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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
Longterm 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
Longterm 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 Longterm Debt
Longterm
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 Aftertax
Beforetax
% cost of = % cost of
cost
Debt
Debt
Debt x  Tax
1 rate 22 Aftertax
Beforetax
% cost of = % cost of
cost
Debt
Debt
Debt Kd = x  Tax
1 rate kd (1  T) 23 Aftertax
Beforetax
% 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 pretax and aftertax cost
What
of debt for Rawo Corporation?
of
25 Pretax cost of debt: (using TVM)
P/Y = 2
N = 40
PMT = 50
FV = 1000
PV = 950
solve: I = 10.61% = kd
solve:
10.61% Aftertax cost of debt:
Kd = kd (1  T)
Kd = .1061 (1  .34)
Kd = .07 = 7%
Kd
7% 26 Pretax cost of debt: (using TVM)
P/Y = 2
N = 40
PMT = 50
FV = 1000
PV = 950
solve: I = 10.61% = kd
solve:
10.61% Aftertax 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
aftertax cost components of your company’s
borrowed capital as follows:
borrowed
ATax
Capital
ATax
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 20year,
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 aftertax 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 10year Tbonds 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%{10.40}) + 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 aftertax 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%
(aftertax) 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
riskfree 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
riskfree 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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 Spring '09
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