fully details about the wacc

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fully details about the wacc

© All Rights Reserved

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You are on page 1of 54

CHAPTER 9

Determining the Cost of Capital

Debt

Preferred

Common Equity

WACC

9-2

firms use?

Long-term debt

Preferred stock

Common equity

9-3

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.

9-4

after-tax capital costs?

can be incorporated either in capital

budgeting cash flows or in cost of

capital.

Most firms incorporate tax effects in

the cost of capital. Therefore, focus

on after-tax costs.

Only cost of debt is affected.

9-5

(embedded) costs or new (marginal)

costs?

to make decisions which involve

raising and investing new capital.

So, we should focus on marginal

costs.

9-6

Cost of Debt

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.

9-7

for $1,153.72. Whats rd?

0 1 2 30

i=? ...

-1,153.72 60 60 60 + 1,000

N I/YR PV PMT FV

OUTPUT 5.0% x 2 = rd = 10%

9-8

after tax (AT) cost of debt is:

rd AT = rd BT(1 - T)

= 10%(1 - 0.40) = 6%.

Use nominal rate.

Flotation costs small, so ignore.

9-9

PP = $113.10; 10%Q; Par = $100; F = $2.

D ps 0.1 $100

rps

Pn $113 .10 $2.00

$10

0.090 9.0%.

$111 .10

9 - 10

Picture of Preferred

0

rps = ?

1 2

...

-111.1 2.50 2.50 2.50

DQ $2.50

$111 .10 .

rPer rPer

$2.50

rPer 2.25%; rps ( Nom ) 2.25%(4) 9%.

$111 .10

9 - 11

Note:

significant, so are reflected. Use

net price.

Preferred dividends are not

deductible, so no tax adjustment.

Just rps.

Nominal rps is used.

9 - 12

investors than debt?

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.

9 - 13

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.

9 - 14

Example:

= 9% - 9%(0.3)(0.4) = 7.92%

rd, AT = 10% - 10%(0.4) = 6.00%

A-T Risk Premium on Preferred = 1.92%

9 - 15

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).

9 - 16

earnings?

out as dividends.

Investors could buy other securities,

earn a return.

Thus, there is an opportunity cost if

earnings are reinvested.

9 - 17

stockholders could earn on

alternative investments of equal

risk.

They could buy similar stocks

and earn rs, or company could

repurchase its own stock and

earn rs. So, rs, is the cost of

reinvested earnings and it is the

cost of equity.

9 - 18

cost of equity, rs:

= rRF + (RPM)b.

2. DCF: rs = D1/P0 + g.

3. Own-Bond-Yield-Plus-Risk

Premium:

rs = rd + RP.

9 - 19

based on the CAPM?

rRF = 7%, RPM = 6%, b = 1.2.

9 - 20

term (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

9 - 21

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.

9 - 22

Given: D0 = $4.19;P0 = $50; g = 5%.

D1 D0 1 g

rs g g

P0 P0

$4.19105

.

0.05

$50

0.088 0.05

13.8%.

9 - 23

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.

9 - 24

earning 15% on equity (ROE = 15%)

and retaining 35% (dividend payout

= 65%), and this situation is

expected to continue.

9 - 25

g = ROE(Retention rate)

g = 0.35(15%) = 5.25%.

Think of bank account paying 15% with

retention ratio = 0. What is g of

account balance? If retention ratio is

100%, what is g?

9 - 26

if g is not constant?

expected to have constant g at

some point, generally in 5 to 10

years.

But calculations get complicated.

See Ch 9 Tool Kit.xls.

9 - 27

plus-risk-premium method.

(rd = 10%, RP = 4%.)

rs = rd + RP

= 10.0% + 4.0% = 14.0%

This RP CAPM RPM.

Produces ballpark estimate of rs.

Useful check.

9 - 28

Whats a reasonable final estimate

of rs?

Method Estimate

CAPM 14.2%

DCF 13.8%

rd + RP 14.0%

Average 14.0%

9 - 29

the firm that will be financed by each

component.

If possible, always use the target

weights for the percentages of the

firm that will be financed with the

various types of capital.

9 - 30

Estimating Weights for the

Capital Structure

If you dont know the targets, it is

better to estimate the weights using

current market values than current

book values.

If you dont know the market value of

debt, then it is usually reasonable to

use the book values of debt,

especially if the debt is short-term.

(More...)

9 - 31

are 3 million shares of stock, the firm

has $25 million of preferred stock,

and $75 million of debt.

(More...)

9 - 32

Vps = $25 million.

Vd = $75 million.

Total value = $150 + $25 + $75 = $250

million.

wce = $150/$250 = 0.6

wps = $25/$250 = 0.1

wd = $75/$250 = 0.3

9 - 33

9 - 34

WACC Estimates for Some Large

U. S. Corporations

Company WACC

General Electric (GE) 12.5

Coca-Cola (KO) 12.3

Intel (INTC) 12.2

Motorola (MOT) 11.7

Wal-Mart (WMT) 11.0

Walt Disney (DIS) 9.3

AT&T (T) 9.2

Exxon Mobil (XOM) 8.2

H.J. Heinz (HNZ) 7.8

BellSouth (BLS) 7.4

9 - 35

WACC?

rates and tax rates.

The firms capital structure and

dividend policy.

The firms investment policy. Firms

with riskier projects generally have a

higher WACC.

9 - 36

Should the company use the

composite WACC as the hurdle rate for

each of its divisions?

risk of an average project undertaken

by the firm.

Different divisions may have different

risks. The divisions WACC should be

adjusted to reflect the divisions risk

and capital structure.

9 - 37

What procedures are used to determine

the risk-adjusted cost of capital for a

particular division?

Estimate the cost of capital that

the division would have if it were a

stand-alone firm.

This requires estimating the

divisions beta, cost of debt, and

capital structure.

9 - 38

Division or a Project

traded companies exclusively in

projects business.

Use average of their betas as

proxy for projects beta.

Hard to find such companies.

9 - 39

between projects ROA and S&P

index ROA.

Accounting betas are correlated

(0.5 0.6) with market betas.

But normally cant get data on new

projects ROAs before the capital

budgeting decision has been made.

9 - 40

Find the divisions market risk and cost

of capital based on the CAPM, given

these inputs:

rd = 12%.

rRF = 7%.

Tax rate = 40%.

betaDivision = 1.7.

Market risk premium = 6%.

9 - 41

risk than average.

Divisions required return on equity:

rs = rRF + (rM rRF)bDiv.

= 7% + (6%)1.7 = 17.2%.

WACCDiv. = wdrd(1 T) + wcrs

= 0.1(12%)(0.6) + 0.9(17.2%)

= 16.2%.

9 - 42

compare with the firms overall WACC?

company WACC = 11.1%.

Typical projects within this division

would be accepted if their returns are

above 16.2%.

9 - 43

Rate of Return

(%) Acceptance Region

WACC

WACCH H

A Rejection Region

WACCA

B

WACCL L

Risk

0 RiskL RiskA RiskH

9 - 44

risk?

Stand-alone risk

Corporate risk

Market risk

9 - 45

calculate.

Market risk is theoretically best in

most situations.

However, creditors, customers,

suppliers, and employees are more

affected by corporate risk.

Therefore, corporate risk is also

relevant.

9 - 46

A Project-Specific, Risk-Adjusted

Cost of Capital

Start by calculating a divisional cost

of capital.

Estimate the risk of the project using

the techniques in Chapter 12.

Use judgment to scale up or down

the cost of capital for an individual

project relative to the divisional cost

of capital.

9 - 47

Why is the cost of internal equity from

reinvested earnings cheaper than the

cost of issuing new common stock?

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.

9 - 48

Estimate the cost of new common

equity: P0=$50, D0=$4.19, g=5%, and

F=15%.

D0 (1 g )

re g

P0 (1 F )

$4.19 1.05

5 .0 %

$50 1 0.15

$4.40

5.0% 15.4%.

$42.50

9 - 49

Estimate the cost of new 30-year debt:

Par=$1,000, Coupon=10%paid annually,

and F=2%.

Using a financial calculator:

N = 30

PV = 1000(1-.02) = 980

PMT = -(.10)(1000)(1-.4) = -60

FV = -1000

Solving for I: 6.15%

9 - 50

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 per-

project cost is fairly small.

We will frequently ignore flotation

costs when calculating the WACC.

9 - 51

dont use the coupon rate on existing

debt. Use the current interest rate on

new debt.

2. When estimating the risk premium for

the CAPM approach, dont subtract

the current long-term T-bond rate from

the historical average return on

(More ...)

common stocks.

9 - 52

been about 12.7% and inflation

drives the current rRF up to 10%, the

current market risk premium is not

12.7% - 10% = 2.7%!

(More ...)

9 - 53

3. Dont use book weights to estimate

the weights for the capital structure.

Use the target capital structure to determine

the weights.

If you dont know the target weights, then

use the current market value of equity, and

never the book value of equity.

If you dont know the market value of debt,

then the book value of debt often is a

reasonable approximation, especially for

short-term debt.

(More...)

9 - 54

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 WACC.

We do adjust for these items when

calculating the cash flows of the

project, but not when calculating the

WACC.

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