CHAPTER 9 The Cost of Capital 1

Topics in Chapter   Cost of capital components    Debt Preferred stock Common equity WACC 2

Determinants of Intrinsic Value: The Weighted Average Cost of Capital Net operating profit after taxes − Required investments in operating capital Free cash flow (FCF) = (1 + WACC) 1 FCF 2 (1 + WACC) 2

···

+ FCF ∞ (1 + WACC) ∞ Market interest rates Market risk aversion Weighted average cost of capital (WACC ) Cost of debt Cost of equity Firm’s debt/equity mix Firm’s business risk

What types of long-term capital do firms use?

   Long-term debt Preferred stock Common equity 4

Capital Components    Capital components are sources of funding that come from investors.

Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the cost of capital.

We do adjust for these items when calculating the cash flows of a project, but not when calculating the cost of capital.

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Tax effects of financing with debt EBIT - interest expense EBT - taxes (34%) EAT with stock 400,000 0 400,000 (136,000) 264,000 with debt 400,000 (50,000) 350,000 (119,000) 231,000

Example: Tax effects of financing with debt EBIT - interest expense EBT - taxes (34%) EAT with stock 400,000 0 400,000 (136,000) 264,000 with debt 400,000 (50,000) 350,000 (119,000) 231,000

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Now, suppose the firm pays $50,000 in dividends to the stockholders.

Example: Tax effects of financing with debt EBIT - interest expense EBT - taxes (34%) with stock 400,000 0 400,000 (136,000) EAT - dividends 264,000 (50,000) Retained earnings 214,000 with debt 400,000 (50,000) 350,000 (119,000) 231,000 0 231,000

A 22-year, 8% semiannual bond sells for $904.91 What’s r d ?

0 r d = ?

1 -904.91

40 2 40 ...

40 + 1,000 INPUTS OUTPUT 44 N -904.91 40 I/YR PV 4.5% x 2 = r d PMT = 9% 1000 FV 44 9

Cost of preferred stock: P ps D ps = $8; F = 2.5% = $100; Use this formula: r ps = D ps P ps (1 – F) = $8 $100(1 – 0.05) $8 = $97.5

= 8.2% 10

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 to raise additional funds 11

What are the two ways that companies can raise common equity?

  Directly, by issuing new shares of common stock.

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

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Why is there a cost for reinvested earnings?

   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.

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Cost for Reinvested Earnings (Continued)   Opportunity cost: The return stockholders could earn on alternative investments of equal risk.

They could buy similar stocks and earn r s , or company could repurchase its own stock and earn r common equity.

s . So, r s , is the cost of reinvested earnings and it is the cost of 14

Three ways to determine the cost of equity, r s : 1. CAPM: r s = r RF = r RF + (r M – r RF )b + (RP M )b.

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

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

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CAPM Cost of Equity: r RF RP M = 5.5%, b = 1.2

= 5%, r s = r RF + (RP M )b = 5% + (5.5%)1.2 = 11.6%.

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DCF Cost of Equity, r s : D 1 = $1.82; P 0 = $32; g = 5.5% r s = D 1 P 0 + g = = $1.82

$32 = 5.7% + 5.5% = 11.2% + 0.058

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Estimating the Growth Rate    Use the historical growth rate if you believe the future will be like the past.

Obtain analysts’ estimates: Value Line, Zacks, Yahoo!Finance.

Use the earnings retention model, 18

Earnings Retention Model (Continued)  Growth from earnings retention model: g = (Retention rate)(ROE) g = (1 – Payout rate)(ROE) 19

The Own-Bond-Yield-Plus-Judgmental-Risk Premium Method   r s r s = r d + Judgmental risk premium = 9% + 3% = 12% 20

What’s a reasonable final estimate of r s ?

Method CAPM DCF r d + judgment Average Estimate 11.6% 11.2% 12.0% 11.6% 21

Determining the Weights for the WACC   The weights are the percentages of the 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 the various types of capital. 22

Estimating Weights for the Capital Structure   If you don’t know the targets, it is better to estimate the weights using current market values than current book values.

If you don’t know the market value of debt, then it is usually reasonable to use the book values of debt, especially if the debt is short-term.

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What’s the WACC using the target weights?

WACC = w d r d (1 – T) + w ps r ps + w s r s WACC = 0.3(9%)(1 − 0.4) + 0.1(8.2%) + 0.6(11.6%) WACC =9.4% 24

What factors influence a company’s WACC?

  Uncontrollable factors:   Market conditions, especially interest rates.

The market risk premium.

 Tax rates.

Controllable factors:  Capital structure policy.

  Dividend policy.

Investment policy. Firms with riskier projects generally have a higher cost of equity.

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