1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity...
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Transcript of 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity...
1
CHAPTER 10
The Cost of Capital
2
Topics
Cost of Capital Components Debt Preferred Common Equity
WACC Composite Risk Adjustments WACC with Flotation Costs
3
Sources of Long-term Capital
10-3
rd
rsrps
rce re
4
WACCWeighted Average Cost of Capital
Where:
wd = % of debt in capital structurewps = % of preferred stock in capital structurewce = % of common equity in capital structure
rd = firm’s cost of debtrps= firm’s cost of preferred stockrs = firm’s cost of equity
T = firm’s corporate tax rate
Weights
Component costs
WACC = wdrd(1-T) + wpsrps + wcers (10.10)
5
Capital Components Capital components = sources of
funding from investors Accounts payable, accruals, and
deferred taxes ≠ sources of funding from investors Not included in calculation of the
cost of capital Adjustments made when calculating
project cash flows
6
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 outstanding debt
7
NCC’s Cost of Debt (rd)
A 22-year, 9% semiannual coupon bond sells for $835.42
Bond pays a semiannual coupon:rd = 5.5% x 2 = 11%
Calculator Solution 44 835.42
45 1000
= 5.50%
8
Component Cost of Debt
Interest is tax deductible, so the after tax (AT) cost of debt is: rd AT = rd BT(1 - T) rd AT = 11%(1 - 0.40) =
6.6% Use nominal rate
9
Flotation Costs on New Debt Flotation costs on debt usually low Frequently ignored
“Project Financing” Adjusts project’s cash flows for
flotation costs of debt Debt has specific claim on the
project’s cash flows
10
Adjusting the Cost of Debt for Flotation Costs
N
1tN
dt
d )]T1(r1[
M
)]T1(r1[
)T1(INT)F1(M 2)-(10
Where:
M = Bond’s par value (face value)
F = Flotation cost as a %
N = Number of coupon payments
T = Corporate tax rate
INT = Dollars of interest per period
rd(1-T) = after tax cost of debt adjusted for inflation
11
NCC’s Cost of Debt (rd) with Flotation Costs
NCC can issue 30-year bonds
N = 60 11% annual coupon rate
Coupons paid semiannually PMT = [(.11 x 1000)/2]*(1-.40) PMT = $33
Flotation cost = 1% PV = -1000(1-.01) = -990
Face value = M = 1000
Calculator Solution 60 990
33 1000
= 3.34%
Nominal after-tax cost of debt with flotation costs = 6.68%
12
Preferred Stock
Flotation costs for preferred are significant Use net price
Preferred dividends are not deductible No tax adjustment Use rps
Nominal rps is used
13
NCC’s Cost of preferred stock: PP = $100 $10 Dividend F =
2.5%
3)-(10 )F1(P
Dr
ps
psps
Where:
Dps = Preferred dividend
PPS = Preferred stock priceF = Flotation cost %
10.3%
)025.1(100$
10$rps
14
Cost of Common Equity
Two Ways to raise equity financing: Directly
Issue new shares of common stock Indirectly
Reinvesting earnings not paid out as dividends
Use retained earnings
15
Funding with New Common Equity
Mature firms rarely issue new equity High flotation costs Negative signal to the market Downward pressure on stock
price
16
Cost of 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 reinvested
17
Cost for Reinvested Earnings
Opportunity cost: The return stockholders could earn on alternative investments of equal risk They could buy similar stocks and earn
rs, or company could repurchase its own stock and earn rs
rs = the cost of reinvested earnings = the cost of equity
18
Three ways to determine the cost of equity, rs:
1. CAPM: rs = rRF + (RM - rRF)β
= rRF + (RPM)β
2. DCF: rs = D1/P0 + g
3. Own-Bond-Yield-Plus-Risk Premium:
rs = rd + Bond RP
19
Three ways to determine the cost of equity, rs:
1. CAPM: rs = rRF + (RM - rRF)β
= rRF + (RPM)β
2. DCF: rs = D1/P0 + g
3. Own-Bond-Yield-Plus-Risk Premium:
rs = rd + Bond RP
20
1. Estimate risk-free rate (rRF)
2. Estimate market risk premium (RPM) or expected return on the market (RM)
3. Estimate beta (β)4. Substitute into CAPM
CAPM Cost of Equity - Steps
21
Estimating rRF
Common stock = long-term security
T-Bills more volatile than T-Bonds Most analysts use the rate on a
long-term (10 to 30 years) government bond as an estimate of rRF
22
Estimating RPM or RM
Historical - Ibbotson & Associates 1926-most recent year 6.5% arithmetic mean - if constant risk
aversion 4.9 % geometric mean – best future
estimate Ex Ante = Forward-Looking
If market in equilibrium: Return Required Return Expected MMRF0
1M RRPrg
P
Dr̂
Historical or analysts’ estimates
Value Line or Reuters
23
RPM Estimate – #1RPM = 11.73%
rM Estimate (Reuters, Spring 2008) Dividend yield on S&P500 = 2.61% Dividend growth rate = 13.20% rM=[0.0261(1+.132)]+0.132=16.15%
Forward-looking RPM: Long-term T-Bond rate = 4.42% 16.15% - 4.42% = 11.73%
Problems: Past = future? Growth rates sensitive to period
measured
gP
)g1(Dr̂
0
0M
24
RPM Estimate – #2 RPM = 17.79%
rM Estimate (Spring 2008) Reuters S&P500 dividend yield = 2.61% Yahoo Earnings growth rate = 19.1% rM=[0.0261(1+.191)]+0.191=22.21%
Forward-looking RPM: 22.21% - 4.42% = 17.79%
Problems: Earnings growth ≠ dividend growth 1-year growth rate ≠ long-term growth Analysts’ accuracy Differing analysts’ opinions
gP
)g1(Dr̂
0
0M
25
Estimating RPM (or RM)
RPM = Equity risk premium Most analysts use a rate of 5% to
6.5% for the market risk premium RM
S&P500 index return =proxy for the market return
RPM=RM- rRF
Brigham-Daves →RPM = [3.5, 6.5]
26
Estimating Beta - β Beta estimates vary Beta estimates are “noisy”
Wide confidence interval Historical Beta
4-5 years/monthly or 1-2 years/weekly
Adjusted Beta Fundamental Beta
Multinational issues
27
NCC’s CAPM Cost of Equity
rs = rRF + (RM - rRF )β
= 8.0% + (6.0%)1.1
= 14.6%
rRF = 8% RPM = 6% β= 1.1
28
Three ways to determine the cost of equity, rs:
1. CAPM: rs = rRF + (RM - rRF)β
= rRF + (RPM)β
2. DCF: rs = D1/P0 + g
3. Own-Bond-Yield-Plus-Risk Premium:
rs = rd + Bond RP
29
DCF Approach: Inputs
1. Current stock price (P0)
2. Current dividend (D0)
3. Growth rate (g)
g expected
5)-(10
o
1ss
s
10
P
Dr̂r
gr
DP̂
30
Estimating the Growth Rate
The historical growth rate If you believe future = past
The earnings retention model Analysts’ estimates:
Value Line, Zack’s, Yahoo.Finance
31
Earnings Retention Model NCC Data:
ROE = 14.5% Dividend payout ratio = 52%
Retention ratio = 100% - dividend payout Retention rate = 100% - 52% = 48%
Retention growth rate: g = ROE x (Retention rate) g = (14.5%) x 0.48 = 7%
32
Earnings Retention Assumptions
1. Retention rate is constant2. ROE on new investments is
constant3. No new common stock will be
issued4. The risk of future projects is very
close to the risk of the overall firm
33
Using Analysts’ Forecasts Analysts’ estimate earnings growth
= proxy for dividend growth Sometimes involve non-constant growth
Develop a proxy constant rate
Analysts’ Estimates for NCC: 10.4% annual growth for 5 years 6.5% growth after 5 years
Analysts’ estimates usually best source
g = 6.9%
34
NCC’s DCF Cost of Equity, rs
rs = D1
P0
+ g =D0(1+g)
P0
+ g
= $2.40
$32+ 0.07
= 0.075 + 0.07
= 14.5%
D1 = $2.40 P0 = $32 g = 7%
35
Three ways to determine the cost of equity, rs:
1. CAPM: rs = rRF + (RM - rRF)β
= rRF + (RPM)β
2. DCF: rs = D1/P0 + g
3. Own-Bond-Yield-Plus-Risk Premium:
rs = rd + Bond RP
36
The Own-Bond-Yield-Plus-Risk-Premium Method: rd = 11%, RP = 3.7%
rs = rd + RP rs = 11.0% + 3.7% = 14.7%
This RP CAPM RPM
Produces ballpark estimate of rs Useful check
37
Final Estimate of rs
Method Estimate
Used by
CAPM 14.6% 74% - 85%
DCF 14.5% 16%
rd + RP 14.7% Non-public
Average 14.6%
38
Flotation Costs for Equityre = Cost of New Equity
9)-(10 g)F1(P
Dr̂r
0
1ee
NCC: D1 = $2.40 P0 = $32 F = 12.5%
15.6%
07.)125.1(32$
40.2$r̂r ee
39
Topics
Cost of Capital Components Debt Preferred Common Equity
WACC Composite Risk Adjusted WACC with Flotation Costs
40
WACCWeighted Average Cost of Capital
Where:
wd = % of debt in capital structurewps= % of preferred stock in capital structurewce= % of common equity in capital structure
rd = firm’s cost of debtrps= firm’s cost of preferred stockrs= firm’s cost of equity
T = firm’s corporate tax rate
Weights
Component costs
WACC = wdrd(1-T) + wpsrps + wcers (10.10)
41
WACC Weights
Weights =percentages of the firm that will be financed by each component
If possible, always use the target weights for the percentages of the firm that will be financed with the various types of capital NCC: 30% debt, 10% Preferred, 60% Equity
42
NCC’s WACCWeighted Average Cost of Capital
WACC =0.3(11%)(1-.40)+0.1(10.3%)+0.6(14.6%)
WACC = 11.77%
Component w r
Debt (before tax)
0.30 11.0%
Preferred Stock 0.10 10.3%
Common equity 0.60 14.6%WACC = wDrD (1- T)+ wPsrPs + wcrs
43
Cost of Capital Issues Before-tax vs. After-tax Capital
Costs Long- and short-term debt affected
Historical Costs vs. Marginal Costs Target Weights vs. Annual Financing
Choices Target Weights vs. Book Values
44
Estimating Weights for the Capital Structure
Estimate the weights using current market values rather than current book values
If market value of debt is not known: Usually reasonable to use the book
values of debt, especially if the debt is short-term
45
Estimating Weights
Given: The stock price is $50 There are 3 million shares of
stock $25 million of preferred stock $75 million of debt
46
Estimating Weights
Vce = $50 x (3 million) = $150 million
Vps = $25 million Vd = $75 million Total value = $150 + $25 + $75 =
$250 million
47
Estimating Weights
Value WeightStock price $50Share O/S 3,000,000
Preferred Stock $25,000,000 $25,000,000 10%
Debt $75,000,000 $75,000,000 30%
$250,000,000 100%
$150,000,000 60%
Total Firm
48
WACC
Tax Rate = 40% Cost of Capital
Stock price $50Share O/S 3,000,000
Preferred Stock $25,000,000 $25,000,000 10% 10.30% 1.03%
Debt $75,000,000 $75,000,000 30% 11.00% 60% 1.98%
$250,000,000 100% 11.77%
WACC
8.76%
Tax Effect
14.60%
Total Firm
Value Weight
$150,000,000 60%
49
Factors that influence a company’s WACC Market conditions
Interest rates The market risk premium Tax rates
Firm’s capital structure Firm’s dividend policy Firm’s investment policy
Firms with riskier projects generally have a higher WACC
50
Topics
Cost of Capital Components Debt Preferred Common Equity
WACC Composite Risk Adjusted WACC with Flotation Costs
51
Risk-Adjusted WACC The composite WACC reflects the
risk of an average project undertaken by the firm
Different divisions/projects may have different risks
The division’s or project’s WACC should be adjusted to reflect the appropriate risk and capital structure
52
Divisional Risk and the Cost of Capital
Rate of Return (%)
WACC
Rejection Region
Acceptance Region
Risk
WACC H
WACC L
WACC F
0 Risk L Risk H
Acceptance Region
Rejection Region
53
Using WACC for All Projects - Example
What would happen if we use the WACC for all projects regardless of risk?
Assume the WACC = 15%Required
Project Return IRR If 15% Risk AdjA 20% 17% Accept RejectB 15% 18% Accept AcceptC 10% 12% Reject Accept
Decision
54
The Risk-Adjusted Divisional Cost of Capital
Estimate the cost of capital that the division would have if it were a stand-alone firm
Requires estimating the division’s beta, cost of debt, and capital structure CAPM frequently used
55
Pure Play Method for Estimating Beta for a Division or a Project
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
56
Huron Steel Example
Riskfree rate = 7%Market risk premium = 6%
Division Beta COC % BusSteel 1.1 13.60% 70%Barge 1.5 16.00% 20%Distrib 0.5 10.00% 10%Overall 1.12 13.72%
Huron Steel Company
57
Subjective Approach Consider the project’s risk
relative to the firm overall If project risk > firm risk
Project discount rate > WACC If project risk < firm risk
Project discount rate < WACC
58
Subjective Approach - Example
Risk Level Discount Rate
Very Low Risk WACC – 8% 7%
Low Risk WACC – 3% 12%
Same Risk as Firm WACC 15%
High Risk WACC + 5% 20%
Very High Risk WACC + 10% 25%
59
Topics
Cost of Capital Components Debt Preferred Common Equity
WACC Composite Risk Adjusted WACC with Flotation Costs
60
Flotation Costs Flotation costs depend on the risk
of the firm and the type of capital being raised
Flotation costs: Highest for common equity Most firms issue equity infrequently
Flotation costs frequently ignored when calculating WACC
61
NCC’s WACC With New Debt
WACC = wdrATd + wpsrps + wcre
WACC = 0.3(6.68%)+0.1(10.3%) +0.6(14.6%)WACC = 2.004% + 1.03% + 9.36% = 11.794%
Component w r
New Debt (after-tax)
d 0.30 6.68%
Preferred Stock ps 0.10 10.3%
New Common equity
c 0.60 14.6%
62
NCC’s WACC With New Debt & New Equity
WACC = wdrATd + wpsrps + wcre
WACC = 0.3(6.68%)+0.1(10.3%) +0.6(15.6%)WACC = 2.004% + 1.03% + 9.36% = 12.394%
Component w r
New Debt (after-tax)
d 0.30 6.68%
Preferred Stock ps 0.10 10.3%
New Common equity
c 0.60 15.6%
63
NCC’s WACC
WACC Description WACC
No New Issues 11.770%
With New Debt 11.794%
With New Debt & New Equity
12.394%
64
Increasing Marginal Cost of Capital Externally raised capital flotation costs
Increases the cost of capital Investors often perceive large capital
budgets as being risky Drives up the cost of capital
If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital
500 700
%
Capital Required
WACC1 = 11.77%
WACC2 = 12.394%
8
9
10
12
13
14
15
16
Increasing Marginal Cost of Capital
61
No external funds
External debt & equity
66
Four Mistakes to Avoid Current (YTM) vs. historical (Coupon rate) cost
of debt Mixing current and historical measures to
estimate the market risk premium Book weights vs. Market Weights
Use Target weights Use market value of equity Book value of debt is a reasonable proxy for market
value Incorrect cost of capital components
Only investor provided funding
67
CHAPTER 10
The Cost of Capital