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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 longterm debt or
We
bonds
bonds
The required return is best estimated by
The
computing the yieldtomaturity 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(1TC) • 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(1TC)
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 aftertax 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
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= R0 = %Bonds x Cost of Bonds x (1T)
+ %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 (1T)
+ %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) – FCD
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 DCLAlternative Computation
DCLS =
Q=
Price =
Variable costs =
FC+Dep =
Interest = Example: Q(P – V)
Q(P – V) – FCD – 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 Breakeven 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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 Spring '08
 Staff
 Managerial Accounting

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