Chap012 Cost of Capital

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12-1

Copyright 2011 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin


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Key Concepts and Skills

Know how to determine:

A firms cost of equity capital

A firms cost of debt A firms overall cost of capital

Understand pitfalls of overall cost of

capital and how to manage them


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Chapter Outline

12.1 The Cost of Capital: Some Preliminaries

12.2 The Cost of Equity

12.3 The Costs of Debt and Preferred Stock12.4 The Weighted Average Cost of Capital

12.5 Divisional and Project Costs of Capital


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Cost of Capital Basics

The cost to a firm for capital funding =the return to the providers of those funds The return earned on assets depends on

the risk of those assets

A firms cost of capital indicates how themarket views the risk of the firms assets

A firm must earn at least the required returnto compensate investors for the financingthey have provided

The required return is the same as theappropriate discount rate


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12-5

Cost of Equity

The cost of equity is the return required byequity investors given the risk of thecash flows from the firm

Two major methods for determining thecost of equity

- Dividend growth model

- SML or CAPM

Return toQuick Quiz


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The Dividend Growth ModelApproach

Start with the dividend growth modelformula and rearrange to solve forRE

gP

DR

gRDP

0

1E

E

10


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Example: Dividend Growth Model

Your company is expected to pay a dividendof $4.40 per share next year. (D1)

Dividends have grown at a steady rate of

5.1% per year and the market expects that tocontinue. (g)

The current stock price is $50. (P0)

What is the cost of equity?

139.051.50

40.4RE


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Example: Estimating the DividendGrowth Rate

One method for estimating the growthrate is to use the historical average

Year Dividend Percent Change

2003 1.232004 1.30

2005 1.36

2006 1.432007 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%


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Advantages and Disadvantages ofDividend Growth Model

Advantage easy to understand and use

Disadvantages

Only applicable to companies currently payingdividends

Not applicable if dividends arent growing at a

reasonably constant rate

Extremely sensitive to the estimated growthrate

Does not explicitly consider risk


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The SML Approach

Use the following information to computethe cost of equity

Risk-free rate, Rf

Market risk premium, E(RM)

Rf

Systematic risk of asset,

)R)R(E(RR fMEfE
http://www.bloomberg.com/


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Example: SML

Companys equity beta = 1.2

Current risk-free rate = 7%

Expected market risk premium = 6% What is the cost of equity capital?

%2.14)6(2.17RE


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Advantages and Disadvantagesof SML

Advantages Explicitly adjusts for systematic risk

Applicable to all companies, as long as beta is

available Disadvantages

Must estimate the expectedmarket risk premium,

which does vary over time

Must estimate beta, which also varies over time

Relies on the past to predict the future, which is not

always reliable


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Example: Cost of Equity

Data: Beta = 1.5 Market risk premium = 9% Current risk-free rate = 6%.

Analysts estimates of growth = 6% per year Last dividend = $2. Currently stock price =$15.65

Using SML: RE = 6% + 1.5(9%) = 19.5% Using DGM: RE = [2(1.06) / 15.65] + .06

= 19.55%


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Cost of Debt

The cost of debt = the required return ona companys debt

Method 1 = Compute the yield to

maturity on existing debt Method 2 = Use estimates of current

rates based on the bond rating

expected on new debt The cost of debt is NOT the coupon rate


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Example: Cost of Debt

Current bond issue:

15 years to maturity

Coupon rate = 12%

Coupons paidsemiannually

Currently bond price =

$1,253.72

301253.72100060

4.45%

YTM = 4.45%*2 = 8.9%


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Component Cost of Debt

Use the YTM on the firms debt

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

If the corporate tax rate = 40%:

)T1(RR CBT,DAT,D

%34.5)40.1%(9.8R AT,D

Return toQuick Quiz


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Cost of Preferred Stock

Preferred pays a constant dividend everyperiod

Dividends expected to be paid forever

Preferred stock is a perpetuity

Example:

Preferred annual dividend = $10 Current stock price = $111.10

RP= 10 / 111.10 = 9%

0

PP

DR


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Weighted Average Cost of Capital

Use the individual costs of capital tocompute a weighted average cost ofcapital for the firm

This average = the required return onthe firms assets, based on themarkets perception of the risk ofthose assets

The weights are determined by howmuch of each type of financing isused

Return toQuick Quiz


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Determining the Weights for theWACC

Weights = percentages of the firmthat will be financed by each

component

Always use the target weights, if

possible If not available, use market values


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Capital Structure Weights

NotationE = market value of equity

= # outstanding shares times price per share

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

V = market value of the firm = D + E

WeightsE/V = percent financed with equity

D/V = percent financed with debtReturn toQuick Quiz


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WACC

WACC = (E/V) x RE +(P/V) x RP + (D/V) x RD x (1- TC)

Where:

(E/V) = % of common equity in capital structure(P/V) = % of preferred stock in capital structure(D/V) = % of debt in capital structure

RE = firms cost of equity

RP = firms cost of preferred stockRD= firms cost of debt

TC= firms corporate tax rate

Weights

Componentcosts


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Estimating Weights

Given: Stock price = $50

3m shares common stock

$25m preferred stock

$75m debt

40% Tax rate

Weights:

E/V = $150/$250 = 0.6 (60%)

P/V = $25/$250 = 0.1 (10%)

D/V = $75/$250 = 0.3 (30%)

Component Values:VE = $50 x (3 m) = $150m

VP = $25m

VD = $75m

VF = $150+$25+$75=$250m


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WACC

WACC = 0.6(14%)+0.1(9%) +0.3(10%)(1-.40)

WACC = 8.4% + 0.9% + 1.8% = 11.1%

Component W R

Debt (before tax) 0.30 10%

Preferred Stock 0.10 9%

Common equity 0.60 14%

WACC = E/V x RE +P/V x RP + D/V x RD (1- TC)


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Table 12.1


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Factors that Influence aCompanys WACC

Market conditions, especially interestrates, tax rates and the market risk

premium The firms capital structure and dividend

policy

The firms investment policy Firms with riskier projects generally have ahigher WACC


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Eastman Chemical 1Equity

Source: http://finance.yahoo.com
http://finance.yahoo.com/http://finance.yahoo.com/


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Eastman Chemical 2Dividend Growth


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EastmanChemical

- 3Beta andDividends



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Market Risk Premium = 7% (assumed)

T-Bill rate = 0.07% (90 day)

Tax rate (assumed) = 35%

Beta (Reuters):

Source: http://www.reuters.com

Eastman Chemical 4Other Data
http://www.reuters.com/http://www.reuters.com/


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Eastman Chemical - 5Cost of Equity - SML

Beta Yahoo.Finance 2.01

Reuters 1.92

Average 1.965

T-Bill rate 0.07%

Market Risk Premium 7%

Cost of Equity (SML) = .07% + (7%)(1.965)= 13.83%

)R)R(E(RR fMEfE


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Eastman Chemical - 6Cost of Equity - DCF

Growth rate 7%

Last dividend $1.76

Stock price $52.99

Cost of Equity (DCF) =

%55.10R

07.99.52

)07.1(76.1$R

gP

DR

E

E

0

1E


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Eastman Chemical - 7Cost of Equity

Cost of Equity In Textbook In Slideshow

SML Method 10.29% 13.83%

DCF Method 14.91% 10.55%Average 12.60% 12.19%


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Eastman Chemical - 8Bonds

Source: http://cxa.marketwatch.com/finra/Bondcenter
http://cxa.marketwatch.com/finra/bondcenterhttp://cxa.marketwatch.com/finra/bondcenter


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Eastman Chemical - 9Bonds

Coupon Face Value Price Weighted

Rate Maturity (millions) % Par ($ m) % YTM YTM

7.00% 2012 $154 100.5 154.8 11.0% 6.784 0.748

6.30% 2018 207 104.0 215.3 15.3% 5.729 0.878

7.25% 2024 497 107.0 531.8 37.9% 6.489 2.457

7.63% 2024 200 100.0 200.0 14.2% 7.623 1.0867.60% 2027 298 101.5 302.5 21.5% 7.443 1.603

$1,356 1404.3 100.0% 6.772

Market Value

Since market values are deemed more relevant, we useonly market value weights

Average YTM = 6.772% versus 8.70% in the textbook

E t Ch i l 10


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Capital structure weights:

E = 72.67 million x $52.99 = $3.851 billion

D = 1.404 billion

V = $3.851 + 1.404 = 5.255 billion

E/V = 3.851 / 5.255 = .7328

D/V = 1.404 / 5.255 = .2672

WACC = .7328(12.19%) + .2672(6.772%)(1-.35)

= 10.11% (versus 9.79% in text)

Eastman Chemical - 10WACC


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Risk-Adjusted WACC

A firms WACC reflects the risk of an

average project undertaken by the firm

Average risk = the firms current operations

Different divisions/projects may have

different risks

The divisions or projects WACC should beadjusted to reflect the appropriate risk and

capital structure

Return to

Quick Quiz


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Using WACC for All Projects

What would happen if we use theWACC for all projects regardless of risk?

Assume the WACC = 15%

Project IRR WACC=15%

A 17% Accept

B 18% Accept

C 12% Reject

Decision


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Using WACC for All Projects

Assume the WACC = 15% Adjusting for risk changes the decisions

RequiredProject Return IRR WACC=15% Risk Adj

A 20% 17% Accept Reject

B 15% 18% Accept Accept

C 10% 12% Reject Accept

Decision


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Divisional Risk & the Cost of Capital

Rate of Return(%)

WACC

Rejection Region

Acceptance Region

Risk

WACCH

WACCL

WACCF

0 RiskL RiskH

Acceptance Region

Rejection Region

REPLACE WITH FIGURE 12.1

Di i i l Ri k & th C t f


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Divisional Risk & the Cost ofCapital


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Pure Play Approach

Find one or more companies thatspecialize in the product or servicebeing considered

Compute the beta for each company Take an average

Use that beta along with the CAPM to

find the appropriate return for a projectof that risk

Pure play companies difficult to find

Return to

Quick Quiz


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Subjective Approach

Consider the projects risk relativeto the firm overall

If the project is riskier than the firm,

use a discount rate greater than theWACC

If the project is less risky than the firm,

use a discount rate less than theWACC

Return to

Quick Quiz


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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%


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Quick Quiz

What are the two approaches for computing thecost of equity? (Slide 12.5)

How do you compute the cost of debt and the aftertax cost of debt? (Slide 12.16)

How do you compute the capital structure weightsrequired for the WACC? (Slide 12.20)

What is the WACC? (Slide 12.18)

What happens if we use the WACC as the discountrate for all projects? (Slide 12.36)

What are two methods that can be used tocompute the appropriate discount rate whenWACC isnt appropriate? (Slide 12.41 and Slide 12.42)


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Chapter 12

END

Chap012 Cost of Capital

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