Ch 08 Cost of Capital

7/29/2019 Ch 08 Cost of Capital

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CHAPTER 8Determining the Cost of Capital

Cost of Capital Components

Debt

PreferredCommon Equity

WACC


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What types of long-term capital do

firms use?

Long-term debtPreferred stock

Common equity


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Capital components are sources offunding that come from investors.

Accounts payable, accruals, anddeferred taxes are not sources of

funding that come from investors, sothey are not included in thecalculation of the cost of capital.

We do adjust for these items whencalculating the cash flows of aproject, but not when calculating thecost of capital.


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Should we focus on before-tax or

after-tax capital costs?

Tax effects associated with financingcan be incorporated either in capitalbudgeting cash flows or in cost ofcapital.

Most firms incorporate tax effects in

the cost of capital. Therefore, focuson after-tax costs.

Only cost of debt is affected.


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Should we focus on historical costs ornew (marginal) costs?

The cost of capital is used primarilyto make decisions which involveraising and investing new capital.

So, we should focus on marginalcosts.


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Cost of Debt

Method 1: Ask an investment bankerwhat the coupon rate would be on

new debt.Method 2: Find the bond rating for

the company and use the yield onother bonds with a similar rating.

Method 3: Find the yield on thecompanys debt, if it has any.


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A 15-year, 12% semiannual bond sells

for $1,153.72. Whats kd?

60 60 + 1,00060

0 1 2 30

i = ?

30 -1153.72 60 1000

5.0% x 2 = kd = 10%

N I/YR PV FVPMT

-1,153.72...

INPUTS

OUTPUT


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Component Cost of Debt

Interest is tax deductible, so theafter tax (AT) cost of debt is:

kd AT = kd BT(1 - T)

= 10%(1 - 0.40) = 6%.

Use nominal rate.Flotation costs small, so ignore.


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Whats the cost of preferred stock?

PP = $113.10; 10%Q; Par = $100; F = $2.

%.0.9090.010.111$

10$

00.2$10.113$

100$1.0

n

ps

psP

Dk

Use this formula:


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Note:

Flotation costs for preferred aresignificant, so are reflected. Usenet price.

Preferred dividends are notdeductible, so no tax adjustment.Just kps.

Nominal kps is used.


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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 toraise additional funds, and (3)preferred stockholders may gaincontrol of firm.


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Directly, by issuing new shares ofcommon stock.

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

What are the two ways that companies

can raise common equity?


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Earnings can be reinvested or paid

out as dividends.

Investors could buy other securities,earn a return.

Thus, there is an opportunity cost ifearnings are reinvested.

Why is there a cost for reinvested

earnings?


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Opportunity cost: The returnstockholders could earn onalternative investments of equalrisk.

They could buy similar stocksand earn ks, or company couldrepurchase its own stock and

earn ks. So, ks, is the cost ofreinvested earnings and it is thecost of equity.


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Three ways to determine the

cost of equity, Ks:

1. CAPM: ks = kRF + (kM - kRF)b

= kRF + (RPM)b.

2. DCF: ks = D1/P0 + g.

3. Own-Bond-Yield-Plus-RiskPremium:

ks = kd + RP.


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Whats the cost of equity

based on the CAPM?kRF = 7%, RPM = 6%, b = 1.2.

ks = KRF + (kM - kRF )b.

= 7.0% + (6.0%)1.2 = 14.2%.


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Issues in Using CAPM

Most analysts use the rate on a long-term (10 to 20 years) governmentbond as an estimate of kRF.

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


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Whats the DCF cost of equity, ks?

Given: D0 = $4.19;P0 = $50; g = 5%.

g

P

gDg

P

Dks

0

0

0

11

$4. .

$50.

. .

.

19 1050 05

0 088 0 05

13 8%.


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Estimating the Growth Rate

Use the historical growth rate if youbelieve the future will be like the

past.Obtain analysts estimates.

Use the earnings retention model,

illustrated on next slide.


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Suppose the company has beenearning 15% on equity (ROE = 15%)and retaining 35% (dividend payout

= 65%), and this situation isexpected to continue.

Whats the expected future g?


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Retention growth rate:

g = ROE(Retention rate)

g = 0.35(15%) = 5.25%.

This is close to g = 5% given earlier.


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Could DCF methodology be applied

if g is not constant?

YES, nonconstant g stocks areexpected to have constant g atsome point, generally in 5 to 10years.

But calculations get complicated.


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Find ks using the own-bond-yield-

plus-risk-premium method.(kd = 10%, RP = 4%.)

ks = kd + RP= 10.0% + 4.0% = 14.0%


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Whats a reasonable final estimate

of ks?

Method Estimate

CAPM 14.2%

DCF 13.8%

kd + RP 14.0%

Average 14.0%


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Determining the Weights for the WACC

The weights are the percentages ofthe 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 thevarious types of capital.


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Estimating Weights for the

Capital Structure If you dont know the targets, it is

better to estimate the weights using

current market values than currentbook values.

If you dont know the market value of

debt, then it is usually reasonable touse the book values of debt,especially if the debt is short-term.

(More...)


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Estimating Weights (Continued)

Suppose the stock price is $50, there

are 3 million shares of stock, the firmhas $25 million of preferred stock,and $75 million of debt.

(More...)


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Vce = $50 (3 million) = $150 million.

Vps = $25 million.

Vd = $75 million.

Total value = $150 + $25 + $75 = $250million.

wce = $150/$250 = 0.6

wps = $25/$250 = 0.1

wd = $75/$250 = 0.3


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Whats the WACC?

WACC = wd

kd

(1 - T) + wps

kps

+ wce

ks

= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)

= 1.8% + 0.9% + 8.4% = 11.1%.


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WACC Estimates for Some Large

U. S. CorporationsCompany WACCGeneral Electric (GE) 12.5Coca-Cola (KO) 12.3Intel (INTC) 12.2Motorola (MOT) 11.7Wal-Mart (WMT) 11.0Walt Disney (DIS) 9.3

AT&T (T) 9.2Exxon Mobil (XOM) 8.2H.J. Heinz (HNZ) 7.8BellSouth (BLS) 7.4


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What factors influence a companys

WACC?

Market conditions, especially interestrates and tax rates.

The firms capital structure anddividend policy.

The firms investment policy. Firmswith riskier projects generally have ahigher WACC.


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1. When a company issues new

common stock they also have to payflotation costs to the underwriter.

2. Issuing new common stock may

send a negative signal to the capitalmarkets, which may depress stockprice.

Why is the cost of internal equity fromreinvested earnings cheaper than thecost of issuing new common stock?


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Estimate the cost of new commonequity: P

0=$50, D

0=$4.19, g=5%, and

F=15%.

g

FP

gDke

)1(

)1(

0

0

%.4.15%0.550.42$

40.4$

%0.515.0150$

05.119.4$


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Estimate the cost of new 30-year debt:Par=$1,000, Coupon=10%paid annually,

and F=2%.

Using a financial calculator:

N = 30PV = 1000(1-.02) = 980

PMT = -(.10)(1000)(1-.4) = -60

FV = -1000

Solving for I: 6.15%


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Comments about flotation costs:

Flotation costs depend on the risk ofthe firm and the type of capital being

raised.The flotation costs are highest for

common equity. However, sincemost firms issue equity infrequently,the per-project cost is fairly small.

We will frequently ignore flotationcosts when calculating the WACC.


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Four Mistakes to Avoid

1. When estimating the cost of debt,dont use the coupon rate on existing

debt. Use the current interest rate onnew debt.

2. When estimating the risk premium for

the CAPM approach, dont subtractthe current long-term T-bond rate fromthe historical average return oncommon stocks. (More ...)


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For example, if the historical kM hasbeen about 12.7% and inflation

drives the current kRF up to 10%, thecurrent market risk premium is not12.7% - 10% = 2.7%!

(More ...)


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3. Dont use book weights to estimatethe weights for the capital structure.

Use the target capital structure to determinethe weights.

If you dont know the target weights, thenuse the current market value of equity, andnever the book value of equity.

If you dont know the market value of debt,

then the book value of debt often is areasonable approximation, especially forshort-term debt.

(More...)


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4. Always remember that capitalcomponents are sources of fundingthat come from investors.

Accounts payable, accruals, anddeferred taxes are not sources of

funding that come from investors, sothey are not included in thecalculation of the WACC.

We do adjust for these items whencalculating the cash flows of theproject, but not when calculating theWACC.

Ch 08 Cost of Capital

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