Chap-9, The Cost of Capital, 2015.pdf

8/18/2019 Chap-9, The Cost of Capital, 2015.pdf

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CHAPTER 9

The Cost of Capital

Sources of capital

Component costs

WACC

Adjusting for flotation costs

Adjusting for risk

9-2

What Sources of Long-term CapitalDo Firms Use?

Long-Term

Capital

Long-TermDebt

PreferredStock

CommonStock

RetainedEarnings

New CommonStock

9-3

From investors‟ point of view: The minimum return a firm needs to earn to satisfy

all of its investors

The weighted average of required returns of the

securities used to finance the firm

From firm‟s point of view: The cost of capital for the firm as a whole

The cost of capital depends primarily on the use of

the funds, not the source

What Is Cost of Capital?

9-4

The various types of debt, preferred stock,

and common equity shown on the B/S

The sources of funding that come frominvestors

A/P, accruals, and deferred taxes are not thesources of funding that come from investors

They are not the components of the cost of capital

Capital Components

9-5

Calculating the WACC

WACC = wdrd(1-T) + wpsrp + wcsrs

The w‟s refer to the firm‟s capital structureweights.

rd= cost of debt

rp= cost of preferred stock

rs= cost of common stock

T= tax rate

Why tax-adjust, i.e. why rd(1-T)?

9-6

Before-tax vs. After-tax CapitalCosts

Tax effects associated with financing can beincorporated either in capital budgeting CFsor in cost of capital

Most firms incorporate tax effects in the costof capital. Therefore, focus on A-T costs

Only cost of debt is affected


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9-7

Historical (Embedded) Costs vs.New (Marginal) Costs

The cost of capital is used in raisingand investing new capital

So, we should focus on marginal costs

9-8

A Three-Step Procedure forEstimating Firm WACC

1. Define the firm‟ s capital structure by

determining the weight of each source ofcapital.

2. Estimate the opportunity cost of each sourceof financing. We will use the current market value of each source of

capital based on its current, not historical, costs.

3. Calculate a weighted average of the costs ofeach source of financing.

9-9

A Template for Calculating WACC

The following template demonstrates how to carry outthe calculation of the WACC from the previous Equation:

(1)

Source ofCapital

Debt

Preferred Stock

Common Stock

Sum=

(2)

Market ValueWeights

wd

wps

wcs

100%

×

×

×

×

(3)

A-T Cost ofFinancing

rd (1-T)

rp

rs

=

=

=

=

(4)

Product of (2)and (3)

wd×rd (1-T)

wps×rp

wcs×rs

9-10

Determining the Firm‟s CapitalStructure Weights

The weights are based on debt (excluding A/Pand accruals), preferred stock, and commonequity

Ideally, the weights should be based on observedmarket values Sometimes all market values may be readily available

We generally use book values for debt and market

values for equity

9-11

Example: Calculating WACC

WACC for Templeton Extended Care Facilities, Inc.

In the spring of 2012, Templeton was considering theacquisition of a chain of extended care facilities and wantedto estimate its own WACC as a guide to the cost of capitalfor the acquisition. Templeton‟ s capital structure consists ofthe following:

9-12

Templeton contacted the firm ‟ s investment banker toget estimates of the firm ‟ s current cost of financing andwas told that if the firm were to borrow the sameamount of money today, it would have to pay lenders8%; however, given the firm ‟ s 25% tax rate, the after-tax cost of borrowing would only be 6% = 8%(1-.25).

Preferred stockholders currently demand a 10% rate ofreturn, and common stockholders demand 15%.

Templeton‟ s CFO knew that the WACC would besomewhere between 6% and 15% since the firm‟ scapital structure is a blend of the three sources ofcapital whose costs are bounded by this range.



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9-13 9-14


STEP 2: Opportunity cost of each source is given

STEP 3: Solve

(1)

Source ofCapital

Debt

Preferred Stock

Common Stock

Sum=

(2)

Market ValueWeights

0.250

0.125

0.625

100%

×

×

×

×

(3)

A-T Cost ofFinancing

0.060

0.100

0.150

=

=

=

=

(4)

Product of (2)and (3)

0.01500

0.01250

0.09375

0.12125

STEP 4: AnalyzeTempleton‟s CFO estimated that the firm's WACC is 12.125%, which lieswithin the range between the highest cost of source of capital (commonstock at 15%) and the lowest (debt at 6%).

9-15

Example: Check Yourself

After completing her estimate of Templeton ’s WACC, theCFO decided to explore the possibility of adding more low-cost debt to the capital structure. With the help of the firm‟sinvestment banker, the CFO learned that Templeton couldprobably push its use of debt to 37.5% of the firm’s capitalstructure by issuing more debt and retiring (purchasing) thefirm’s preferred shares. This could be done withoutincreasing the firm‟s costs of borrowing or the required rateof return demanded by the firm’s common stockholders.What is your estimate of the WACC for Templeton under this

new capital structure proposal? WACC = wd×rd×(1-T) + wcs×rs

=0.375 x 0.06 + 0.625 x 0.15=11.625%.9-16

The Cost of Debt (rd)

Method 1: Ask an investment banker what thecoupon rate would be on new debt

Method 2: Find the bond rating for the firmand use the yield on other bonds with asimilar rating

Method 3: Find the yield on the firm‟s debt, if

it has any

9-17

Components of Cost of Debt

The pretax rd is the financing cost associatedwith new funds through LT borrowing

The rd is the rate of return the firm‟s lendersdemand when they loan money

The pretax rd=YTM

Net proceeds are the funds received from the sale ofa debt security.

Flotation costs are the total costs of issuing andselling a security which include underwriting costsand administrative costs

9-18

Example-1: Before Tax Cost ofDebt

A 15-year, 12% semiannual bond sells for $1,153.72.The before-tax cost of debt (rd) by applying the bond

pricing formula will be as follows:

%10=r

)2 /r+1(

000,1$+})2 /r+1( –1{

2 /r

60$=72.153,1$

d

51×2d

51×2 –d

d


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9-19

Example-1: Cost of Debt withFlotation Cost

Humble Manufacturing is interested in measuring its overallcost of capital. The firm is in the 40% tax bracket. The firmcan raise an unlimited amount of debt by selling $1,000-par-value, 10% coupon interest rate, 10-year bonds onwhich annual interest payments will be made. To sell theissue, an average discount of $30 per bond must be given.The firm must also pay flotation costs of $20 per bond.What is the after-tax cost of debt?

nd

n –d

dB )r+1(

M+})r+1( –1{

r

CI=F) – V(

%83.10=

)r+1(

000,1$+})r+1( –1{

r

100$=$50) –000,1($ 10

d

10 –d

d

Net proceeds: $1,000-$30-$20= $950

A-T cost of debt (YTM)will be: rd = rd (1-T)

=10.83% (1-0.40) =6.5%

9-20

Example-2: The Cost of Debt

What will be the YTM on a debt that has par value of$1,000, a coupon interest rate of 5%, time to

maturity of 10 years and is currently trading at $900?What will be the cost of debt if the tax rate is 30%?

0638.0=)r+1(

1000$+})r+1( –1{

r

50$=900$ 10

d

10 –d

d

%47.4=0.30)-1(×0638.0=

T)-1(r=)(YTMdebtof costT- A ,Thus d

Solution:

*F= Flotation costs are very small, so ignore them

nd

n –d

dB )r+1(

M+})r+1( –1{

r

CI=F) – V(

9-21

Basket Wonders has a 15-year, 12% semiannualcoupon bond which sells for $1,153.72 with 0flotation cost. What is the cost of debt (rd) giventhe tax rate 40%?

%10=2×%5=r Annualized

)2 /r+1(

1000$+})2 /r+1( –1{

2 /r

2 /120$=7.1153$

d

30d

30 –d

d

Example-3: The Cost of Debt

Solution:

%6=0.40)-1(×10.0=

T)-1(r=)(YTMdebtof costT- A ,Thus d

*Flotation costs are small, so ignore them 9-22

The Cost of Preferred Stock (rp)

The rp is the rate of return on investment ofthe preferred shareholders

The cost is not adjusted for taxes sincedividends are paid to preferred stockholders outof A-T income.

The rp can be inferred from its trading price andthe fixed dividend:

rP = DPs / P0

9-23

Example-1: The Cost of PreferredStock

Assume that Basket Wonders has preferredstock outstanding with par value of $100,dividend per share of $10, and a current marketvalue of $111.10 per share.

rp = $10 / $111.10= 9%

9-24


Preferred stock: Thefirm can sell 11% (annual

dividend) preferred stockat its $100-per-share parvalue. The cost of issuingand selling the preferredstock is expected to be $4

per share. An unlimitedamount of preferred stockcan be sold under theseterms.

%5.11=96$

11$=r

96$=

)tcos.flo4$ –100$=N

11$=100$×11.0=D

;N

D=r

ps

ps

ps

ps

ps

ps

(


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9-25


Preferred stock:

The cost of preferredstock if PPs =$113.10; dividend =10% paid quarterly,Par = $100; flotationcost (F) = $2, will

be:%00.9=090.0=

2$-10.113$

10$=

)ostFlotationC-P

D

ps

ps

9-26


Preferred stock:

The Cost of preferredstock if PPs =$116.95; dividend =10% paid quarterly,Par = $100; flotationcost (F) = $5%, will

be %00.9=090.0=

10.111$

10$=

)0.05-1(95.116$

)100($1.0=

)F-1(P

D

ps

ps

9-27

Is Preferred Stock More or Less Riskyto Investors Than Debt?

More risky!

A firm is not bound to pay preferred dividend

However, firms try to pay preferred dividend,otherwise,

Firms cannot pay common dividend

It is difficult to raise additional funds

Preferred stockholders may gain control of firm

9-28

Why Is the Yield on Preferred StockLower Than Debt?

Corporations own most preferred stock,because 70% of preferred dividends arenontaxable to corporations

For the issuing firm, preferred stock often has alower B-T yield than the B-T yield on debt

The A-T yield to investors and A-T cost to theissuer are higher on preferred than on debt

Consistent with the higher risk and the A-T yield

9-29

Illustrating the differences between A-T yield on debt and preferred stock

Recall, that the firm‟s tax rate is 40%, and its B-T costs of debt and preferred stock are rd =10% and rps = 9%, respectively.

A-T rps = rps – {rps (1 – 0.3)(T)}

= 9% - {9% (0.7)(0.4)} = 6.48%

A-T rd = 10% - 10% (0.4) = 6.00%

A-T Risk Premium on Preferred = 0.48%

9-30

The Cost of Common Stock (rs)

The rs is the rate of return investors expectto receive from investing in firm ‟ s stock

This return comes in the form DY and CGY

Harder to estimate since stockholders do nothave a contractually defined return

Three approaches to estimating the rs Dividend growth model

CAPM

Before-tax cost of debt plus risk premium


6/10

9-31

Three Ways to Determine the Costof Common Stock, rs

DGM: rs = D1 / P0 + g

Or rs = D1 / Ns+ g

CAPM: rs = rRF + (rM – rRF) β

B-T Cost of Debt Plus Risk-Premium*:rs = rd + RP

Ns =Net proceeds from the sale of common stock

*A „RP‟ is expected return for common stock over debt, not the sameas „RP‟ in CAPM

9-32

Example of DGM: Cost of CommonStock

Humble Manufacturing is interested in measuring itsoverall cost of capital. The firm is in the 40% tax bracket.

Current investigation has gathered the following data:

Common Stock: The firm‟s common stock is currentlyselling for $80 per share. The firm expects to pay cash

dividends of $6 per share next year. The firm‟s dividendshave been growing at an annual rate of 6%, and this rateis expected to continue in the future. The stock will haveto be underpriced by $4 per share, and flotation costs areexpected to amount to $4 per share. The firm can sell an

unlimited amount of new common stock under theseterms.

9-33

%3.14=%6+%3.8=

%6+$4-80$

6$=r

g+N

D=r

s

s

1

s

When g is constant


9-34

If D0 = $4.19, P0 = $50, and g = 5%, what‟sthe cost of common equity based upon the DCFapproach?

D1 = D0 (1+g)

D1 = $4.19 (1 + .05)= $4.3995

rs = D1 / P0 + g

= $4.3995 / $50 + 0.05 = 13.8%


9-35

If the rRF = 7%, RPM = 6%, and the firm‟sbeta is 1.2, what‟s the cost of commonequity based upon the CAPM?

rs = rRF + (rM – rRF) β

= 7.0% + (6.0%)1.2 = 14.2%

Example of CAPM: Cost of CommonStock

9-36

Example of B-T Cost of Debt Plus Risk-Premium: Cost of Common Stock

If rd = 10% and RP = 4%, what is rs usingB-T Cost of Debt Plus Risk-Premium?

Solution: rs = k d + RPrs = 10.0% + 4.0% = 14.0%

This RP is not the same as the RPM in CAPM;rather it is RP in expected return for common

stock over debt

This method produces a ballpark estimate of rs,and can serve as a useful check.


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9-37

What Is a Reasonable FinalEstimate of rs?

Method Estimate

CAPM 14.2%

DGM 13.8%

B-T rd + RP 14.0%

Average 14.0%

Generally, the three methods wil l not agree.

We must decide how to weight –we wil l use an averageof these three.

9-38

Why Is There a Cost for RetainedEarnings?

R/Es can be reinvested or paid out as dividends

Investors could buy other securities and earn areturn

If retained, there is an opportunity cost

Investors could buy similar stocks and earn rs Firm could repurchase its own stock and earn rs

Therefore, rs is the cost of R/Es

9-39

Example of Cost of RetainedEarnings

Humble Manufacturing is interested in measuringits overall cost of capital. The firm is in the 40%tax bracket. Current investigation has gatheredthe following data:

Retained earnings: The firm expects to have$225,000 of retained earnings available in thecoming year. Once these retained earnings are

exhausted, the firm will use new common stockas the form of common stock equity financing.

9-40

%5.13=%6+%5.7=

%6+80$

6$=

g+P

D=r=r

0

1sr

Example of Cost of RetainedEarnings

9-41

Why is the cost of retained earningscheaper than the cost of issuing newcommon stock?

When a company issues new common stockthey also have to pay flotation costs to theunderwriter

Issuing new common stock may send anegative signal to the capital markets, whichmay depress the stock price

9-42

If issuing new common stock incurs aflotation cost of 15% of the proceeds,what is re? P0 = $50, g=5%, D0=$4.19

15.4%=

5.0%+$42.50

$4.3995 =

5.0%+0.15)-$50(1

)$4.19(1.05 =

g+F)-(1P

g)+(1D =r

0

0

e


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9-43

Flotation costs

Flotation costs depend on the risk of the firm

and the type of capital being raised.

The flotation costs are highest for commonequity. However, since most firms issue equityinfrequently, the per-project cost is fairly small.

We will frequently ignore flotation costs whencalculating the WACC.

9-44

Ignoring floatation costs, what isthe firm‟s WACC?

WACC = wdrd(1-T) + wpsrp + wcsrs= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)

= 1.8% + 0.9% + 8.4%

= 11.1%

9-45

What factors influence acompany‟s composite WACC?

Market conditions

The firm‟s capital structure and dividendpolicy

The firm‟s investment policy. Firms withriskier projects generally have a higherWACC

9-46

Should the company use thecomposite WACC as the hurdle ratefor each of its projects?

NO! The composite WACC reflects the risk ofan average project undertaken by the firm.Therefore, the WACC only represents the

“hurdle rate” for a typical project with averagerisk.

Different projects have different risks. Theproject‟s WACC should be adjusted to reflect

the project‟s risk.

9-47

Risk and the Cost of Capital

Rate of Return(%)

WACC

Rejection Region

Acceptance Region

Risk

L

B

A

H12.0

8.0

10.010.5

9.5

0 RiskL RiskA RiskH

9-48

What are the three types ofproject risk?

Stand-alone risk

Corporate risk

Market risk


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9-49

How is each type of risk used?

Market risk is theoretically best in mostsituations

However, creditors, customers, suppliers, andemployees are more affected by corporate risk

Therefore, corporate risk is also relevant

9-50

Problem Areas in Cost of Capital

Depreciation-generated funds Privately owned firms

Measurement problems

Adjusting costs of capital for different risk

Capital structure weights

9-51

How are risk-adjusted costs of capitaldetermined for specific projects ordivisions?

Subjective adjustments to the firm‟scomposite WACC.

Attempt to estimate what the cost of capitalwould be if the project/division were a stand-alone firm. This requires estimating theproject‟s beta.

9-52

Finding a divisional cost of capital:Using similar stand-alone firms toestimate a project‟s cost of capital

Comparison firms have the followingcharacteristics: Target capital structure consists of 40%

debt and 60% equity.

rd = 12%

rRF = 7%

RPM = 6%

βDIV = 1.7 Tax rate = 40%

9-53

Calculating a divisional cost of capital

Division‟s required return on equity

rs = rRF + (rM – rRF)β

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

Division‟s weighted average cost of capital

WACC = wd rd ( 1 – T ) + wc rs= 0.4 (12%)(0.6) + 0.6 (17.2%) =13.2%

Typical projects in this division are acceptable iftheir returns exceed 13.2%.

9-54

Exercise Problem:9-1

David Ortiz Motors has a target capital structureof 40% debt and 60% equity. The yield tomaturity on the company‟s outstanding bonds is9%, and the company‟s tax rate is 40%. Ortiz‟sCFO has calculated the company‟s WACC as9.96%. What is the company‟s cost of equitycapital?

Solution:

%13=r

)09.0)(4.0-1(4.0+)r(6.0=0996.0

equity

equity


10/10

9-55


Tunney Industries can issue perpetual preferred

stock at a price of $50 a share. The issue isexpected to pay a constant annual dividend of$3.80 a share. The flotation cost on the issue isestimated to be 5%. What is the company‟s costof preferred stock, rpref

Solution:

%8=)05.0-1(50

8.3=r ef Pr

9-56

A company‟s 6% coupon rate, semiannualpayment, $1,000 par value bond which matures

in 30 years sells at a price of $515.16. Thecompany‟s federal-plus-state tax rate is 40%.What is the firm‟s component cost of debt forpurposes of calculating the WACC?

Solution:

%2.7=)4.01%(12=debtof Cost

%12=i

)2 /i+1(

000,1+)2 /i+1(1[

2 /i

30=16.515

60

60


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Chap-9, The Cost of Capital, 2015.pdf