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Feb 05, 2017

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lecture

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You are on page 1of 41

1. Buchan Enterprises is considering investing in a new machine. The machine will be purchased

on 1 January in Year 1 at a cost of 50,000. It is estimated that it would last for 5 years, and it

will then be sold at the end of the year for 2,000 in cash. The respective net cash flows

estimated to be received by the company as a result of purchasing the machine during each year

of its life are as follows:

Year

1 8,000

2 16,000

3 40,000 ????

4 45,000

5 35,000

Required:

Calculate (a) the payback period for the project

(b) net present value

To Buy or Not to Buy?

Mr Char sells kuey teow at a stall near to Sunway

University. He has been using the same wok in his

business over the last 20 years. It has come to a

point of time where this wok can no longer

accommodate the increased of sales. He has

been scouting for a good wok around Aoen and

found out this brand Lo Goumot. The wok will

cost him RM500 and he foresees that the wok

will help him to generate cash flow of:- Year 1,

RM200, Year 2, RM150, Year 3, RM130 and Year

4, RM100. Should he purchase this work? Assume

a discount rate of 6%.

Principles of Business Finance

Learning Outcomes

By the end of this lecture, students

should be able to:-

Calculate a firms cost of equity capital

and cost of debt,

Calculate a firms overall cost of capital

(WACC).

The Security Market Line

Line that results when the expected returns

and beta coefficients is plot.

This line is used to describe the relationship

between systematic risk and expected return

in financial markets.

After NPV, the SML is arguable the most

important concept in modern finance.

Capital Asset Pricing Model (CAPM) is the

equation of the SML showing the relationship

between expected return and beta.

E(Ri) = Rf + [E(Rm) Rf] X i

The SML & The Cost of Capital

SML tells us the reward for bearing risk in

financial markets.

At an absolute minimum, any new investment a

firm undertakes must offer an expected return

that is no worse than what the financial

markets offer for the same risk.

Reason: the shareholders can always invest for

themselves in the financial markets.

To benefit the shareholders is by finding

investments with expected returns that are

superior to what the financial markets offer

for the same risk.

The SML & The Cost of Capital

The determine whether an investment has a

positive NPV, we essentially compare the expected

return on that new investment to what the financial

market offers on an investment with the same

beta.

This is why the SML is so important.

It tells us the going rate for bearing risk in the

economy.

The appropriate discount rate on a new project is

the minimum expected rate of return an investment

must offer to be attractive.

Can be interpreted as the opportunity cost

associated with the firms capital investment.

Introduction to the Cost of

Capital

Security Market Line (SML) is used to explore

the relationship between the expected return

on a security and its systematic risk. This is

from the viewpoint of shareholder in a firm.

This lecture, we look at from the viewpoint of

the company. That is how these returns and

securities look from the viewpoint of the

companies that issue them.

Return an investor in a security receives is the

cost of that security to the company that

issued it.

Required Return Vs. Cost of

Capital

If the required return of an investment is

10%, it means the investment will have a

positive NPV only if its return exceeds

10% OR

The firm must earn 10% on the investment

just to compensate its investors for the

use of the capital needed to finance the

project.

Cost of capital associated with an

investment depends on the risk of an

investment.

Why Cost of Capital Is

Important

We 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

Our cost of capital provides us with an

indication of how the market views the risk

of our assets

Knowing our cost of capital can also help us

determine our required return for capital

budgeting projects

Financial Policy and Cost of

Capital

A firms overall cost of capital will reflect

the required return on the firms assets as

a whole.

The overall cost of capital is a mixture of

the returns needed to compensate its

creditors and those needed to compensate

its stockholders.

In other words, a firms cost of capital

reflects both its cost of debt capital and

its cost of equity capital.

Cost of Equity

The cost of equity is the return required by equity

investors given the risk of the cash flows from the

firm

Business risk

Financial risk

There are two major methods for determining the

cost of equity

Dividend growth model

SML or CAPM

The Dividend Growth Model

Approach

Start with the dividend growth model

formula and rearrange to solve for RE

D1

P0

RE g

D1

RE g

P0

Dividend Growth Model

Example

Suppose 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?

D1

RE g

P0

1.50

0.051

25

0.111

11.1%

Example: Estimating the

Dividend Growth Rate

One method for estimating the growth rate is to use

the historical average

Year Dividend Percent Change

2005 1.23 -

2006 1.30 (1.30 1.23) / 1.23 = 5.7%

2007 1.36 (1.36 1.30) / 1.30 = 4.6%

2008 1.43 (1.43 1.36) / 1.36 = 5.1%

2009 1.50 (1.50 1.43) / 1.43 = 4.9%

Advantages and Disadvantages

of Dividend Growth Model

Advantages

easy to understand

easy to use

Disadvantages

Only applicable to companies currently paying dividends

Not applicable if dividends arent growing at a reasonably

constant rate

Extremely sensitive to the estimated growth rate. An

increase in g of 1% increases the cost of equity by 1%

Does not explicitly consider risk

The SML Approach

Use the following information to compute our cost of

equity

Risk-free rate, Rf

Market risk premium, E(RM) Rf

Systematic risk of asset,

RE Rf E(E(RM) Rf )

Example: SML

Suppose your company has an equity beta of 0.58,

and the current risk-free rate is 6.1%. If the

expected market risk premium is 8.6%, what is your

cost of equity capital?

R E R f E (E(R M ) R f )

6.1% 0.58(8.6%)

11.1%

Since we came up with similar numbers using both

the dividend growth model and the SML approach,

we should feel good about our estimate

Advantages and Disadvantages

of SML

Advantages

Explicitly adjusts for systematic risk

Applicable to all companies, as long as we can estimate 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 using the past to predict the future, which is not

always reliable

Example: Cost of Equity

Suppose our 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 DGM: RE = [2(1.06) / 15.65] + 0.06 = 19.55%

Cost of Debt

The cost of debt is the required return on

our companys debt

We usually focus on the cost of long-term

debt or bonds

The required return is best estimated by

computing the yield-to-maturity on the

existing debt

We may also use estimates of current

rates based on the bond rating we expect

when we issue new debt

The cost of debt is NOT the coupon rate

Example: Cost of Debt

Suppose we have a 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 for $908.72 per $1,000 bond. What

is the cost of debt?

50 N; 45 PMT; 1000 FV; -908.72 PV; CPT I/Y = 5%;

YTM = 5(2) = 10%

Cost of Preferred Stock

Reminders

Preferred stock generally pays a constant dividend

each period

Dividends are expected to be paid every period

forever

Preferred stock is a perpetuity, so we take the

perpetuity formula, rearrange and solve for RP

D

RP

P0

Example: Cost of Preferred

Stock

Your company has preferred stock that

has an annual dividend of $3. If the

current price is $25, what is the cost of

preferred stock?

D

RP

P0

3

12%

25

Cost of Preferred Stock

Most preferred stock dividends are stated

as a dollar amount: x dollars per year.

When dividends are stated this way, the

stock is often referred to as x-dollar

preferred stock.

Sometimes preferred stock dividends are

stated as an annual percentage rate. This

rate represents the % of the stocks par,

or face, value that equals the annual

dividend.

The Weighted Average Cost

of Capital

We can use the individual costs of

capital that we have computed to get

our average cost of capital for the

firm.

This average is the required return on

the firms assets, based on the markets

perception of the risk of those assets

The weights are determined by how

much of each type of financing is used

Capital Structure Weights

Notation

E = market value of equity

= # of outstanding shares times price per share

D = market value of debt

= # of outstanding bonds times bond price

V = market value of the firm

=D+E

Weights

wE = E/V = percent financed with equity

wD = D/V = percent financed with debt

Example: Capital Structure

Weights

Suppose 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?

wE = E/V = 500 / 975 = .5128 = 51.28%

wD = D/V = 475 / 975 = .4872 = 48.72%

Taxes and the WACC

We are concerned with after-tax cash flows, so we

also need to consider the effect of taxes on the

various costs of capital

Interest expense reduces our tax liability

This reduction in taxes reduces our cost of debt

After-tax cost of debt = RD(1-TC)

Dividends are not tax deductible, so there is no tax

impact on the cost of equity

WACC = wERE + wDRD(1-TC)

Extended Example: WACC

Equity Information Debt Information

50 million shares $1 billion in

$80 per share outstanding debt

Beta = 1.15 (face value)

Market risk premium = Current quote = 110

9% Coupon rate = 9%,

Risk-free rate = 5% semiannual coupons

15 years to maturity

Tax rate = 40%

Extended Example: WACC

What is the cost of equity?

RE = 5 + 1.15(9) = 15.35%

What is the cost of debt?

30 N; -1,100 PV; 45 PMT; 1,000 FV; CPT I/Y =

3.9268

RD = 3.927(2) = 7.854%

What is the after-tax cost of debt?

RD(1-TC) = 7.854(1-.4) = 4.712%

Extended Example: WACC

What are the capital structure weights?

E = 50 million (80) = 4 billion

D = 1 billion (1.10) = 1.1 billion

V = 4 + 1.1 = 5.1 billion

wE = E/V = 4 / 5.1 = .7843

wD = D/V = 1.1 / 5.1 = .2157

WACC = .7843(15.35%) + .2157(4.712%) = 13.06%

Table 14.1 Cost of Equity

Table 14.1 Cost of Debt

Table 14.1 WACC

Before you go.

Q1. The Down and Out Co. just issued a

dividend of $2.40 per share on its common

stock. The company is expected to maintain

a constant 5.5 percent growth rate in its

dividends indefinitely. If the stock sells for

$52 a share, what is the companys cost of

equity?

Q2.Waller, Inc., is trying to determine

its cost of debt. The firm has a debt

outstanding with 15 years to maturity

that is quoted at 107 percent of face

value. The issue makes semi-annual

payments and has an embedded cost of 7

percent annually. What is the companys

pretax cost of debt? If the tax rate is

35 percent, what is the after-tax cost of

debt?

Q2. Answer

Q9. Mullineaux Corporation has a target capital

structure of 60 percent common stock, 5 percent

preferred stock, and 35 percent debt. Its cost of

equity is 14 percent, the cost of preferred stock is 6

percent, and the cost of debt is 8 percent. The

relevant tax rate is 35 percent.

a. What is Mullineauxs WACC?

b. The company president has approached you about

Mullineauxs capital structure. He wants to know

why the company doesnt use more preferred

stock financing because it costs less than debt.

What would you tell the president?

The End

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