12.0 Chapter 12 Cost of Capital. 12.1 Issues in Chapter 12 What is cost of capital? Why is cost of...
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Transcript of 12.0 Chapter 12 Cost of Capital. 12.1 Issues in Chapter 12 What is cost of capital? Why is cost of...
12.1
Chapter
12Cost of Capital
12.2
Issues in Chapter 12
What is cost of capital?Why is cost of capital important?Know how to determine a firm’s cost of equity
Common stockPreferred stock
Know how to determine a firm’s cost of debt Know how to determine a firm’s overall cost
of capital, or weighted average of cost of capital (WACC)
12.3
Cost of Capital: Georgia Pacific Co.“On a market-value basis, our debt-to-capital ratio was 47 percent. By employing this capital structure, we believe that our weighted average cost of capital is nearly optimized – at approximately 10 percent …..” from Annual Report
12.4
The Cost of Capital: What is it? Simply speaking, it refers to the opportunity cost
that a firm incurs in raising capital to finance new projects. Ways to finance new project
“GE issued 6% 20-year bonds and borrowed capital from JP Morgan to invest on new technology for its electronic division.”
“eBay paid 0.39 share to acquire each of the approximately 68 million fully diluted shares of PayPal. Based on eBay's closing price Thursday of $51.90 in 4 p.m. on the Nasdaq Stock Market trading, the deal was valued at $1.4 billion.” (from WSJ, October 14, 2002)
12.5
What types of long-term capital do firms use?
Debt
Long-term debt (e.g., bond)
Equity
Preferred stock
Common stock
Note: Accounting identity: Assets = Liabilities + Equity
12.6
The Cost of Capital
What the firm must pay for capital in the capital markets More specifically, minimum rate of return required
on new investments
Depends on the risk associated with the firm’s activities Equal to the equilibrium rate of return demanded by
investors in the capital markets for securities of that degree of risk
12.7
Why Cost of Capital is Important
We know that the return earned on assets depends on the risk of those assets (risk and return trade-off)
Our cost of capital provides us with an indication of how the market views the risk of our assets
WACC
12.8
Why Cost of Capital is Important
Knowing our cost of capital can also help us determine our discount rate for capital budgeting projects The firm uses it to discount future cash
flows from investment to be made by the firm. That is, a rate in computing NPV.
We need to earn at least the cost of capital to compensate our investors for the financing they have provided
12.9
For example, suppose a firm considers an investment proposal that requires an initial investment of $1 million. The investment will generate $400,000 per year for next three years. Find NPV. The cost of capital is 8%.CF0 = -1,000,000, CF1 = 400,000, CF2 = 400,000,
CF3 = 400,000, I = 8, NPV = +30,839, Accept it!Had the cost of capital been 10%, the NPV
would’ve been -$5,259, so we reject the investment proposal
12.10
Why Cost of Capital is Important
Conclusion: Acceptance of new investment depends on the cost of capital (or discount rate)
Cost of capital = Discount rate
12.11
Why Cost of Capital is Important
Conclusion: The return to an investor is the same as the cost to the company (opportunity cost concept)
Cost of capital = required rate of return
12.12
Final conclusion
Cost of capital to fund investments
= Required return from investments
= Discount rate for computing NPVs
12.13
Weighted Average of Cost of Capital
WACC = RD(1-t)(D/V) + RE(E/V)
whereV = value of the firms = debt + equity = D + ERD = the cost of debt
RE = the cost of equity Cost of common stock Cost of preferred stock
t = the firm’s marginal tax rate
12.14
WACC: The Cost of Debt
The cost of debt is the return that the firm’s creditors demand on new borrowing.
We usually focus on the cost of long-term debt or bonds
The required return is best estimated by computing the yield-to-maturity on the existing debt
The cost of debt is NOT the coupon rate
12.15
Example: Cost of Debt
Suppose Greenspan Co. has a bond issue currently outstanding that has 25 years left to maturity. The coupon rate is 9% and coupons are paid semiannually. The bond is currently selling for $908.72 per $1,000 bond. What is the cost of debt?N = 50; PMT = 45; FV = 1000; PV = -908.72; I/Y = 5%; YTM = 5(2) = 10%
12.16
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 liabilityThis reduction in taxes reduces our cost of debtAfter-tax cost of debt = RD(1-t)
Dividends are not tax deductible, so there is no tax impact on the cost of equity
WACC = wERE + wDRD(1-t)
12.17
WACC: Cost of EquityThe cost of equity is the return required by
equity investors given the risk of the cash flows from the firm
We know that the return earned on assets depends on the risk of those assets
The return to an investor is the same as the cost to the company
The cost of equity is the return required by equity investors given the risk of the cash flows from the firm
12.18
WACC: Cost of Equity
There are two methods for determining the cost of equityDividend Growth ModelSecurity Market Line (SML) / Capital Asset
Pricing Model (CAPM)
12.19
The Dividend Growth Model Approach
Start with the dividend growth model formula and rearrange to solve for RE
gP
DR
gR
DP
E
E
0
1
10
12.20
The CAPM or SML Approach
Use the following information to compute our cost of equityRisk-free rate, Rf
Market risk premium, E(RM) – Rf
Systematic risk of asset,
))(( fMEfE RRERR
12.21
Example: Cost of Equity
Suppose Greenspan Co. has a beta of 1.5. The market return is expected to be 15% and the current risk-free rate is 6%. We have used analysts’ estimates to determine that the market believes our dividends will grow at 6% per year and our last dividend was $2. Our stock is currently selling for $15.65. What is our cost of equity?Using SML: RE = 6% + 1.5(9%) = 19.5%
Using DGM: RE = [2(1.06) / 15.65] + .06 = 19.55%
12.22
So we have two numbers.
We simply take an average of these two measurements to get the final cost of equity.
Average = (19.5%+19.55%)/2
= 19.525%
12.23
Now we are ready to compute WACC.
We can use the individual component costs of capital to get our “average” cost of capital for the firm.
The weights are determined by how much of each type of financing that we use
12.24
Capital Structure Weights
NotationE = market value of equity = # outstanding shares
times price per shareD = market value of debt = # outstanding bonds
times bond priceV = market value of the firm = D + E
WeightswE = E/V = percent financed with equity
wD = D/V = percent financed with debt
12.25
Example: Capital Structure Weights
Suppose Greenspan Co. has a total 10 million shares of outstanding common stock with the current market price of $47.5 per share and a total 400,000 shares of corporate bonds with the market price of $1,250 per share.What are the market values of equity and debt?
MVE = 10 million shares * $47.5 = $475 million MVD = 400,000 shares * $1,250 = $500 million
What are the capital structure weights? V = 500 million + 475 million = 975 million wE = E/D = 475 / 975 = .4872 = 48.72 % wD = D/V = 500 / 975 = .5128 = 51.28%
12.26
WACC: Greenspan Co.
Suppose t = 30%.
WACC
= RD(1-t)(D/V) + RE(E/V)
= 10%(1-.3)(.5128) + 19.525%(.4872)
= .1310 or 13.10%
12.27
Example: WACC
Highfield Industries must make an estimate of the weighted average cost of capital (WACC). The stock of Highfield Industries has an expected dividend next year of $1.56, an estimated growth rate of 4%, and the stock is currently selling for $26. The beta of Highfield Industries is 1.25. Debt similar to Highfield’s is selling in the bond market at a price of $1,172.90. The bonds have a 10% annual coupon, paid semiannually, 15 years to maturity and a par value of $1,000. The risk free rate is 4% and the expected return on the market is 12%. Highfield has a corporate tax rate of 35%. Currently Highfield has the optimal capital structure with 45% of debt and 55% of equity. Find the WACC.
Microsoft Excel Worksheet
12.28
What if your company has outstanding preferred stock?
RemindersPreferred generally pays a constant dividend every
periodDividends are expected to be paid forever
Preferred stock pays perpetuity, so we take the perpetuity formula, rearrange and solve for RP.
RP = D / P0
12.29
Example: Cost of Preferred Stock
Your company has preferred stock that has an annual dividend of $3. If the current price is $25, what is the cost of preferred stock?
RP = 3 / 25 = 12%
12.30
Example: IBM IBM needs an estimate of the weighted average of cost of
capital for their firm. The firm has just paid a dividend of $1.27, a current stock price of $20.00, and an expected growth rate in dividends of 10%. The IBM’s beta is 1.25. The risk free rate is 5% and the expected return on the market portfolio is 13%. The company has bonds outstanding with a par value of $1,000, coupon rate of 8% paid semiannually, and 5 years until maturity. These bonds are selling in the market of $852.80. IBM also carries preferred stocks on its balance sheet. The preferred stocks sell for $30 per share and they pay a dividend of $3 per share. IBM faces 30% marginal tax rate, and has 40% debt, 10% preferred stock, and 50% common stock in its capital structure.
Microsoft Excel Worksheet
12.31
IBM example, Continued
1. Calculate the cost of debt.
2. Calculate the cost of common stock, using Gordon Growth Model and Capital Asset Pricing Model (CAPM). Take an average.
3. Calculate the cost of preferred stock.
4. Calculate the weighted average of cost of capital.
12.32
IBM example, Continued
IBM currently considers producing a new mainframe computer. The financial analysts of the company agree that this new project will carry the same level of risk as the average risk of the company. The new investment will require $1,000,000 and expected cash inflows will be $250,000 annually for five years (net of tax). Should IBM take on this project?
Compute Net Present Value (NPV) using the cost of capital we just computed.
12.33
Divisional and Project Costs of CapitalUsing the WACC as our discount rate is only
appropriate for projects that are the same risk as the firm’s current operations
If we are looking at a project that is NOT the same risk as the firm, then we need to determine the appropriate discount rate for that project
Different projects or divisions often require separate discount rates. Why? See the next slide.
12.34
Example Suppose you are a financial analyst of “Headache Free,
Co.,” a leading pain relief drug manufacturer. Currently, the WACC of the company to be 10%. The CEO of the company just announced that the company will invest in anti-AIDS drug research. Would you recommend that the company use the same 10% as a hurdle rate for anti-AIDS research project?
No! The anti-AIDS research project is potentially riskier than the average of typical projects for a pain relief drug company. Should use a higher rate than 10%.
Company WACC ≠ Individual Project WACC
12.35
General Electric and its subsidiaries
12.36
Subjective Approach - Example
Risk Level Discount Rate
Very Low Risk WACC – 8%
Low Risk WACC – 3%
Same Risk as Firm WACC
High Risk WACC + 5%
Very High Risk WACC + 10%
12.37
WACC Estimates for Some Large
U. S. CorporationsCompany 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
12.38
Costs of Capital for various industries by Value Line
Cost of Capital by Industry
Our cost of capital provides us with an indication of how the market views the risk of our assets!