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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 longterm capital
do firms use? (a1)
do
Longterm 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 Beforetax vs. Aftertax 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 15year, 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 15year, 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 (1F)
= 0.1($100)
$116.95(10.05)
$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 OwnBondYieldPlusRiskPremium
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 RiskAdjusted 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
Standalone 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 30Year 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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This note was uploaded on 02/14/2012 for the course BUS 420 taught by Professor Poindexter during the Spring '08 term at N.C. State.
 Spring '08
 poindexter
 Management, Cost Of Capital, Debt

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