Cost of Capital Lecture -Kisk

8/21/2019 Cost of Capital Lecture -Kisk

http://slidepdf.com/reader/full/cost-of-capital-lecture-kisk 1/36

Kevin Campbell, University o f Stirling, November 2005 11

2008

KOSZT I

STRUKTURA

KAPITAŁU




Cost of CapitalCost of Capital - The return the firm’s

investors could expect to earn if they

invested in securities with comparabledegrees of risk

Capital Structure - The firm’s mix of longterm financing and equity financing




Cost of Capital The cost of capital represents the overall cost

of financing to the firm

The cost of capital is normally the relevantdiscount rate to use in analyzing an investment

The overall cost of capital is a weightedaverage of the various sources:

• !"" # eighted !verage "ost of "apital

• !"" # !fter-tax cost x weights




Cost of Debt The cost of debt to the firm is the effective yield to

maturity $or interest rate% paid to its bondholders

&ince interest is tax deductible to the firm' theactual cost of debt is less than the yield tomaturity:

• !fter-tax cost of debt # yield x $( - tax rate%

The cost of debt should also be ad)usted forflotation costs $associated with issuing newbonds%




with stock with debt

EBIT 400,000 400,000

- interest expense 0 (50,000)

EBT 400,000 350,000

- taxes (34%) (13,000) (11!,000)E"T #4,000 #31,000

Example: Tax effects ofExample: Tax effects of

financing with debtfinancing with debt

*ow' suppose the firm pays +,' in dividendsto the shareholders




with stock with debt

EBIT 400,000 400,000

- interest expense 0 (50,000)EBT 400,000 350,000

- taxes (34%) (13,000) (11!,000)

E"T #4,000 #31,000

- di$idends (50,000) 0

etained earnin&s #14,000 #31,000

Example: Tax effects ofExample: Tax effects of

financing with debtfinancing with debt




"'ter-tax cost Be'ore-tax cost Tax

o' ebt o' ebt a$in&s

33,000 * 50,000 - 1+,000

33,000 * 50,000 ( 1 - 34)

Or, if we want to look at percentage costs:

-*Cost of Debt




"'ter-tax Be'ore-tax .ar&ina/

% cost o' % cost o' x tax

ebt ebt rate

d * kd (1 - T)

0 * 10 (1 - 34)

-

* 11

Cost of Debt




Prescott Corporation issues a $,!!! par,"! #ear bond pa#ing the market rate of

!% Coupons are annual% The bond willsell for par since it pa#s the market rate,but flotation costs amount to $&! perbond%

'hat is the pre(tax and after(tax cost ofdebt for Prescott Corporation)

EXAMPLE: Cost of Debt




Pre(tax cost of debt:*&! + !!P-./0 "!, 1d2 3 !!!P-./ "!, 1d2

using a financial calculator: 1d + !%4

0fter(tax cost of debt:

1d + 1d ( T2

1d + %!4 ( %562

1d + %!7 + 7

EXAMPLE: Cost of Debt

&o a (. bondcosts the firmonly /.

$with flotation costs%because interestis tax deductible




Cost of New Pefee!

Sto"# 0referred stock:

• has a fixed dividend $similar to debt%

• has no maturity date• dividends are not tax deductible and are

expected to be perpetual or infinite

"ost of preferred stock # dividendprice - flotation cost




Cost of Pefee! sto"#:

E$a%pleBaker Corporation has preferred stock that sells for $100 per share and pays an annualdiidend of $10!50! "f the flotation costs are $4 per share# hat is the cost of ne preferred stock%

10!94&!10944'$100

$10!50 (

) ===




Cost of E&'it(:Retai)e! Ea)i)*shy is there a cost for retained earnings1

2arnings can be reinvested or paid out as

dividends 3nvestors could buy other securities' and

earn a return4

Thus' there is an opportunity cost ifearnings are retained




Cost of E&'it(:Retai)e! Ea)i)*s "ommon stock equity is available throughretained earnings $562% or by issuing new

common stock:• "ommon equity # 562 7 *ew common stock




Cost of E&'it(:

New Co%%o) Sto"#The cost of new common stock is higher

than the cost of retained earnings

because of flotation costs• selling and distribution costs $such as

sales commissions% for the new

securities




Cost of E&'it(There are a number of methods used to

determine the cost of equity

e will focus on two

8ividend growth 9odel

"!09




T+e Di,i!e)! -owt+ Mo!el

Appoa"+

2stimating the cost of equity: the dividend growth modelapproach

!ccording to the constant growth (Gordon) model' D( P - # R E - g

5earranging D(

R E # + g

P -




E$a%ple: Esti%ati)* t+e

Di,i!e)! -owt+ Rate 0ercentageear 8ividend 8ollar "hange "hange

(;; +<4 --

(;;( <4< +4< (4.(;;= <4/, 4>, /4;,

(;;> ,4=, 4, (4,>

(;;< ,4?, 4< /4?=

!verage @rowth 5ate

$(4 7 /4;, 7 (4,> 7 /4?=%6< # ;4=,.




Di,i!e)! -owt+ Mo!el

This model has drawbacks:

&ome firms concentrate on growth and do notpay dividends at all' or only irregularly

@rowth rates may also be hard to estimate !lso this model doesn’t ad)ust for market risk

Therefore many financial managers prefer thecapital asset pricing model $"!09% - or securitymarket line $&9A% - approach for estimating thecost of equity




Capital 0sset Pricing 8odel C0P82

*+ f m f R R β Rkj −+=

Cost of

capital 9isk(freereturn

0erage rate of return

on common stocks'.;2

Co(ariance

of returns againstthe portfolio

departure from the aerage2< = , securit# is safer than '.; aerage

< > , securit# is riskier than '.; aerage




T+e Se"'it( Ma#et Li)e .SML/

e2ired rateo' ret2rn

ercent

05 10 15 #0

. * ' ( 6 7 ' )

Beta (risk)

.arket risk pre6i26

#00

180

10

140

1#0

100

80

55

'




0i)!i)* t+e Re&'ie! Ret') o)

Co%%o) Sto"# 'si)* t+e Capital

Asset Pi"i)* Mo!el,he Capital -sset )ricin. /odel +C-)/* can e used to estiate thereuired return on indiidual stocks! ,he forula

( ) ( ( f f −+= β

here ( euired return on stock

f isk'free rate of return +usually current rate on ,reasury Bill*!

β Beta coefficient for stock represents risk of the stock

( eturn in arket as easured y soe proy portfolio +inde*

uppose that Baker has the folloin. alues

f 5!5&

β 1!0

( 12&

!




0i)!i)* t+e Re&'ie! Ret') o)

Co%%o) Sto"# 'si)* t+e Capital

Asset Pi"i)* Mo!el ,hen# usin. the C-)/ e ould .et a reuired return of

( ) 12&5!5'121!05!5( =+=

!




CAPM1SML appoa"+

0dantage: 2valuates risk' applicableto firms that don’t pay dividends

?isadantage: *eed to estimate

• Beta

• the risk premium $usually based on past data'not future pro)ections%

• use an appropriate risk free rate of interest




Esti%atio) of 2eta: Meas'i)*Ma#et Ris#

9arket 0ortfolio - 0ortfolio of all assets inthe economy

3n practice a broad stock market index'such as the 3@' is used to represent themarket

Beta - sensitivity of a stock’s return to thereturn on the market portfolio




Esti%atio) of 2eta

Theoretically' the calculation of beta isstraightforward:

0roblems

(4Betas may vary over time4

=4The sample size may be inadequate4

>4Betas are influenced by changing financial leverage and business risk4

&olutions

• 0roblems ( and = $above% can be moderated by more sophisticated statisticaltechniques4

• 0roblem > can be lessened by ad)usting for changes in business and financialrisk4

• Aook at average beta estimates of comparable firms in the industry4

2*+

*#+

M

iM

M

M i

R!ar

R RCov β ==




Stabilit( of 2eta

9ost analysts argue that betas are generallystable for firms remaining in the same industry

That’s not to say that a firm’s beta can’t change• "hanges in product line

• "hanges in technology

• 8eregulation

• "hanges in financial leverage




What is the appropriate risk-free rate?

Use the yield on a long-term bond if you areanalyzing cash ows from a long-term investment

For short-term investments, it is entirelyappropriate to use the yield on short-termgovernment securities

Use the nominal risk-free rate if you discountnominal cash ows and real risk-free rate if youdiscount real cash ows




Survey evidence: What do youuse for the risk-free rate?

Corporations Financial Advisors

90-day -bill !"#$ 90-day -bill !%0#$

&-' year reasuries !'#$ (-%0 year reasuries !%0#$%0-year reasuries !&&#$ %0-&0 year reasuries !&0#$

)0-year reasuries !"#$ &0-year reasuries !"0#$

%0-&0 year reasuries !&&#$ *+ !%0#$

%0-years or 90-day depends!"#$

*+ !%(#$.ource/ runer et1 al1 !%992$




3ei*+te! A,ea*e Cost of Capital

.3ACC/

!"" weights the cost of equity and the costof debt by the percentage of each used in afirm’s capital structure

!""#$26 C% x 52 7 $86 C% x 58 x $(-T"%

• $26C%# 2quity . of total value

• $86C%#8ebt . of total value

• $(-Tc%#!fter-tax . or reciprocal of corp tax rate Tc4The after-tax rate must be considered becauseinterest on corporate debt is deductible




3ACC Ill'statio)

-BC Corp has 1!4 illion shares coon alued at $20 per

share $28 illion! et has face alue of $5 illion and trades

at 93& of face +$4!65 illion* in the arket! ,otal arket alue

of oth euity : det thus $32!65 illion! ;uity & !8576and et & !1424

isk free rate is 4&# risk preiu7& and -BC<s =!74

eturn on euity per /> ; 4& : +7& !74*9!18&

,a rate is 40&

Current yield on arket det is 11&




3ACC Ill'statio)

?-CC +;@A* ; : +@A* +1',c*

!8576 !0918 : +!1424 !11 !60*

!088126 or 8!81&




0i)al )otes o) 3ACC

!"" should be based on market rates andvaluation' not on book values of debt or equity

Book values may not reflect the current

marketplace !"" will reflect what a firm needs to earn on

a new investment4 But the new investmentshould also reflect a risk level similar to the

firm’s Beta used to calculate the firm’s 524• 3n the case of !B" "o4' the relatively low !"" of

D4D(. reflects !B"’s E#4/<4 ! riskier investmentshould reflect a higher interest rate4




0i)al )otes o) 3ACC

The !"" is not constant

3t changes in accordance with the risk of

the company and with the floatationcosts of new capital




Ma*i)al "ost of "apital a)!i),est%e)t po4e"ts10

140

1#0

100

80

0

40

#0

00

ercent

10 15 1! 503!"6o2nt o' capita/ (9 6i//ions)

11#3%

+0 85 !5

.ar&ina/

cost o'capita/

6c

"

B:

E

;<

=

10++%

1041%

-

-

-

-

-

-

-

-

-



T+e E)! 56

F!03T!G - bogactwo zebrane uprzednio w celu pod)Hcia dalsze) produkc)i $I4 Juesnay' KC333% wszelki wynik procesu produkcy)nego' ktLry przeznaczony )est do pLMnie)szego

wykorzystania w procesie produkcy)nym $9"Fenzzie' *ardelli'(;;(% caNoksztaNt zaangaOowanych w przedsiHbiorstwie wewnHtrznych i

zewnHtrznych' wNasnych i obcych' terminowych i nieterminowych zasobLw$bilans% &T5PFTP5! F!03T!GP proporc)a udziaNu kapitaNu wNasnego i obcego w finansowaniu dziaNalnoQci

przedsiHbiorstwa relac)a wartoQci zadNuOenia dNugoterminowego do kapitaNLw wNasnych

przedsiHbiorstwa

struktura finansowania @ struktura kapitaAu + BobowiBania bieDce ramy statycznego kompromisu' w ktLrym przedsiHbiorstwo ustala docelowRwielkoQS wskaMnika zadNuOenia i stopniowo zbliOa siH do )ego osiRgniHcia4

Documents

Cost of Capital Lecture -Kisk