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Copyright 2011 Pearson Prentice Hall. All rights reserved.

The Cost ofCapital

Chapter 14

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Copyright 2011 Pearson Prentice Hall. All rights reserved.14-2

Slide Contents

Learning Objectives

Principles Used in This Chapter

1. The Cost of Capital: An Overview

2. Determining the Firms Capital StructureWeights

3. Estimating the Costs of Individual Sources ofCapital

4. Summing Up Calculating the Firms WACC

5. Estimating Project Cost of Capital

6. Floatation costs and Project NPV

Key Terms

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Learning Objectives

1. Understand the concepts underlying thefirms overall cost of capital and thepurpose of its calculation.

2. Evaluate a firms capital structure, anddetermine the relative importance(weight) of each source of financing.

3. Calculate the after-tax cost of debt,preferred stock, and common equity.

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Copyright 2011 Pearson Prentice Hall. All rights reserved. 14-4

Learning Objectives (cont.)

4. Calculate a firms weighted averagecost of capital

5. Discuss the pros and cons of using

multiple, risk-adjusted discount rates.Describe the divisional cost of capitalas a viable alternative for firms withmultiple divisions.

6. Adjust NPV for the costs of issuing newsecurities when analyzing newinvestment opportunities.

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Principles Used in This Chapter

Principle #1: Money Has a Time Value.

Principle #3: Cash Flows Are the Source ofValue.

Estimates of investors required rate of returnextracted from observed market prices arebased on principles #1 and #3.

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Principles Used in This Chapter(cont.)

Principle #2: There Is a Risk-ReturnTradeoff.

Investors who purchase a firms common stockrequire a higher expected return than investorswho loan money.

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14.1 The Costof Capital:An Overview

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The Cost of Capital: An Overview

Cost of capital is the weighted average ofthe required returns of the securities thatare used to finance the firm. We refer to

this as the firms Weighted Average Costof Capital, or WACC.

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The Cost of Capital: An Overview(cont.)

Most firms raise capital with a combinationof debt, equity, and hybrid securities.

WACC incorporates the required rates ofreturn of the firms lenders and investorsand the particular mix of financing sourcesthat the firm uses.

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How does riskiness of firm affect WACC?

Required rate of return on securities will be

higher if the firm is riskier.

Risk will influence how the firm chooses tofinance i.e. proportion of debt and equity.

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WACC is useful in a number of settings:

WACC is used to value the firm.

WACC is used as a starting point for

determining the discount rate for investmentprojects the firm might undertake.

WACC is the appropriate rate to use whenevaluating performance, specifically whether

or not the firm has created value for itsshareholders.

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WACC equation

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Three Step Procedure for EstimatingFirm WACC

1. Define the firms capital structure bydetermining the weight of each source ofcapital. (see column 2, figure 14-2)

2. Estimate the opportunity cost of eachsource of financing. We will use thecurrent market value of each source ofcapital based on its current, not historical,

costs. (see column 3, figure 14-2)

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Three Step Procedure for EstimatingFirm WACC (cont.)

3. Calculate a weighted average of the costsof each source of financing. (see column4, figure 14-2)

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14.2 Determiningthe Firms CapitalStructure Weights

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Determining the Firms CapitalStructure Weights

The weights are based on the followingsources of capital: debt (short-term andlong-term), preferred stock and common

equity.

Liabilities such as accounts payable andaccrued expenses are not included incapital structure.

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Determining the Firms CapitalStructure Weights (cont.)

Ideally, the weights should be based onobserved market values. However, not allmarket values may be readily available.

Hence, we generally use book values fordebt and market values for equity.

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Checkpoint 14.1

Calculating the WACC for Templeton Extended CareFacilities, Inc.In the spring of 2010, Templeton was considering the acquisition of a chain ofextended care facilities and wanted to estimate its own WACC as a guide tothe cost of capital for the acquisition. Templetons capital structure consists ofthe following:

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Checkpoint 14.1

Calculating the WACC for Templeton Extended CareFacilities, Inc. (Cont.)Templeton contacted the firms investment banker to get estimates of thefirms current cost of financing and was told that if the firm were to borrowthe same amount of money today, it would have to pay lenders 8%;however, given the firms 25% tax rate, the after-tax cost of borrowing wouldonly be 6% 8%(1.25). Preferred stockholders currently demand a 10% rateof return, and common stockholders demand 15%. Templetons CFO knewthat the WACC would be somewhere between 6% and 15% since the firmscapital structure is a blend of the three sources of capital whose costs arebounded by this range.

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Checkpoint 14.1

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Checkpoint 14.1

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Checkpoint 14.1

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Checkpoint 14.1:Check Yourself

After completing her estimate of Templetons WACC, the CFOdecided to explore the possibility of adding more low-costdebt to the capital structure. With the help of the firmsinvestment banker, the CFO learned that Templeton couldprobably push its use of debt to 37.5% of the firms capitalstructure by issuing more debt and retiring (purchasing) thefirms preferred shares. This could be done withoutincreasing the firms costs of borrowing or the required rateof return demanded by the firms common stockholders.What is your estimate of the WACC for Templeton under thisnew capital structure proposal?

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Step 1: Picture the Problem

0%

2%

4%

6%

8%

10%

12%

14%

16%

Debt Prefered Stock Common Stock

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Step 1: Picture the Problem (cont.)

37.5%Debt

62.5%,Common stock

Capital Structure Weights

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Step 2: Decide on a SolutionStrategy

We need to determine the WACC basedon the given information:

Weight of debt = 37.5%; Cost of debt = 6%

Weight of common stock = 62.5%; Cost ofcommon stock =15%

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Step 2: Decide on a SolutionStrategy (cont.)

We can compute the WACC based on thefollowing equation:

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Step 3: Solve

The WACC is equal to 11.625% ascalculated below.

Weights Cost Product

Debt 0.375 0.06 0.0225

Common Stock 0.625 0.15 0.09375

Preferred Stock 0 0.1 0

1 WACC 0.11625

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Step 4: Analyze

We observe that as Templeton chose toincrease the level of debt to 37.5% andretire the preferred stock, the WACC

decreased marginally from 12.125% to11.625%.

Thus altering the weights will change theWACC.

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14.3 Estimatingthe Cost of

IndividualSources of Capital

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The Cost of Debt

The cost of debt is the rate of return thefirms lenders demand when they loanmoney to the firm.

Note, the rate of return is not the same ascoupon rate, which is the rate contractuallyset at the time of issue.

We can estimate the markets required rate

of return by examining the yield tomaturity on the firms debt.

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The Cost of Debt (cont.)

After-tax cost of debt = Yield (1-tax rate)

Example 14.1 What will be the yield to

maturity on a debt that has par value of$1,000, a coupon interest rate of 5%,time to maturity of 10 years and iscurrently trading at $900? What will be thecost of debt if the tax rate is 30%?

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Enter:

N = 10; PV = -900; PMT = 50; FV =1000

I/Y = 6.38%

After-tax cost of Debt = Yield (1-tax rate)

= 6.38 (1-.3)

= 4.47%

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It is not easy to find the market price of aspecific bond as most bonds do not tradein the public market.

Because of this, it is a standard practice toestimate the cost of debt using yield tomaturity on a portfolio of bonds withsimilar credit rating and maturityas the

firms outstanding debt.

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The Cost of Preferred Equity

The cost of preferred equity is the rate ofreturn investors require of the firm whenthey purchase its preferred stock. The

cost is not adjusted for taxes sincedividends are paid to preferredstockholders out of after-tax income.

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The Cost of Preferred Equity (cont.)

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Example 14.2 Consider the preferredshares of Relay Company that are tradingat $25 per share. What will be the cost of

preferred equity if these stocks have a parvalue of $35 and pay annual dividend of4%?

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kps = $1.40 $25 = .056 or 5.6%

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The Cost of Common Equity

The cost of common equity is the rate ofreturn investors expect to receive frominvesting in firms stock. This return comes

in the form of cash distributions ofdividends and cash proceeds from the saleof the stock.

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The Cost of Common Equity (cont.)

Cost of common equity is harder toestimate since common stockholders donot have a contractually defined return

(similar to interest on bonds or dividendson preferred stock). There are twoapproaches to estimating the cost ofcommon equity:

Dividend growth model (introduced in chapter10)

CAPM (introduced in chapter 8)

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The Dividend Growth Model Discounted Cash Flow Approach

Using this approach, we estimate theexpected stream of dividends as thesource of future estimated cash flows.

We use the estimated dividends andcurrent stock price to calculate the internalrate of return on the stock investment.This return is used as an estimate of cost

of equity.

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Checkpoint 14.2

Estimating the Cost of Common Equity for Pearson plcUsing the Dividend Growth Model

Pearson plc (PSO) is an international media company thatoperates three business groups: Pearson Education, theFinancial Times, and Penguin. In the spring of 2009, PearsonsCFO called for an update of the firms cost of capital. The firstphase of the estimation focused on the firms cost of commonequity. How would the CFO determine the cost of thecompanys equity, using the dividend growth model?

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Checkpoint 14.2

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Checkpoint 14.2

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Prepare two additional estimates ofPearsons cost of common equity using thedividend growth model where you usegrowth rates in dividends that are 25%lower than the estimated 6.25% (i.e., for gequal to 5% and 7.81%)

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We are given the following:

Price of common stock (Pcs ) = $10.09

Growth rate of dividends (g) = 5% and 7.81% Dividend (D0) = $0.47 per share

Cost of equity is given by dividend yield +

growth rate.

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Dividend Yield=D1 P0GrowthRate (g) Cost ofEquity (kcs )

St 2 D id S l ti

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We can determine the cost of equity usingequation 14-3a

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Step 3: Solve

At growth rate of 5%

kcs = {$0.47(1.05)/$10.09} + .05

= .0989 or 9.89%

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Step 3: Solve (cont.)

At growth rate of 7.81%

kcs = {$0.47(1.0781)/$10.09} + .0781

= .1283 or 12.83 %

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Step 4: Analyze

Pearsons cost of equity is estimated at9.89% and 12.83% based on the differentassumptions for growth rate.

Thus growth rate is an important variablein determining the cost of equity.However, estimating the growth rate is not

easy.

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Estimating the Rate of Growth, g

The growth rate can be obtained fromvarious websites that post analystsforecasts of growth rates.

We can also estimate the growth rateusing the historical data and computingthe arithmetic average or geometric

average.

Estimating the Rate of Growth g

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Estimating the Rate of Growth, g(cont.)

Pros and Cons of the Dividend

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Pros and Cons of the DividendGrowth Model Approach

While dividend growth model is easy touse, it is severely dependent upon thequality of growth rate estimates.

Furthermore, not all firms pay dividends.

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The Capital Asset Pricing Model

CAPM was used in chapter 8 to determinethe expected or required rate of return forrisky investments.

The Capital Asset Pricing Model

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The Capital Asset Pricing Model(cont.)

Equation 14-4 illustrates that the expectedreturn on common stock is determined bythree key ingredients:

The risk-free rate of interest, The beta or systematic risk of the common

stock returns, and

The market risk premium.

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Advantages of the CAPM approach

1. The model is simple to understand anduse.

2. The model does not depend on dividendsor growth rate so it can be applied tocompanies that do not currently paydividends or are not expected to

experience a constant rate of growth individends.

Disadvantages of the CAPM

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Disadvantages of the CAPMApproach

1. CAPM does not offer any guidance on theappropriate choice for the risk-free rate.Risk-free rate may vary widely dependingon the Treasury security chosen.

2. Estimates ofbeta can vary widelydepending upon the market index andtime period chosen.

3. Estimates ofmarket risk premium will alsovary depending on the time period andsecurity chosen.

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Checkpoint 14.3

Estimating the Cost of Common Equity for Pearson plcusing the CAPM

A review of current market conditions at the end of March 2009reveals that the 10-year U.S. Treasury Bond yield that we willuse to measure the risk-free rate was 2.81%, the estimated

market risk premium is 6.5%, and the beta for Pearsonscommon stock is 1.20.

Determine Pearsons cost of common equity using the CAPM, asof March 2009.

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Checkpoint 14.3

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Checkpoint 14.3

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Prepare two additional estimates of Pearsons costof common equity using the CAPM where you usethe most extreme values of each of the threefactors that drive the CAPM.

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CAPM describes the relationship betweenthe expected rates of return on riskyassets in terms of their systematic risk. Its

value depends on: The risk-free rate of interest,

The beta or systematic risk of the commonstock returns, and

The market risk premium.

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However, there can be wide variation inthe estimates for each one of thesevariables.

Here we are given the following estimates: The risk-free rate of interest (.03% or 3.73%)

The beta or systematic risk of the commonstock returns (1 or 1.5)

The market risk premium (4% or 8%)

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The cost of equity can be estimated usingthe CAPM equation:

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The cost of equity is given by Risk-free rate +(Risk premium Beta) :

Risk-FreeRate Risk PremiumBeta

Cost ofEquity

Step 2: Decide on a Solution

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Since we have been given the estimatesfor market factors (risk-free rate and riskpremium) and firm-specific factor (beta),

we can determine the cost of equity usingCAPM.

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Step 3: Solve

kcs = 0.03 + 1(4) = 4.03%

kcs = 3.73 + 1.5(8) = 15.73%

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Step 4: Analyze

Pearsons cost of equity is shown to besensitive to the estimates used for risk-free rate of interest, beta and market riskpremium.

Based on the estimates used, the cost ofcommon equity ranges from 4.03% to

15.73%.

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14.4 SummingUp Calculating

the Firms WACC

Summing Up Calculating the

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Summing Up Calculating theFirms WACC

The final step is to calculate the firmsoverall cost of capital by taking theweighted average of the firms financingmix that we evaluated in Steps One andTwo.

Summing Up Calculating the

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Summing Up Calculating theFirms WACC (cont.)

When estimating the firms WACC,following issues should be kept in mind:

Determine weights based on market valuerather than book value.

Use market based opportunity costs ratherthan historical rates (such as coupon rates).

Use forward looking weights and opportunitycosts.

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14.5 EstimatingProject Cost of

Capital

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Estimating Project Cost of Capital

Should the firms WACC be used toevaluate all new investments?

In theory, it is appropriate only if the risk ofthe new project is equal to the overall risk ofthe firm. This may generally not be the casenecessitating the need for a unique cost ofcapital for each project.

Estimating Project Cost of Capital

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Estimating Project Cost of Capital(cont.)

However, a recent survey found that morethan 50% of the firms tend to use single,company-wide discount rate to evaluate allof their investment proposals.

There are advantages and costs associatedwith estimating a unique discount rate for

each project.

The Rationale for Using Multiple

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e at o a e o Us g u t p eDiscount Rates

Multiple discount rates is consistent withfinance theory that suggests that uniquediscount rate will reflect the unique risk ofthe investment.

Figure 14-6 illustrates the problems thatarise when a single discount rate is used to

evaluate investment projects with differentlevels of risk.

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Why Dont Firms Typically Use

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y yp yProject Cost of Capital?

1. It may be difficult to trace the source offinancing for individual project since mostfirms raise money in bulk for all theprojects.

2. It adds to the time and cost in gettingapproval for new projects.

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Estimating Divisional WACCs

If a firm undertakes investment with verydifferent risk characteristics, it will try toestimate divisional WACCs.

The divisions are generally defined bygeographical regions (e.g., Asian regionversus European region) or industry.

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Estimating Divisional WACCs (cont.)

Advantages of a divisional WACC: The discount rate reflects the risk of projects

evaluated by different divisions.

It requires estimating only one cost of capitalestimate for the entire division (rather thanone for each project).

It limits managerial latitude and the attendantinfluence costs.

Using Pure Play Firms to Estimate

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g yDivisional WACCs

Here a firm with multiple divisions mayidentify a comparable firm with only onedivision (called a pure play firm).

The estimate of pure play firms cost ofcapital can then be used as a proxy forthat particular divisions cost of capital.

Divisional WACC Estimation Issues

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and Limitations

While divisional WACC is an improvementover a single, company-wide WACC, it hasa number of limitations:

1. The sample of firms in a given industry mayinclude firms that are not good matches forthe firm or one of its divisions.

2. The division being analyzed may not have acapital structure that is similar to the sample

of firms in the industry data.

Divisional WACC Estimation Issues

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and Limitations (cont.)

3. The firms in the chosen industry that areused to proxy for divisional risk may not begood reflections of project risk.

4. Good comparison firms for a particular

division may be difficult to find.

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14.6 FloatationCosts and Project

NPV

WACC, Floatation Costs and Project

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14-91

NPV

Floatation costs are costs incurred by afirm when it raises money to finance newinvestments by selling bonds and stocks.

For example, these costs may include feespaid to an investment banker, and costsincurred when securities are sold at a

discount to the current market price.


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14-92

NPV (cont.)

Because of floatation costs, the firm willhave to raise more than the amount itneeds.


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14-93

NPV (cont.)

Example 14.3 If a firm needs $100 millionto finance its new project and thefloatation cost is expected to be 5.5%,how much should the firm raise by sellingsecurities?


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14-94

NPV (cont.)

= $100 million (1-.055) = $105.82 million

Thus the firm will raise $105.82 million,which includes floatation cost of $5.82million.

Ch k i t 14 4

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14-95

Checkpoint 14.4

Incorporating Flotation Costs into theCalculation of NPVThe Tricon Telecom Company is considering a $100 millioninvestment that would allow it to develop fiber optic high-speedInternet connectivity to its 2 million subscribers. The investment willbe financed using the firms desired mix of debt and equity with 40%

debt financing and 60% common equity financing. The firmsinvestment banker advised the firms CFO that the issue costsassociated with debt would be 2% while the equity issue costs wouldbe 10%.

Tricon uses a 10% cost of capital to evaluate its telecom investmentsand has estimated that the new fiber optic project will yield futurecash flows valued at $115 million. However, to this point noconsideration has been given to the effect of the costs of raising thefinancing for the project or flotation costs. Should the firm go forwardwith the investment in light of the flotation costs?

Ch k i t 14 4

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14-96

Checkpoint 14.4

Ch k i t 14 4

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14-97

Checkpoint 14.4

Checkpoint 14 4

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14-98

Checkpoint 14.4

Checkpoint 14 4: Check Yourself

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14-99


Before Tricon could finalize the financingfor the new project, stock marketconditions changed such that new stockbecame more expensive to issue. In fact,

floatation costs rose to 15% of newequity issued and the cost of debt rose to3%. Is the project still viable (assumingthe present value of future cash flows

remain unchanged)?

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14-100


The NPV will be equal to the present valueof the future cash flows less the initialoutlay and floatation costs.

NPV

= PV(inflows) Initial outlay Floatation costs

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14-101


NPV

PV of Cash INflows

Initial Outlay

Floatation costs

Step 2: Decide on a Solution

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14-102

Strategy

We need to first estimate the averagefloatation costs that Tricon will incur whenraising the funds. This can be done usingequation 14-5.

Step 2: Decide on a SolutionS ( )

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14-103

Strategy (cont.)

Next, the grossed-up investment outlaycan be estimated using equation 14-6 andsubtracted from the present value of theexpected future cash flows to determinewhether the project has a positive NPV.

St 3 S l

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14-104

Step 3: Solve

We can use equation 14-5 to estimate theweighted average floatation cost asfollows:

= .40 .03 + .60 .15 = .102 or 10.2%

St 3 S l ( t )

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14-105


The grossed up initial outlay for $100 millionproject can be estimated using equation 14-6:

= $100 million (1- 0.102) =$111.36 million

Thus, floatation costs is equal to $11.36 million.

St 3 S l ( t )

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14-106


NPV = $115 million - $111.36 million= $3.64 million

St 4 A l

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14-107

Step 4: Analyze

The project is feasible even afterconsideration of higher floatation costs asthe NPV is positive at $3.64 million.

However, the problem illustrates thatfloatation costs can be significant andcannot be ignored while evaluating

projects.

K T

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Key Terms

Cost of capital Cost of debt

Cost of preferred equity

Cost of common equity Divisional WACC

Floatation costs

Weighted Average Cost of Capital

Documents

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