Unformatted text preview: 6-1 Chapter 5
The Cost of Capital Capital components Debt Preferred Common Equity Equity cost approaches CAPM DCF Bond Yield Plus Risk Premium WACC 6-2 Davis Industries Tax rate is 40% Bond outstanding: 15 yrs, 10% coupon, selling at $ 1,081.44 Do not use short term debt on a permanent basis Preferred 9%payment ($100 face), quarterly pymts, flotation on new preferred $2.5 Common stock $76, Last Div=$5, growth rate=6% Beta= 1.25, T-bonds= 7%, Mkt Risk Premium= 5% Risk premium in using Bond yield plus = 4% Flotation costs on new common 10% Capital strucutre: 30% long-term debt, 10% preferred, 60% equity RE= $300,000; Depreciation = $500,000 6-3 What capital should be included in the WACC? 1. 2. 3. Long Term Debt Preferred Stock Common Equity:
Retained earnings New common stock 6-4 Focus on before-tax or after-tax capital costs? The WACC used to discount cashflows is after-tax. Therefore, use A-T WACC. Only kd needs adjustment. 6-5 Why adjust kd? The cost of debt is deductible. Costs of preferred and common are not deductible. 6-6 Historical vs. Marginal Cost? What is marginal cost? Decisions are being made regarding new capital investment. Therefore, the cost of the next dollar of capital is the relevant question (i.e. marginal cost). 6-7 Calculate kd:
Coupon = 10% semiaannual Price = $1,081.44; 15 years 0
50+1,000 Inputs 30 N Output -1,081.44 50 1,000 PMT I/YR PV 4.5% x 2 = kd = 9% FV 6-8 Component Cost of Debt kd AT = kd BT (1-T) = 9% (1-0.40) = 5.4% Use nominal rate. 6-9 Should flotation costs be considered? Total costs of issuing and selling a security reduce the net proceeds from the sale These costs are typically small on public debt issues. Most debt is privately placed directly with large investors. So flotation costs are almost nonexistent . What is the component cost of preferred stock? PPS=$115; 9%Q; Par=$100; F=$2.50 6-10 Formula: = DPS kPS= PNet 0.09($100) $115.00 - $2.50 = $9 $112.50 = 0.080 = 8.0% 6-11 Preferred Stock Cashflows 0 -112.50 1 2.25 2 2.25 $2.25 kPer 8 $112.50 = D = k-g kPer = $2.25/$112.50 = 2.00% kNom = 2% x 4 = 8% 6-12 Notes on preferred: Flotation costs for preferred are significant, so they are included. Use net price. Preferred dividends are not deductible, so no tax adjustment. Just kPS. Nominal kPS is used. 6-13 Is preferred stock more or less risky to investors than debt? More risky; company is not required to pay preferred dividends. However, firms try to pay preferred dividends. Otherwise,
cannot pay common dividends, difficult to raise additional funds, preferred stockholders may gain control of the firm. 6-14 Why is there a cost for retained earnings? Earnings can be reinvested or paid out as dividends. Investors could use dividends to buy other securities and earn a return. Thus, there is an opportunity cost if earnings are retained. 6-15 Opportunity cost is the return stockholders could earn on alternative investments of equal risk. They could buy similar stocks and earn ks, or the company could repurchase its own stock and earn ks. So ks is the cost of retained earnings. 6-16 Three approaches to determine the cost of retained earnings ks: 1. Capital Asset Pricing Model (CAPM)
(incorporates historical market risk) 2. Discounted Cash Flow (DCF)
(incorporates expectations for future earnings) 3. Bond Yield Plus Risk Premium(BYRP)
(incorporates known relationships between methods of financing) 6-17 Three approaches to determine the cost of retained earnings ks: 1. CAPM: kS = kRF + (kM - kRF)b 2. DCF: kS = D1/P0 + g 3. Bond-Yield-Plus-Risk Premium (BYRP): kS = kd + RP 6-18 What is the cost of retained earnings based on the CAPM? kS = kRF + (kM - kRF)b = 7.0% + (5.0%)(1.25) = 13.25% Why is the T-bond rate a better measure of kRF than the T-bill? The T-bond rate: 6-19 Embodies long-term inflation expectations. Is influenced less by Federal Reserve actions, currency flows, etc. Is the more logical investment alternative to stocks. 6-20 How can RPM be measured? Ex post data e.g. Ibottson and Assoc. provides this on an annual basis : RPM = 7.2% for 1926-1993. Future estimates by financial analysts of market minus Tbond Could use D/P + g for S&P (Km) with analysts estimate of g. 6-21 What is the DCF cost of retained earnings kS? Given: D0 = $5.00; = (1+ D1 P0 = $76; g D06%?g) kS = +g = +g P0 P0 = $5.00(1.06) $76 + 0.06 =13.0% 6-22 How do we estimate g? Point to point Average to average Retention Growth Formula Use analysts' predictions 6-23 Suppose the company has been earning 15.5% on equity (ROE = 15.5%) and retaining 40% (dividend payout = 60%), and this situation is expected to continue. What's the expected future g? 6-24 Retention growth rate g = b(ROE) = 0.40 (15.5%) = 6.20% Here b = fraction retained. This g is close to g = 6% as given. 6-25 Find kS using the bond-yieldplus-risk premium method. kS = kd + RP = 9.0% + 4.0% = 13.0% This RP = CAPM RP Produces ballpark estimate of kS. Usefule check on the DCF and and CAPM methods. 6-26 What's a reasonable final estimate of kS ? Method CAPM DCF kd + RP Average Estimate 13.25% 13.00% 14.00% 13.10% Usually not so close. 6-27 What is the WACC using retained earnings for the equity component? WACC1 = Wdkd (1-t) + WPkP + WSkS = .3 (5.4%) + .1(8%) + .6(13.1%) = 10.3% = Cost of new capital until the retained earnings is used up. 6-28 FLOTATION ADJUSTMENTS Most companies place their new debt privately (no flotation) and most companies raise equity internally (RE)-(no flotation). New stock issues by established companies are very rare. Here's what happens if you have flotation 6-29 FLOTATION ADJUSTMENTS Average Flotation Costs: $ Raised Equity up to $10M 13% $20-$40M 7% $80-$100M 4.8% $200-$500M 3.5% Debt 4.4% 2.5% 2.2% 2.2% 6-30 How do we find the cost of new common stock, ke? Use the DCF formula, but must adjust P0 for flotation cost. End up with ke > ks. 6-31 Flotation cost F = 10%: ke = = D0 (1+ g) P0 (1-F) +g $5.00 (1.06) + .06 = 13.75% 76 (1- .10) 6-32 Flotation Adjustment
ke (DCF) =13.75% ks (DCF) = 13.0% Difference = flotation adjustment = 13.74% - 13.0% = 0.75% Add the 0.75% flotation adjustment to average kS = 13.1%to find average ke: ke = 13.1%+ 0.75% = 13.85% 6-33 Summary of Component Costs of Capital kd (1-t) kp ks ke = 5.4% = 8% = 13.1% = 13.85% Optimal Mix: 30% debt 10% preferred 60% equity 6-34 WACC with new common equity? WACC2 = Wdkd (1-t) + WPkP + Weke = .3(5.4%) + .1(8%) + .6(13.85%) = 10.7% 6-35 Summary to this point: kS or ke 13.10% 13.85% WACC 10.3% 10.7% WACC rises because new stock costs more. 6-36 Find retained earnings breakpoint. Optimal proportion of equity = 60% Amount of retained earnings available = $300,000 BPRE = Dollars of RE Fraction of equity = $300,000/.60 = $500,000 6-37 How would the company raise the $500,000 of new capital? .3(500K) = $150,000 Debt .1(500K) = 50,000 Preferred .6(500K) = 300,000 Retained Earnings 500,000 Total 6-38 What is the MCC schedule?
A plot of the firms WACC versus new dollars of capital raised. Shows the cost of each additional, or marginal, dollar raised. 6-39 WACC % WACC1 = 10.3% 12 WACC2 = 10.7% 10 $500K $ of New Capital ($000) 6-40 Would the MCC schedule remain constant beyond the RE breakpoint regardless of the amount of capital required? NO. As more and more new capital is required in any year, the company's WACC would eventually rise above 10.7%. 6-41 Would what the company planned to do with the money it raised have any effect on the WACC? It might. We have implicitly assumed that the company would invest in assets with equal risk as existing assets. If the company planned to invest in riskier assets, this would raise the cost of capital. 6-42 What effect does depreciation have on the MCC schedule? Depreciation reduces tax liability Increased net income is available to for dividends or retained earnings e.g. could repurchase debt or stock These funds therefore have an opportunity cost equal to the WACC using retained earnings, 10.3%. This will shift the MCC schedule outward by the $ of depreciation. 6-43 Would depreciation affect the acceptability of proposed capital budgeting projects and the size of the total capital budget? Possibly. If the lower cost MCC is shifted to the right, the cost of capital used to evaluate projects may be lower. If lots of good projects are available, then the shift will affect project selection. 6-44 Three Types of Risk Stand-alone risk Corporate risk Market risk Market, or beta, risk is most relevant for estimating the WACC. 6-45 Should the firm use the same WACC for all projects? No! The company should estimate divisional WACCs based on divisional betas and divisional debt capacities. The company might consider further adjustments to divisional WACCs for particularly risky or safe projects. ...
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