You are on page 1of 49

Chapter 10 Cost of Capital

Cost of Capital Components


-Debt -Preferred -Common Equity

WACC

Cal State - East Bay

10 - 1

What types of long-term capital do firms use?


Long-term debt Preferred stock Common equity
New Issues

Retained Earnings

Cost of a source of capital for the company would be the investors required return on that investment.
Cal State - East Bay
10- 2

Intuition
NPV CFFA0

1 r

CFFA1
1

1 r

CFFAm
m

The required return r must 1. compensate our investors (common, preferred, and bonds) for the risks they bear 2. take into account what fraction of the funding is coming from each type of investor 3. take taxes into account
Cal State - East Bay
10- 3

Why Cost of Capital Is Important


The return earned on assets depends on the risk of those assets Our cost of capital provides us with an indication of how the market views the risk of our assets The cost of capital is our required return for capital budgeting projects

Cal State - East Bay

10- 4

Required Return
The required return is based on the risk of the cash flows With the required return we can compute the NPV We need to earn at least the required return to compensate our investors for the financing they have provided

Cal State - East Bay

10- 5

Initial Assumptions
1. The cash flows of the project are of similar risk to those of the existing firm 2. The project will use a similar mix of financing as the existing firm

Cal State - East Bay

10- 6

Comments about flotation costs:


Flotation costs depend on the risk of the firm and the type of capital being raised. The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the perproject cost is fairly small. We will frequently ignore flotation costs when calculating the WACC.
Cal State - East Bay
10- 7

Why is the cost of internal equity from reinvested earnings cheaper than the cost of issuing new common stock?

1. When a company issues new common stock they also have to pay flotation costs to the underwriter. 2. Issuing new common stock may send a negative signal to the capital markets, which may depress stock price.

Cal State - East Bay

10- 8

Cost of Equity
The return required by common stockholders to invest in our project given the riskiness of project cash flows. Two methods Dividend growth model
SML or CAPM

Cal State - East Bay

10- 9

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

Cal State - East Bay

10- 10

The Dividend Growth Model Approach


Start with the dividend growth model formula and rearrange to solve for RE
D 1 + g P 0 D0 ( 1+ g ) + g P 0
10- 11

RE = RE =

Cal State - East Bay

2. Using DCF:
You are estimating the cost of retained earnings for Jax Liquor. The current stock price is $40 and the next expected dividend is $2.00. The companys dividends are expected to grow at a constant annual rate of 6%.

D0 1 g D1 rs g g P P 0 0
$2.00 0.06 $40 .00

0.11
Cal State - East Bay
10- 12

Estimating the Growth Rate


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

Cal State - East Bay

10- 13

Example: Estimating the Dividend Growth Rate


One method for estimating the growth rate is to use the historical average
Year 1995 1996 1997 1998 1999
Cal State - East Bay

Dividend 1.23 1.30 1.36 1.43 1.50

Percent Change
(1.30 1.23) / 1.23 = 5.7% (1.36 1.30) / 1.30 = 4.6% (1.43 1.36) / 1.36 = 5.1% (1.50 1.43) / 1.43 = 4.9%

Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%


10- 14

Advantages and Disadvantages of Dividend Growth Model


Advantage easy to understand and use Disadvantages
Only applicable to companies currently paying dividends Not applicable if dividends arent growing at a reasonably constant rate Sensitive to the estimated growth rate Does not explicitly consider systematic risk
Cal State - East Bay

10- 15

Could DCF methodology be applied if g is not constant?


YES, nonconstant g stocks are expected to have constant g at some point, generally in 5 to 10 years. But calculations get complicated.

Cal State - East Bay

10- 16

The SML Approach (CAPM)


Use the following information to compute our cost of equity

RE R f E ( E ( RM ) R f )

Cal State - East Bay

10- 17

Issues in Using CAPM


Most analysts use the rate on a longterm (10 to 20 years) government bond as an estimate of rRF. For a current estimate, go to www.bloomberg.com, select U.S. Treasuries from the section on the left under the heading Market.
More
Cal State - East Bay
10- 18

Issues in Using CAPM (Continued)


Most analysts use a rate of 5% to 6.5% for the market risk premium (RPM) Estimates of beta vary, and estimates are noisy (they have a wide confidence interval). For an estimate of beta, go to www.bloomberg.com and enter the ticker symbol for STOCK QUOTES.

Cal State - East Bay

10- 19

Advantages

Advantages and Disadvantages of SML

Explicitly adjusts for systematic risk Applicable to all companies

Disadvantages
Have to estimate the expected market risk premium Have to estimate beta We are relying on the past to predict the future, which is not always reliable

Cal State - East Bay

10- 20

1. Using CAPM
You are trying to estimate the cost of retained earnings for Xenex CO. A 10-year treasury bond is currently yielding 7%. You estimate that the companys beta is 1.14 and that the required return on the market is 12%. The cost of retained earnings using CAPM would be:
rs 0.07 1.14 (0.12 0.07 ) 0.127 12 .7%

Cal State - East Bay

10- 21

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 Estimated by computing the yield-tomaturity 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
Cal State - East Bay
10- 22

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

Cal State - East Bay

10- 23

Cost of Debt
Assume that a firm has an outstanding 30year semi-annual coupon bond with a face value of $1,000 and an annual coupon rate of 14%. The bond is selling at par. If the company issues new bonds, a flotation cost of 5% would be incurred. The firms combined marginal federal and state tax rate is 40%. What is the cost of debt?
Cal State - East Bay

10- 24

Cost of Debt
First calculate the YTM, taking into account that the firm only receives (1-0.05)$1,000 = 950 per bond issued: 0 1 2 60

i=?
-950
70

...
1,000 70 + 1,000

INPUTS OUTPUT
Cal State - East Bay

60
N

-950
I/YR
PV

70
PMT

1,000
FV

7.37% x 2 = rd = 14.74%
10- 25

Cost of Debt
Interest is tax deductible, so the after tax (AT) cost of debt is:
rd AT = rd BT(1 - T) = 14.74%(1 - 0.40) = 8.84%.

Use nominal rate

Cal State - East Bay

10- 26

Cost of Preferred Stock


Preferred generally pays a constant dividend every period, g = 0. Dividends are expected to be paid every period forever

D0 (1 g ) Rp g P0 D Rp P0
Cal State - East Bay
10- 27

Cost of preferred stock?


A firm can issue 8% preferred stock with a par value of $100. The flotation cost is 2% of the par value. Use this formula:
rps D ps PF

8 $100 $2.00 $8 0.0816 8.16%. $100 2

Cal State - East Bay

10- 28

Is preferred stock more or less risky to investors than debt?


More risky; company not required to pay preferred dividend.
However, firms want to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, and (3) preferred stockholders may gain control of firm.

Cal State - East Bay

10- 29

Why is yield on preferred lower than rd?


Corporations own most preferred stock, because 70% of preferred dividends are nontaxable to corporations. Therefore, preferred often has a lower B-T yield than the B-T yield on debt. The A-T yield to investors and A-T cost to the issuer are higher on preferred than on debt, which is consistent with the higher risk of preferred.
Cal State - East Bay
10- 30

Example:
rps = 9% rd = 10% T = 40%

rps, AT = rps - rps (1 - 0.7)(T) = 9% - 9%(0.3)(0.4) = 7.92% rd, AT = 10% - 10%(0.4) = 6.00% A-T Risk Premium on Preferred = 1.92%

Cal State - East Bay

10- 31

Average the returns required to attract different types of investors to get a single discount rate. This average is the overall required return on our assets, based on the markets perception of the risk of those assets The weights are determined by how much of each type of financing that we use
Cal State - East Bay
10- 32

The Weighted Average Cost of Capital WACC

Capital Structure Weights


Notation E = market value of equity = # outstanding shares times market price per common share D = market value of debt = # outstanding bonds times bond market price P = market value of preferred = # outstanding shares times market price per preferred share V = market value of the firm = D + E + P Capital Structure Weights wE = E/V = percent financed with equity wD = D/V = percent financed with debt wp = P/V = percent financed with preferred
Cal State - East Bay
10- 33

Taxes and the WACC


We are concerned with after-tax cash flows, so we 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) + wPRP
Cal State - East Bay
10- 34

Example:
Current (Optimal) Capital Structure: Debt: 25% Pref St: 15% Com St:60% NI = $17,142.86 Div pay-out ratio: 30%; tax rate = 40% D0 = $3.60; P0 = $60; g=9% rRF = 11%; rM = 14%; beta = 1.51 Flotation costs on new common stock(F) = 10% Par value of new preferred stock = $100 Dividend on new preferred stock = $11 Flotation Cost on new preferred stock = $5 per share Before-tax required return on new debt = 12%
Cal State - East Bay
10- 35

Find the component costs of capital


After-tax cost of new debt: Cost of Preferred Stock:
rd(1-t) = 0.12(1-0.40) = 0.072 = 7.2%
rps =D/(P-F) = 11/(100-5) = 0.1158 = 11.58%

Cost of Retained Earnings:

Cost of New Common Stock:

Method 1: rs=D1/P0+g = 3.60(1.09)/60+0.09 = 0.1554 Method 2: rs= rRF +(rM rRF) = 0.11+1.51(.14-.11) = .1553
re = D1/(P-F)+g = 3.60(1.09)/(60(1-0.1))+0.09 = 0.1627

Cal State - East Bay

10- 36

How much new capital could be raised before the firm needs to sell new equity? Retained Earnings available:
NI(1-div payout ratio) = 17142.86(1-.30) = 12,000

Retained Earnings Breakpoint


12,000/0.60 = $20,000

Cal State - East Bay

10- 37

WACC
Using retained earnings:
WACC = 0.25(0.12)(1-0.4)+0.15(0.1158)+0.60(0.1554) = 0.1286 = 12.86%

Using new common stock:


WACC = 0.25(0.12)(1-0.4)+0.15(0.1158)+0.60(0.1627) = 0.1330 = 13.30%

Cal State - East Bay

10- 38

Graphically:
WACC

13.30% 12.86%

$20,000
Cal State - East Bay

$ of new capital
10- 39

WACC Estimates for Some Large U. S. Corporations


Company WACC Intel (INTC) 16.0 Dell Computer (DELL) 12.5 BellSouth (BLS) 10.3 Wal-Mart (WMT) 8.8 Walt Disney (DIS) 8.7 Coca-Cola (KO) 6.9 H.J. Heinz (HNZ) 6.5 Georgia-Pacific (GP) 5.9
Cal State - East Bay

wd 2.0% 9.1% 39.8% 33.3% 35.5% 33.8% 74.9% 69.9%


10- 40

What factors influence a companys WACC?


Market conditions, especially interest rates and tax rates. The firms capital structure and dividend policy. The firms investment policy. Firms with riskier projects generally have a higher WACC.

Cal State - East Bay

10- 41

WACC as Discount Rate

WACC wE RE wD RD 1 T wP RP
NPV CFFA0 CFFA1 CFFAm

1 WACC

1 WACC

IRR ?
Cal State - East Bay
10- 42

Divisional and Project Costs of Capital


Using the WACC as our discount rate is only appropriate for projects that are the same risk and will be financed in the same way as the firms current operations If we are looking at a project that is NOT the same risk or financed in the same way as the firm, then we need to determine the appropriate discount rate for that project For example, divisions often require separate discount rates
Cal State - East Bay

10- 43

Using WACC for All Projects Example


What would happen if we use the WACC for all projects regardless of risk? Assume the WACC = 15%
Project A B C
Cal State - East Bay

IRR 17% 18% 12%

WACC 15% 15% 15%

Truth 20% 16% 10%


10- 44

FIGURE 15.1

Cal State - East Bay

10- 45

The Pure Play Approach


Find one or more companies that specialize in the product or service that we are considering Compute the beta for each company Take an average Use that beta along with the CAPM to find the appropriate return for a project of that risk Often difficult to find pure play companies
Cal State - East Bay
10- 46

Subjective Approach
Consider the projects risk relative to the firm overall If the project is more risky than the firm, use a discount rate greater than the WACC If the project is less risky than the firm, use a discount rate less than the WACC You may still accept projects that you shouldnt and reject projects you should accept, but your error rate should be lower than not considering differential risk at all
Cal State - East Bay
10- 47

Subjective Approach Example


Risk Level Low Risk Same Risk as Firm High Risk Discount Rate WACC 4% WACC = 14% WACC + 6%

Cal State - East Bay

48

FIGURE 15.2

Cal State - East Bay

10- 49