Costs of Capital

8/13/2019 Costs of Capital

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Fall 2005 Dr. Tuftes FIN 4250 Notes 2

What Are the Big FinancingIssues?

Cost of Capital Divisional Hurdles

Capital Structure Leverage Refunding

Dividends


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What Is Capital?

Funding for long term investment Two types

Fixed payout Bonds, preferred stock, etc. Variable payout

Common stock, retained earnings


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What is the Cost of Capital?

Each type of capital has its own cost(measured as a rate)

The cost of capital is a weighted averageof these rates So, our goal is to calculate WACC the

weighted average cost of capital


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How Is the Cost of Capital Used,and How Does It Behave?

A firm uses the cost of capital to figure outhow to finance the marginal investment Marginal in the sense of next or additional

Typically retained earnings are a cheaperway to fill your variable payout category(because there are flotation costs with

issuing new equity) So, most firms WACC is lower for smallinvestments, and higher for large ones


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What Is the Difficulty in CalculatingCost of Capital?

Firms have different ways in which theyraise capital

The problems are that: Their costs are quoted in different ways There are idiosyncrasies with each type of

security


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What Should Go Into the Cost ofCapital?

Capital is long term Debt Common stock Preferred stock Retained earnings

Other long term items can be added


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Is the Cost of Bond Financing theRate On Existing Bonds?

No rates change You want the marginal rate that you would pay on

new financing Note that flotation costs are often ignored because

they are small for bonds The marginal rate is caused by three things

The risk-free rate (which incorporates expectations ofinflation)

The risk premium (determined by the market and yourprospects)

Tax considerations


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Is the Earnings/Price Ratio theCost of Common Stock?

Yes if the firm is not expected to grow Of course, in this case you probably wouldnt

be as worried about the cost of capitalanyway

No if the firm is growing


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Is the Dividend/Price Ratio the Costof Preferred Stock?

No Preferred stock often has higher

placement costs Most preferred dividends (70%) are non-

taxable


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How Do I Calculate the Cost ofBonds?

The current price must equal the PV of thematurity value, plus the PV of the streamof coupons

P = M/(1+k) N + sum{C/(1+k) n} Solve for k

Deflate k by the appropriate tax rate to getthe cost of bonds, k d=k(1-t)


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What Are the Pitfalls with the Costof Bonds?

Thin trading Use a bond rating as a proxy

Yield curve extrapolation Is the horizon your costing currently

available? Callability

This is a mess because you have toincorporate how the yield curve might effectyour decision to call but it can be done


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How Do I Calculate the Cost ofCommon Stock?

Use the CAPM Use discounted cash flow

Note that you have to use this method toreasonably account for flotation costs on newissues


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How Do I Use the CAPM toCalculate the Cost of Equity?

Obtain: A risk-free rate The market risk premium The for your firm

Be aware that all of those must be chosenappropriately for the horizon of your project which might be different than what you woulduse to make a portfolio investment decision

Calculate the cost of capital k s = k rf + (km-krf ) Note that there isnt a reasonable way toincorporate flotation costs


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How Do I Use Discounted CashFlow to Calculate the Cost of

Equity? Obtain the:

Current price

Expected future dividends Expected future growth rate

Calculate: kcs = g + D(1+g)/(P-Flotation Costs)


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Where Do I Get an ExpectedGrowth Rate to Use for Costing?

Use analysts forecasts Use the product of the retention rate and

the return on equity


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How Do I Calculate the Cost ofPreferred Stock?

Cost is the dividend divided by the amountyou clear after flotation, weighted by howmuch is taxable.

kps = (1-.3t)D/(Price-Flotation Cost)


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How Do I Value the Cost ofRetained Earnings?

Retained earnings and common stock arecosted in the same ways Use the: CAPM (see above) Discounted cash flow (see above) Construct a guesstimate:

From your current bond yield plus a risk premium

Then make a judgment call combining allof them


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How Do I Construct Weighted Costof Capital?

The rates are weighted across the componentsby their share of your capital structure Need to decide whether to use book or market value,

lean towards the latter Usually there are two possibilities:

Bonds, preferred stock, and retained earnings, or Bonds, preferred stock, and new equity issues

The difference is how much the flotation costs ofnew issues effect your choice to retain earnings


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What Is a Marginal Cost of CapitalChart?

This shows the rates, as well as the stepat the cutoff where new equity has to beissued for a large enough investment

Generally shown as two flat segments witha step In reality, the rightward segment will

eventually slope upward reflecting limitedability to place large amounts of commonstock


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How Is Depreciation Handled?

Depreciation is a source of internal cashflow, just like retained earnings

Therefore, count it as a retained earning inyour calculations


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What Factors Effect the Cost ofCapital That A Firm Cant Control?

Interest rates Tax rates


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What Factors Effect the Cost ofCapital That A Firm Can Control?

Capital structure Perhaps you can assume more debt to lower

the cost of capital

Dividend policy Perhaps you can reduce your dividends to

reduce the cost of capital

Investment policy Perhaps you can choose less risky projects


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What Are the Potential Pitfalls InCalculating the Cost of Capital?

Private ownership less data Small firms less data

Measurement problems What is the risk-free rate What is the expected growth rate? What is the risk premium?

Capital structure may change


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What Are the Mistakes to Avoid?

Use the current rather than the historicalcost of debt

Dont mix a historical risk premium with acurrent risk-free rate in the CAPM

Unless the firm has an explicit target, yourshare weights should be based on market

valuations Accounts payable and accruals are notsources of capital


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What About Corporate DivisionsWith Different Projects?

Different divisions within a firm will haveinvestment opportunities with different rates ofreturn

But, remember that rates of return are correlated withrisk

A pitfall for a company is that the riskierdivision(s) may have more projects that clear the

investment hurdle so a company that doesnthave divisional hurdles may find itself gettingriskier through time


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How Can the Volatility ofDifferent Divisions Be

Measured? You can calculate betas for different divisions

Obviously this will be easiest if the divisions are stand-alone and

have their own equity Alternatively, you can

Look at the betas for firms that have operations similar toyour divisions

Recall that beta is the ratio of the variances of your riskpremium to that of the market, and proxy for those premiumswith earnings

Make an adjustment based on standard deviations ofearnings without reference to beta


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How Will Cost of Capital Vary Across Divisions?

This really depends on whether your fixedpayout items are issued for the corporationas a whole or by each division

It doesnt matter as much if common stockis issued by the corporation rather than bythe divisions This is because most divisions have either an

explicit or implicit capability of retainingearnings


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How Will Cost of Capital Behave IfDebt Is Corporate But EarningsCan Be Retained at the Division

Level?

The only difference in cost of capital will befrom how beta effects the weight you put oncommon stock or retained earnings


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What Are the Pitfalls In Having

Corporate Debt But DivisionalEquity (or Retained Earnings)?

This may still allow the risky division togrow faster as it takes advantage ofcheaper debt available from thecorporation


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How Will Cost of Capital Behave If

All Capital Is Raised at the DivisionLevel?

Now the bond market will also be pricingthe risk of the division, and the higher riskdivision will not have an advantage

On the other hand, what is the point ofhaving a division (as opposed to anindependent firm) in this case?


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What Are the Pitfalls In LettingDivisions Have Their Own Debt?

Firms dont know too much about theappropriateness of their own capitalstructure, so how would you know howmuch debt each division could carry?

Who will back up the debt Division: then whats the point of keeping

them as a subsidiary? Corporation: there is a moral hazard for

divisional managers


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How Serious a Short-TermProblem Can Differences In

Divisional Risk Be? This problem becomes smaller as:

The firm gets larger The projects get smaller The time frame is shorter

For example, suppose the firm has X% debt. Adopting projects with Y% debt will only slowlymove the overall structure from X% to Y%.


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Are There Incentive Problems WithDivisions?

Firms exist because they are better at reducingtransactions costs than markets This is the Coase Theorem

But markets trade off risk for return in a cheapand decentralized way

Financing with divisions is a problem theCoase Theorem says we should go the otherway Incentive problems come about when we do that

incompletely


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What Is Capital Structure?

The breakdown of the firms capital (long-term financing) into fixed and variablepayout items And then into finer categories


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What Is the Appropriate CapitalStructure?

The short answer is that there isnt one The long answer is that we probably cant

tell what the appropriate capital structureis, so most firms work under theassumption that they shouldnt change theexisting capital structure drastically It worked before, it will work again


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Why Should We Care AboutCapital Structure?

Firms have business risk generated by whatthey do

But then firms adopt additional financial riskwhen they finance with debt They trade off access to capital at lower rates for

potential loss of control if they cant make payments In principle, you can measure these with return

on equity A leverage firm will have a higher ROE, but its hard

to demonstrate this because it isnt clear what tocompare it to


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What Is the (Nave) Theory ofCapital Structure?

The Modigliani-Miller Theorem says that(in the absence of distortionary taxes) afirm cant improve its profitability bychanging its capital structure This is basically a you- cant -game-the-system

result

The problem with it is that in the real world,we do have distortionary taxes


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What Is the (Not-So-Nave) Theoryof Capital Structure?

Our tax system favors debt financingwithout limits

Theoretically then, it is optimal to beinfinitely leveraged This may seem strange, but it follows

because the cost of being overleveraged

(bankruptcy) is not explicit or tangible


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What Is An Even Less NaveTheory of Capital Structure?

Marginal tax rates on equity are not as high aswe think Double taxation is a misnomer the rates arent

added theyre compounded Marginal tax rates on debt may be higher than

we think Individual rates are often higher than corporate and

capital gains rates We may be pretty close to the basic Modigliani-

Miller result


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Capital Structure

What are the pros and cons?

Is there an ideal one?


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What Are the Advantages ofFinancing with Debt?

Tax benefit Because it requires a consistent cash flow,

it disciplines managers


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What are the Disadvantages ofFinancing with Debt?

Increased risk of loss of control (throughbankruptcy)

Increased potential for conflict betweenequity holders and debt holders

Loss of flexibility for future financing


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What are the Tax Benefits ofDebt?

Tax write-off (100% of interest in the U.S.) Most countries have this

Some try to correct for it Carrot: the U.K. - tax credit on dividends Stick: Germany - tax penalty on retained earnings

Wh I Fi V l P iti l


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Why Is Firm Value PositivelyCorrelated with Reasonable Debt

Levels? All firms increase their value by issuing debt,since there is a positive present valueassociated with not paying taxes on interest you

will pay in the future This gain is the tax rate expected on future

earnings times the face value of debt at issue Note that this tax rate is not marginal, since it

covers all the debt not just changes in debt Note that this says nothing about costs of debt

h l d


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What Savings Are Realizedfrom Debt Finance?

Effective interest rates on debt are lower kD = r(1-t) Note that we use the marginal tax rate since

we are talking about new debt Note that this is only a benefit if your actually

making earnings that can be taxed.


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What Can We Predict About theRelationship of Taxes and Debt?

Firms that face higher tax rates should havemore leverage We see this with REITs, which dont pay corporate

taxes, and are less leveraged than similar firms

Firms that can shield themselves in other ways say through depreciation should have lessdebt

Changes in tax rates should be correlated withchanges in leverage ratios

Countries with higher taxes should have moreleveraged firms


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How Does Debt Discipline a Firm?

Free cash flows those over whichmanagers have some discretion invitemanagement inefficiency

For practical purposes, there has to besome limit to how much you need todiscipline your managers so this isnt an

argument for infinite leverage


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What Can We Infer From thePropensity of Debt to Rein In

Management? Managers with a preference for equity financing probably

dont want investors watching them too closely Countries in which shareholders have more power

should also be ones in which leverage is higher Takeover targets are less leveraged than other firms

Operating efficiency is higher in leveraged firms


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When Is Bankruptcy More Likely?

Operating cash flows are small relative todebt obligations

Operating cash flows are relatively volatile

h h f


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What Are the Direct Costs ofBankruptcy?

Not very high 1% of assets held 5 years prior to bankruptcy 5% of assets at the time of bankruptcy

This reflects slow dissolution of assets prior tofiling

Costs are higher if the firm is holding

assets that are less liquid

h A h di C f


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What Are the Indirect Costs ofBankruptcy?

Declining revenue associated withbankruptcy fears on the part of customers

Stricter terms on payables

Wh F A Lik l


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What Features Are Likely toLead to Higher Indirect Costs?

Sellers of products with: Long lives Lots of replacement parts Lots of service

Sellers of products whose quality cant bedetermined in advance

Firms producing products with lots ofcomplements

What Sort of Firms Will Use More


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What Sort of Firms Will Use MoreDebt Because of the Nature of

Bankruptcy Costs? Stable cash flows Debt payments that can be linked to cash

flows Implicit or explicit government backup Firms whose assets are easily divisible

and marketable Brand names are likely to be associated with

lower debt

Wh I h A P bl i h


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What Is the Agency Problem withBorrowing?

Equity holders: Control decision making Prefer riskier projects (since equity is like a

call option) Debt holders

Can end up assuming more risk than they

want to Owning a bond is like selling the company a

put in exchange for a risk-free note

What Aspects of Financial


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What Aspects of FinancialManagement Are Affected by this

Agency Problem? Project choice Choice of project financing Cash disbursement

H D h A P bl


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How Does the Agency Problem Affect Project Choice?

Managers devise projects and calculate hurdlerates

Bondholders lend money based on hurdle rates

and perceived risk of projects Once money is lent, equity holders have an

incentive to find even riskier projects This transfer wealth from bondholders to equityholder Perversely, equityholders may even be interested in

projects with negative NPV because they are highrisk, and on net are winners for equityholders


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Wh t I th A P bl f


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What Is the Agency Problem forProject Finance?

Equityholders have the authority to giveissuers of new debt priority (in bankruptcy)over existing debt This transfers some of the wealth of old

debtholders to equityholders

How Do Bondholders Protect


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How Do Bondholders ProtectThemselves from Being

Disprioritized? Write a put clause into the bond contract

This allows the bonds to be sold back to thefirm - at the holders discretion and at facevalue

What Is the Agency Problem


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What Is the Agency Problemwith Cash Disbursement?

In the absence of viable projects,equityholders usually want to either: Pay out cash as dividends, or

Use it to repurchase stock

Debtholders prefer that cash be retainedto ensure that they get paid There is evidence that bond prices go down

after dividend announcements

How Do Debtholder Protect


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Themselves Against Poor Use of

Cash? Covenants that restrict dividend rates Hybrid securities like convertible bonds

What Are the Implications of the


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What Are the Implications of the Agency Cost Problems?

Bond prices will be higher due toexpectations of abuse

Direct costs of monitoring covenants willpush bond prices higher

Indirect costs of foregone opportunitiesthat covenants restrict

a re e mp ca ons o


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a re e mp ca ons oLoss of Flexibility from Debt

Finance? How do we value this? Flexibility is more valuable when:

You have more potential projects You have better potential projects Your projects will yield more volatile cash

flows This is consistent with why Microsoft or Intel

uses little (long-term) debt but holds much cash

What Is the EBIT EPS


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What Is the EBIT-EPSTradeoff?

EBIT and EPS are positively correlated Assuming a standard strategy of issuing

debt to buy stock, A graph of the two will be steeper as the firm

becomes more leveraged


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What Happens to Modigliani-Miller


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pp gWith Taxes and Interest Write-

Offs? Allowing for taxes with a write-off of

interest - makes the optimal capitalstructure 100% debt

What Happens to (Modigliani)-


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pp ( g )Miller with Realistic Taxes On All

Parties? Capital structure wont matter if:

All tax rates are zero Tax rates on debt and equity are the same Taxes on personal income (which is the

relevent rate for debt) are substantially higher

than on corporations making up for thedouble taxation of equity

What Is the Practical Implication of


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What Is the Practical Implication ofthe Modigliani-Miller Theorem?

They were the first to point out that therewere tradeoffs worth thinking about Up to this time you determined you capital

structure through imitation It implies that a firm is made or broken on

the basis of project choice

Bad choices cant be fixed with finance Good choices cant be ruined with finance


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How Is Modigliani-Miller Helpful?

Its really saying that the cost of capital doesntchange when you change your capital structure

How is this possible?

As you shift more towards an asset with a low rate,you increase the costs associated with that methodas well

Its a zero profit condition for capital structure

changes Project decisions canand should be made on the

merits of the project, not on how it is financed

What Are the Two Practical


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What Are the Two PracticalViews On Debt?

There is no optimal level of debt Debt is preferable up to some threshold

level


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Does Financing Mix Change


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Does Financing Mix Change Across the Firms Life Cycle?

On net, the costs of debt appear to declineas the business grows to maturity (andinto decline)

Increasing factors: Tax benefits Added discipline

Declining factors

Bankruptcy costs Agency costs Need for flexibility

Does Financing Mix Depend On


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Does Financing Mix Depend OnYour Industry?

There is strong empirical evidence tosupport this

This doesnt mean this is evidence of amanagement strategy Each firm may be drawn to a similar capital

structure by the costs and benefits of debt


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What Is the Significance of the


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What Is the Significance of theFinancing Hierarchy?

The street seems to use this ranking as anindicator of financial strength If you are issuing convertible preferred, it is a

sign of weakness More extremely, issuing securities at all isa sign of weakness If you prefer retained earnings, and you have

to issue securities, it is a sign you arent doingwell enough to support the projects comingyour way

Costs of Capital

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