cost of capital_ chapter 10

Cal State - East Bay 10 - 1

Chapter 10Cost of Capital

• Cost of Capital Components-Debt-Preferred-Common Equity

• WACC

Cal State - East Bay 10- 2

What types of long-term capital do firms use?

• Long-term debt

• Preferred stock

• Common equity- New Issues

- Retained Earnings

Cost of a source of capital for the company would be the investors’ required return on that investment.

Intuition

The required return r must… 1. compensate our investors (common,

preferred, and bonds) for the risks they bear2. take into account what fraction of the funding is

coming from each type of investor3. take taxes into account

1

0 11 1mm

CFFACFFANPV CFFA

r r


Why Cost of Capital Is Important

• The return earned on assets depends on the risk of those assets

• Our cost of capital provides us with an indication of how the market views the risk of our assets

• The cost of capital is our required return for capital budgeting projects


Required Return• The required return is based on the risk of the

cash flows• With the required return we can compute the

NPV• We need to earn at least the required return to

compensate our investors for the financing they have provided


Initial Assumptions1. The cash flows of the project are of similar risk

to those of the existing firm2. The project will use a similar mix of financing

as the existing firm


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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.

10- 7


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 internal equity from reinvested earnings cheaper than the cost of issuing new common stock?

10- 8

Cost of Equity• The return required by common

stockholders to invest in our project given the riskiness of project cash flows.

• Two methodsDividend growth model

SML or CAPM



• Directly, by issuing new shares of common stock.

• Indirectly, by reinvesting earnings that are not paid out as dividends (i.e., retaining earnings).

What are the two ways that companies can raise common equity?

The Dividend Growth Model Approach

• Start with the dividend growth model formula and rearrange to solve for RE

1

0

0

0

(1 )

E

E

DR g

PD g

R gP

= +

+= +



2. Using DCF:

11.0

06.000.40$

00.2$

gPgDg

PDrs

0

0

0

1 1

You are estimating the cost of retained earnings for Jax Liquor. The current stock price is $40 and the next expected dividend is $2.00. The company’s dividends are expected to grow at a constant annual rate of 6%.


Estimating the Growth Rate• Use the historical growth rate if you

believe the future will be like the past.• Obtain analysts’ estimates: Value Line,

Zack’s, Yahoo!.Finance.• Use the earnings retention model,

illustrated on next slide.

Example: Estimating the Dividend Growth Rate

• One method for estimating the growth rate is to use the historical average– Year Dividend Percent Change– 1995 1.23– 1996 1.30– 1997 1.36– 1998 1.43– 1999 1.50

•(1.30 – 1.23) / 1.23 = 5.7%•(1.36 – 1.30) / 1.30 = 4.6%•(1.43 – 1.36) / 1.36 = 5.1%•(1.50 – 1.43) / 1.43 = 4.9%

•Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%Cal State - East Bay 10- 14

Advantages and Disadvantages of Dividend 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

– Sensitive to the estimated growth rate – Does not explicitly consider systematic risk



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.

The SML Approach (CAPM)• Use the following information to compute

our cost of equity

))(( fMEfE RRERR



Issues in Using CAPM

• Most analysts use the rate on a long-term (10 to 20 years) government bond as an estimate of rRF. For a current estimate, go to www.bloomberg.com, select “U.S. Treasuries” from the section on the left under the heading “Market.”

More…

http://www.bloomberg.com/


Issues in Using CAPM (Continued)

• Most analysts use a rate of 5% to 6.5% for the market risk premium (RPM)

• Estimates of beta vary, and estimates are “noisy” (they have a wide confidence interval). For an estimate of beta, go to www.bloomberg.com and enter the ticker symbol for STOCK QUOTES.

http://www.bloomberg.com/

Advantages and Disadvantages of SML

• Advantages– Explicitly adjusts for systematic risk– Applicable to all companies

• Disadvantages– Have to estimate the expected market risk premium– Have to estimate beta– We are relying on the past to predict the future,

which is not always reliable



1. Using CAPM• You are trying to estimate the cost of retained

earnings for Xenex CO. A 10-year treasury bond is currently yielding 7%. You estimate that the company’s beta is 1.14 and that the required return on the market is 12%. The cost of retained earnings using CAPM would be:

%7.12127.0)07.012.0(14.107.0 sr

Cost of Debt• The cost of debt is the required return on

our company’s debt• We usually focus on the cost of long-term

debt or bonds• Estimated by computing the yield-to-

maturity on the existing debt• We may also use estimates of current

rates based on the bond rating we expect when we issue new debt

• The cost of debt is NOT the coupon rate



Cost of Debt

• Method 1: Ask an investment banker what the coupon rate would be on new debt.

• Method 2: Find the bond rating for the company and use the yield on other bonds with a similar rating.

• Method 3: Find the yield on the company’s debt, if it has any.


Cost of Debt• Assume that a firm has an outstanding 30-

year semi-annual coupon bond with a face value of $1,000 and an annual coupon rate of 14%. The bond is selling at par. If the company issues new bonds, a flotation cost of 5% would be incurred. The firm’s combined marginal federal and state tax rate is 40%. What is the cost of debt?


Cost of Debt

70 70 + 1,0001,000

0 1 2 60i = ?

60 -950 70 1,000

7.37% x 2 = rd = 14.74% N I/YR PV FVPMT

-950

...

INPUTS

OUTPUT

First calculate the YTM, taking into account that the firm only receives (1-0.05)$1,000 = 950 per bond issued:


Cost of Debt

• Interest is tax deductible, so the after tax (AT) cost of debt is:

rd AT = rd BT(1 - T)

= 14.74%(1 - 0.40) = 8.84%.

• Use nominal rate

Cost of Preferred Stock• Preferred generally pays a constant

dividend every period, g = 0.• Dividends are expected to be paid every

period forever

0

0

0

(1 )p

p

D gR g

PDRP



Cost of preferred stock?

%.16.80816.02100$

8$

00.2$100$8

FPD

r psps

Use this formula:

A firm can issue 8% preferred stock with a par value of $100. The flotation cost is 2% of the par value.


Is preferred stock more or less risky to investors than debt?

• More risky; company not required to pay preferred dividend.

• However, firms want to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, and (3) preferred stockholders may gain control of firm.


Why is yield on preferred lower than rd?

• Corporations own most preferred stock, because 70% of preferred dividends are nontaxable to corporations.

• Therefore, preferred often has a lower B-T yield than the B-T yield on debt.

• The A-T yield to investors and A-T cost to the issuer are higher on preferred than on debt, which is consistent with the higher risk of preferred.


Example:

rps = 9% rd = 10% T = 40%

rps, AT = rps - rps (1 - 0.7)(T)

= 9% - 9%(0.3)(0.4) = 7.92%rd, AT = 10% - 10%(0.4) = 6.00%

A-T Risk Premium on Preferred = 1.92%

The Weighted Average Cost of CapitalWACC

• Average the returns required to attract different types of investors to get a single discount rate.

• This “average” is the overall required return on our assets, based on the market’s perception of the risk of those assets

• The weights are determined by how much of each type of financing that we use


Capital Structure Weights• Notation

E = market value of equity = # outstanding shares times market price per common share

D = market value of debt = # outstanding bonds times bond market price

P = market value of preferred = # outstanding shares times market price per preferred share

V = market value of the firm = D + E + P• Capital Structure Weights

wE = E/V = percent financed with equity

wD = D/V = percent financed with debt

wp = P/V = percent financed with preferredCal State - East Bay 10- 33

Taxes and the WACC

• We are concerned with after-tax cash flows, so we need to consider the effect of taxes on the various costs of capital

• 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 impact on the cost of equity

• WACC = wERE + wDRD(1-TC) + wPRP



Example:• Current (Optimal) Capital Structure:

– Debt: 25% Pref St: 15% Com St:60%• NI = $17,142.86• Div pay-out ratio: 30%; tax rate = 40%• D0 = $3.60; P0 = $60; g=9%• rRF = 11%; rM = 14%; beta = 1.51• Flotation costs on new common stock(F) = 10%• Par value of new preferred stock = $100• Dividend on new preferred stock = $11• Flotation Cost on new preferred stock = $5 per share• Before-tax required return on new debt = 12%


Find the component costs of capital

• After-tax cost of new debt:rd(1-t) = 0.12(1-0.40) = 0.072 = 7.2%

• Cost of Preferred Stock:rps =D/(P-F) = 11/(100-5) = 0.1158 = 11.58%

• Cost of Retained Earnings:Method 1:

rs=D1/P0+g = 3.60(1.09)/60+0.09 = 0.1554Method 2:

rs= rRF +(rM – rRF) = 0.11+1.51(.14-.11) = .1553• Cost of New Common Stock:

re = D1/(P-F)+g = 3.60(1.09)/(60(1-0.1))+0.09 = 0.1627


How much new capital could be raised before the firm needs to sell new equity?

• Retained Earnings available:NI(1-div payout ratio) = 17142.86(1-.30) = 12,000

• Retained Earnings Breakpoint 12,000/0.60 = $20,000


WACC• Using retained earnings:

WACC = 0.25(0.12)(1-0.4)+0.15(0.1158)+0.60(0.1554) = 0.1286 = 12.86%

• Using new common stock:WACC = 0.25(0.12)(1-0.4)+0.15(0.1158)+0.60(0.1627)

= 0.1330 = 13.30%


Graphically:

$20,000 $ of new capital

WACC

13.30%

12.86%


WACC Estimates for Some Large U. S. Corporations

Company WACC wd

Intel (INTC) 16.0 2.0%Dell Computer (DELL) 12.5 9.1%BellSouth (BLS) 10.3 39.8%Wal-Mart (WMT) 8.8 33.3%Walt Disney (DIS) 8.7 35.5%Coca-Cola (KO) 6.9 33.8%H.J. Heinz (HNZ) 6.5 74.9%Georgia-Pacific (GP) 5.9 69.9%


What factors influence a company’s WACC?

• Market conditions, especially interest rates and tax rates.

• The firm’s capital structure and dividend policy.

• The firm’s investment policy. Firms with riskier projects generally have a higher WACC.

10- 41

WACC as Discount Rate

IRR ?

1

0 11 1m

m

CFFACFFANPV CFFA

WACC WACC

1E E D D P PWACC w R w R T w R


Divisional and Project Costs of Capital

• Using the WACC as our discount rate is only appropriate for projects that are the same risk and will be financed in the same way as the firm’s current operations

• If we are looking at a project that is NOT the same risk or financed in the same way as the firm, then we need to determine the appropriate discount rate for that project

• For example, divisions often require separate discount rates


Using WACC for All Projects - Example

• What would happen if we use the WACC for all projects regardless of risk?

• Assume the WACC = 15%

Project IRR WACC Truth A 17% 15% 20% B 18% 15% 16% C 12% 15% 10%


FIGURE 15.1


The Pure Play Approach• Find one or more companies that specialize

in the product or service that we are considering

• Compute the beta for each company• Take an average• Use that beta along with the CAPM to find

the appropriate return for a project of that risk• Often difficult to find pure play companies


Subjective Approach• Consider the project’s risk relative to the firm

overall• If the project is more risky than the firm, use a

discount rate greater than the WACC• If the project is less risky than the firm, use a

discount rate less than the WACC• You may still accept projects that you shouldn’t

and reject projects you should accept, but your error rate should be lower than not considering differential risk at all


Subjective Approach - Example

Risk Level Discount Rate

Low Risk WACC – 4%

Same Risk as Firm WACC = 14%

High Risk WACC + 6%

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FIGURE 15.2


cost of capital_ chapter 10

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