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Unformatted text preview: 1 0 ower Point Presentation designed by Dr. Sylvia C. Hudgins for Finance 323 at ODU Required Return 2 The required return is the same as the The appropriate discount rate and is based on the risk of the cash flows the 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 or We need to earn at least the required return We to compensate our investors for the financing they have provided financing 3 Required Rates on Projects An important part of capital budgeting is setting the An required rate for the individual project required Example: Consider the following project 0 1 -1,000 +1,100 If Required Rate = 9%: NPV = -1,000 + 1,100 = $9.17 (1+ .09 ) Accept Project since NPV > 0 If Required Rate = 11%: NPV = -1,000 + 1,100 = –$9.01 (1+ .11 ) Reject Project since NPV < 0 In order to estimate correct required rate, companies In order to estimate correct required rate, companies must find their own unique cost of raising capital must find their own unique cost of raising capital Why Cost of Capital Is Important 4 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 of Knowing our cost of capital can also help us Knowing determine our required return for capital budgeting projects budgeting Cost of Debt 5 The cost of debt is the required return on our The company’s debt company’s We usually focus on the cost of long-term debt or We bonds bonds The required return is best estimated by The computing the yield-to-maturity on the existing debt debt We may also use estimates of current rates based We on the bond rating we expect when we issue new debt debt The cost of debt is NOT the coupon rate Computing Cost of Each Source 1. Compute Cost of Debt Required rate of return for creditors Same cost found in Chapter 7 as “required rate for Same debtholders (r)” debtholders n P0 = It ∑ (1 + r ) n t =1 + $M (1+r)n where: It = Dollar Interest Payment Po = Market Price of Debt M = Maturity Value of Debt 6 7 Computing Cost of Each Source 1. Compute Cost of Debt Example Investors are willing to pay $938.55 for a bond that pays $90 a year for 10 years. What is the before tax cost of debt? n It P0 = ∑ n t =1 (1 + r ) + $M (1+r)n + $1,000 (1+r)10 12 $90 938.55 = ∑ 12 t =1 (1 + r ) 10.00 N 10 I% PV PMT FV ? -938.55 90 1000 Computing Cost of Each Source 8 1. Compute Cost of Debt Example Investors are willing to pay $938.55 for a bond that pays $90 a year for 10 years. What is the before tax cost of debt? The before tax cost of debt is 10% Interest is tax deductible Interest is tax deductible Marginal Tax Rate = 40% After tax cost of bonds = r(1 - T) = 10.0%(1– 0.40) = 6 % Cost of Preferred Stock 9 Reminders Preferred generally pays a constant dividend every period Dividends are expected to be paid every period forever Preferred stock is an perpetuity, so we take Preferred the perpetuity formula, rearrange and solve for RP solve RP = D / P0 Computing Cost of Each Source 2. Compute Cost Preferred Stock Cost to raise a dollar of preferred stock. From Chapter 8: Required rate Rps = Dividend (D) Market Price (P0) 10 Computing Cost of Each Source 11 2. Compute Cost Preferred Stock Example Your company can issue preferred stock for a price of $42. The preferred stock pays a $5 dividend. Cost of Preferred Stock Rps = $5.00 $42.00 = 11.90% No adjustment is made for taxes as No adjustment is made for taxes as dividends are not tax deductible. dividends are not tax deductible. Computing Cost of Each Source 12 3. Compute Cost of Common Equity The cost of equity is the return required by The equity investors given the risk of the cash flows from the firm flows There are two major methods for There determining the cost of equity determining Dividend growth model SML or CAPM (We will not look at these) Computing Cost of Each Source 13 3. Compute Cost of Common Equity Dividend Growth Model Assume constant growth in dividends (Chap. 8) Rcs D1 = P0 +g Example The market price of a share of common stock is $60. The dividend just paid is $3, and the expected growth rate is 10%. Rcs = 3(1+0.10) + .10 = .155 = 15.5% 60 The main limitation in this method is estimating growth accurately. The main limitation in this method is estimating growth accurately. 14 Example: Estimating the Dividend Growth Rate One method for estimating the growth rate is to One use the historical average use Year Dividend Percent Change 1995 4.96 (5.46 – 4.96) / 4.96 = 10% 1996 5.46 1997 6.00 (6.00 – 5.46) / 5.46 = 9.8% 1998 6.62 (6.62 – 6.00) / 6.00 = 10.4% 1999 7.27 (7.27 – 6.62) / 6.62 = 9.8% Average = (10 + 9.8 + 10.4 + 9.8) / 4 = 10% Advantages and Disadvantages of Dividend 15 Growth Model Advantage – easy to understand and use Disadvantages Only applicable to companies currently paying dividends Not applicable if dividends aren’t growing at a reasonably constant rate Extremely sensitive to the estimated growth rate – an increase in g of 1% increases the cost of equity by 1% Does not explicitly consider risk The Weighted Average Cost of Capital 16 We can use the individual costs of capital We that we have computed to get our “average” cost of capital for the firm. “average” This “average” is the required return on our This assets, based on the market’s perception of the risk of those assets of The weights are determined by how much The of each type of financing that we use of Weighted Cost of Capital Model 17 Model Assumptions Constant Business Risk Constant Financial Risk Constant Dividend Policy Calculation of WACC 1. Compute the cost of each source of capital(Cost of 1. Debt, Cost of Preferred Stock and Cost of Common Equity) Equity) 2. Determine percentage of each source of 2. capital(Capital Structure Weights) capital(Capital 3. Calculate Weighted Average Cost of Capital 3. (WACC) (WACC) Capital Structure Weights 18 Long Term Liabilities and Equity • To calculate the weighted average cost of capital. WACC = wERE + wDRD(1-TC) • Weights of each source should reflect expected Weights financing mix financing • Market Value Weights are preferred Market • Balance Sheet percentages are often used if market Balance values are not available to calculate the weighted average cost of capital. average Capital Structure Weights WACC = wERE + wDRD(1-TC) Notation E = market value of equity = # outstanding shares times price per share D = market value of debt = # outstanding bonds times bond price V = market value of the firm = D + E Weights wE = E/V = percent financed with equity wD = D/V = percent financed with debt 19 20 Capital Structure Weights Long Term Liabilities and Equity Green Apple Company Market Values Bonds Preferred Stock Common Stock 4,000 1,000 5,000 Compute Firm’s Capital Structure (% of each source) Amount of Bonds 4,000 = 40% Bonds: 10,000 Total Capital Sources 21 Capital Structure Weights Long Term Liabilities and Equity Green Apple Company Market Values Bonds Preferred Stock Common Stock 4,000 1,000 5,000 Compute Firm’s Capital Structure (% of each source) Amount of Preferred Stock 1,000 = 10% Preferred Stock: 10,000 Total Capital Sources 22 Capital Structure Weights Long Term Liabilities and Equity Green Apple Company Market Values Bonds Preferred Stock Common Stock 4,000 1,000 5,000 Compute Firm’s Capital Structure (% of each source) Amount of Common Stock 5,000 = 50% Common Stock: 10,000 Total Capital Sources 23 Capital Structure Weights Long Term Liabilities and Equity Green Apple Company Market Values Bonds Preferred Stock Common Stock 4,000 1,000 5,000 40% 10% 50% When money is raised for capital projects, approximately 40% of the money comes from selling bonds, 10% comes from selling preferred stock and 50% comes from retaining earnings or selling common stock 24 Computing WACC Green Apple Company estimates the following costs Green for each component in its capital structure: for Source of Capital Cost Bonds Preferred Stock Common Stock Rd = 10% Rps = 11.9% Rcs = 15.5% Green Apple’s tax rate is 40% Computing WACC 25 We are concerned with after-tax cash flows, so we We need to consider the effect of taxes on the various costs of capital various Interest expense reduces our tax liability This reduction in taxes reduces our cost of debt After-tax cost of debt = RD(1-TC) Dividends are not tax deductible, so there is no tax Dividends impact on the cost of equity impact WACC= R0 = %Bonds x Cost of Bonds x (1-T) + %Preferred x Cost of Preferred + %Common x Cost of Common Stock 26 Capital Structure Weights Long Term Liabilities and Equity Green Apple Company Market Values Bonds Preferred Stock Common Stock 4,000 1,000 5,000 WACC= R0 = %Bonds x Cost of Bonds x (1-T) + %Preferred x Cost of Preferred + %Common x Cost of Common Stock WACC = .40 x 10% (1-.4) + .10 x 11.9% + .50 x 15.5% = 11.34% Factors Determining Cost of Capital General Economic Conditions Affect interest rates Market Conditions Affect risk premiums Operating and Financing Decisions Affect business risk Affect financial risk Amount of Financing Affect flotation costs and market price of security 27 Risk 28 Variability of revenues from expected Two types of Risk: Business Risk & Financial Risk Business Risk Risk Due to Operations Measured by variability of EBIT (earnings before interest and taxes) Risk 29 Financial Risk Risk due to raising money with fixed income securities Financial risk is high with high levels of debt financing Financial leverage - the use of fixed income securities to finance a portion of assets Example Firm A is an all equity firm -- it has no financial leverage Firm B is financed by 50% debt and 50% equity -- it uses financial leverage Operating Leverage 30 Degree of Operating Leverage (Accounting Basis) With FIXED operating costs, there will be operating leverage Operating Leverage is responsiveness of a firm’s EBIT to fluctuations in Sales Degree of Operating Leverage (DOL) Measurement of Operating Leverage For a unique level of sales, DOL changes as sales change. % Change in EBIT DOLS = % Change in Sales Unique Level of Sales Unique Level of Sales 31 Operating Leverage Measurement of DOL(accounting basis) Calculation using per unit information: Q(P – V) DOLS = Q(P – V) – FC-D Example: Q = 3,750 units Price = $800 per unit Variable costs = $400 per unit Fixed Costs+Depreciation=$1,000,000 per year. 3,750(800 – 400) DOL3,750 units = 3,750(800 – 400) – 1,000,000 Interpretation: If sales change 1%, then Interpretation: If = 3 times EBIT will change sales change 1%, then EBIT will change3% in the same direction. 3% in the same direction. Financial Leverage 32 Degree of Financial Leverage Finance a portion of the firm’s assets with securities that have fixed financial costs Debt Preferred Stock Financial Leverage measures changes in earnings per share as EBIT changes. Degree of Financial Leverage (DFL) at one level of EBIT: % Change in EPS DFLEBIT = % Change in EBIT Unique Level of EBIT Unique Level of EBIT Financial Leverage Measurement of DFL EBIT DFLEBIT = EBIT – I Example: EBIT = $500,000 Interest Charges = $200,000 500,000 DFLEBIT=500,000 = 500,000 – 200,000 = 1.67 times Interpretation: When EBIT changes 1% (from an existing Interpretation: When EBIT changes 1% (from an existing level of $500,000) Earnings Per Share will change 1.67% level of $500,000) Earnings Per Share will change 1.67% 33 Combined Leverage Degree of Combined Leverage Measures changes in Earnings Per Share given changes in Sales Combines both Operating and Financial Leverage Computed for a specific level of sales % Change in EPS DCLS = % Change in Sales Unique Level of Sales Unique Level of Sales 34 Combined Leverage Measurement of DCL DCLS = DOLS x DFLEBIT Example: DFLEBIT = 1.67 DOLS = 3.0 DCL3,750 = 3.0 x 1.67 = 5.0 times Interpretation: When sales change 1%, Earnings Per Share Interpretation: When sales change 1%, Earnings Per Share will change 5.0% will change 5.0% 35 36 Combined Leverage Measurement of DCL--Alternative Computation DCLS = Q= Price = Variable costs = FC+Dep = Interest = Example: Q(P – V) Q(P – V) – FC-D – I 3,750 units $800 per unit $400 per unit $1,000,000 per year $200,000 per year 3,750(800 – 400) DCLS = 3,750(800 – 400) – 1,000,000 – 200,000 = 5 times Interpretation: When sales change 1%, Earnings Per Share Interpretation: When sales change 1%, Earnings Per Share will change 5.0% will change 5.0% The Effects of Financial Leverage A Proposed Change in Financial Leverage: Current Assets $5,000,000 Proposed $5,000,000 Debt $0 $2,500,000 Equity $5,000,000 $2,500,000 Debt/Equity 0 1 Share Price $10 $10 Shares Outstanding 500,000 250,000 Interest Rate 10% n/a 37 38 The Effects of Financial Leverage Current Capital Structure:No Debt (Ignore Taxes) Recession Expected Expansion $300,000 $650,000 $800,000 0 0 0 Net Income $300,000 $650,000 $800,000 EBIT Interest ROE 6% 13% 16% EPS $.60 $1.30 $1.60 With no debt: ROE=NI/$5,000,000 EPS = NI/500,000 39 The Effects of Financial Leverage Proposed Capital Structure:Debt/Equity=1 Recession Expected Expansion $300,000 $650,000 $800,000 250,000 250,000 250,000 Net Income $ 50,000 $400,000 $550,000 EBIT Interest ROE 2% 16% 22% EPS $.20 $1.60 $2.20 With debt: ROE=NI/$2,500,000 EPS = NI/250,000 Computing Break-even EBIT 40 A. With no debt: A. EPS = EBIT/500,000 EPS B. With $2,500,000 in debt at 10%: B. EPS = (EBIT - $250,000)/250,000 C. These are equal when: C. EPSBE = EBITBE/500,000 = (EBITBE - $250,000)/250,000 EPSBE EBIT (EBIT D. With a little algebra: D. EBITBE = $500,000 EBITBE $500,000 So EPSBE = $1.00/share So BE ...
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