Chapter 12 Corporate finance

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Chapter 12 Cost of Capital

The required return for an asset is a function of the risk of the asset and the return to the investoris the same as the cost to the company. The firms cost of capital provides an indication of howthe market views the risk of the asset. Knowing the cost of capital helps the financial manager

determine the required return for capital projects.

The required return is the same as the appropriate discount rate and is based on the risk of thecash flows. We need to know the required return for an investment before we can compute theNP and make a decision about whether or not to take the investment. We need to earn at leastthe required return to compensate our investors for the financing they have provided.

Weighted !verage "ost of "apital #W!""$

%iven the following information& what is the W!"" for the following firm'

(ebt) *&+++ bonds with a par value of ,-&+++ and a quoted price of --./0. The bondshave coupon rate of 1 percent and 2 years to maturity.

Preferred3tock)

+&+++ shares of 4.0 percent preferred selling at a price of ,/0.

"ommon3tock)

5++&+++ shares of stock selling at a market price of ,52. The beta of the stock is+.*. The stock just paid a dividend of ,.-+ per share and the dividends aree6pected to grow at / percent per year indefinitely.

7arket) The e6pected return on the market is -5 percent and the risk8free rate is 4.0

percent. The company is in the 42 percent ta6 bracket.

-. "omponent "osts

(ebt

( )( ) ( )( )

+

=

&2

&2

+++&-

1+0+.-/&-

YTMYTM PVIFPVIFA

N #$#2$ 9 0/

"pt : 4.+2; 9


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Preferred 3tock

kp9+

-

P

(9

/0

4.0+9 .+042 or 0.42 ;

Aquity)

The cost of equity is the return required by equity investors given the risk of the cash flows fromthe firm.

ke9 BfC DA#B7$ E BfF 9 4.0 C +.*D-5 E 4.0F 9 -.*0;

Advantages of the CAPM

Explicitly adjusts for systematic risk

Applicale to all companies! as long as "e can compute eta

#isadvantages of the CAPM

$ave to estimate the expected market risk premium! "hich does vary over time

$ave to estimate eta! "hich also varies over time

%e are relying on the past to predict the future! "hich is not al"ays reliale

ke9+

-

P

(C g 9

52

.-+#-.+/$C .+/ 9 .-+/5 or -+./5;

Advantage of &ordon &ro"th Model

Easy to understand and use

#isadvantages of &ordon &ro"th Model

'nly applicale to companies currently paying dividends

(ot applicale if dividends aren)t gro"ing at a reasonaly constant rate

Extremely sensitive to the estimated gro"th rate an increase in g of 1* increases the

cost of e+uity y 1*

#oes not explicitly consider risk

ke9

-+./5;-.*0;+9 --.2+;

Page ?in 4-- "hapter - @ecture Notes


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. "omponent Weights

(ebt) #*&+++$#,-&-/.0+$ 9 ,-+&-42&0++

wd9+.44-

P3) #+&+++$#,/0$ 9 ,-&4++&+++ wp9+.+5

A) #5++&+++$#,52$ 9 ,-*&++&+++

we9 +./1

,4+&/42&0++

4. W!""

W!"" 9 w(B(#-8T"$ C wPBPC wABA

W!"" 9 #+.44-$#/.+/;$#- E +.42$ C #+.+5$#0.42$ C #+./1$#--.2+$ 9 2.2/;

?in 4-- "hapter - @ecture NotesPage 4


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The Perkins "ompany has employed you to analyGe a capital project. :t has given you thefollowing information)

Bond Coupon Rate Price Quote Maturity Number of Bonds Outstanding

1 6.75 95.5 22 35,000

2 7.25 110 20 45,000

The bonds make semiannual interest payments and the marginal ta6 rate is 5+ percent. Perkinse6pects the ne6t dividend #(-$ to be ,+.50 and its common stock is currently selling for ,0./0per share. The e6pected growth rate in earnings and dividends is a constant 0;. Perkins has abeta of -.4& the risk8free rate is 4 percent& and the e6pected market return is -.0 percent. Perkinshas 0&+++&+++ shares of common stock outstanding.

To complete the analysis& the NP and :BB need to be calculated the project. The initialinvestment is ,-. million. The net cash flows are ,/ million for years one through four and ,2million for year five. 3hould Perkins accept this project'

-. "omponent "osts

(ebt

Hond -

( ) ( )

+

=

&

&

+++&-

0./1++.*00

YTMYTM PVIFPVIFA

N #$#$ 9 55

"pt : 4.02; 9


5/7

Hond -) #40&+++$#,*00.++$ 9 ,44&50&+++

wd-9 +.5+4-

Hond ) #50&+++$#,-&-++.++$ 9 ,5*&0++&+++

wd9 +.0*/*

,2&*0&+++

B(9 w(-B(-C w(B(

B(9 #+.5+4-$#1.-/;$ C #+.0*/*$#/.4/;$ 9 /./2;

Aquity

ke9 BfC DA#B7$ E BfF 9 4.+ C -.4D-.0 E 4.+F 9 -0.40;

ke9+

-

P( C g 9

0./0

+.50 C .+0 9 .-4++ or -4.++;

ke9

-4.++;-0.40;+9 -5.-10;

. "omponent Weights

(ebt) ,2&*0&+++ wd9+.41+*

A) #0&+++&+++$#,0./0$ 9 ,-5+&/0&+++ we9 +./*-

,4&00+&+++

4. W!""

W!"" 9 w(B(#-8T"$ C wPBPC wABA

W!"" 9 #+.41+*$#/./2;$#- E +.5+$ C #+./*-$#-5.-10$ 9 -+.5+5;

"?+ 8-.

"?- /.+ ?- 5

"? 2.+ ? -

: -+.5+5

?in 4-- "hapter - @ecture NotesPage 0


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;

"pt NP ,--.04

"pt :BB 5-.2+;

!djusting the cost of capital

W!"" and "!P7

(raw graph

(ivisional "ost of "apital

Ising the W!"" as our discount rate is only appropriate for projects that are the same riskas the firmJs current operations

:f we are looking at a project that is NT the same risk as the firm& then we need todetermine the appropriate discount rate for that project

(ivisions also often require separatediscount rates

Transco Begulated& @ow Bisk

%enco Inregulated& Ligh Bisk

Page /?in 4-- "hapter - @ecture Notes


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3ubjective !pproach

"onsider the projectJs risk relative to the firm overall

:f the project is more risky than the firm& use a discount rate greater than the W!""

:f the project is less risky than the firm& use a discount rate less than the W!""

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Chapter 12 Corporate finance