Cost of Capital

Presented by:Coteng, Walter

Malapitan, Jhe-annePagulayan, JemaimaValdez, Jenya Dan

What is the “Cost” of Capital?

Cost of Capital - The return the firm’s investors could expect to earn if they invested in securities with comparable degrees of risk.

Capital Structure - The firm’s mix of long term financing and equity financing.

What sources of long-term capital do firms use?

Long-Term Capital

Long-Term Debt

Preferred Stock

Common Stock

Retained Earnings

New Common

Stock

*Calculating the weighted average cost of capital:

WACC = wdrd(1-T) + wprp + wcrs

• The w’s refer to the firm’s capital structure weights.

• The r’s refer to the cost of each component.

Weighted Average Cost of Capital (WACC) - The expected rate of return on a portfolio of all the firm’s securities.

Should our analysis focus on before-tax or after-tax capital costs?• Stockholders focus on A-T

cashflows. Therefore, we should focus on A-T capital costs, i.e. use A-T costs of capital in WACC. Only rd needs adjustment, because interest is tax deductible.

Should our analysis focus on historical costs or new costs?

• The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on today’s marginal costs.

How are the weights determined?

• In estimating WACC, do not use the Book Value of securities.

• In estimating WACC, use the Market Value of the securities.

• Book Values often do not represent the true market value of a firm’s securities.

COST OF DEBT

– Before-Tax cost of Debt

(rd )

- The interest rate a firm must pay on its new debt.

- Yield to maturity (or yield to call if the debt is likely to be called) on their currently outstanding debt.

Principal payment – Price of the bond

Annual interest payment + Number of years to

maturity 0.6 (Price of the bond) + 0.4 (Principal payment)

Yield to Maturity

After –Tax cost of Debt - The relevant cost of

new debt, taking into account the tax deductibility of interest;

- It is used to calculate WACC.

After-Tax Cost of Debt= r d ( 1 – T )

Example:• Assume that a company issues

bond at price of P940 with interest payments of P101.50 for 20 years and a maturity payment of P1,000. What is the Yield to maturity?

Annual interest payment + Number of years to maturity 0.6 (Price of the bond) + 0.4 (Principal payment)

Y' = $101. 50 + 1,000 - 940 20 .6 ($940) + .4 ($1,000) = $101.50 + 60 20 $564 + $400 Y’ = $101.50 + 3 = $104.50 = 10.84% $964 $964

Principal payment – Price of the bond

Example:• L company can borrow at an

interest rate of 10% and its marginal federal-plus-state tax rate is 35%, its after-tax cost of debt will be…

After-tax cost of debt = rd (1-T)

= 10% (1-35%)

= 6.5%

Cost of Preferred Stock, rp

WACC = wdrd(1-T) + wprp + wcrs

• rp is the marginal cost of preferred stock.

• The rate of return investors require on the firm’s preferred stock.

What is the cost of preferred stock?

• The cost of preferred stock can be solved by using this formula:

rp = Dp / Pp

= $10 / $111.10 = 9%

Example

• L Company issued P100 par value preferred stock 12 years ago. The stock provided a 9% yield at the time of issue. The preferred stock is now selling for P72. What is the current yield or cost of the preferred stock?

Solution

rp = Dp/Pp

= ($100 x 9%)/ $72

= 12.5%

Where: rp – cost of preferred stock

Dp – annual dividend

Pp – current price

Component cost of preferred stock

• Preferred dividends are not tax-deductible, so no tax adjustments necessary. Just use rp.

• Nominal rp is used.

Is preferred stock more or less risky to investors than debt?• More risky; company not

required to pay preferred dividend.

• However, firms try to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, (3) preferred stockholders may gain control of firm.

Why is the yield on preferred stock lower than debt?

• Corporations own most preferred stock, because 70% of preferred dividends are nontaxable to corporations.

• Therefore, preferred stock often has a lower B-T yield than the B-T yield on debt.

• The A-T yield to an investor, and the A-T cost to the issuer, are higher on preferred stock than on debt. Consistent with higher risk of preferred stock.

Cost of Equity

WACC = wdrd(1-T) + wprp + wcrs

• rs is the marginal cost of common equity using retained earnings.

• The rate of return investors require on the firm’s common equity using new equity is re.

Cost of Retained Earnings, rs

• Earnings can be reinvested or paid out as dividends.

• Investors could buy other securities, earn a return.

• If earnings are retained, there is an opportunity cost (the return that stockholders could earn on alternative investments of equal risk).

The Capital Asset Pricing Model (CAPM) Approach

rs = rRF + (RPM) bi

= rRF + (rM - rRF) bi

where:

rs - required return on common stock

rRF - risk-free rate of return

bi - beta coefficient

rM - return in the market as measured by an approximate index

Example: CAPM Approach

• If L company’s beta is 1.5, the risk-free rate is 10%, and the average return on the market is 13%, what will be its cost of common equity?

rs= rRF + (rM - rRF) bi

= 10% + (13% - 10%) 1.5

rs = 14.5%

Bond-Yield-plus-Risk-Premium Approach

*risk premium estimate : 3%-5%.

rs= Bond yield + Risk premium

Example:If L’s bonds yield 13%, its cost of equity might be estimated as follows:

rs = 13% + 4%

= 17%

Discounted-Yield-plus-Growth-Rate or

Discounted Cash Flow (DCF) Approach

rs = + gwhere:D1= dividend expected to be paid at the end of the yearP0 = current stock price

g = Constant growth rate in dividends

Example: DCF Approach• L’s stock sells for P23.20, its next

expected dividend is P1.50, and analysis expect its growth rate to be 9.3%. Thus,

rs = + g

= + 9.3%= 6.47% + 9.3%

= 15.77%

Averaging the Alternative Estimates

If management is highly confident of one method, it would probably use that method’s estimate. Otherwise, it might use an average of the three methods.

Solving for the Average:

CAPM: rs = 14.5%

Bond-Yield-plus-Risk-Premium: rs= 17%

DCF: rs = 5.77%

Average = = 15.76%

Why is the cost of retained earnings cheaper than the cost of issuing new common stock?

• When a company issues new common stock they also have to pay flotation costs to the underwriter.

• Issuing new common stock may send a negative signal to the capital markets, which may depress the stock price.

If issuing new common stock incurs a flotation cost of 15% of the proceeds, what is ke?

15.4%

5.0% $42.50$4.3995

5.0% 0.15)-$50(1

)$4.19(1.05

g F)-(1Pg)(1D

k0

0e

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, since most firms issue equity infrequently, the per-project cost is fairly small.

• We will frequently ignore flotation costs when calculating the WACC.

What factors influence a company’s composite WACC?• Market conditions.

- Interest rates- Stock prices- Tax rates

• The firm’s capital structure and dividend policy.

• The firm’s investment policy. Firms with riskier projects generally have a higher WACC.

Should the company use the composite WACC as the hurdle rate for each of its projects?

• NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the “hurdle rate” for a typical project with average risk.

• Different projects have different risks. The project’s WACC should be adjusted to reflect the project’s risk.

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

What are the three types of project risk?

• Stand-alone risk• Corporate risk• Market risk

How is each type of risk used?

• Market risk is theoretically best in most situations.

• However, creditors, customers, suppliers, and employees are more affected by corporate risk.

• Therefore, corporate risk is also relevant.

Problem areas in cost of capital

• Depreciation-generated funds

• Privately owned firms• Measurement problems• Adjusting costs of capital for

different risk• Capital structure weights

How are risk-adjusted costs of capital determined for

specific projects or divisions?

• Subjective adjustments to the firm’s composite WACC.

• Attempt to estimate what the cost of capital would be if the project/division were a stand-alone firm. This requires estimating the project’s beta.

Finding a divisional cost of capital:Using similar stand-alone firms to estimate a project’s cost of capital

• Comparison firms have the following characteristics:–Target capital structure consists

of 40% debt and 60% equity.– rd = 12%– rRF = 7%–RPM = 6%–βDIV = 1.7–Tax rate = 40%

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 if their returns exceed 13.2%.