5_Cost of Capital | Cost Of Capital | Preferred Stock

Copyright © 2004 McGraw-Hill Australia Pty Ltd

PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-1
Chapter 5
Cost of Capital
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-2
18.1 The Cost of Capital: Some Preliminaries
18.2 The Cost of Equity
18.3 The Costs of Debt and Preference Shares
18.4 The Weighted Average Cost of Capital
18.5 Divisional and Project Costs of Capital
18.6 Flotation Costs and the Weighted Average Cost
of Capital
18.7 Summary and Conclusions
Chapter Organisation
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-3
The Cost of Capital: Preliminaries
• Vocabulary—the following all mean the same thing:
– required return
– appropriate discount rate
– cost of capital.
• The cost of capital is an opportunity cost—it depends on
where the money goes, not where it comes from.
• The assumption is made that a firm’s capital structure is
fixed—a firm’s cost of capital then reflects both the cost of
debt and the cost of equity.
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-4
Chapter Objectives
• Apply the dividend growth model approach and the SML
approach to determine the cost of equity.
• Estimate values for the costs of debt and preference shares.
• Calculate the WACC.
• Discuss alternative approaches to estimating a discount rate.
• Understand the effects of flotation costs on WACC and the
NPV of a project.
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-5
Cost of Equity
• The cost of equity is the return required by
equity investors given the risk of the cash
flows from the firm.
• There are two major methods for determining the
cost of equity:
– Dividend growth model
– SML or CAPM.
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-6
The Dividend Growth Model
Approach
• According to the constant growth model:




Rearranging:

g R
g D
P
E

) (1

0
0
÷
+
=
g
P
D
R
E

0
1
+ =
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-7
Example—Cost of Equity Capital:
Dividend Approach
Reno Co. recently paid a dividend of 15 cents per
share. This dividend is expected to grow at a rate
of 3 per cent per year into perpetuity. The current
market price of Reno’s shares is $3.20 per share.
Determine the cost of equity capital for Reno Co.
( )
7.8% or 0.078
0.03
$3.20
1.03 $0.15

=
+ =
E
R
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-8
Estimating g
( )
9.025%
/4 7.62 10.53 7.95 10.00 rate growth Average
=
+ + + =
One method for estimating the growth rate is to use the historical
average.
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-9
The Dividend Growth Model
Approach

Advantages
• Easy to use and understand.

Disadvantages
• Only applicable to companies paying dividends.
• Assumes dividend growth is constant.
• Cost of equity is very sensitive to growth estimate.
• Ignores risk.
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-10
The SML Approach
Required return on a risky investment is dependent on three
factors:

– the risk-free rate, R
f
– the market risk premium, E(R
M
) – R
f
– the systematic risk of the asset relative to the average, |
| |
f M E f E
R R R R ÷ × + = |
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-11
Example—Cost of Equity Capital:
SML Approach
• Obtain the risk-free rate (R
f
) from financial press—
many use the 1-year Treasury note rate, say, 6 per cent.
• Obtain estimates of market risk premium and security beta:
– historical risk premium = 7.94 per cent (Officer, 1989)
– beta—historical
 investment information services
 estimate from historical data
• Assume the beta is 1.40.
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-12
Example—Cost of Equity Capital:
SML Approach (continued)
| |
( )
% .
% . . %
R R R R
f M E f E
12 17
94 7 40 1 6
=
× + =
÷ × | + =
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-13
The SML Approach
Advantages
• Adjusts for risk.
• Accounts for companies that don’t have a constant dividend.

Disadvantages
• Requires two factors to be estimated: the market risk
premium and the beta co-efficient.
• Uses the past to predict the future, which may not be
appropriate.
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-14
The Cost of Debt

• The cost of debt, R
D
, is the interest rate on new borrowing.

• R
D
is observable:
– yields on currently outstanding debt
– yields on newly-issued similarly-rated bonds.

• The historic cost of debt is irrelevant—why?
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-15
Example—Cost of Debt
Ishta Co. sold a 20-year, 12 per cent bond 10 years
ago at par. The bond is currently priced at $86.
What is our cost of debt?
( )
( )
( )
( )
14.4%
/2 $86 $100
/10 $86 $100 $12

/2 NP PV
/ NP PV

=
+
÷ +
=
+
÷ +
=
n I
R
D
The yield to maturity is 14.4 per cent, so this is used
as the cost of debt, not 12 per cent.
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-16
The Cost of Preference Shares
• Preference shares pay a constant dividend every period.
• Preference shares are a perpetuity, so the cost is:




• Notice that the cost is simply the dividend yield.
0

P
D
R
p
=
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-17
Example—Cost of Preference Shares

• An $8 preference share issue was sold 10 years ago. It sells
for $120 per share today.

• The dividend yield today is $8.00/$120 = 6.67 per cent, so
this is the cost of the preference share issue.
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-18
The Weighted Average Cost of Capital
Let: E = the market value of equity = no.
of outstanding shares × share
price
D = the market value of debt = no. of
outstanding bonds × price
Then: V = E + D
So: E/V + D/V = 100%
That is: The firm’s capital structure weights
are E/V and D/V.
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-19
The Weighted Average Cost of
Capital
• Interest payments on debt are tax deductible, so the after-tax
cost of debt is:



• Dividends on preference shares and ordinary shares are not
tax-deductible so tax does not affect their costs.
• The weighted average cost of capital is therefore:
( )
C D
T R 1 debt of cost tax - After ÷ × =
() () ( )
C D E
T R
V
D
R
V
E
1 WACC÷ × × + × =
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-20
Example—Weighted Average Cost of
Capital
Zeus Ltd has 78.26 million ordinary shares on
issue with a book value of $22.40 per share and a
current market price of $58 per share. The
market value of equity is therefore $4.54 billion.
Zeus has an estimated beta of 0.90. Treasury
bills currently yield 4.5 per cent and the market
risk premium is assumed to be 7.94 per cent.
Company tax is 30 per cent.
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-21
Example—Weighted Average Cost of
Capital (continued)
The firm has four debt issues outstanding:
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-22
Example—Cost of Equity
(SML Approach)
| |
( )
% .
% . . % .
R R R R
f M E f E
65 11
94 7 90 0 5 4
=
× + =
÷ × | + =
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-23
Example—Cost of Debt
The weighted average cost of debt is 7.15 per cent.
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-24
Example—Capital Structure Weights
• Market value of equity = 78.26 million × $58 = $4.539 billion.
• Market value of debt = $1.474 billion.
( ) ( )
9.32% or 0.0932
0.30 1 0.0715 0.245 0.1165 0.755 WACC
75.5% or 0.755
$6.013b
$4.539b

24.5% or 0.245
$6.013b
$1.474b

billion $6.013 billion $1.474 billion $4.539
=
÷ × + =
= =
= =
= + =
V
E
V
D
V
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-25
WACC

• The WACC for a firm reflects the risk and the target capital
structure to finance the firm’s existing assets as a whole.

• WACC is the return that the firm must earn on its existing
assets to maintain the value of its shares.

• WACC is the appropriate discount rate to use for cash flows
that are similar in risk to the firm.
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-26
Divisional and Project Costs of
Capital

• When is the WACC the appropriate discount rate?
– When the project’s risk is about the same as the firm’s
risk.

• Other approaches to estimating a discount rate:
– divisional cost of capital—used if a company has more
than one division with different levels of risk
– pure play approach—a WACC that is unique to a
particular project is used
– subjective approach—projects are allocated to specific
risk classes which, in turn, have specified WACCs.
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-27
The SML and the WACC
Expected
return (%)
Beta
SML
WACC = 15%
= 8%
Incorrect
acceptance
Incorrect
rejection
B
A
16
15
14
R
f
=7
A
= .60
firm
= 1.0
B
= 1.2
If a firm uses its WACC to make accept/reject decisions for all types of projects, it will have a
tendency towards incorrectly accepting risky projects and incorrectly rejecting less risky
projects.
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-28
Example—Using WACC for all
Projects
• What would happen if we use the WACC for all
projects regardless of risk?
• Assume the WACC = 15 per cent

Project Required Return IRR Decision
A 15% 14% Reject
B 15% 16% Accept

• Project A should be accepted because its risk is low (Beta =
0.60), whereas Project B should be rejected because its risk
is high (Beta = 1.2).
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-29
The SML and the Subjective
Approach
Expected
return (%)
Beta
SML
20
WACC = 14
10
R
f
= 7
Low risk
(–4%)
Moderate risk
(+0%)
High risk
(+6%) A
With the subjective approach, the firm places projects into one of several risk classes. The discount
rate used to value the project is then determined by adding (for high risk) or subtracting (for low risk)
an adjustment factor to or from the firm’s WACC.
= 8%
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-30
Flotation Costs
• The issue of debt or equity may incur flotation costs such as
underwriting fees, commissions, listing fees.

• Flotation costs are relevant expenses and need to be
reflected in any analysis.
D E A
f
V
D
f
V
E
f × + × =
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-31
Example—Project Cost including
Flotation Costs
Saddle Co. Ltd has a target capital structure of 70
per cent equity and 30 per cent debt. The
flotation costs for equity issues are 15 per cent of
the amount raised and the flotation costs for debt
issues are 7 per cent. If Saddle Co. Ltd needs
$30 million for a new project, what is the ‘true
cost’ of this project?
( )( )
12.6%
0.07 0.30 0.15 0.70
=
× + × =
A
f
The weighted average flotation cost is 12.6 per
cent.
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-32
Example—Project Cost including
Flotation Costs (continued)
( )
( )
million $34.32
0.126 1
$30m
project of cost True
million $30 costs flotation ignoring cost Project
=
÷
=
=
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-33
Example—Flotation Costs and NPV
• Apollo Co. Ltd needs $1.5 million to finance a new project
expected to generate annual after-tax cash flows of $195 800
forever. The company has a target capital structure of 60 per
cent equity and 40 per cent debt. The financing options
available are:
– An issue of new ordinary shares. Flotation costs of equity
are 12 per cent of capital raised. The return on new
equity is 15 per cent.
– An issue of long-term debentures. Flotation costs of debt
are 5 per cent of the capital raised. The return on new
debt is 10 per cent.

• Assume a corporate tax rate of 30 per cent.
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-34
Example—NPV (No Flotation Costs)
( ) ( )
322 $159
000 500 $1
0.118
800 $195
NPV
11.8% or 0.118
0.30 1 0.1 0.4 15% 0.6 WACC
=
÷ =
=
÷ × + =
Copyright © 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-35
Example—NPV (With Flotation Costs)
( ) ( )
( )
$7340
982 651 $1 -
0.118
800 $195
NPV
982 651 $1
0.092 1
000 500 $1
cost True
9.2% or 0.092
0.05 0.4 0.12 0.6
=
=
=
÷
=
=
× + × =
A
f
Flotation costs decrease a project’s NPV and
could alter an investment decision.

Chapter Organisation
18.1 The Cost of Capital: Some Preliminaries 18.2 The Cost of Equity 18.3 The Costs of Debt and Preference Shares 18.4 The Weighted Average Cost of Capital 18.5 Divisional and Project Costs of Capital 18.6 Flotation Costs and the Weighted Average Cost of Capital

18.7 Summary and Conclusions
Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

18-2

The Cost of Capital: Preliminaries

• •

Vocabulary—the following all mean the same thing: – required return – appropriate discount rate – cost of capital. The cost of capital is an opportunity cost—it depends on where the money goes, not where it comes from. The assumption is made that a firm’s capital structure is fixed—a firm’s cost of capital then reflects both the cost of debt and the cost of equity.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright

18-3

Thompson.Chapter Objectives • • • • Apply the dividend growth model approach and the SML approach to determine the cost of equity. • Understand the effects of flotation costs on WACC and the NPV of a project. Calculate the WACC. Discuss alternative approaches to estimating a discount rate. Estimate values for the costs of debt and preference shares. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross. Christensen. Westerfield and Jordan Slides prepared by Sue Wright 18-4 .

Cost of Equity • The cost of equity is the return required by equity investors given the risk of the cash flows from the firm. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross. Christensen. Westerfield and Jordan Slides prepared by Sue Wright 18-5 . • There are two major methods for determining the cost of equity: – – Dividend growth model SML or CAPM. Thompson.

The Dividend Growth Model Approach • According to the constant growth model: D(1 g ) 0 P 0 R g E Rearranging: D R  1 g E P 0 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross. Christensen. Thompson. Westerfield and Jordan Slides prepared by Sue Wright 18-6 .

8% Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross.Example—Cost of Equity Capital: Dividend Approach Reno Co. Thompson. Westerfield and Jordan Slides prepared by Sue Wright 18-7 .20 per share. Determine the cost of equity capital for Reno Co.20  0.15 1.03 R  E $3. This dividend is expected to grow at a rate of 3 per cent per year into perpetuity. Christensen.078 or 7. recently paid a dividend of 15 cents per share.   0. The current market price of Reno’s shares is $3.03 $0.

00  7.5 /4  9.Estimating g One method for estimating the growth rate is to use the historical average. Christensen.95 10. Westerfield and Jordan Slides prepared by Sue Wright 18-8 .6 10. Thompson.   Average growth rate   7.025% Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross.

Disadvantages • • • • Only applicable to companies paying dividends. Christensen. Westerfield and Jordan Slides prepared by Sue Wright 18-9 . Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross. Thompson. Assumes dividend growth is constant. Cost of equity is very sensitive to growth estimate.The Dividend Growth Model Approach Advantages • Easy to use and understand. Ignores risk.

 R R R R    E f E M f Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross. Christensen. Thompson. Westerfield and Jordan Slides prepared by Sue Wright   18-10 . E(RM) – Rf the systematic risk of the asset relative to the average.The SML Approach Required return on a risky investment is dependent on three factors: – – – the risk-free rate. Rf the market risk premium.

6 per cent. say.Example—Cost of Equity Capital: SML Approach • • Obtain the risk-free rate (Rf) from financial press— many use the 1-year Treasury note rate. Westerfield and Jordan Slides prepared by Sue Wright 18-11 . 1989) – beta—historical  investment information services  estimate from historical data Assume the beta is 1. • Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross. Christensen.94 per cent (Officer. Obtain estimates of market risk premium and security beta: – historical risk premium = 7.40. Thompson.

Westerfield and Jordan Slides prepared by Sue Wright 18-12 .Example—Cost of Equity Capital: SML Approach (continued) R f  E M R R f E R   . % 17 12 %. Christensen. % 6  40 94 1 7    Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross. Thompson. .

Thompson. Disadvantages • • Requires two factors to be estimated: the market risk premium and the beta co-efficient. Uses the past to predict the future. Westerfield and Jordan Slides prepared by Sue Wright 18-13 . Accounts for companies that don’t have a constant dividend.The SML Approach Advantages • • Adjusts for risk. which may not be appropriate. Christensen. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross.

Christensen.The Cost of Debt • • The cost of debt. is the interest rate on new borrowing. Thompson. RD. Westerfield and Jordan Slides prepared by Sue Wright 18-14 . The historic cost of debt is irrelevant—why? • Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross. RD is observable: – yields on currently outstanding debt – yields on newly-issued similarly-rated bonds.

What is our cost of debt? / I  NPn PV R D PV NP   /2 $12  $100  $86 /10  $100 /2 $86  14.Example—Cost of Debt Ishta Co. Westerfield and Jordan Slides prepared by Sue Wright 18-15 . so this is used as the cost of debt.4% The yield to maturity is 14. The bond is currently priced at $86.4 per cent. sold a 20-year. Thompson. 12 per cent bond 10 years ago at par. Christensen. not 12 per cent. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross.

The Cost of Preference Shares • • Preference shares pay a constant dividend every period. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross. so the cost is: D Rp  P0 • Notice that the cost is simply the dividend yield. Christensen. Westerfield and Jordan Slides prepared by Sue Wright 18-16 . Preference shares are a perpetuity. Thompson.

Thompson.Example—Cost of Preference Shares • An $8 preference share issue was sold 10 years ago.67 per cent. It sells for $120 per share today. Christensen. • Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross. The dividend yield today is $8. so this is the cost of the preference share issue.00/$120 = 6. Westerfield and Jordan Slides prepared by Sue Wright 18-17 .

Christensen. Thompson. of outstanding bonds × price Then: So: That is: V=E+D E/V + D/V = 100% The firm’s capital structure weights are E/V and D/V. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross. of outstanding shares × share price D = the market value of debt = no. Westerfield and Jordan Slides prepared by Sue Wright 18-18 .The Weighted Average Cost of Capital Let: E = the market value of equity = no.

The weighted average cost of capital is therefore: E   WACCC  D   R RT E V 1 D V Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross.The Weighted Average Cost of Capital • Interest payments on debt are tax deductible. so the after-tax cost of debt is: After R . Westerfield and Jordan Slides prepared by Sue Wright   18-19 .cost T tax  1 of D C debt  • • Dividends on preference shares and ordinary shares are not tax-deductible so tax does not affect their costs. Christensen. Thompson.

40 per share and a current market price of $58 per share. Christensen. Company tax is 30 per cent. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross. Zeus has an estimated beta of 0. Westerfield and Jordan Slides prepared by Sue Wright 18-20 . The market value of equity is therefore $4.54 billion.5 per cent and the market risk premium is assumed to be 7.94 per cent.90. Treasury bills currently yield 4.Example—Weighted Average Cost of Capital Zeus Ltd has 78. Thompson.26 million ordinary shares on issue with a book value of $22.

Westerfield and Jordan Slides prepared by Sue Wright 18-21 . Thompson.Example—Weighted Average Cost of Capital (continued) The firm has four debt issues outstanding: Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross. Christensen.

Thompson. 7  5  90 94   Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross. % 11 65 . Westerfield and Jordan Slides prepared by Sue Wright 18-22 . Christensen. % 4 .% 0 .Example—Cost of Equity (SML Approach) R f E R f M R E R  .

Example—Cost of Debt The weighted average cost of debt is 7. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross. Thompson. Christensen. Westerfield and Jordan Slides prepared by Sue Wright 18-23 .15 per cent.

26 million × $58 = $4. Westerfield and Jordan Slides prepared by Sue Wright 18-24 .539 billion.5% V $6.0715 10.013 billion $1.5% V $6.1165  0.013b $4.245 24.755 0.30  0.245   0.474 billion.474 billion  $6. Thompson.0932 or 9.755 75. V $4.539  billion  $1.539b or E  0.013b  WACC  0. Market value of debt = $1.Example—Capital Structure Weights • • Market value of equity = 78.474b or D  0.32% Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross. Christensen.

WACC is the appropriate discount rate to use for cash flows that are similar in risk to the firm. Thompson. WACC is the return that the firm must earn on its existing assets to maintain the value of its shares. • • Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross.WACC • The WACC for a firm reflects the risk and the target capital structure to finance the firm’s existing assets as a whole. Christensen. Westerfield and Jordan Slides prepared by Sue Wright 18-25 .

18-26 • Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross. Other approaches to estimating a discount rate: – divisional cost of capital—used if a company has more than one division with different levels of risk – pure play approach—a WACC that is unique to a particular project is used – subjective approach—projects are allocated to specific risk classes which. have specified WACCs.Divisional and Project Costs of Capital • When is the WACC the appropriate discount rate? – When the project’s risk is about the same as the firm’s risk. Westerfield and Jordan Slides prepared by Sue Wright . Christensen. in turn. Thompson.

The SML and the WACC Expected return (%) SML = 8% 16 15 14 Incorrect rejection B A Incorrect acceptance WACC = 15% Rf =7 Beta A = . Christensen. Thompson.60 firm = 1. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross. Westerfield and Jordan Slides prepared by Sue Wright 18-27 .2 If a firm uses its WACC to make accept/reject decisions for all types of projects.0 B = 1. it will have a tendency towards incorrectly accepting risky projects and incorrectly rejecting less risky projects.

Christensen.Example—Using WACC for all Projects • What would happen if we use the WACC for all projects regardless of risk? • Assume the WACC = 15 per cent Project A B • Required Return 15% 15% IRR 14% 16% Decision Reject Accept Project A should be accepted because its risk is low (Beta = 0.2). Thompson. whereas Project B should be rejected because its risk is high (Beta = 1. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross. Westerfield and Jordan Slides prepared by Sue Wright 18-28 .60).

The discount rate used to value the project is then determined by adding (for high risk) or subtracting (for low risk) an adjustment factor to or from the firm’s WACC. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross. Thompson. Westerfield and Jordan Slides prepared by Sue Wright 18-29 . Christensen. the firm places projects into one of several risk classes.The SML and the Subjective Approach Expected return (%) SML = 8% 20 A WACC = 14 10 Rf = 7 Low risk (–4%) Moderate risk (+0%) High risk (+6%) Beta With the subjective approach.

Thompson. Westerfield and Jordan Slides prepared by Sue Wright 18-30 . commissions. listing fees. Flotation costs are relevant expenses and need to be reflected in any analysis. Christensen.Flotation Costs • The issue of debt or equity may incur flotation costs such as underwriting fees. • E f Df f    A VE VD Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross.

Example—Project Cost including Flotation Costs Saddle Co.30 A  12. Thompson.15  0. If Saddle Co.6% The weighted average flotation cost is 12. what is the ‘true cost’ of this project? f     0. Christensen.07 0.70 0. Ltd needs $30 million for a new project. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross. Westerfield and Jordan Slides prepared by Sue Wright 18-31 . Ltd has a target capital structure of 70 per cent equity and 30 per cent debt.6 per cent. The flotation costs for equity issues are 15 per cent of the amount raised and the flotation costs for debt issues are 7 per cent.

126  $34.32 million Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross. Westerfield and Jordan Slides prepared by Sue Wright 18-32 .Example—Project Cost including Flotation Costs (continued)  Project cost ignoring  $30 flotation million costs  $30m True project cost of    1 0. Christensen. Thompson.

Thompson. The financing options available are: – An issue of new ordinary shares. Flotation costs of debt are 5 per cent of the capital raised.5 million to finance a new project expected to generate annual after-tax cash flows of $195 800 forever. The return on new debt is 10 per cent. Assume a corporate tax rate of 30 per cent. – An issue of long-term debentures. Ltd needs $1. Christensen. The return on new equity is 15 per cent. The company has a target capital structure of 60 per cent equity and 40 per cent debt. • Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross. Flotation costs of equity are 12 per cent of capital raised. Westerfield and Jordan Slides prepared by Sue Wright 18-33 .Example—Flotation Costs and NPV • Apollo Co.

30 0.118 or 11.4 1 0.8% $195 800 NPV   500 $1 000 0. Westerfield and Jordan Slides prepared by Sue Wright 18-34 .118  $159 322 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross.6  0. Christensen.Example—NPV (No Flotation Costs)  WACC15%      0. Thompson.1  0.

118 $7340 Flotation costs decrease a project’s NPV and could alter an investment decision. Thompson. Westerfield and Jordan Slides prepared by Sue Wright 18-35 .092 9. Christensen.4  fA  0.12  0.092  1 $195 800 NPV  -$1 651 982 0.6 0.Example—NPV (With Flotation Costs)  0.05 0. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross.2% or $1 000 500 True  cost $1 651 982  0.

Sign up to vote on this title
UsefulNot useful