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BUS 420 Chapter_10

# BUS 420 Chapter_10 - CHAPTER 10 CHAPTER Determining the...

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Unformatted text preview: CHAPTER 10 CHAPTER Determining the Cost of Capital 1 Focus Areas Focus Cost of Capital Components ◦ Debt ◦ Preferred ◦ Common Equity WACC 2 What types of long-term capital do firms use? (a1) do Long-term debt Preferred stock Common equity 3 Capital Components (a1) Capital Capital components are sources of funding that come from investors. Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the cost of capital. We do adjust for these items when calculating the cash flows of a project, but not when calculating the cost of capital. 4 Before-tax vs. After-tax Capital Costs (a2/a3) Costs Tax effects associated with financing. Tax effects in the cost of capital. Cost of debt. Historical (Embedded) Costs vs. Historical New (Marginal) Costs New •Raising and investing new capital. 5 Cost of Debt (b) Cost Method 1: Investment banker. Method 2: Bond ratings. Method 3: Yield on the company’s debt. 6 A 15-year, 12% semiannual bond sells for \$1,153.72. What’s rd? sells Settings: 1_p/yr 0 1 60 I = ? ­1,153.72 INPUTS OUTPUT 2 30 60 ... 60 + 1,000 30 ­1153.72 60 1000 N I/YR PV PMT 5.0% x 2 = rd = 10% FV 7 A 15-year, 12% semiannual bond sells for \$1,153.72. What’s rd? sells Settings: 2_p/yr 0 1 60 I = ? ­1,153.72 INPUTS OUTPUT 2 30 60 ... 60 + 1,000 30 ­1153.72 60 1000 N I/YR PV rd = 10% PMT FV 8 Component Cost of Debt (b) Component Interest is tax deductible, so the after tax (AT) cost of debt is: ◦ rd AT = rd BT(1 - T) ◦ rd AT = 10%(1 - 0.40) = 6%. Use nominal rate. Flotation costs small, so ignore. 9 Cost of preferred stock: 10%Q; Par = \$100; F = 5% (C1) \$100; Use this formula: rps = Dps = Pps (1-F) = 0.1(\$100) \$116.95(1-0.05) \$10 = 0.090 = 9.0% \$111.10 10 Is preferred stock more or less risky to investors than debt? (c2) risky Why is yield on preferred lower than rd? (c2) 11 Example: Example: rps = 9%, rd = 10%, T = 40% (c2) rps, AT = rps ­ rps (1 ­ 0.7)(T) = 9% ­ 9%(0.3)(0.4) = 7.92% rd, AT = 10% ­ 10%(0.4) = 6.00% A­T Risk Premium on Preferred = 1.92% 12 What are the two ways that companies can raise common equity? (d1 & d2) can Directly Indirectly Why is there a cost for Why reinvested earnings? reinvested Reinvestment vs. payout Buying other securities Opportunity costs 13 Three ways to determine the cost of equity, rs: (d3) the 1. CAPM: rs = rRF + (rM ­ rRF)b = rRF + (RPM)b. 2. DCF: rs = D1/P0 + g. 3. Own­Bond­Yield­Plus­Risk Premium: rs = rd + Bond RP. 14 CAPM Cost of Equity: rRF = 7%, RPM = 6%, b = 1.2. (d3) rs = rRF + (RPM )b. = 7.0% + (6.0%)1.2 = 14.2%. 15 DCF Cost of Equity, rs: DCF D0 = \$4.19; P0 = \$50; g = 5%. (e1) rs = D1 P0 + g = D0(1+g) P0 + g = \$4.19(1.05) + 0.05 \$50 = 0.088 + 0.05 = 13.8% 16 Earnings Retention Model (e2) (e2) Suppose the company has been earning 15% on equity (ROE = 15%) and retaining 35% (dividend payout = 65%), and this situation is expected to continue. What’s the expected future g? 17 Earnings Retention Model (Continued) (e2) (Continued) Growth from earnings retention model: g = (Retention rate)(ROE) g = (1 - payout rate)(ROE) g = (1 – 0.65)(15%) = 5.25%. This is close to g = 5% given earlier. Think of bank account paying 15% with retention ratio = 0. What is g of account balance? If retention ratio is 100%, what is g? 18 Could DCF methodology be applied if g is not constant? (e3) applied YES, nonconstant g stocks are expected to have constant g at some point, generally in 5 to 10 years. 19 The Own-Bond-Yield-Plus-Risk-Premium Method: rd = 10%, RP = 4%. (f) rs = rd + R P rs = 10.0% + 4.0% = 14.0% This bond RP ≠ CAPM RPM. Produces ballpark estimate of rs. Useful check. 20 What’s a reasonable final estimate of rs? (g) estimate Method Estimate CAPM 14.2% DCF 13.8% rd + RP 14.0% Average 14.0% 21 Weights for the WACC Weights Percentages Target weights Estimation Market vs. Book value of debt. 22 Weights for the capital structure structure Suppose the stock price is \$50, there are 3 million shares of stock, the firm has \$25 million of preferred stock, and \$75 million of debt. Vce = \$50 (3 million) = \$150 million. Vps = \$25 million. Vd = \$75 million. Total value = \$150 + \$25 + \$75 = \$250 million. wce = \$150/\$250 = 0.6 wps = \$25/\$250 = 0.1 wd = \$75/\$250 = 0.3 23 What’s the WACC? (h) What’s WACC = wdrd(1 - T) + wpsrps + wcers WACC = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) WACC = 1.8% + 0.9% + 8.4% = 11.1%. 24 What factors influence a company’s WACC? (i) Is the firm’s WACC correct for each of its divisions? (j) each 25 The Risk-Adjusted Divisional Cost of Capital (k) Cost Estimate the cost of capital that the division would have if it were a standalone firm. This requires estimating the division’s beta, cost of debt, and capital structure. ◦ Pure play ◦ Beta method 26 Divisional Cost of Capital Using CAPM (l) CAPM Target debt ratio = 10%. rd = 12%. rRF = 7%. Tax rate = 40%. betaDivision = 1.7. Market risk premium = 6%. Division’s required return on equity: rs = rRF + (rM – rRF)bDiv. rs = 7% + (6%)1.7 = 17.2%. WACCDiv. = wd rd(1 – T) + wc rs = 0.1(12%)(0.6) + 0.9(17.2%) = 16.2%. 27 What are the three types of project risk? (m) project Stand-alone risk Corporate risk Market risk 28 Costs of Issuing New Common Stock (n) Stock Flotation costs. Market signals. 29 Cost of New Common Equity: P0=\$50, D0=\$4.19, g=5%, and F=15%. =\$4.19, (o1) (o1) re = = = D0(1 + g) P0(1 ­ F) + g \$4.19(1.05) \$50(1 – 0.15) + 5.0% \$4.40 + 5.0% = 15.4% \$42.50 30 Cost of New 30-Year Debt: Par=\$1,000, Coupon=10% paid annually, and F=2%. (o2) (o2) Using a financial calculator: ◦ N = 30 ◦ PV = 1000(1-.02) = 980 ◦ PMT = -(.10)(1000)(1-.4) = -60 ◦ FV = -1000 Solving for I/YR: 6.15% 31 Four Mistakes to Avoid (p) Four Current vs. historical cost of debt 2. Mixing current and historical measures to estimate the market risk premium 3. Book weights vs. Market Weights 4. Incorrect cost of capital components 1. 32 ...
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