WACC&WMCC - Goals of the Corporation Primary goal:...

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Unformatted text preview: Goals of the Corporation Primary goal: stockholder wealth Primary maximization—translates to maximizing maximization—translates stock price. stock Managerial incentives Social responsibility 1 Managerial Actions to Managerial Maximize Stockholder Wealth Maximize Capital Structure Decision Capital Budgeting Decision Dividend Policy Decision 2 Value of the Firm Market Factors/Considerations Economic Conditions Government Regulations and Rules Competitive Environment Firm Factors/Considerations Normal Operations Financing Policy Investing Policy Dividend Policy Investor Factors/Considerations Income/Savings Age/Lifestyle Interest Rates Risk Attitude Net Cash Flows, CF ^ ^ Rates of Return, r ^ N^ C1 F C2 F CN F Ct F = + +...+ =Σ 1 2 N t ( +r) ( +r) 1 1 ( +r) 1 ( +r) 1 t3 1 = Factors Influenced by Managers Factors that Affect Stock Price that Projected earnings per share Timing of earnings streams Risk of projected earnings Use of debt (capital structure) Dividend policy 4 Investing activities Invest in projects that yield a return greater Invest than the minimum acceptable hurdle rate. than The hurdle rate should be higher for riskier projects The and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt) (equity) Returns on projects should be measured based on Returns cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. negative 5 Where we’re going... Corporate Finance: Cost of capital Capital Budgeting (Invesment) Leverage Capital Structure Dividends 6 The investment decision Assets Current Assets Fixed Assets Liabilities & Equity Current Liabilities Long-term Debt Preferred Stock Preferred Common Equity Common 7 Looking at our the Asset Side 8 Looking at our the Asset Side 9 The financing decision Assets Current Assets Fixed Assets Liabilities & Equity Current Liabilities Long-term Debt Preferred Stock Preferred Common Equity Common 10 Looking at our the Liabilities Side 11 Looking at our the Liabilities Side 12 Capital Structure Liabilities & Equity Current Liabilities } Assets Current assets Long-term Debt Long-term Preferred Stock Preferred Common Equity Common 13 Cost of Capital For Investors, the rate of return on a the security is a benefit of investing. benefit For Financial Managers, that same that rate of return is a cost of raising funds cost that are needed to operate the firm. that In other words, the cost of raising In funds is the firm’s cost of capital. cost 14 How can the firm raise capital? Bonds Preferred Stock Common Stock Each of these offers a rate of return to Each rate investors. investors. This return is a cost to the firm. This cost “Cost of capital” actually refers to the weighted cost of capital - a weighted weighted average cost of financing sources. 15 Why Cost of Capital Is Important The return earned on assets depends on the risk of The those assets those The return to an investor is the same as the cost to The the company the Our cost of capital provides us with an indication Our of how the market views the risk of our assets of Knowing our cost of capital can also help us Knowing determine our required return for capital required budgeting projects budgeting 16 Required Return The required return is the same as the appropriate The discount rate and is based on the risk of the cash flows flows 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 17 Cost of Debt For the issuing firm, the cost of debt For cost is: the rate of return required by the rate investors, investors, adjusted for flotation costs (any adjusted flotation costs associated with issuing new bonds), and adjusted for taxes. adjusted taxes. 18 Example: Tax effects Example: of financing with debt of EBIT - interest expense EBT - taxes (34%) EAT with stock with 400,000 0 400,000 (136,000) (136,000) 264,000 with debt with 400,000 (50,000) (50,000) 350,000 (119,000) (119,000) 231,000 19 Example: Tax effects Example: of financing with debt of EBIT - interest expense EBT - taxes (34%) EAT with stock with 400,000 0 400,000 (136,000) (136,000) 264,000 with debt with 400,000 (50,000) (50,000) 350,000 (119,000) (119,000) 231,000 Now, suppose the firm pays $50,000 in Now, dividends to the stockholders. dividends 20 Example: Tax effects Example: of financing with debt of with stock with EBIT 400,000 - interest expense 0 EBT 400,000 - taxes (34%) (136,000) (136,000) EAT 264,000 - dividends (50,000) (50,000) Retained earnings 214,000 Retained with debt with 400,000 (50,000) (50,000) 350,000 (119,000) (119,000) 231,000 0 231,000 21 After-tax Before-tax % cost of = % cost of cost Debt Debt Debt x - Tax 1 rate 22 After-tax Before-tax % cost of = % cost of cost Debt Debt Debt Kd = x - Tax 1 rate kd (1 - T) 23 After-tax Before-tax % cost of = % cost of cost Debt Debt Debt Kd .066 .066 = = x - Tax 1 rate kd (1 - T) .10 (1 - .34) 24 Example: Cost of Debt Rawo Corporation issues a $1,000 Rawo $1,000 par, 20 year bond paying the market 20 rate of 10%. Coupons are 10%. semiannual. The bond will sell for par since it pays the market rate, but flotation costs amount to $50 per $50 bond. Tax rate is 34%. bond. What is the pre-tax and after-tax cost What of debt for Rawo Corporation? of 25 Pre-tax cost of debt: (using TVM) P/Y = 2 N = 40 PMT = -50 FV = -1000 PV = 950 solve: I = 10.61% = kd solve: 10.61% After-tax cost of debt: Kd = kd (1 - T) Kd = .1061 (1 - .34) Kd = .07 = 7% Kd 7% 26 Pre-tax cost of debt: (using TVM) P/Y = 2 N = 40 PMT = -50 FV = -1000 PV = 950 solve: I = 10.61% = kd solve: 10.61% After-tax cost of debt: Kd = kd (1 - T) Kd Kd = .1061 (1 - .34) Kd Kd = .07 = 7% Kd 7% So, a 10% bond costs the firm only 7% (with only 7% flotation costs) flotation since the interest since is tax deductible. is 27 Cost of Preferred Stock Finding the cost of preferred stock Finding is similar to finding the rate of return , except that we have to return consider the flotation costs flotation associated with issuing preferred stock. stock. 28 Cost of Preferred Stock Recall: 29 Cost of Preferred Stock Recall: kp = D Po = Dividend Price 30 Cost of Preferred Stock Recall: kp = D Po = Dividend Price From the firm’s point of view: From firm’s 31 Cost of Preferred Stock Recall: kp = D Po = Dividend Price From the firm’s point of view: From firm’s kp = D Pnet = Dividend Net Price 32 Cost of Preferred Stock Recall: kp = D Po = Dividend Price From the firm’s point of view: From firm’s kp = D Pnet = Pnet = Price - flotation costs! Dividend Net Price 33 Example: Cost of Preferred If Rawo Corporation issues If preferred stock, it will pay a dividend of $8 per year and $8 should be valued at $75 per share. $75 If flotation costs amount to $1 $1 per share, what is the cost of preferred stock for Rawo? preferred 34 Cost of Preferred Stock 35 Cost of Preferred Stock D kp = kp Pnet = Dividend Net Price 36 Cost of Preferred Stock D kp = kp Pnet = 8.00 74.00 = Dividend Net Price = 37 Cost of Preferred Stock D kp = kp Pnet = 8.00 74.00 = Dividend Net Price = 10.81% 38 Cost of Common Stock There are two sources of Common Equity: 1) Internal common equity (retained 1) Internal earnings). earnings). 2) External common equity (new common 2) External stock issue). stock Do these two sources have the same cost? 39 Cost of Internal Equity Since the stockholders own the firm’s Since retained earnings, the cost is simply the stockholders’ required rate of return. return. Why? If managers are investing If stockholders’ funds, stockholders will expect to earn an acceptable rate of return. return. 40 Cost of Internal Equity How do you determine the cost of retained earnings? How many models can be used to calculate cost of retained earnings? 41 Cost of Internal Equity 1) Dividend Growth Model 2) Capital Asset Pricing Model (CAPM) 3) Bond’s Yield plus Risk Premium 42 Cost of Internal Equity 1) Dividend Growth Model 1) Dividend ks = D1 Po +g 2) Capital Asset Pricing Model (CAPM) 2) Capital kj = krf + βj (km - krrff ) 43 Cost of Internal Equity 3) Bond Yield plus Risk Premium ks = YTM + RP RP 44 Cost of External Equity Dividend Growth Model Dividend D1 ke = Pnet + g 45 Cost of External Equity Dividend Growth Model Dividend D1 ke = Pnet + g Net proceeds to the firm after flotation costs! 46 Weighted Cost of Capital The weighted cost of capital is just the The weighted average cost of all of the financing sources. financing 47 Weighted Cost of Capital Suppose you have determined the individual Suppose after-tax cost components of your company’s borrowed capital as follows: borrowed A-Tax Capital A-Tax Capital Source Cost Structure Source debt 6% 20% debt preferred 11% 10% common 15% 70% 48 Weighted Cost of Capital (20% debt, 10% preferred, 70% common) Weighted cost of capital = = 0.20 (6%) + 0.10 (11%) + 0.70 (15%) = 1.2% + 1.11% + 10.50% = 12.81% This is your company’s current WACC 49 Weighted Cost of Capital You are contemplating selling $10 million worth of 20-year, You 9% coupon bonds, interest to be paid every six month, with a par value of $1,000. Because current market interest rates are greater than 9%, the firm must sell the bonds at $980. Flotation costs are 2% or $20. If your tax rate is 40%, what is after-tax cost of debt? If The net proceeds is $960 ($980 - $20). Periodical coupon payment is $45 every six months. Maturity value is $1,000 and period to maturity is 40. 50 Weighted Cost of Capital You are also contemplating the issuance of a 8.57% preferred You stock that is expected to sell for its $70 per share par value. The cost of issuing and selling the stock is expected to be $7.50 per share. What is the cost of preferred? Do we need to adjust the cost for tax? for The annual dividend is $6.00 (8.57% x $70). The The net proceeds price (Pnet) is $62.50 ($70 - $7.50). 51 Weighted Cost of Capital Assume your company has just paid a dividend of $2.50 per Assume share, expects dividends to grow at 10% indefinitely, and share price is currently selling for $50.00 per share. share Assume also the 10-year T-bonds currently yield 5.0%, the Assume market risk premium is 9%, and company’s beta is 1.20, the firm’s cost of retained earnings will be: firm’s a. Constant Dividend Growth Model b. Security Market Line Approach c. Bond’s yield plus risk premium Which one you want to use? Determining ks requires some judgment! 52 Weighted Cost of Capital Weighted WACC = Ka = Wd*Kd + Wp*Kp + Ws*Ks or Ke Capital Structure Weights: The weights in the above equation are intended to represent a specific financing mix (where Wd = % of debt, Wp = % of preferred, and Ws= % of common). Specifically, these weights are the target percentages of debt and equity that will minimize the firm’s overall cost of raising funds. 53 Weighted Cost of Capital Assume the market value of debt is $40 million, the market value of the firm’s preferred stock is $10 million, and the market value of the firm’s equity is $50 million. What is the firm’s capital structure? Book value vs. market value weight? MV of securities closely approximate the actual dollar to be received from their sale, and therefore preferred than BV weight. 54 Weighted Cost of Capital Weighted Using the component costs in the earlier example along with Using the market value weights, we may calculate the weighted average cost of capital as follows: average WACC = WACC 0.40(9.4488%{1-0.40}) + 0.10(9.62%) + 0.50(15.8%) 0.40 (5.6693%) + 0.10(9.62%) + 0.50 (15.8%) 0.40 2.2677% + 0.962% + 7.90% 2.2677% = 11.1297% ≈ 11.13% 11.13% The firm should accept all projects that will earn a return The greater than 11.13%. It also assumed that the firm has sufficient retained earnings to fund any anticipated investment projects. investment 55 Weighted Cost of Capital Continuing with our example, how much would it cost the firm to raise new equity if flotation costs amount to $4.20 per share? WACCnew= . 40(5.67%) + .10(9.62%) + .50(16%) 40(5.67%) = 11.23% 11.23% If the firm has to issue new common stock, then its If WACC increases to 11.23%. WACC 56 Marginal Cost of Capital (MCC) MCC:- the weighted average cost of raising additional MCC:funds. Often MCC is greater than existing WACC. The cost new funding increases because:The 1. Firm’s risk increases, which causes investors to 1. require a higher rate of return require 2. Cost of issuing new funds (flotation costs) increase 3. or both 57 Marginal Cost of Capital Marginal Question: At what level of total new financing would Question: your cost of capital increase from 11.13% to 11.23%? your The break point (BP) will determine the level. BP is defined as the level at which total financing will use BP up one type of capital. Total amount of a given type of capital at a lower cost Proportion of this type of capital in the capital structure Proportion 58 Marginal Cost of Capital Marginal Lets assume that the firm expects to generate Lets $200,000 in retained earnings that can be used for investments this year. When it is exhausted, the firm must issue new (more expensive) common stock. must BPre = $200,000 / 0.50 = $400,000 re 59 Marginal Cost of Capital Marginal $400,000 is the amount of total new funds the firm $400,000 can raise before WACC increases from 11.13% to 11.23%. 11.23%. One place we know there will always be a break One point is when the amount of income is not paid out as dividends – i.e, the addition to retained earnings in the current period – is exhausted. in 60 Combining MCC & Combining Investment Opportunities Investment Another example: Current after-tax component costs and its capital Current structure weights are as follows:structure Cost of Debt = 5.67% 40% Cost of preferred = 9.62% 10% Cost of retained earnings = 15.8% 50% 61 WMCC & IOS Lets assume the firm has $2 million of retained Lets earnings available. When it is exhausted, the firm must issue new (more expensive) equity, cost of 16%. Furthermore, the company believes it can raise $1 million of cheap debt after which it will cost 7% (after-tax) to raise additional debt. Given this information, lets determine the firm’s Given break points, WACCs, ranges of total new financing, draw the MCC & IO schedules and use them to make financing/investment decisions. make 62 WMCC & IOS The Weighted Marginal Cost of Capital (WMCC) The Finding Break Points BPre = $2,000,000/.50 = $4,000,000 BPdebt = $1,000,000/.40 = $2,500,000 This implies that the firm can fund up to $4 million of new investment before it is forced to issue new equity and $2.5 million of new investment before it is forced to raise more expensive debt. 63 WMCC& IOS WMCC& WACC for Ranges of Total New Financing Range of total Source of New Financing Capital Weighted Cost Debt 40% 5.67% 2.268% 10% 9.62% 0.962% Common 50% 15.80% 7.900% WACC $2.5 to $4.0 million Cost Preferred $0 to $2.5 million Weight 11.130% 40% 7.00% 2.800% Preferred 10% 9.62% 0.962% Common 50% 15.80% 7.900% WACC over $4.0 million Debt 11.662% Debt 40% 7.00% 2.800% Preferred 10% 9.62% 0.962% Common 50% 16.00% 8.000% WACC 11.762% 64 WMCC Schedule WMCC 11.76% 11.75% 11.66% 11.50% 11.25% 11.13% $2.5 $4.0 Total New Financing (millions) 65 IOS Firm has the following investment opportunities Firm available: available: Initial Cumulative Project IRR Ivestment Investment A 13.0% $ 1,000,000 $ 1,000,000 B 12.0% $ 1,000,000 $ 2,000,000 C 11.5% $ 1,000,000 $ 3,000,000 D 11.0% $ 1,000,000 $ 4,000,000 E 10.0% $ 1,000,000 $ 5,000,000 66 WMCC & IOS 13.0% 12.0% A WMCC B 11.66% This indicates that the firm can accept only Projects A & B. 11.5% C 11.13% 11.0% D $1.0 $2.0 $2.5 $3.0 $4.0 Total New Financing or Investment ($m) 67 Cost of debt 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 $1000 bond. What is the cost of debt? debt? 68 Cost of debt 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 $1000 bond. What is the cost of debt? debt? N = 50; PMT = 45; FV = 1000; PV = 908.75; I/Y = 50; 10%/2= 5%; YTM = 5(2) = 10% 10%/2= 69 Cost of preferred stock Your company has preferred stock that has an Your annual dividend of $3. If the current price is $25, what is the cost of preferred stock? $25, 70 Cost of preferred stock Your company has preferred stock that has an Your annual dividend of $3. If the current price is $25, what is the cost of preferred stock? $25, RP = 3 / 25 = 12% 71 Cost of common stock equity Suppose our company has a beta of 1.5. The market Suppose risk premium is expected to be 9% and the current risk-free rate is 6%. We have used analysts’ estimates to 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? our 72 Cost of common stock equity Suppose our company has a beta of 1.5. The market Suppose risk premium is expected to be 9% and the current risk-free rate is 6%. We have used analysts’ estimates to 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? our Using SML: RE = 6% + 1.5(9%) = 19.5% Using DGM: RE = [2(1.06) / 15.65] + .06 = 19.55% 19.55% 73 Cost of common stock equity Using SML: RE = 6% + 1.5(9%) = 19.5% Using DGM: RE = [2(1.06) / 15.65] + .06 = 19.55% 19.55% Now, which cost are you going to use? Now, 74 Weighted Average Cost of Capital We can use the individual costs of capital that we We have computed to get our “average” cost of capital for the firm. the This “average” is the required return on our assets, This based on the market’s perception of the risk of those assets assets The weights are determined by how much of each The type of financing that we use type 75 Capital Structure Weights Suppose you have a market value of Suppose Equity: 5m shares of $1.00 par value selling for $3.50 Bonds: Issued $3m at par, now trading at $998.50 Bonds: Preferred: Issued 40,000 12% preferred stock of $25 par value, currently selling $25 par What are the capital structure weights? 76 Capital Structure Weights Suppose you have a market value of Suppose Equity equal to $17.5m(5m shares, selling for $3.50) Bonds equal to $2,995,500 (Par of $3m, traded at $998.50) $998.50) Preferred equal $1m (40,000 preferred stock at market price of $25) market What are the capital structure weights? V = $17.5m + $2,995,500 + $1m = $21.4955m $17.5m wE = E/V = 17.5 / 21.4955 = 0.8141 = 81.41% wD = D/V = 2.9955 / 21.4955 = 0.1394 = 13.94% wp = P/V = 1 / 21.4955 = 0.0465 = 4.65% 77 Weighted Average Cost of Capital WACC = wdrd(1 - T) + wpsrps + wcers WACC = 0.1394(10%)(0.6) + 0.0465(12%) + WACC 0.8141(19.55%) 0.8141(19.55%) WACC = 0.8364% + 0.558% + 15.9157% = WACC 17.3101% ≈17.31% ≈17.31% 78 ...
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