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Chapter 9 : The Cost of CapitalFinancial Management: Theory and Practice13th EDITION

Dahlia Djunaidy122 121 022Sundari Siedarta122 121 119Yulita Nova122 121 138

Magister Management Trisakti

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Cost of CapitalWeighted Average Cost of Capital - WACC weighted average cost of capital (WACC), is weighted average of required rate of return on each capital component or component costCapital Component or Componen Cost

Capital components are sources of funding that come from investors.

A/P, accruals, and deferred taxes are not sources of funding that come from investors, & not included in the calculation of the cost of capital.

These items are adjusted for when calculating project cash flows, not when calculating the cost of capital.

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Cost of CapitalWeighted Average Cost of Capital - WACC 3

Weighted Average Cost of Capital

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Cost of CapitalBASIC DEFINITION

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Cost of CapitalCost Of Debt rd (1 - T)

Determining Cost of DebtMethod 1: Ask an investment banker what coupon rate would be on new debt.Method 2: Find bond rating for the company and use yield on similarly rated bonds. (use the market price of the bonds to find the yield to maturity)Method 3: Find yield on the companys existing debt.6

Cost of Capitalthe weighted average cost of capital is calculated using theafter-tax cost of debt, rd(1 T )which is :the interest rate on debt (rd) less the tax savings (T )

Assume :tax rate = 40%, Interest rate on Debt = 9%After tax-cost of debt= rd (1 T)= 9% (1 0.4)= 5.4%

Cost Of Debt rd (1 - T)

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Cost of CapitalFor cost of debt, dont use coupon rate on existing debt, which represents cost of past debt.

Use the current interest rate on new debt

Flotation Costs and the Cost of DebtCost Of Debt rd (1 - T)

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Cost of CapitalFlotation Costs and the Cost of Debt

Cost Of Debt rd (1 - T)

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Cost of CapitalThe Cost of Short-Term DebtFor Calculating WACC; the cost of short term debt should include as a Capital Component; mostly like Bank Loans,

The interest rate on short-term debt is its pre-tax cost, and it must be adjusted to Determine its after-tax cost.

Flotation costs small, so Flotation adjustments are not requiredCost Of Debt rd (1 - T)

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Cost of CapitalCost of Preferred Stock, rps

Flotation costs for preferred are significant, so are reflected. Use net price.

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

Nominal rps is used.11

Cost of Capital 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.Is preferred stock more or less risky to investors than debt?Cost of Preferred Stock, rps

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Cost of Capitalcomponent cost of preferred stock, rpsUse :rps =DpsPps (1 F)Dps= the preferred dividend, Pps = the preferred stock price, F = the flotation cost as a percentage of proceeds.Cost of Preferred Stock, rps

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Cost of CapitalIlustration :Cost of preferred stock: Pps = $125; 10.26% Div; Par = $100; F = 8.8%Use :rps =DpsPps (1 F)=10.26 % ($100)$125.00(1 0.088)=$10.26$114.=0.090 = 9.0%Cost of Preferred Stock, rps

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Cost of CapitalCost of Common Stock, rs

Companies can raise common equity in two ways: by selling newly issued shares to the public,

(2) by retaining and reinvesting earnings.15

Cost of Capital Earnings can be reinvested or paid out as dividends. Investors could buy other securities, earning a return. Thus, there is an opportunity cost if earnings are reinvested Cost for Reinvested EarningsCost of Common Stock, rs

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Cost of Capital 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. So, rs, is cost of reinvested earnings and is cost of common equity.Cost for Reinvested Earnings - continuedCost of Common Stock, rs

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Cost of CapitalThree ways to determine the cost of equity, rs: 1.CAPM: rs = rRF + (rM rRF)bi = rRF + (RPM)bi2.DCF: rs = D1/P0 + g3.Own-Bond-Yield-Plus-Judgmental-Risk Premium: rs = rd + Bond RP.Cost of Common Stock, rs

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Cost of CapitalThe CAPM Approach Capital Asset Pricing Model

rs = rRF + (rM rRF)b1 = rRF + (RPM)b1rs =Cost of EquityrRF = Estimate Risk Free RateRPM = (rM rRF) = Market Risk Premiumb1 = Beta Coefficient

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Cost of CapitalEstimate Risk Free Rate- use the rate on 10-year Treasury bonds (T-Bonds) Or- most analysts use the yield on yields on 20- or 30-year T-bonds are also reasonable proxies.

WHY ?Common stocks are long-term securities .Short-term Treasury bill rates are more volatile than are long-term Treasury bond rates and, a time period of 10 years is a reasonable average for projects lives, the return on a 10-year T-bond is a logical choice for the risk-free rate.

The CAPM Approach Capital Asset Pricing Model

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Cost of CapitalEstimating the Market Risk Premium1. Historical Risk Premium2. Forward-Looking Risk Premiums

The CAPM Approach Capital Asset Pricing Model

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Cost of CapitalThe CAPM Approach Capital Asset Pricing Model

3. Survey of Expert that the forward-looking marketrisk premium should be based on inflation-adjusted expected returns

4. Brigham Opinion When stock prices are relatively high, investors feel less risk averse, so we would use a risk premium at the low end of our range.Conversely, when prices are depressed, we would use a premium atthe high end of the range. Estimating the Market Risk Premium22

Cost of CapitalillustrationThe CAPM Approach Capital Asset Pricing Model

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rRF = 5%, RPM = 5.5%, bi = 1.2cost of equity is rs = r RF + ( Rpm ) bi= 5 % + ( 5.5% ) 1.2= 5% + 6.6%= 11 % 23

Cost of CapitalDividend yield Plus Growth Rate ORDiscounted Cash Flow DCF Approach

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Cost of CapitalDividend yield Plus Growth Rate ORDiscounted Cash Flow DCF Approach

Estimating Inputs for the DCF Approach3 inputs are required to use the DCF approach: - the current stock price,- the current dividend, and - the marginal investors expected dividend growth rate. 25

Cost of CapitalDividend yield Plus Growth Rate ORDiscounted Cash Flow DCF Approach

Historical Growth Rate = which implicitly assume that investors expect past results to be repeated in the future (mostly use at slow Growing companies )

Retention Growth Model = which implicitly assumes that investors expect historical payout ratios and ROEs to be repeated

Analysts Forecasts = usually predict actual future growthEstimated Expected Devidend Growth Rate

g = ROE (Retention ratio)26

Cost of CapitalDividend yield Plus Growth Rate ORDiscounted Cash Flow DCF Approach

IllustrationAssume :stock sells = $32, next expected dividend = $1.82, expected growth rate = 5.5%. not expected to repurchase any stock.

DCF = ^ rs = rs = $ 1.82 + 5.5% $ 32 = 5.7% + 5.5 % = 11. 2 %27

Cost of CapitalOver Own-Bond Yield Plus Judgmentalrisk OrPremium Approach

rs = rd + Bond RP or rs = Companys own bond yield + Judgmental risk premiumAssume bonds yield = 9.0% judgmental risk premium estimated = 3%

rs = 9 % + 3 % = 12 %28

Cost of CapitalComparison of The CAPM, DCF and Premium Risk MethodsThe overall average of these three methods results are unusually close, so it would make little difference which one we used.

- The CAPM Recent surveys indicate that the CAPM is by far the most widely used method- DCF Method mostly down used- Premium Risk - is relied upon primarily by companies that are not publicly traded29

Cost of Capital ADJUSTING THE COST OF EQUITYFOR FLOTATION COSTSIssue New common Stock = cost of external equity

The cost of new common equity, re , or external equity is higher than the cost of equity raised internally by reinvesting earnings, rs, because of the flotation cost involved in issuing new common stockUse :D1 re = + g P0 (1 - F)30

Cost of CapitalIlustration :Cost of new common equity: D1 = $1.82; 5.5% growth; Par = $32; F = 12.5%Use : D1 $1.82re = + g = + 5.5% P0 (1 - F) $32 (1 0.125)= 6.5% + 5.5%= 12% ADJUSTING THE COST OF EQUITYFOR FLOTATION COSTS31

Cost of CapitalComposite or weighted average cost of capitalWACC = wd rd (1-T) + Wstd Rstd + wps rps + ws rs

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Cost of CapitalIlustration :Assume : wd = 30% wps = 10% ws = 60% rps = 8.2% rs = 11.6% rd = 9%. T = 40%weighted average of capital? WACC = 0.3(9%) (1-0.4) + 0.1(8.2%) + 0.6(11.6%)= 1.62% + 0.82% + 6.96%= 9.4%Composite or weighted average cost of capital33

Cost of CapitalMarginal Rates versus Historical Rates the WACC is the cost the company would incur to raise each new, ormarginal, dollar of capitalit is not the average cost of dollars raised in the past.

2. Target Weights versus Annual Financing Choices the percentages of each capital component, called weights, should be based on managements target capital structure, not on the particular sources of financing in any single year.

3. Weights for Component Costs: Book Values versus Market Values versus Targets the target weights should be based on market values and not on book valuesComposite or weighted average cost of capitalTips34

Cost of CapitalFactors That Affect the WACCCan not Control

The stock and bond markets.(2) The market risk premium(3) The tax ratesCan control

Its capital structure policy(2) Its dividen policy(3) Its investment (capital budgeting) policy35

Cost of CapitalStand-alone riskis the variability of the projects expected returns Corporate or within-firm, riskis the variability the project contributes to the corporations returns, giving consideration to the fact that the project represents only one asset of the firm s portfolio of assets The tax ratesis the risk the project as seen by a well-diversified stockholders who owns many different stocksAdjusting the Cost of Capital for Risk Estimating the Cost of Capital for Individual Projects36

Cost of CapitalThe analysts the use this estimated value of equity to estimate the cost capital, next use the cost of capital to estimate the value of the firm, and finally complete the circle by using the estimated value of the firm to estimate the value of its equityPrivately Owned Firms and Small Business37

Cost of CapitalFour Mistakes to AvoidNever base the cost of debt on the coupon rate on a firms existing debt.When estimating the market risk premium for the CAPM method, never use the historical average return on stocks in conjunction with the current return on T-bonds.Never use the current book value capital structure to obtain the weights when estimating the WACC.Always remember that capital are funds that come from investors.38

Cost of CapitalQuestions???39

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