CH 11 Cost of Capital

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CHAPTER 11
The Cost of Capital
Cost of Capital Components Debt Preferred Common Equity WACC

Copyright 2002 Harcourt, Inc. All rights reserved.
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What types of long-term capital do firms use? Long-term debt Preferred stock Common equity
Copyright 2002 Harcourt, Inc.
All rights reserved.
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Should we focus on before-tax or after-tax capital costs? Tax effects associated with financing 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 aftertax costs. Only cost of debt is affected.
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Should we focus on historical (embedded) costs or new (marginal) costs? The cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we should focus on marginal costs.
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A 15-year, 12% semiannual bond sells for $1,153.72. Whats kd?

0
i=?
1 60
30
...
60 60 + 1,000
-1,153.72
INPUTS OUTPUT
30
N I/YR
-1153.72 60
PV PMT
1000
FV
5.0% x 2 = kd = 10%
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Component Cost of Debt Interest is tax deductible, so kd AT = kd BT(1 - T) = 10%(1 - 0.40) = 6%. Use nominal rate. Flotation costs small, so ignore.
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Whats the cost of preferred stock? PP = $113.10; 10%Q; Par = $100; F = $2. Use this formula:
k ps = Dps Pn
0.1 ( $100 ) = $113 .10 $2.00 $10 = = 0.090 = 9.0%. $111 .10
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Picture of Preferred
0 -111.1 kps = ? 1 2.50 2 2.50
...
2.50
DQ $2.50 $111 .10 = = . k Per k Per
k Per
$2.50 = = 2.25%; k ps(Nom) = 2.25%( 4) = 9%. $111 .10

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Note: Flotation costs for preferred are significant, so are reflected. Use net price. Preferred dividends are not deductible, so no tax adjustment. Just kps. Nominal kps is used.
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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.
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Why is yield on preferred lower than kd? 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.
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Example:
kps = 9% kd = 10% T = 40%
kps, AT = kps - kps (1 - 0.7)(T) = 9% - 9%(0.3)(0.4) = 7.92% kd, AT = 10% - 10%(0.4) = 6.00% A-T Risk Premium on Preferred = 1.92%
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What are the two ways that companies can raise common equity? Companies can issue new shares of common stock. Companies can reinvest earnings.
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Why is there a cost for reinvested earnings? Earnings can be reinvested or paid out as dividends. Investors could buy other securities, earn a return. Thus, there is an opportunity cost if earnings are reinvested.
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Opportunity cost: The return stockholders could earn on alternative investments of equal risk. They could buy similar stocks and earn ks, or company could repurchase its own stock and earn ks. So, ks, is the cost of reinvested earnings and it is the cost of equity.
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Three ways to determine the cost of equity, ks: 1. CAPM: ks = kRF + (kM - kRF)b = kRF + (RPM)b. 2. DCF: ks = D1/P0 + g. 3. Own-Bond-Yield-Plus-Risk Premium:
ks = kd + RP.
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Whats the cost of equity based on the CAPM? kRF = 7%, RPM = 6%, b = 1.2.
ks = kRF + (kM - kRF )b. = 7.0% + (6.0%)1.2 = 14.2%.
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Whats the DCF cost of equity, ks? Given: D0 = $4.19;P0 = $50; g = 5%.
D 0 (1 + g) D1 ks = +g= +g P0 P0
$4.19(105) . = + 0.05 $50 = 0.088 + 0.05 = 13.8%.
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Suppose the company has been earning 15% on equity (ROE = 15%) and retaining 35% (dividend payout = 65%), and this situation is expected to continue. Whats the expected future g?
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Retention growth rate: g = b(ROE) = 0.35(15%) = 5.25%. Here b = Fraction retained. Close to g = 5% given earlier. Think of bank account paying 10% with b = 0, b = 1.0, and b = 0.5. Whats g?
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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. See Ch 11 Tool Kit.xls.
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Find ks using the own-bond-yieldplus-risk-premium method. (kd = 10%, RP = 4%.) ks = kd + RP = 10.0% + 4.0% = 14.0% This RP CAPM RPM. Produces ballpark estimate of ks. Useful check.
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Whats a reasonable final estimate of ks? Method CAPM DCF kd + RP Average Estimate 14.2% 13.8% 14.0% 14.0%
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Whats the WACC?
WACC = wdkd(1 - T) + wpskps + wceks = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1%.
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WACC Estimates for Some Large U. S. Corporations

Company Intel General Electric Motorola Coca-Cola Walt Disney AT&T Wal-Mart Exxon H. J. Heinz BellSouth
WACC 12.9% 11.9 11.3 11.2 10.0 9.8 9.8 8.8 8.5 8.2
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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.
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Should the company use the composite WACC as the hurdle rate for each of its projects? NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the hurdle rate for a typical project with average risk. Different projects have different risks. The projects WACC should be adjusted to reflect the projects risk.
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Risk and the Cost of Capital

Rate of Return (%)
Acceptance Region WACC 12.0 10.5 10.0 9.5 8.0 L A B H Rejection Region
Risk L
Risk A
Risk H
Risk
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Divisional Cost of Capital

Rate of Return (%)
13.0 11.0 10.0 9.0 7.0 Project L Composite WACC for Firm A Division Hs WACC WACC
Project H
Division Ls WACC
Risk L
Risk Average
Risk H
Risk
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What are the three types of project risk?
Stand-alone risk Corporate risk Market risk
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How is each type of risk used? 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.
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What procedures are used to determine the risk-adjusted cost of capital for a particular project or division? Subjective adjustments to the firms composite WACC. Estimate what the cost of capital would be if the project/division were a stand-alone firm. This requires estimating the projects beta.
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Methods for Estimating Beta for a Division or a Project 1. Pure play. Find several publicly traded companies exclusively in projects business. Use average of their betas as proxy for projects beta. Hard to find such companies.
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2. Accounting beta. Run regression 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.
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Find the divisions market risk and cost of capital based on the CAPM, given these inputs: Target debt ratio = 10%. kd = 12%. kRF = 7%. Tax rate = 40%. betaDivision = 1.7. Market risk premium = 6%.
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Beta = 1.7, so division has more market risk than average. Divisions required return on equity: ks = kRF + (kM kRF)bDiv. = 7% + (6%)1.7 = 17.2%. WACCDiv. = wdkd(1 T) + wcks = 0.1(12%)(0.6) + 0.9(17.2%) = 16.2%.
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How does the divisions WACC compare with the firms overall WACC? Division WACC = 16.2% versus company WACC = 11.1%. Indicates that the divisions market risk is greater than firms average project. Typical projects within this division would be accepted if their returns are above 16.2%.
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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.
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Estimate the cost of new common equity: P0=$50, D0=$4.19, g=5%, and F=15%.
ke
D 0 (1 +g) = +g P0 (1 ) F
$4.19( 1.05 ) = + 5 .0 % $50( 1 0.15 ) $4.40 = + 5.0% = 15.4%. $42.50
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Estimate the cost of new 30-year debt: Par=$1,000, Coupon=10%paid annually, and F=15%. Using a financial calculator: N = 30 PV = 1000(1-.02) = 980 PMT = -(.10)(1000)(1-.4) = -60 FV = -1000 Solving for I: 6.15%
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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 per-project cost is fairly small. We will frequently ignore flotation costs when calculating the WACC.
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Four Mistakes to Avoid 1. When estimating the cost of debt, use the current interest rate on new debt, not the coupon rate on existing 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 common stocks.
(More ...)
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For example, if the historical kM has been about 12.7% and inflation drives the current kRF up to 10%, the current market risk premium is not 12.7% - 10% = 2.7%!
(More ...)
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3. 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(More...) term debt.
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4. 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 WACC. We do adjust for these items when calculating the cash flows of the project, but not when calculating the WACC.

CH 11 Cost of Capital

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11 - 1

Cost of Capital Components Debt Preferred Common Equity WACC

Copyright 2002 Harcourt, Inc.

All rights reserved.

A 15-year, 12% semiannual bond sells for $1,153.72. Whats kd?

Copyright 2002 Harcourt, Inc.

Copyright 2002 Harcourt, Inc.

All rights reserved.

DQ $2.50 $111 .10 = = . k Per k Per

$2.50 = = 2.25%; k ps(Nom) = 2.25%( 4) = 9%. $111 .10

Copyright 2002 Harcourt, Inc.

Copyright 2002 Harcourt, Inc.

All rights reserved.

Copyright 2002 Harcourt, Inc.

All rights reserved.

All rights reserved.

ks = kRF + (kM - kRF )b. = 7.0% + (6.0%)1.2 = 14.2%.

Copyright 2002 Harcourt, Inc.

All rights reserved.

Copyright 2002 Harcourt, Inc.

All rights reserved.

Copyright 2002 Harcourt, Inc.

All rights reserved.

Could DCF methodology be applied if g is not constant?

Copyright 2002 Harcourt, Inc.

All rights reserved.

Whats the WACC?

WACC Estimates for Some Large U. S. Corporations

Risk and the Cost of Capital

Copyright 2002 Harcourt, Inc.

All rights reserved.

Divisional Cost of Capital

Copyright 2002 Harcourt, Inc.

All rights reserved.

What are the three types of project risk?

Stand-alone risk Corporate risk Market risk

Copyright 2002 Harcourt, Inc.

All rights reserved.

Copyright 2002 Harcourt, Inc.

All rights reserved.

Copyright 2002 Harcourt, Inc.

All rights reserved.

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