Chapter 9 THE COST OF CAPITAL

Download Report

Transcript Chapter 9 THE COST OF CAPITAL

10 - 1

CHAPTER 10

The Cost of Capital



Cost of capital components



Accounting for flotation costs



WACC



Adjusting cost of capital for risk



10 - 2

What types of capital do firms use?

10 - 3

Should we focus on

before-tax

or after-tax capital costs?

Stockholders focus on A-T CFs.

Therefore, we should focus on A-T capital costs, i.e., use A-T costs in WACC. Only k adjustment.

10 - 4

Should we focus on historical (

embedded

) costs or new (

marginal

) costs?

The cost of capital is used primarily to make decisions that involve raising

new

capital. So, focus on

today’s marginal costs

(for WACC).

10 - 5

A 15-year, 12% semiannual bond sells for $1,153.72. What’s k d ? 0 -1,153.72

i = ?

1 60 2 60 ...

10 - 6

Component Cost of Debt



Interest is tax deductible, so k d AT = k d BT (1 – T) = 10%(1 – 0.40) = 6%.



Use nominal rate.



Flotation costs small.

Ignore.

10 - 7

What’s the cost of preferred stock? P p = $111.10; 10%Q; Par = $100.

Use this formula: k p



D p P p



$ 10 $ 111 .



0 .

090



9 .

0 %.

10 - 8

Picture of Preferred Stock 0 -111.1

k p = ?

1 2.50

2 ...

2.50

D $2.50

$111.10 = = .

k Per k Per



2.50

k Per = = 2.25%; $111.10

k p(Nom) = 2.25%(4) = 9%.

10 - 9

Note:



Preferred dividends are

not tax deductible

, so no tax adjustment. Just k p .



Nominal k

p is used.



Our calculation ignores flotation costs.

10 - 10

Is preferred stock more or less risky to investors than debt?



More risky; company not required to pay preferred dividend.



However, firms try to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, (3) preferred stockholders may gain control of firm.

10 - 11

Why is yield on preferred lower than k d ?



Corporations own most preferred stock, because

70% of preferred dividends are nontaxable to corporations



Therefore, preferred often has a lower B-T yield than the B-T yield on debt.



The

A-T yield

to an investor, and the A-T cost to the issuer, are

higher

on preferred than on debt. Consistent with higher risk of preferred.

10 - 12

Example: k p = 9% k d = 10% T = 40% k p, AT = k p – k p (1 – 0.7)(T) = 9% – 9%(0.3)(0.4) = 7.92%.

k d, AT = 10% – 10%(0.4) = 6.00%. A-T Risk Premium on Preferred = 1.92%.

Why is there a cost for retained earnings?

10 - 13 

Earnings can be reinvested or paid out as dividends.



Investors could buy other securities, earn a return.



Thus, there is an opportunity cost if earnings are retained.

10 - 14 

Opportunity cost

: The return stockholders could earn on alternative investments of equal risk.



They could buy similar stocks and earn k s , or company could repurchase its own stock and earn k s . So, k s is the cost of retained earnings.

Three ways to determine cost of common equity, k s :

10 - 15

1. CAPM: k s = k RF + (k M – k RF )b.

2. DCF: k s = D 1 /P 0 + g.

3. Own-Bond-Yield-Plus-Risk Premium: k s = k d + RP.

10 - 16

What’s the cost of common equity based on the CAPM?

k RF = 7%, RP M = 6%, b = 1.2.

k s = k RF + (k M – k RF )b.

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

What’s the DCF cost of common equity, k s ? Given: D 0 = $4.19; P 0 = $50; g = 5%.

10 - 17

k s D P 0 1 D 0 (1 + g) P 0 $50 = 0.088 + 0.05

= 13.8%.

10 - 18

Suppose the company has been earning 15% on equity (ROE = 15%) and retaining 35% (dividend payout = 65%), and this situation is expected to continue.

What’s the expected future g ?

10 - 19

Retention growth rate: g = (1 – Payout)(ROE) = 0.35(15%) = 5.25%.

Here (1 – Payout) = Fraction retained.

Close to g = 5% given earlier. Think of bank account paying 10% with payout = 100%, payout = 0%, and payout = 50%. What’s g?

10 - 20

Could DCF methodology be applied if g is not constant?



YES

, nonconstant g stocks are expected to have constant g at some point, generally in 5 to 10 years.



But calculations get complicated.

10 - 21

Find k s using the own-bond-yield-plus risk-premium method. (k d = 10%, RP = 4%.) k s = k d + RP = 10.0% + 4.0% = 14.0%



This RP



CAPM RP.



Produces ballpark estimate of k s . Useful check.

10 - 22

What’s a reasonable final estimate of k s?

10 - 23

Why is the cost of retained earnings cheaper than the cost of issuing new common stock? 1. When a company issues new common stock they also have to pay flotation costs to the underwriter.

2. Issuing new common stock may send a negative signal to the capital markets, which may depress stock price.

10 - 24

Two approaches that can be used to account for flotation costs:



Include the flotation costs as part of the project’s up-front cost. This reduces the project’s estimated return.



Adjust the cost of capital to include flotation costs. This is most commonly done by incorporating flotation costs in the DCF model.

10 - 25

New common, F = 15%: k e



D 0 P 0 ( 1



( 1



g F ) )





$ 4 .

$ 50



1 .

05 1



0 .

  

5 .

0 %



$ 4 .

40 $ 42 .



5 .

0 %



15 .

4 %.

Comments about flotation costs:

10 - 26 

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



The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small.



We will frequently ignore flotation costs when calculating the WACC.

10 - 27

What’s the firm’s WACC (ignoring flotation costs)?

WACC = w d k d (1

–

T) + w p k p + w c k s = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1%.

10 - 28

What factors influence a company’s composite WACC?



Market conditions.



The firm’s capital structure and dividend policy.



The firm’s investment policy. Firms with riskier projects generally have a higher WACC.

10 - 29

WACC Estimates for Some Large U. S. Corporations, Nov. 1999 Company Intel General Electric Motorola Coca-Cola Walt Disney AT&T Wal-Mart Exxon H. J. Heinz BellSouth Copyright © 2001 by Harcourt, Inc.

WACC 12.9% 11.9

11.3

11.2

10.0 9.8

9.8

8.8

8.5

8.2

10 - 30

Should the company use the composite WACC as the hurdle rate for each of its projects?



NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the “hurdle rate” for a typical project with average risk.



Different projects have different risks. The project’s WACC should be adjusted to reflect the project’s risk.

10 - 31

Risk and the Cost of Capital Rate of Return (% ) 12.0

10.5

10.0

9.5

8.0

10 - 32

Rate of Return (%) Divisional Cost of Capital Division H’s WACC 13.0

11.0

10.0

9.0

7.0

10 - 33

What are the three types of project risk?



Stand-alone risk



Corporate risk



How is each type of risk used?

10 - 34 

Market risk is theoretically best in most situations.



However, creditors, customers, suppliers, and employees are more affected by corporate risk .



Therefore, corporate risk is also relevant.

10 - 35

What procedures are used to determine the risk-adjusted cost of capital for a particular project or division?



Subjective adjustments to the firm’s composite WACC.



Attempt to estimate what the cost of capital would be if the project/division were a stand-alone firm. This requires estimating the project’s beta.

10 - 36

Methods for Estimating a Project’s Beta 1. Pure play . Find several publicly traded companies exclusively in project’s business.

Use average of their betas as proxy for project’s beta.

Hard to find such companies.

10 - 37

2. Accounting beta . Run regression between project’s ROA and S&P index ROA.

Accounting betas are correlated (0.5 – 0.6) with market betas.

But normally can’t get data on new projects’ ROAs before the capital budgeting decision has been made.

10 - 38

Find the division’s market risk and cost of capital based on the

CAPM

, given these inputs:



Target debt ratio = 40%.



k d



k RF = 12%.

= 7%.



Tax rate = 40%.



beta Division = 1.7.



Market risk premium = 6%.

10 - 39 

Beta = 1.7

, so division has more market risk than average.



Division’s required return on equity : k s = k RF + (k M – k RF )b Div.

= 7% + (6%)1.7 = 17.2%.

WACC Div.

= w d k d (1 – T) + w c k s = 0.4(12%)(0.6) + 0.6( 17.2% ) = 13.2% .

10 - 40

How does the division’s market risk compare with the firm’s overall market risk?



Division WACC = 13.2% versus company WACC = 11.1%.



Indicates that the division’s market risk is greater than firm’s average project.



“Typical” projects within this division would be accepted if their returns are above 13.2%.