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Unformatted text preview: FINC 202 2009 Lecture 02: WACC (2) 1 In this lecture we will cover: The cost of Retained Earnings and New Debt Weights Breakpoints and Marginal cost of capital 2 Cost of retained Earnings rEquity (RE) rS reflects opportunity cost of • Not selling their shares to get their money out for reinvestment elsewhere Or at least not getting the RE out to reinvest Adjustments not required for • (a) Tax as there is no tax shield. Dividends are paid from NPAT EBT is taxed irrespective of choice between Dividends and RE • (b) Flotation costs. RE is cumulated from ____________________ 3 Dividend Valuation Model D1 rS = +g P0
Capital Asset Pricing Model rS = rRF + β ( rM − rRF )
Risk Premium Approach rS = rd + suitable Risk Premium
4 Growth Rate: The “g” variable Suppose the company has been earning 15% on equity Suppose (ROE = 15%) (ROE and retaining 35% (dividend payout = 65%), and and this situation is expected to continue. What’s the expected future g? g? Growth rate:
g = (1 – Payout)(ROE) = = Here (1 – Payout) = Fraction retained. Here Close to g = 5% given earlier. Close
Task: Task: Think of a bank with a ROE of 10% with dividend payout to you = 100% or 0% or 50%. What’s g? What’s Solution 1 (“g” problem)
Interest income to the bank is 10% If the bank pays out 0%, the growth rate will be: _________________________________ If the bank pays out 100%, then the growth rate will be: _________________________________ If the bank pays out 50%, then the growth rate will be _________________________________ 7 Could Discounted Dividend Model or Could DCF methodology be applied if g is not constant? constant? YES, nonconstant g stocks are expected to have constant g at some point, generally in 5 to 10 years. But _______________________. Cost of new equity
rE computed using adjusted Dividend Valuation Model D1 rE = +g ; NP NP = P0 ( 1 − F % ) Adjustments for tax effects? • No. There is ______________________________________ 9 rE exceeds rS Why? • Cost of flotation of new shares ⇒ NP < P0 Smaller denominator (NP) ⇒ larger ratio for rE D1 D1 > P0 ( 1 − F % ) P0 NPAT N ⇑⇒ ⇓ ie, EPS ⇓ ⇒P ⇓ 0 N 10 • New issues also usually depress the share price Problem 2 The cost of a new issue was 3 percent of the issue price per share The issue price per share is $10.80 The constant dividend growth rate is 10% The next dividend is expected to be 20 cents. Find the cost of the new equity capital, rE 11 Solution 2 12 Component Weights components can be • actual weights based on historical data • target weights based on ____________________________ target weights preferred to actual weights
• Changes in economic environment: Credit squeeze ⇒ rd ⇑ & cost of distress ⇑ Firm would want less debt, more equity
13 Book weights versus Market weights Book weights • Easy to compute, • But based on Historical Cost
Becomes __________________________________________ Market weights
• • More realistic But subject to change as Market Value of equity changes MVEQUITY = P0 x N MVDEBT = Present Value of Bonds etc 14 Computing WACC
Assume that firm has no convertible debt.
• (But we can add in a term it if it comes up.) If new equity NOT required WACC = wd rd ( 1 − tC ) + wP rP + wS rS
If new equity required WACC = wd rd ( 1 − tC ) + wP rP + wS rE 15 Problem 3 Yolanda Skateboards Ltd has sources of funds with the following market values:
Total Debt Preference Shares Ordinary Equity 6,000,000 3,000,000 3,000,000 The pretax cost of debt 8% The cost of preference capital 8% The cost of ordinary equity 10% The tax rate is 40% Find Yolanda’s WACC 16 Solution 3 17 Marginal Cost of Capital Marginal MCC is: The current top step in WACC MCC rises in steps because: • lenders/investors require higher risk premiums for increases in amounts they lend • Retained earnings get exhausted A breakpoint occurs when ___________________ Example: breakpoint with shift from RE to new equity: The formula is: NPAT ( 1 − d ) BPRE = wEQUITY
18 Problem 3 Yolanda Skateboards forecasts the following information for next year: NPAT = $4 m Dividend payout ratio = 40% Cost of equity capital rE (RE) = 10% Weighting of equity = 25% What is the maximum dollar value of investments Yolanda can make with funds sourced from RE before it has to raise new equity? 19 Insert Solution to Problem 3 here 20 Equity Breakpoint What can we tell about our WACC from Yolanda’s equity breakpoint? Above $9.6 million of investment funding required, the cost of equity goes up. • Shifts from rS to rE • We shift to a ________________________________.
MCC2 MCC1 WACC % $m $9.6m 21 Equity Breakpoint How many breakpoints for Equity? Only one: Because Retained earnings gets exhausted only once in project assessment horizon Only one issue of new shares with issue size tailored to _____________________________________ 22 Other Breakpoints Breakpoint for Preference Equity? Yes/No
• Because existing ‘prefs’ in balance sheet already funding past projects, not future ones • we fund future projects with one preferred stock issue for ____________________________ 23 Other Breakpoints Breakpoints for Debt • New breakpoint for each increase in cost of debt. This is related to how much is borrowed in what packages. Three Breakpoint Example for Yolanda Skateboards: (Bond issues of $10m, $12m, $8m) 1. Can borrow $10m at 8% 2. Can borrow a further $12m at 8.5% 3. Can borrow a further $8 m at 9% 4. Above that all new borrowing is 9.5% 24 Example of Debt Breakpoints How to calculate Debt Breakpoints: BPDEBT $m borrowable at r % = wd Let Yolanda Skateboard Ltd’s wd = 50% BPDEBT 1: $10m/0.5 = _________________ BPDEBT 2: $20m from above + $12m/0.5 = ________ BPDEBT 3: $44m from above + $8m/0.5 = _________ 25 Diagram putting all the breakpoint information Diagram together together WACC %
MCC4 MCC3 MCC2 MCC1 MCC5 9.6 20 44 60 Funds $m
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- Spring '09