The Cost of Capital Cost of Capital, Discounts Rates, and the required Rate of Return

We know how to do capital budgeting problems, but what about the discount rate?

We also know that the discount rate will depend on the risk of the project:

Investors will require a higher required rate of return for riskier projects Investors will look at projects as portfolios and therefore the systematic risk is the correct measure of risk !ny unsystematic risk can be diversified away, and no compensation for this is necessary

Required rate of return, appropriate discount rate, and cost of capital are different names for the same concept

"he cost of capital depends on the risk, and hence primarily on the use of the funds, not the source

#irm$s overall cost of capital reflects the required rate of return on the firm$s assets as a whole "his overall cost of capital is called the weighted average cost of capital, and reflects the costs of debt, equity, and preferred stock

The weighted average cost of capital (WACC)

!ssume the firm has a target capital structure %mi& of debt and equity' (apital structure weights: )alue of the #irm * )alue of +quity , )alue of -referred , )alue of .ebt )*+,-,. w+ * + / %+ ,- , .' * + / ) w. * . / %+ , - , .' * . / ) w- * - / %+ , - , .' * - / )

Weighted !verage (ost of (apital: W!(( * 0W!(( * w+ 0+ , w- 0- , w. 0. %1 "c'

Focus on before ta! or after ta! capital costs"

2hareholders are concerned with cash flows available to them after corporate ta&es have been paid "herefore, use !fter-"a& W!(( 3nly r. needs adjustment

Wh# ad$ust rD "

"he cost of debt is ta& deductible to the issuing firm (osts of preferred and common are not deductible

What is %arginal cost"

.ecisions are being made regarding new capital investment "herefore, the cost of the ne&t dollar of capital is the relevant question %marginal cost' &ar'et or (oo' )alues"

(ost of capital measures marginal cost of issuing new securities to finance projects "hese securities are issued at market value Weights assigned to debt and equity in calculating W!(( should be based on market value

The Cost of Debt

*!a%ple+ Calculate the return on debt if #ou 'now the following infor%ation+ (oupon * 145 semiannual6 #ace * 71,444 -rice * 71,481 996 :aturity * 1; years

+&ample: -harmacia has bonds outstanding with the following specifications "hese are <4-year, =5 annual coupon bonds, and selling at >?5 of their face value %71,444' What is the cost of debt for -harmacia?

What if Debt isn,t -ublicl# Traded"

.ote: 2ince the bond pays a coupon semi-annually, and earns 9 ;5 in si& months, we coiuld also calculate the effective annual rate %+!0' +!0 * %1 49;' @ - 1 * AAAAAAAA5

Bowever, nominal rates are generally used for the cost of debt

0eason:

Flotation cost - "otal costs of issuing and selling a security reduce the net proceeds from the sale

"hese costs are typically small on public debt issues

:ost debt is privately placed directly with large investors 2o flotation costs are almost none&istent Flotation Cost Approaches

Incorporate into component costs of capital bond price * par value * 71,444 flotation costs * 15 of issue * 714 net proceeds * 7>>4 "reat flotation costs as investment outlay of new project cost of capital theoretically depends on risk of use of funds, not source increase initial cost to account for flotation costs

The Cost of -referred *quit#

*!a%ple+ Calculate the return on preferred stoc' if #ou 'now the following infor%ation+ -rice *711@ ;6 .ividend Cield * >56 -ar*71446

-referred dividends are not ta& deductible, so no ta& adjustment Dust rEominal r- is used -referred stock tends to be a small part of a firmFs capital structure, and in practice is often ignored

/s -referred stoc' %ore or less ris'# than debt" Corporations own %ost preferred stoc', because 012 of preferred dividends are nonta!able to corporations3

"herefore, preferred often has a lower G-" yield than debt "he !-" yield to an investor, and the !-" cost to the issuer, are higher on preferred than on debt

The Cost of *quit#

+quity consists of two components: retained earnings and new equity issues

Wh# is there a cost for retained earnings"

+arnings can be reinvested or paid out as dividends Investors could use dividends to buy other securities and earn a return "hus, there is an opportunity cost if earnings are retained 3pportunity cost is the return stockholders could earn on alternative investments of equal risk

"hey could buy similar stocks and earn 0+, or the company could repurchase its own stock and earn 0+ 2o 0+ is the cost of retained earnings

Cost of Retained *arnings

&odel /+ The 4ecurit# &ar'et 5ine (4&5) Approach 0emember, the required rate of return on a risky assets depends on: the risk free rate, 0f the market risk premium, +%0:' 0f the systematic risk of the asset, relative to the average,

"he 2:H, or (!-: tells us that the e&pected return on the firm$s equity is: +%0+' * 0f , + I+%0:' 0fJ !nd, if we drop the e&pectations: 0+ * 0f , + I0: 0fJ

*!a%ple+

r0# * risk free rate * = 45 current rate on government security 0-: * %r: - r0#' * ; 45 b2 * 1 @;

*!a%ple+

-harmacia has an equity beta of 1 ?, the risk free rate for return is equal to ;5, and the return on a well-diversified market portfolio is 1;5 What is the cost of equity capital for -harmacia?

The Ris' Free rate+ T bonds vs3 T bills

+mbodies long-term inflation e&pectations

Is influenced less by #ederal 0eserve actions, currency flows, etc

Is the more logical investment alternative to stocks since they have similar investment horiKons

6ow do we calculate the ris' pre%iu% on the %ar'et"

+& post data %Bistorical' e g Ibottson and !ssoc provides this on an annual basis : 0-: * = <5 for 1>@?-1>>?

#uture estimates by financial analysts of market minus "-bond

&odel //+ The Dividend 7rowth (or Discounted Cash Flow) &odel

-4 * %.4 I1 , gJ' / %0+ g' * .1 / %0+ g'

0+ * %.1 / -4', g

+&ample:

What is the .(# %discounted cash flow' cost of retained earnings? Liven: .4 * 7; 446-4 * 7=?6 g * ?5?

-harmacia has just paid a 7> dividend "he dividends are e&pected to grow at 1@5 per year -harmacia currently sells for 711@ per share What is the cost of equity capital for -harmacia?

Disadvantages of Discounted Cash Flow &ethod

:odel is simple to use, but there are many disadvantages and problems:

Cou need a firm that pays dividends Cou need very constant growing dividends Cou need a very accurate estimate of the growth rate

Can Discounted Cash Flow &ethod be used if g is not constant"

.ew Co%%on 4toc' versus Retained *arnings Eew (ommon stock incurs flotation costs 2ome books suggest increasing the discount rate to reflect flotation costs +nd up with a cost of new equity greater than the cost of retained earnings

Gut M required return should reflect risk of investment %use of funds, not source of funds'

+&ample:

The Weighted Average Cost of Capital Gook value debt * 7< million -referred stock is selling for 7144/share and there are 14,444 shares out

(ommon stock is selling for 7@4/share and there are <44,444 shares out "arget capital structure %market value' G * <45 - * 145 2 * ?45 0eturn on debt * >5 0eturn on -referred * 85 0eturn on +quity * 1< 15 "a& rate * 945

-harmacia has 7@44 million worth of equity and 7?44 million worth of debt on its balance sheet "he market value of the equity is 7?;4 million, and the market value of the debt is 7>=; million "he corporate ta& rate is <95 What is the W!(( for -harmacia?

We can use the W!(( as the discount rate in capital budgeting only if the project has a similar risk as the firm as a whole If the project has a risk that is different from the firm as a whole, the 2:H approach is needed -ure -lay !pproach: if there is no beta for the project available, use the W!(( or beta from a company that has similar risk as the project *!a%ple: Liant +agle is considering an e&pansion in the pharmaceutical business "he problem that they are facing is that they do not have a beta for this project available, and they realiKe that the risk involved with the pharmaceutical business is quite different from being in the grocery store business What discount rate could Liant +agle use?