Topic 5 (2012-13A)MP(1)

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Corporate Financial Policy

Semester A 2012-13City University of Hong Kong

AC4331 Topic 5

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Topic 5

.

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1-2

Introduction to Financial Management

Free Cash Flow

Financial Planning and Forecasting

Financial Assets and Time Value of Money

Risk and Return Bond and Stock Valuation

Cost of Capital Cash Flow Estimation and Risk Analysis

Capital Structure and Leverage

Treasury and Valuation

Enterprise Risk Management Dividends and Share Repurchase

Merger and Acquisitions

Working Capital Management

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Extra Ref:Financial Management, Theory and Practice, 12eEugene and

Brigham

Topic 5:Cost of Capital

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Chapter 11

Sources of Capital

Component Costs

WACC Adjusting for Flotation Costs

Adjusting for Risk

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Long-Term

Capital

Long-Term

Debt

Preferred

Stock

Common

Stock

Retained

Earnings

New Common

Stock

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WACC = wdrd(1 T) + wprp + wcrs

The ws refer to the firms capital structure

weights.The rs refer to the cost of each component.

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Stockholders focus on A-T CFs. Therefore,we should focus on A-T capital costs, i.e. useA-T costs of capital in WACC. Only rd needs

adjustment, because interest is taxdeductible.

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The cost of capital is used primarily to makedecisions that involve raising new capital.So, focus on todays marginal costs (for

WACC).

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Use accounting numbers or market value

(book vs. market weights)? Use actual numbers or target capital

structure?

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rd is the marginal cost of debt capital.

The yield to maturity on outstanding L-Tdebt is often used as a measure of rd.

Why tax-adjust; i.e., why rd(1 T)?

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Remember, the bond pays a semiannualcoupon, so rd = 5.0% x 2 = 10%.

INPUTS

OUTPUTN I/YR PMTV FV30

5

60 10001153.72

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Interest is tax deductible, so

A-T rd = B-T rd(1 T)

= 10%(1 0.40) = 6%

Use nominal rate. Flotation costs are small, so ignore them.

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rp is the marginal cost of preferred stock,

which is the return investors require on afirms preferred stock. Preferred dividends are not tax-deductible,

so no tax adjustments necessary. Just use

nominal rp. Our calculation ignores possible flotation

costs.

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The cost of preferred stock can be solved byusing this formula:

rp = Dp/Pp= $10/$111.10= 9%

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More risky; company not required to paypreferred 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 offirm.

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Preferred stock will often have a lower B-Tyield than the B-T yield on debt. Corporations own most preferred stock, because

70% of preferred dividends are excluded from

corporate taxation.

The A-T yield to an investor, and the A-Tcost to the issuer, are higher on preferredstock than on debt. Consistent with higherrisk of preferred stock.

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rs is the marginal cost of common equity

using retained earnings. The rate of return investors require on

the firms common equity using newequity is re.

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Earnings can be reinvested or paid out asdividends.

Investors could buy other securities, earn a

return. If earnings are retained, there is an

opportunity cost (the return thatstockholders could earn on alternative

investments of equal risk). Investors could buy similar stocks and earn rs.

Firm could repurchase its own stock and earn rs.

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CAPM: rs = rRF + (rM rRF)b

DCF: rs = (D1/P0) + g

Own-Bond-Yield-Plus-Risk-Premium:rs = rd + RP

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The rRF = 7%, RPM= 6%, and the firms beta is1.2.

rs = rRF + (rM rRF)b= 7.0% + (6.0%)1.2 = 14.2%

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D0 = $4.19, P0 = $50, and g = 5.

D1 = D0(1 + g)

= $4.19(1 + 0.05)= $4.3995

rs = (D1/P0) + g

= ($4.3995/$50) + 0.05= 13.8%

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Find the Cost of Common EquityUsing the DCF Approach

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Yes, nonconstant growth stocks are expectedto attain constant growth at some point,generally in 5 to 10 years.

May be complicated to compute.

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rd = 10% and RP = 4.

This RP is not the same as the CAPM RPM.

This method produces a ballpark estimate ofrs, and can serve as a useful check.

rs = rd + RP

rs = 10.0% + 4.0% = 14.0%

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Find rs Using the Own-Bond-Yield-Plus-Risk-Premium Method

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Method Estimate

CAPM 14.2%

DCF 13.8%

rd + RP 14.0%Average 14.0%

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When a company issues new common stockthey also have to pay flotation costs to theunderwriter.

Issuing new common stock may send anegative signal to the capital markets, whichmay depress the stock price.

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15.4%

5.0%$42.50

$4.3995

5.0%0.15)$50(1

)$4.19(1.05

gF)(1P

g)(1Dr

0

0e

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Flotation costs depend on the firms risk andthe type of capital being raised.

Flotation costs are highest for common

equity. However, since most firms issueequity infrequently, the per-project cost isfairly small.

We will frequently ignore flotation costs when

calculating the WACC.

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WACC = wdrd(1 T) + wprp + wcrs= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)= 1.8% + 0.9% + 8.4%= 11.1%

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Market conditions.

The firms capital structure and dividendpolicy.

The firms investment policy. Firms withriskier projects generally have a higherWACC.

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NO! The composite WACC reflects the risk ofan average project undertaken by the firm.Therefore, the WACC only represents thehurdle rate for a typical project withaverage risk.

Different projects have different risks. Theprojects WACC should be adjusted to reflect

the projects risk.

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Q11-1 (part a-f) Q11-4

P11-6

P11-9 P11-13

P11-15

P11-17

P11-18 P11-19

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Topic 5 (2012-13A)MP(1)