Unformatted text preview: FINC 202 (2009) LECTURE 01:
Weighted Average Cost of Capital Alias “Cost of Capital” You have met this before Therefore we will look at specific aspects of it 1 Cost of capital is weighted average cost of ost longterm finance: Ignore in longterm
FINC202 New Convertible Debt New Preference shares WACC = wd rd ( 1 − tC ) + wcd rcd ( 1 − tC ) + wp rp + wS rS 2 spontaneous liabilities (L*) excluded from WACC because it: represents Free Capital No interest payable unless overdue! And is not under management’s control And L* is used in the funding of Current Assets But not in funding Longterm assets
3 WACC a key concept in corporate finance WACC a key concept in corporate finance
Investments must generate return > WACC Why? If NOT, then firm has negative future cashflows How? Profitability maximised when WACC minimised Maximise rate of return [Project IRRs minus WACC] Relation to Objective Function Shareprice maximised when WACC minimised Future v Past? Forward looking = FUTURE projects
4 Assumptions (We later relax all of these!): Assumptions Constant business risk Firm’s new projects similar to firm’s old projects No change in nature of activity No change in business risk Constant financial risk Existing capital structure will be kept No change in debt as % of TA Constant dividend payout ratio Implies CONSTANT, predictable ΔRE 5 Factors influencing firm’s WACC:
Three closely related factors General economic & market conditions Movements in Aggregate Demand Are the projected IRRs going to eventuate? More projects ⇒ more funds needed ⇒ WACC ⇑ Changes in availability of credit The level of market interest rates. 6 Firm’s operating & financing decisions How much new investment is sensible? How risky is the new investment going to be? What are the choices in the market for funding it? Amount of financing required: The MORE raised ⇒ the RISKIER ⇒ r ⇑ d and rS ⇑ 7 Components of WACC Components
Basic approach: WACC = rRF + various risk premia rDebt = r* + IP + LP + DRP + MRP rEquity = rRF + β(rM – rRF) (rM – rRF)=“RP” Four (or five!) component costs: rd(1tC) rS rE rp rcd 8 Component costs must be: Component costs must be Computed on aftertax basis Tax shield effect Interest is tax deductible Hence % Cost of Debt < % Interest Adjusted for flotation costs Some experts say YES! Some say NO! If yes, then… • NP = Net proceeds after flotation costs Reflect marginal costs of new funds These new funds might be ΔRE ΔDebt Δ Ordinary Equity Underlying mechanism is: ⇑ Risk ⇒ MCC ⇑ 9 The Net Proceeds Approach to the Cost of Debt and The the Cost of Equity etc the
We have a choice as to how to deal with the fact that issuing debt and issuing equity is costly.
1. EITHER calculate rd and rE from Net Proceeds raised
= Total debt raised minus flotation costs Cost of bond prospectus Merchant bankers’ fees = Total new equity raised, minus flotation costs Cost of share prospectus Merchant bankers’ fees We will use this method first 2. OR treat flotation costs as a separate calculation And add them onto a project’s outlay cash flow In which case …
• • rd = a bond’s YTM rS = rRF + β (rM – rRF)
10 Cost of Debt rDebt(1tC) (Net Proceeds Approach) (Net Pretax costof debt is computed by solving bond valuation equation NP = I × PVIFArd ,t + M × PVIFrd ,t Net Proceeds (from the firm’s viewpoint) NOTE: See Excel Example in next slide Aftertax cost of debt reduced by tax deductibility of interest rd ( 1 − tC ) 11 Cost of Debt Example: Fiveyear semiannual bond with a 10% (nominal) coupon and a 10% (nominal) YTM Note: YTM @ 10% is the YTM for investors who buy at the price, P0. Coupon YTMPER nper FV Therefore P0 = $50 0.05 10 $1,000 $1,000 3% =YTM for investors This is 10% (periodic) (nominal) Investors pay this much for a bond i.e, 0.03 Let Flotation cost be P0(1F) =
kD = IRR of: $970 Company gets only this much after issuance costs
0 1 2 3 4 5 6 7 8 9 10 $970 50 50 50 50 50 50 50 50 50 1050 5.40% 10.79% Rd= IRR of: YTM from Company's point of view = IRR = =kD This is greater than: = rd (nominal) periodic nominal YTM from Investors' point of view = 5.00% 10.00% periodic nominal 12 Problem 1 If the interest rate is 9%, what is the after tax cost of debt when the tax rate is: 20% 30% 40% If the YTM on a bond is 11% to investors and 12% (after flotation costs) for the issuing firm, and the tax rate is 33 cents in the dollar, what is the after tax cost of debt to the issuing company? Should this rd(1tC) be used as the discount rate to the bond? If so why? If not, why not? 13 Solution 1 9 % × (1 0.2) = 7.2 % 9 % × (1 0.3) = 6.3 % 9 % × (1 0.4) = 5.4 % 12% × (1 0.33) = 8.04%
No, the 12% YTM was determined by the price paid to the issuer by the investor (the amount lent) with flotation costs subtracted. The 8.04% figure is for use by the issuer firm in its WACC calculation. 14 Cost of Preference Shares (rpref)
Perpetual preference shares rPref computed from perpetuity formula rPref DPREF = NP DPREF = P0 ( 1 − F % ) Redeemable preference shares (fixed term) rPref computed from bond valuation equation NP = DPREF × PVIFArPref ,t + M × PVIFrPref ,t 15 Tax adjustment not required Tax adjustment not required rPref should exceed rd(1tC) No tax adjustment as preference dividends are not tax deductible Pref Shares are lower ranked than DEBT if firm is dissolved Nature of Preference dividends Legally equity but is de facto debt May cause problems if not paid 16 Unpaid Preference Dividends
No ordinary dividend can be issued The unpaid preference dividend may be accumulated Nonpayment may give holders right to appoint representatives to the Board of Directors Nonpayment may make raising of further new funds difficult 17 To be paid before ordinary dividend. Problem 2 A firm wishes to issue 1 million perpetual preference shares at $2 per share. The shares will have a 20 cent dividend paid annually. The flotation cost of the issue is 5 percent of the gross amount raised. What is the cost of this preference share capital? 18 Solution 2 $0.2 = 0.10526315 $2(1 − 0.05) ≈ 10.53% 19 Cost of Equity (RE & New Issues)
Cost of Retained Earnings Three lines of reasoning for a cost ascribed to retained earnings Could be paid out as a dividend to shareholders OR left in firm as funding Shareholders could use dividend cash to buy other financial securities And earn a return on these Therefore shareholders have an opportunity cost if cash becomes RE 20 ...
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 Spring '09
 WarwickAnderson
 Weighted average cost of capital, preference shares, flotation costs

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