10 - 1 copyright © 2001 by harcourt, inc.all rights reserved. chapter 10 the cost of capital cost...

10 - 1

Copyright © 2001 by Harcourt, Inc. All rights reserved.

CHAPTER 10The Cost of Capital

Cost of capital componentsAccounting for flotation costsWACCAdjusting cost of capital for riskEstimating project risk

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Coleman Technologies

Marginal tax rate is 40 percent. Current price of its 12 percent coupon,

semiannual bonds with 15 years to maturity is $1,153.72.

Current price of 10 percent, $100 par preferred stock is $111.10.

Common stock is selling at $50 per share. Its last dividend was $4.19 and constant 5 percent growth rate.

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Coleman’s beta is 1.2.The yield on T-bonds is 7 percent.The market risk premium is

estimated to be 6 percent.For the bond-yield-plus-risk-premium

approach, the firm uses a 4 percent risk premium.

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The firm’s target capital structure is:

30 percent long-term debt;

10 percent preferred stock; and

60 percent common equity.

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What are the sources of capital for firms?

Debt

Preferred stock

Common equity:

Retained earnings

New common stock

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The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on today’s marginal costs (for WACC).

Should we focus on historical (embedded) costs or new (marginal)

costs?

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A 15-year, 12% semiannual bond sells for $1,153.72. What’s kd?

60 60 + 1,00060

0 1 2 30i = ?

30 -1153.72 60 1000

5.0% x 2 = kd = 10%

N I/YR PV FVPMT

-1,153.72

...

INPUTS

OUTPUT

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Component Cost of Debt

Interest is tax deductible, so

kd AT = kd BT(1 – T)

= 10%(1 – 0.40) = 6%.Use nominal rate.Flotation costs small.

Ignore.

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What’s the cost of preferred stock? Pp = $111.10; 10%Q; Par = $100.

Use this formula:

%.0.9090.010.111$

10$P

Dk

p

p

p

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Picture of Preferred Stock

2.50 2.50

0 1 2kp = ?

-111.1

...

2.50

$111.10 = = .

kPer = = 2.25%;

kp(Nom) = 2.25%(4) = 9%.

DQ

kPer

$2.50kPer

$2.50$111.10

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Note:

Preferred dividends are not tax deductible, so no tax adjustment. Just kp.

Nominal kp is used.

Our calculation ignores flotation costs.

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Why is there a cost for retained earnings?

Earnings can be reinvested or paid out as dividends.

Investors could buy other securities, earn a return.

Thus, there is an opportunity cost if earnings are retained.

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Opportunity cost: The return stockholders could earn on alternative investments of equal risk.

They could buy similar stocks and earn ks, or company could repurchase its own stock and earn ks. So, ks is the cost of retained earnings.

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Three ways to determine cost of common equity, ks:

1. CAPM: ks = kRF + (kM – kRF)b.

2. DCF: ks = D1/P0 + g.

3. Own-Bond-Yield-Plus-Risk Premium: ks = kd + RP.

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What’s the cost of common equity based on the CAPM?

kRF = 7%, RPM = 6%, b = 1.2.

ks = kRF + (kM – kRF )b.

= 7.0% + (6.0%)1.2 = 14.2%.

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What’s the DCF cost of commonequity, ks? Given: D0 = $4.19;

P0 = $50; g = 5%.

D1

P0

D0(1 + g)P0

$4.19(1.05)$50

ks = + g = + g

= + 0.05

= 0.088 + 0.05= 13.8%.

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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?

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Retention growth rate:

g = (1 – Payout)(ROE) = 0.35(15%) = 5.25%.

Here (1 – Payout) = Fraction retained.

Close to g = 5% given earlier.

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Could DCF methodology be applied if g is not constant?

YES, nonconstant g stocks are expected to have constant g at some point, generally in 5 to 10 years.

But calculations get complicated.

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Find ks using the own-bond-yield-plus-risk-premium method. (kd = 10%, RP = 4%.)

This RP CAPM RP.Produces ballpark estimate of ks.

Useful check.

ks = kd + RP

= 10.0% + 4.0% = 14.0%

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What’s a reasonable final estimate of ks?

Method Estimate

CAPM 14.2%

DCF 13.8%

kd + RP 14.0%

Average 14.0%

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1. When a company issues new common stock they also have to pay flotation costs to the underwriter.

2. Issuing new common stock may send a negative signal to the capital markets, which may depress stock price.

Why is the cost of retained earnings cheaper than the cost of issuing new

common stock?

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Two approaches that can be used to account for flotation costs:

Include the flotation costs as part of the project’s up-front cost. This reduces the project’s estimated return.

Adjust the cost of capital to include flotation costs. This is most commonly done by incorporating flotation costs in the DCF model.

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New common, F = 15%:

g)F1(P)g1(D

k0

0e

%.4.15%0.550.42$

40.4$

%0.515.0150$05.119.4$

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Comments about flotation costs:

Flotation costs depend on the risk of the firm and the type of capital being raised.

The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small.

We will frequently ignore flotation costs when calculating the WACC.

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What’s the firm’s WACC (ignoring flotation costs)?

WACC = wdkd(1 – T) + wpkp + wcks

= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)

= 1.8% + 0.9% + 8.4% = 11.1%.

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What factors influence a company’s composite WACC?

Market conditions.The firm’s capital structure and

dividend policy.The firm’s investment policy. Firms

with riskier projects generally have a higher WACC.

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WACC Estimates for Some Large U. S. Corporations, Nov. 1999

Company WACCIntel 12.9%General Electric 11.9Motorola 11.3Coca-Cola 11.2Walt Disney 10.0 AT&T 9.8Wal-Mart 9.8Exxon 8.8H. J. Heinz 8.5BellSouth 8.2

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Should the company use the composite WACC as the hurdle rate for

each of its projects?

NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the “hurdle rate” for a typical project with average risk.

Different projects have different risks. The project’s WACC should be adjusted to reflect the project’s risk.

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Risk and the Cost of Capital

Rate of Return(%)

WACC

Rejection Region

Acceptance Region

Risk

L

B

A

H12.0

8.0

10.010.5

9.5

0 RiskL RiskA RiskH

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Divisional Cost of CapitalRate of Return

(%)WACC

Project H

Division H’s WACC

Risk

Project LComposite WACCfor Firm A

13.0

7.0

10.0

11.0

9.0

Division L’s WACC

0 RiskL RiskAverage RiskH

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What are the three types of project risk?

Stand-alone riskCorporate riskMarket risk

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How is each type of risk used?

Market risk is theoretically best in most situations.

However, creditors, customers, suppliers, and employees are more affected by corporate risk.

Therefore, corporate risk is also relevant.

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Subjective adjustments to the firm’s composite WACC.

Attempt to estimate what the cost of capital would be if the project/division were a stand-alone firm. This requires estimating the project’s beta.

What procedures are used to determine the risk-adjusted cost of capital for a

particular project or division?

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Methods for Estimating a Project’s Beta

1. Pure play. Find several publicly traded companies exclusively in project’s business.

Use average of their betas as proxy for project’s beta.

Hard to find such companies.

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2. Accounting beta. Run regression between project’s ROA and S&P index ROA.

Accounting betas are correlated (0.5 – 0.6) with market betas.

But normally can’t get data on new projects’ ROAs before the capital budgeting decision has been made.

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Find the division’s market risk and cost of capital based on the CAPM, given

these inputs:

Target debt ratio = 40%.kd = 12%.

kRF = 7%.Tax rate = 40%.betaDivision = 1.7.Market risk premium = 6%.

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Beta = 1.7, so division has more market risk than average.

Division’s required return on equity:

ks = kRF + (kM – kRF)bDiv.

= 7% + (6%)1.7 = 17.2%.

WACCDiv. = wdkd(1 – T) + wcks

= 0.4(12%)(0.6) + 0.6(17.2%)

= 13.2%.

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How does the division’s market risk compare with the firm’s overall market

risk?

Division WACC = 13.2% versus company WACC = 11.1%.

Indicates that the division’s market risk is greater than firm’s average project.

“Typical” projects within this division would be accepted if their returns are above 13.2%.

10 - 1 copyright © 2001 by harcourt, inc.all rights reserved. chapter 10 the cost of capital cost...

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percent preferred stock

cost of preferred stock

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opportunity cost

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percent common equity

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