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CHAPTER 9

The Cost of Capital

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Topics in Chapter

Cost of capital components
  

Debt Preferred stock Common equity

 

WACC Factors that affect WACC Adjusting cost of capital for risk
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Determinants of Intrinsic Value: The Weighted Average Cost of Capital
Net operating profit after taxes − Required investments in operating capital =

Free cash flow (FCF)

Value =

FCF1 FCF2 FCF∞ + + ··· + (1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average cost of capital (WACC)
Market interest rates Market risk aversion

Cost of debt Cost of equity

Firm’s debt/equity mix Firm’s business risk

What types of long-term capital do firms use?
  

Long-term debt Preferred stock Common equity

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Capital Components

Capital components are sources of funding that come from investors. Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the cost of capital. We do adjust for these items when calculating the cash flows of a project, but not when calculating the cost of capital.
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Before-tax vs. Therefore. 6 . Most firms incorporate tax effects in the cost of capital. Only cost of debt is affected. After-tax Capital Costs    Tax effects associated with financing can be incorporated either in capital budgeting cash flows or in cost of capital. focus on after-tax costs.

So. 7 .Historical (Embedded) Costs vs. we should focus on marginal costs. New (Marginal) Costs  The cost of capital is used primarily to make decisions which involve raising and investing new capital.

if it has any. Method 3: Find the yield on the company’s debt. 8 . Method 2: Find the bond rating for the company and use the yield on other bonds with a similar rating.Cost of Debt    Method 1: Ask an investment banker what the coupon rate would be on new debt.

60 60 60 + 1. What’s rd? 0 rd = ? 1 2 30 .0% x 2 = rd = 10% 9 . 12% semiannual bond sells for $1.A 15-year.72 60 PV PMT 1000 FV OUTPUT 5.72 INPUTS 30 N I/YR -1153..153..153.000 -1.72.

Flotation costs small.Component Cost of Debt  Interest is tax deductible.   Use nominal rate. 10 .40) = 6%. so the after tax (AT) cost of debt is: rd AT = rd BT(1 – T) rd AT = 10%(1 – 0. so ignore.

1($100) = = $116.Cost of preferred stock: Pps = $116.05) $10 $111.95.090 = 9. 10%Q. F = 5% Use this formula: rps = Dps Pps (1 – F) 0.95(1 – 0.10 11 = 0.0% . Par = $100.

25%. 2.50 rPer = = 2.. rps(Nom) = 2.50 2 ∞ .25%(4) = 9% $111..50 -111.50 2.50 $111.10 = = rPer rPer $2.10 12 .1 DQ $2.Time Line of Preferred 0 rps = ? 1 2.

so no tax adjustment.Note:    Flotation costs for preferred are significant. so are reflected. 13 . Use net price. Nominal rps is used. Just rps. Preferred dividends are not deductible.

and (3) preferred stockholders may gain control of firm.Is preferred stock more or less risky to investors than debt?   More risky. 14 . company not required to pay preferred dividend. However. (2) difficult to raise additional funds. (1) cannot pay common dividend. firms want to pay preferred dividend. Otherwise.

which is consistent with the higher risk of preferred. preferred often has a lower B-T yield than the B-T yield on debt. because 70% of preferred dividends are nontaxable to corporations.Why is yield on preferred lower than rd?    Corporations own most preferred stock. The A-T yield to investors and A-T cost to the issuer are higher on preferred than on debt. Therefore. 15 .

92% 16 .92% rd.00% A-T Risk Premium on Preferred = 1. T = 40% rps. AT = 10% – 10%(0. rd = 10%. AT = rps – rps(1 – 0.Example: rps = 9%.4) = 6.7)(T) = 9% – 9%(0.4) = 7.3)(0.

Indirectly. 17 . retaining earnings).. by issuing new shares of common stock.e.What are the two ways that companies can raise common equity?   Directly. by reinvesting earnings that are not paid out as dividends (i.

there is an opportunity cost if earnings are reinvested. 18 . earning a return.Why is there a cost for reinvested earnings?    Earnings can be reinvested or paid out as dividends. Thus. Investors could buy other securities.

They could buy similar stocks and earn rs. or company could repurchase its own stock and earn rs. is the cost of reinvested earnings and it is the cost of common equity.Cost for Reinvested Earnings (Continued)   Opportunity cost: The return stockholders could earn on alternative investments of equal risk. So. 19 . rs.

2. rs: 1. 20 . 3. CAPM: rs = rRF + (rM – rRF)b = rRF + (RPM)b.Three ways to determine the cost of equity. DCF: rs = D1/P0 + g. Own-Bond-Yield-Plus-JudgmentalRisk Premium: rs = rd + Bond RP.

CAPM Cost of Equity: rRF = 5.0%)1. RPM = 6%.6%. 21 .8%.2 rs = rRF + (RPM )b = 5.2 = 12. b = 1.6% + (6.

Issues in Using CAPM  Most analysts use the rate on a long-term (10 to 20 years) government bond as an estimate of rRF. (More…) 22 .

and estimates are “noisy” (they have a wide confidence interval).5% to 6% for the market risk premium (RPM) Estimates of beta vary. 23 .Issues in Using CAPM (Continued)   Most analysts use a rate of 3.

g = 5.26.6% + 5.058) + 0.058 $50 = 6. rs: D0 = $3.8% = 12. P0 = $50.4% 24 .DCF Cost of Equity.12(1.8% rs = D1 +g= D0(1 + g) +g P0 P0 = $3.

illustrated on next slide. 25 . Yahoo!Finance.Estimating the Growth Rate    Use the historical growth rate if you believe the future will be like the past. Zacks. Use the earnings retention model. Obtain analysts’ estimates: Value Line.

If this situation is expected to continue. what’s the expected future g? 26 .Earnings Retention Model   Suppose the company has been earning 15% on equity (ROE = 15%) and has been paying out 62% of its earnings.

27 .Earnings Retention Model (Continued)  Growth from earnings retention model: g = (Retention rate)(ROE) g = (1 – Payout rate)(ROE) g = (1 – 0.8% given earlier.62)(15%) = 5.7%. This is close to g = 5.

nonconstant g stocks are expected to have constant g at some point. See the Web 9A worksheet in the file Ch09 Tool Kit. generally in 5 to 10 years.xls. But calculations get complicated. 28 .Could DCF methodology be applied if g is not constant?   YES.

2% = 13.2%   rs = rd + Judgmental risk premium rs = 10. Produces ballpark estimate of rs.The Own-Bond-Yield-Plus-Judgmental-RiskPremium Method: rd = 10%.0% + 3. RPM. 29 . Useful check.2%   This over-own-bond-judgmental-risk premium  CAPM equity risk premium. RP = 3.

What’s a reasonable final estimate of rs? Method CAPM Estimate 12.8% DCF rd + judgment Average 12.8% 30 .2% 12.4% 13.

If possible. 31 . always use the target weights for the percentages of the firm that will be financed with the various types of capital.Determining the Weights for the WACC   The weights are the percentages of the firm that will be financed by each component.

(More…) 32 . it is better to estimate the weights using current market values than current book values.Estimating Weights for the Capital Structure   If you don’t know the targets. then it is usually reasonable to use the book values of debt. If you don’t know the market value of debt. especially if the debt is short-term.

and $75 million of debt. the firm has $25 million of preferred stock. (More…) 33 . there are 3 million shares of stock.Estimating Weights (Continued)  Suppose the stock price is $50.

Vps = $25 million. Total value = $150 + $25 + $75 = $250 million. Vd = $75 million.Estimating Weights (Continued)     Vs = $50(3 million) = $150 million. 34 .

Estimating Weights (Continued)    ws = $150/$250 wps = $25/$250 wd = $75/$250 = 0.3  The target weights for this company are the same as these market value weights. but often market weights temporarily deviate from targets due to changes in stock prices.6 = 0.1 = 0. 35 .

What’s the WACC using the target weights? WACC = wdrd(1 – T) + wpsrps + wsrs WACC = 0.4% 36 .38% ≈ 10.6(12.1(9%) + 0.4) + 0.8%) WACC = 10.3(10%)(1 − 0.

Capital structure policy. The market risk premium. especially interest rates. Tax rates. 37  Controllable factors:    . Dividend policy.What factors influence a company’s WACC?  Uncontrollable factors:    Market conditions. Investment policy. Firms with riskier projects generally have a higher cost of equity.

38 . Different divisions may have different risks. The division’s WACC should be adjusted to reflect the division’s risk and capital structure.Is the firm’s WACC correct for each of its divisions?   NO! The composite WACC reflects the risk of an average project undertaken by the firm.

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. and capital structure. cost of debt. 39 .

40 . Use average of their betas as proxy for project’s beta. Hard to find such companies.Pure Play Method for Estimating Beta for a Division or a Project    Find several publicly traded companies exclusively in project’s business.

6) with market betas.Accounting Beta Method for Estimating Beta    Run regression between project’s ROA and S&P Index ROA. Accounting betas are correlated (0. But normally can’t get data on new projects’ ROAs before the capital budgeting decision has been made.5 – 0. 41 .

rRF = 5. Market risk premium = 6%.7. betaDivision = 1. 42 .6%.Divisional Cost of Capital Using CAPM       Target debt ratio = 10%. Tax rate = 40%. rd = 12%.

6) + 0. WACCDiv.8%.6% + (6%)1.Divisional Cost of Capital Using CAPM (Continued) Division’s required return on equity: rs = rRF + (rM – rRF)bDiv.8%) = 14.7 = 15. = wd rd(1 – T) + wsrs = 0. rs = 5.9% 43 .1(12%)(0.94% ≈ 14.9(15.

44 .9%.4%.Division’s WACC vs.9% versus company WACC = 10. Firm’s Overall WACC?   Division WACC = 14. “Typical” projects within this division would be accepted if their returns are above 14.

What are the three types of project risk?    Stand-alone risk Corporate risk Market risk 45 .

Market risk is theoretically best in most situations. corporate risk is also relevant. However. and employees are more affected by corporate risk. Therefore.How is each type of risk used?     Stand-alone risk is easiest to calculate. 46 . customers. creditors. suppliers.

A Project-Specific. 47 . Risk-Adjusted Cost of Capital   Start by calculating a divisional cost of capital. Use judgment to scale up or down the cost of capital for an individual project relative to the divisional cost of capital.

Costs of Issuing New Common Stock   When a company issues new common stock they also have to pay flotation costs to the underwriter. which may depress stock price. Issuing new common stock may send a negative signal to the capital markets. 48 .

15) = $3.12(1.6% $42.8% = 13.8% = $50(1 – 0.058) + 5.Cost of New Common Equity: P0 = $50. D0 = $3.30 + 5.8%. and F = 15% re = D0(1 + g) P0(1 – F) +g $3.50 49 .12. g = 5.

02) = 980 PMT = -(0.000)(1 – 0.000. Coupon = 10% paid annually.15% 50 . and F = 2%  Using a financial calculator:     N = 30 PV = 1.10)(1.4) = -60 FV = -1.000  Solving for I/YR: 6.Cost of New 30-Year Debt: Par = $1.000(1 – 0.

We will frequently ignore flotation costs when calculating the WACC. since most firms issue equity infrequently. the per-project cost is fairly small.Comments about flotation costs:    Flotation costs depend on the risk of the firm and the type of capital being raised. However. 51 . The flotation costs are highest for common equity.

 (More…) 52 . historical cost of debt Mixing current and historical measures to estimate the market risk premium Book weights vs.Four Mistakes to Avoid     Current vs. Market Weights Incorrect cost of capital components See next slides for details.

Historical Cost of Debt   When estimating the cost of debt. which represents the cost of past debt. don’t use the coupon rate on existing debt.Current vs. Use the current interest rate on new debt. (More…) 53 .

the current market risk premium is not 12.Estimating the Market Risk Premium   When estimating the risk premium for the CAPM approach.2% – 10% = 2.2%! (More…) 54 . don’t subtract the current long-term T-bond rate from the historical average return on common stocks. if the historical rM has been about 12.2% and inflation drives the current rRF up to 10%. For example.

especially for short-term debt. If you don’t know the market value of debt.Estimating Weights    Use the target capital structure to determine the weights. then use the current market value of equity. (More…) 55 . then the book value of debt often is a reasonable approximation. If you don’t know the target weights.

Capital components are sources of funding that come from investors.   Accounts payable. accruals. and deferred taxes are not sources of funding that come from investors. but not when calculating the WACC. 56 . so they are not included in the calculation of the WACC. We do adjust for these items when calculating project cash flows.