cost of caoital tutorial

8/9/2019 cost of caoital tutorial

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9 - 1

CHAPTER 9Determining the Cost of Capital

Cost of Capital Components

Debt

PreferredCommon Equity

WACC



9 - 2

What types of long-term capital dofirms use?

Long-term debtPreferred stock

Common equity



9 - 3

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, sothey are not included in thecalculation of the cost of capital.

We do adjust for these items whencalculating the cash flows of aproject, but not when calculating thecost of capital.



9 - 4

S

hould we focus on before-tax or after-tax capital costs?

Tax effects associated with financing

can be incorporated either in capitalbudgeting cash flows or in cost of capital.

Most firms incorporate tax effects in

the cost of capital. Therefore, focuson after-tax costs.

Only cost of debt is affected.



9 - 5

S

hould we focus on historical(embedded) costs or new (marginal)costs?

The cost of capital is used primarilyto make decisions which involveraising and investing new capital.

So, we should focus on marginalcosts.



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Cost of Debt

Method 1: Ask an investment banker what the coupon rate would be on

new debt.Method 2: Find the bond rating for

the company and use the yield onother bonds with a similar rating.

Method 3: Find the yield on thecompany¶s debt, if it has any.



9 - 7

A 15-year, 12% semiannual bond sellsfor $1,153.72. What¶s r d?

60 60 + 1,00060

0 1 2 30

i = ?

30 -1153.72 60 1000

5.0% x 2 = r d = 10%

N I/YR PV FVPMT

-1,153.72

...

INPUTS

OUTPUT



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Component Cost of Debt

Interest is tax deductible, so theafter tax (AT) cost of debt is:

r d AT = r d BT(1 - T)

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

Use nominal rate.

Flotation costs small, so ignore.



9 - 9

What¶s the cost of preferred stock?PP = $113.10; 10%Q; Par = $100; F = $2.

%....

..

.

!!!

!

n

ps

ps P

Dr !

Use this formula:



9 - 10

Picture of Preferred

2.50 2.50

0 1 2r ps = ?

-111.1

g

...

2.50

.50.2$

10.111$ Per Per

Q

r r !!

%.9)4%(25.2%;25.210.111$

50.2$)( !!!!

Nom ps Per r r



9 - 11

Note:

Flotation costs for preferred are

significant, so are reflected. Usenet price.

Preferred dividends are notdeductible, so no tax adjustment.

Just r ps.

Nominal r ps is used.



9 - 12

Is preferred stock more or less risky toinvestors than debt?

More risky; company not required to

pay preferred dividend.

However, firms want to pay preferreddividend. Otherwise, (1) cannot pay

common dividend, (2) difficult toraise additional funds, and (3)preferred stockholders may gaincontrol of firm.



9 - 13

Why is yield on preferred lower than r d?

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 costto the issuer are higher on preferredthan on debt, which is consistent withthe higher risk of preferred.



9 - 14

Example:

r ps = 9% r d = 10% T = 40%

r ps, AT = r ps - r ps (1 - 0.7)(T)

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

r d, AT = 10% - 10%(0.4) = 6.00%

A-T Risk Premium on Preferred = 1.92%



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Directly, by issuing new shares of common stock.

Indirectly, by reinvesting earningsthat are not paid out as dividends(i.e., retaining earnings).

What are the two ways that companiescan raise common equity?



9 - 16

Earnings can be reinvested or paidout as dividends.

Investors could buy other securities,earn a return.

Thus, there is an opportunity cost if earnings are reinvested.

Why is there a cost for reinvestedearnings?



9 - 17

Opportunity cost: The returnstockholders could earn onalternative investments of equal

risk.They could buy similar stocks

and earn r s, or company couldrepurchase its own stock and

earn r s. So, r s, is the cost of reinvested earnings and it is thecost of equity.



9 - 18

Three ways to determine thecost of equity, r s:

1. CAPM: r s = r RF + (r M - r RF)b

= r RF + (RPM)b.

2. DCF: r s = D1 /P0 + g.

3. Own-Bond-Yield-Plus-RiskPremium:

r s = r d + RP.



9 - 19

What¶s the cost of equitybased on the CAPM?r RF = 7%, RPM = 6%, b = 1.2.

r s = r RF + (r M - r RF )b.

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



9 - 20

Issues in Using CAPM

Most analysts use the rate on a long-term (10 to 20 years) governmentbond as an estimate of r

RF. For a

current estimate, go towww.bloomberg.com, select ³U.S.Treasuries´ from the section on the

left under the heading ³Market.´

More«



9 - 21

Issues in Using CAPM (Continued)

Most analysts use a rate of 5% to 6.5%for the market risk premium (RPM)

Estimates of beta vary, and estimatesare ³noisy´ (they have a wideconfidence interval). For an estimateof beta, go to www.bloomberg.com

and enter the ticker symbol for STOCKQUOTES.



9 - 22

What¶s the DCF cost of equity, r s?Given: D0 = $4.19;P0 = $50; g = 5%.

g P

g D

g P

D

r s

!!0

0

0

1 1

!

!

!

$4. .

$50.

. .

.

19 1050 05

0 088 0 05

13 8%.



9 - 23

Estimating the Growth Rate

Use the historical growth rate if youbelieve the future will be like the

past.

Obtain analysts¶ estimates: ValueLine, Zack¶s, Yahoo!.Finance.

Use the earnings retention model,illustrated on next slide.



9 - 24

Suppose the company has beenearning 15% on equity (ROE = 15%)and retaining 35% (dividend payout

= 65%), and this situation isexpected to continue.

What¶s the expected future g?



9 - 25

Retention growth rate:

g = ROE(Retention rate)

g = 0.35(15%) = 5.25%.

This is close to g = 5% given earlier.Think of bank account paying 15% withretention ratio = 0. What is g of account balance? If retention ratio is100%, what is g?



9 - 26

Could DCF methodology be appliedif g is not constant?

YES, nonconstant g stocks areexpected to have constant g atsome point, generally in 5 to 10years.

But calculations get complicated.See ³Ch 9 Tool Kit.xls´.



9 - 27

Find r s

using the own-bond-yield-plus-risk-premium method.

(r d = 10%, RP = 4%.)

This RP { CAPM RPM. Produces ballpark estimate of r s.

Useful check.

r s = r d + RP

= 10.0% + 4.0% = 14.0%



9 - 28

What¶s a reasonable final estimate

of r s?

Method Estimate

CAPM 14.2%

DCF 13.8%

r d + RP 14.0%

Average 14.0%



9 - 29

Determining the Weights for the WACC

The weights are the percentages of the firm that will be financed by each

component.

If possible, always use the targetweights for the percentages of the

firm that will be financed with thevarious types of capital.



9 - 30

Estimating Weights for the

Capital Structure

If you don¶t know the targets, it isbetter to estimate the weights using

current market values than currentbook values.

If you don¶t know the market value of

debt, then it is usually reasonable touse the book values of debt,especially if the debt is short-term.

(More...)



9 - 31

Estimating Weights (Continued)

Suppose the stock price is $50, thereare 3 million shares of stock, the firmhas $25 million of preferred stock,and $75 million of debt.

(More...)



9 - 32

Vce = $50 (3 million) = $150 million.Vps = $25 million.

Vd = $75 million.

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

wce = $150/$250 = 0.6

wps = $25/$250 = 0.1

wd = $75/$250 = 0.3



9 - 33

What¶s the WACC?

WACC = wdr d(1 - T) + wpsr ps + wcer s

= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)

= 1.8% + 0.9% + 8.4% = 11.1%.



9 - 34

WACC Estimates for Some Large

U. S. Corporations

Company WACCGeneral Electric (GE) 12.5

Coca-Cola (KO) 12.3Intel (INTC) 12.2Motorola (MOT) 11.7Wal-Mart (WMT) 11.0Walt Disney (DIS) 9.3

AT&T (T) 9.2Exxon Mobil (XOM) 8.2H.J. Heinz (HNZ) 7.8BellSouth (BLS) 7.4



9 - 35

What factors influence a company¶sWACC?

Market conditions, especially interestrates and tax rates.

The firm¶s capital structure anddividend policy.

The firm¶s investment policy. Firms

with riskier projects generally have ahigher WACC.



9 - 36

Should the company use the

composite WACC as the hurdle rate for each of its divisions?

NO! The composite WACC reflects therisk of an average project undertakenby the firm.

Different divisions may have different

risks. The division¶s WACC should beadjusted to reflect the division¶s riskand capital structure.



9 - 37

Estimate the cost of capital that

the division would have if it were astand-alone firm.

This requires estimating the

division¶s beta, cost of debt, andcapital structure.

What procedures are used to determine

the risk-adjusted cost of capital for aparticular division?



9 - 38

Methods for Estimating Beta for aDivision or a Project

1. Pure play. Find several publicly

traded companies exclusively inproject¶s business.

Use average of their betas as

proxy for project¶s beta.Hard to find such companies.



9 - 39

2. Accounting beta. Run regressionbetween project¶s ROA and S&Pindex ROA.

Accounting betas are correlated(0.5 ± 0.6) with market betas.

But normally can¶t get data on newprojects¶ ROAs before the capital

budgeting decision has been made.



9 - 40

Find the division¶s market risk and cost

of capital based on the CAPM, giventhese inputs:

Target debt ratio = 10%.r d = 12%.

r RF = 7%.

Tax rate = 40%.betaDivision = 1.7.

Market risk premium = 6%.



9 - 41

Beta = 1.7, so division has more marketrisk than average.

Division¶s required return on equity:

r s = r RF + (r M ± r RF)bDiv.

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

WACCDiv. = wdr d(1 ± T) + wcr s

= 0.1(12%)(0.6) + 0.9(17.2%)= 16.2%.



9 - 42

How does the division¶s WACCcompare with the firm¶s overall WACC?

Division WACC = 16.2% versus

company WACC = 11.1%.

³Typical´ projects within this divisionwould be accepted if their returns are

above 16.2%.



9 - 43

Divisional Risk and the Cost of Capital

R a t e o f R e t u r n(% )

W A C C

R e j e c t io n R e g i o n

A c c e p t a n c e R e g i o n

R i s k

L

B

A

HW A C C H

W A C C L

W A C C A

0 R i s k L R i s k A R i s k H



9 - 44

What are the three types of project

risk?

Stand-alone risk

Corporate risk

Market risk



9 - 45

How is each type of risk used?

Stand-alone risk is easiest tocalculate.

Market risk is theoretically best inmost 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 costof capital.

Estimate the risk of the project usingthe techniques in Chapter 12.

Use judgment to scale up or downthe cost of capital for an individualproject relative to the divisional costof capital.



9 - 47

1. When a company issues new

common stock they also have to payflotation costs to the underwriter.

2. Issuing new common stock may

send a negative signal to the capitalmarkets, which may depress stockprice.

Why is the cost of internal equity from

reinvested earnings cheaper than thecost of issuing new common stock?



9 - 48

Estimate the cost of new common

equity: P0=$50, D0=$4.19, g=5%, andF=15%.

g F P

g Dr e

!

)1(

)1(

0

0

%.4.15%0.550.42$

40.4$

%0.515.0150$

05.119.4$

!!

!



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

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, sincemost firms issue equity infrequently,

the per-project cost is fairly small.We will frequently ignore flotation

costs when calculating the WACC.



9 - 51

Four Mistakes to Avoid

1. When estimating the cost of debt,don¶t use the coupon rate on existing

debt. Use the current interest rate onnew debt.

2. When estimating the risk premium for

the CAPM approach, don¶t subtractthe current long-term T-bond rate fromthe historical average return oncommon stocks. (More ...)



9 - 52

For example, if the historical r M hasbeen about 12.7% and inflation

drives the current r RF up to 10%, thecurrent market risk premium is not12.7% - 10% = 2.7%!

(More ...)



9 - 53

3. Don¶t use book weights to estimate

the weights for the capital structure.Use the target capital structure to determinethe weights.

If you don¶t know the target weights, thenuse the current market value of equity, andnever the book value of equity.

If you don¶t know the market value of debt,

then the book value of debt often is areasonable approximation, especially for short-term debt.

(More...)



9 - 54

4. Always remember that capital

components are sources of fundingthat come from investors.

Accounts payable, accruals, anddeferred taxes are not sources of funding that come from investors, sothey are not included in thecalculation of the WACC.

We do adjust for these items whencalculating the cash flows of theproject, but not when calculating theWACC.

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cost of caoital tutorial