$5 million
$3 million $2 million $6 million $5 million

11.5%
9.5% 9.0% 12.5% 12.5%

High
Low Average High Average

G
H

$6 million
$3 million

7.0%
11.5%

Low
Low

Risk and the Cost of Capital


Rate of Return (%)
Acceptance Region W ACC 12.0 10.5 10.0 9.5 8.0 L A B H Rejection Region

Risk L

Risk A

Risk H

Risk

Three types of project risk:


Stand-alone risk
The risk an asset would have if it were a firms only asset and if investors owned only one stock. It is measured by the variability of the assets expected returns (Variance and Standard Deviation)

Corporate risk (Within-Firm risk)


Risk not considering the effects of stockholders diversification Measured by a projects effect on uncertainty about the firms future earnings Affects external parties (creditors, customers, suppliers, employees), hence it is relevant.

Market risk/non-diversifiable risk/systematic risk


That part of a projects risk that cannot be eliminated by diversification Measured by the projects beta coefficient Theoretically best in most situations

Problem areas in cost of capital not covered in basic finance


Depreciation-generated funds Privately owned firms Measurement problems Adjusting costs of capital for different risk Capital structure weights

How are risk-adjusted costs of capital determined for specific projects or divisions?
Subjective adjustments to the firms composite COC or WACC.
Attempt to estimate what the cost of capital would be if the project/division were a standalone firm. This requires estimating the projects beta.

Finding a divisional cost of capital: Using similar stand-alone firms to estimate a projects cost of capital Comparison firms have the following characteristics: Target capital structure consists of 40% debt and 60% equity. rd = 12% rRF = 7% MRP = 6% DIV = 1.7 Tax rate = 40%

Calculating a divisional cost of capital


Divisions required return on equity

Divisions weighted average cost of capital

Calculating a divisional cost of capital


Divisions required return on equity
ks = kRF + (kM kRF) = 7% + (6%)1.7 = 17.2%

Divisions weighted average cost of capital


WACC = wd kd ( 1 T ) + wc ks = 0.4 (12%)(0.6) + 0.6 (17.2%) =13.2%

Typical projects in this division are acceptable if their returns exceed 13.2%.

Nothing follows