Unformatted text preview: Cost of Capital Cost Chapter Outline Chapter The Cost of Capital: Some Preliminaries The Cost of Equity The Costs of Debt and Preferred Stock The Weighted Average Cost of Capital Divisional and Project Costs of Capital Flotation Costs and the Weighted Average Cost Flotation of Capital of We know that the return earned on assets We depends on the risk of those assets depends The return to an investor is the same as the The cost to the company cost Our cost of capital provides us with an Our indication of how the market views the risk of our assets our Knowing our cost of capital can also help us Knowing determine our required return for capital budgeting projects budgeting Why Cost of Capital Is Important Important Required Return Required The required return is the same as the The appropriate discount rate and is based on the risk of the cash flows risk We need to know the required return for an We investment before we can compute the NPV and make a decision about whether or not to take the investment investment We need to earn at least the required return to We compensate our investors for the financing they have provided have Cost of Equity Cost The cost of equity is the return required by The equity investors given the risk of the cash flows from the firm from There are two major methods for determining There the cost of equity the Dividend growth model SML or CAPM The Dividend Growth Model Approach Approach Start with the dividend growth model Start formula and rearrange to solve for RE formula D1 P= 0 RE − g D1 RE = +g P 0 Suppose that your company is expected to pay Suppose a dividend of $1.50 per share next year. There has been a steady growth in dividends of 5.1% per year and the market expects that to continue. The current price is $25. What is the cost of equity? cost Dividend Growth Model Example Example 1.50 RE = + .051 = .111 = 11.1% 25 Example: Estimating the Dividend Growth Rate Dividend One method for estimating the growth rate is to One use the historical average use Year 2002 2003 2004 2005 2006 Dividend 1.23 1.30 1.36 1.43 1.50 Percent Change  (1.30 – 1.23) / 1.23 = 5.7% (1.36 – 1.30) / 1.30 = 4.6% (1.43 – 1.36) / 1.36 = 5.1% (1.50 – 1.43) / 1.43 = 4.9% Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1% Advantages and Disadvantages of Dividend Growth Model of Advantage – easy to understand and use Disadvantages Only applicable to companies currently paying Only dividends dividends Not applicable if dividends aren’t growing at a Not reasonably constant rate reasonably Extremely sensitive to the estimated growth rate – Extremely an increase in g of 1% increases the cost of equity by 1% by Does not explicitly consider risk The SML Approach The Use the following information to Use compute our cost of equity compute Riskfree rate, Rf Market risk premium, E(RM) – Rf Systematic risk of asset, β Systematic RE = R f + β E ( E ( RM ) − R f ) Example  SML Example Suppose your company has an equity beta Suppose of .58 and the current riskfree rate is 6.1%. If the expected market risk premium is 8.6%, what is your cost of equity capital? what RE = 6.1 + .58(8.6) = 11.1% Since we came up with similar numbers using Since both the dividend growth model and the SML approach, we should feel pretty good about our estimate estimate Advantages and Disadvantages of SML of Advantages Explicitly adjusts for systematic risk Applicable to all companies, as long as we can Applicable estimate beta estimate Have to estimate the expected market risk premium, Have expected which does vary over time which Have to estimate beta, which also varies over time We are using the past to predict the future, which is We not always reliable not Disadvantages Example – Cost of Equity Example Suppose our company has a beta of 1.5. The market Suppose risk premium is expected to be 9% and the current riskrisk free rate is 6%. We have used analysts’ estimates to free determine that the market believes our dividends will grow at 6% per year and our last dividend was $2. Our stock is currently selling for $15.65. What is our cost of equity? equity? Using SML: RE = 6% + 1.5(9%) = 19.5% Using DGM: RE = [2(1.06) / 15.65] + .06 = 19.55% 19.55%
Since the two models are reasonably close, we can assume Since that our cost of equity is probably around 19.5% that Cost of Debt Cost The cost of debt is the required return on our The company’s debt company’s We usually focus on the cost of longterm debt or We bonds bonds The required return is best estimated by computing the The yieldtomaturity on the existing debt yieldtomaturity We may also use estimates of current rates based on We the bond rating we expect when we issue new debt the The cost of debt is NOT the coupon rate coupon rate was the cost of debt for the company when the coupon bond was issued bond we’re interested in the rate we would have to pay on newly we’re issued debt, which could be very different from past rates. issued Example: Cost of Debt Example: Suppose we have a bond issue currently Suppose outstanding that has 25 years left to maturity. The coupon rate is 9% and coupons are paid semiannually. The bond is currently selling for $908.72 per $1,000 bond. What is the cost of debt? debt? N = 50; PMT = 45; FV = 1000; PV =908.72; 50; YTM = 5(2) = 10% YTM Cost of Preferred Stock Cost Reminders Preferred stock generally pays a constant dividend Preferred each period each Dividends are expected to be paid every period Dividends forever forever Preferred stock is a perpetuity, so we take the Preferred perpetuity formula, rearrange and solve for RP perpetuity RP = D / P0 Example: Cost of Preferred Stock Stock Your company has preferred stock that Your has an annual dividend of $3. If the current price is $25, what is the cost of preferred stock? preferred RP = 3 / 25 = 12% The Weighted Average Cost of Capital Capital We can use the individual costs of capital that We we have computed to get our “average” cost of capital for the firm. capital This “average” is the required return on the This firm’s assets, based on the market’s perception of the risk of those assets of The weights are determined by how much of The each type of financing is used each Capital Structure Weights Capital Notation E = market value of equity = # of outstanding shares times market price per share price D = market value of debt = # of outstanding bonds times bond market price price
• we would find the market value of each bond issue and then add we them together. them V = market value of the firm = D + E Weights wE = E/V = percent financed with equity wD = D/V = percent financed with debt Note that • preferred stock would just become another component of the preferred equation if the firm has issued it equation • we generally ignore current liabilities in our computations; we however, if a company finances a substantial portion of its assets with current liabilities, it should be included in the process. with Example: Capital Structure Weights Weights Suppose you have a market value of Suppose equity equal to $500 million and a market value of debt = $475 million. value What are the capital structure weights?
• V = 500 million + 475 million = 975 million • wE = E/V = 500 / 975 = .5128 = 51.28% • wD = D/V = 475 / 975 = .4872 = 48.72% Taxes and the WACC Taxes We are concerned with aftertax cash flows, so we also We need to consider the effect of taxes on the various costs of capital of Interest expense reduces our tax liability This reduction in taxes reduces our cost of debt Aftertax cost of debt = RD(1TC) Dividends are not tax deductible, so there is no tax Dividends impact on the cost of equity impact WACC = wERE + wDRD(1TC) Extended Example – WACC  I Extended Equity Information Debt Information 50 million shares $80 per share Beta = 1.15 Market risk premium = 9% Riskfree rate = 5% $1 billion in outstanding $1 debt (face value) debt Current quote = 110 Coupon rate = 9%, Coupon semiannual coupons semiannual 15 years to maturity Reminder: bond prices are Reminder: quoted as a percent of par value value Tax rate = 40% Extended Example – WACC  II Extended What is the cost of equity? RE = 5 + 1.15(9) = 15.35% N = 30; PV = 1,100; PMT = 45; FV = 1,000; CPT I/Y = 3.9268 RD = 3.927(2) = 7.854% RD(1TC) = 7.854(1.4) = 4.712% E = 50 million (80) = 4 billion, D = 1 billion (1.10) = 1.1 billion V = 4 + 1.1 = 5.1 billion wE = E/V = 4 / 5.1 = .7843, wD = D/V = 1.1 / 5.1 = .2157 WACC = .7843(15.35%) + .2157(4.712%) = 13.06% What is the cost of debt? What is the aftertax cost of debt? What are the capital structure weights? What is the WACC? WACC WACC Divisional and Project Costs of Capital Capital Using the WACC as our discount rate is only appropriate Using for projects that have the same risk as the firm’s current operations operations If we are looking at a project that does NOT have the If same risk as the firm, then we need to determine the appropriate discount rate for that project appropriate WACC is not very useful for companies that have WACC several disparate divisions. several Divisions also often require separate discount rates If WACC was used for every division, then the riskier divisions If would get more investment capital and the less risky divisions would lose the opportunity to invest in positive NPV projects. would Using WACC for All Projects Example Example What would happen if we use the WACC What for all projects regardless of risk? for Assume the WACC = 15% Project Required Return IRR A 20% 17% B 15% 18% C 10% 12% The Pure Play Approach The Find one or more companies that specialize in Find the product or service that we are considering the Compute the beta for each company Take an average Use that beta along with the CAPM to find the Use appropriate return for a project of that risk appropriate Often difficult to find pure play companies Subjective Approach Subjective Consider the project’s risk relative to the firm overall If the project has more risk than the firm, use a discount If rate greater than the WACC rate If the project has less risk than the firm, use a discount If rate less than the WACC rate You may still accept projects that you shouldn’t and You reject projects you should accept, but your error rate should be lower than not considering differential risk at all all Subjective Approach  Example Subjective
Risk Level Very Low Risk Low Risk Same Risk as Firm High Risk Very High Risk Discount Rate WACC – 8% WACC – 3% WACC WACC + 5% WACC + 10% Flotation Costs Flotation The required return depends on the risk, not The how the money is raised how However, the cost of issuing new securities However, should not just be ignored either should Basic Approach Compute the weighted average flotation cost Use the target weights because the firm will issue Use securities in these percentages over the long term securities NPV and Flotation Costs Example Example Your company is considering a project that will cost $1 million. Your The project will generate aftertax cash flows of $250,000 per year for 7 years. The WACC is 15% and the firm’s target D/E ratio is .6 The flotation cost for equity is 5% and the flotation cost for debt is 3%. What is the NPV for the project after adjusting for flotation costs? costs? D/E = .6; Let E = 1; then D = .6, V = .6 + 1 = 1.6 D/V = .6 / 1.6 = .375; E/V = 1/1.6 = .625 fA = (.375)(3%) + (.625)(5%) = 4.25% PMT = 250,000; N = 7; r = 15%; PV of future cash flows = 1,040,105 PMT NPV = 1,040,105  1,000,000/(1.0425) = 4,281 The project would have a positive NPV of 40,105 without The considering flotation costs considering Once we consider the cost of issuing new securities, the NPV Once becomes negative becomes Comprehensive Problem Comprehensive A corporation has 10,000 bonds outstanding with a 6% annual coupon rate, 8 corporation years to maturity, a $1,000 face value, and a $1,100 market price. The company’s 100,000 shares of preferred stock pays a $3 annual dividend, and sell for $30 per share. The company’s 500,000 shares of common stock sell for $25 per share, have a beta of 1.5, the risk free rate is 4%, and the market return is 12%. Assuming a 40% tax rate, what is the company’s WACC? return MV of debt = 10,000 x $1,100 = $11,000,000 Cost of debt = YTM= 4.48% MV of preferred = 100,000 x $30 = $3,000,000 Cost of preferred = 3/30 => 10% MV of common = 500,000 x $25 = $12,500,000 Cost of common = .04 + 1.5 x (.12  .04) = 16% Total MV of all securities = $11M + $3M + $12.5M = 26.5M Weight of debt = 11M/26.5M = .4151 Weight of preferred = 3M/26.5M = .1132 Weight of common = 12.5M/26.5M = .4717 WACC = .4151 x .0448 x (1  .4) + .1132 x .10 + .4717 x .16 = .0979 = 9.8% ...
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This note was uploaded on 04/13/2010 for the course BUSINESS engl 102 taught by Professor Seyhanözmenek during the Spring '10 term at Middle East Technical University.
 Spring '10
 SeyhanÖzmenek
 Cost Of Capital, Debt

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