CF

473.32

11

Winter 2014

Questions

1. What cash flows should I consider?

2. How does the market set “r”?

3. How should I set “r”?

Setting “r”

basic idea if

• project return > cost of money

then• value of firm should

Cost of Money

finalinterim• Debt

value if soldpayments

principal

face value

dividends

dividends

interest

coupon

Common shares

Preferred shares

• Equity

• Loans

• Bonds

firm gets money from 2 sources

sources expect benefits back

Cost of Money

3 ideas to measure this:1. dividend growth

2. earnings retention

3. WACC

Cost of Money

1. dividend growth

• remember this formula?

• change the labels slightly

• rearrange it

p0 share price now

d1 dividend a year from now

g rate of growth

re return on equity

gr

dp

1

s

gr

dp

e 1

0

gp

dre

0

1

Cost of Money

1. dividend growth• need to know g

» dividend history

gp

dre

0

1

dividend history

dividend

2007 $1.10 change growth

2008 $1.20 $0.10 9.09%2009 $1.35 $0.15 12.50%2010 $1.50 $0.15 11.11%2011 $1.55 $0.05 3.33%

average 9.01%

g = .0901

gp

dre

0

1

Cost of Money

1. dividend growth

2. earnings retention

3. WACC

gp

dre

0

1

Cost of Money

1. dividend growth

2. earnings retention same formula

different method of finding g

gp

dre

0

1

ROEratioretention g

Cost of Money

1. dividend growth

2. earnings retention

3. WACC“weighted average cost of capital”

• uses ideas from CAPM

3. WACC

of $ we get from outside world• what do we pay for debt?

• what do we pay for equity?

• what proportion of each do we have?

cddee trwrwWACC 1

3. WACC

weight of equity

rate on equity

rate on debtweight of debt

corporate tax rate

% market value of equity

% market value of debtYTM

cddee trwrwWACC 1

crucial: market prices

3. WACC

cddpepe

femfce tYTM

v

v

p

d

v

vrrr

v

vWACC 1

0

cddee trwrwWACC 1

fmfe rrrr

v

ve

v

vd

dYTM

Cost of Debt

long-term debt bonds

• YTM not coupon rate

• expected bond ratings

Cost of Debt

example current bond issue

• $1,000 face value

• 2 years to maturity

• 10% coupon rate (“embedded cost”) paid semiannually

• currently selling for 107% of face value

what is cost of debt?

ignoring taxes for now

Cost of Equity

example for our firm

• $25.00 current stock price

• $1.80 last dividend

• 7% annual dividend growth

• 0.9 β analysts’ estimates

Cost of Equity

example current in our market

• 8% risk-free rate

• 7% market risk premium

2 More Things on ch 14

1. applying WACC’s r2. flotation costs

1. Applying WACC’s r

WACC’s r used to decide yes or no? which is best?

appropriate for project same risk overall firm core business

otherwise adaptation needed

1. Adapting WACC’s r

when a specific division’s project outside core business

then find firms that do these projects

• use their average βs

or adjust subjectively

1. Adapting WACC’s r adjusting subjectively

• example

risk level r

very low WACC - .08

low WACC - .03

same as firm WACC

high WACC + .05

very high WACC + .10

2. Flotation Costs

r depends on risk not how $ raised

however cost of issuing must be included

2. Flotation Costs

basic approach: weighted average flotation cost

Use target weights because firm will issue securities in these percentages over the long term.

2. Flotation Costs

project cost

• $1 million

after-tax cash flows• $250,000/year

• 7 years

2. Flotation Costs

project WACC

• 15%

firm’s target D/E ratio is .6 flotation costs

• 5% equity

• 3% debt

2. Flotation Costs

nn

nnn r)(

CF

r)(

CF

r)(

CFNPV

1...

11 2

2

1

1

00.000,50272 CF

421,044,386.1 CF

15.0r

710 015.1

00.000,250...

015.1

00.000,250

015.1

42.386,044,1NPV

Questions

1. What cash flows should I consider?

2. How does the market set r?

3. How should I set r?

nn

nnn r)(

CF

r)(

CF

r)(

CFNPV

1...

11 2

2

1

1

1. What cash flows?

ch 10

Has it flowed already?

Would it flow without the project?

1. What cash flows?

Has it flowed “already”? sunk costs research costs decision-making costs sales to date

1. What cash flows?

Would it flow without the project?• if so, don’t count it

Incremental only lost gained

“The stand-alone principal”

1. What cash flows?

Incremental only lost

• capital

• operating

gained• revenues

• CCA tax shield benefits

CCA tax shield

c cost of asset

tCCA CCA tax rate

tc corporate tax rate

r discount rate

s salvage value

n number of periods in the project

nCCA

cCCA

CCA

cCCAoninstallatiequipment

r)(rt

tst

r

r.

rt

ttccPV

1

1

1

501 shieldCCA tax

Equipment cost c $100,000

Installation & delivery cost c $10,000

Salvage s $17,000

when? n 6

Marginal tax rate tc40%

CCA tax rate d 20%

discount rate r 10%

6shieldCCA tax )10.01(

1

10.020.0

40.020.0000,17

10.01

10.05.01

10.00.20

40.00.20110,000 PV

“hurdle rate”

0544125shieldCCA tax .,$PV

nCCA

cCCA

CCA

cCCAoninstallatiequipment

r)(rt

tst

r

r.

rt

ttccPV

1

1

1

501 shieldCCA tax