Transcript WACC, Powerpoint

9-1
CHAPTER 9
The Cost of Capital
Cost of Capital Components
Debt
Preferred
Common Equity
WACC
9-2
What types of long-term capital do
firms use?
Long-term debt
Preferred stock
Common equity
9-3
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.
9-4
Should we focus on before-tax or
after-tax capital costs?
Tax effects associated with financing
can be incorporated either in capital
budgeting cash flows or in cost of
capital.
Most firms incorporate tax effects in
the cost of capital. Therefore, focus
on after-tax costs.
Only cost of debt is affected.
9-5
Should we focus on historical
(embedded) costs or new (marginal)
costs?
The cost of capital is used primarily
to make decisions which involve
raising and investing new capital.
So, we should focus on marginal
costs.
9-6
Cost of Debt
Method 1: Ask an investment banker
what the coupon rate would be on
new debt.
Method 2: Find the bond rating for
the company and use the yield on
other bonds with a similar rating.
Method 3: Find the yield on the
company’s debt, if it has any.
9-7
A 15-year, 12% semiannual bond sells
for $1,153.72. What’s rd?
0
1
2
30
i=?
...
60
-1,153.72
INPUTS
30
N
OUTPUT
60
-1153.72 60
I/YR
PV
PMT
5.0% x 2 = rd = 10%
60 + 1,000
1000
FV
9-8
Component Cost of Debt
Interest is tax deductible, so the
after tax (AT) cost of debt is:
rd AT = rd BT(1 - T)
= 10%(1 - 0.40) = 6%.
Use nominal rate.
Flotation costs small, so ignore.
9-9
What’s the cost of preferred stock?
PP = $113.10; 10%Q; Par = $100; F = $2.
Use this formula:
rps 
Dps
Pn
0.1 $100 

$113.10  $2.00
$10

 0.090  9.0%.
$111.10
9 - 10
Picture of Preferred
0
-111.1
rps = ?
1
...
2.50
2.50
$111.10 
rPer
2
DQ
rPer

2.50
$2.50

.
rPer
$2.50

 2.25%; rps ( Nom )  2.25%(4)  9%.
$111.10
9 - 11
Note:
Flotation costs for preferred are
significant, so are reflected. Use
net price.
Preferred dividends are not
deductible, so no tax adjustment.
Just rps.
Nominal rps is used.
9 - 12
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).
9 - 13
Why is there a cost for reinvested
earnings?
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 reinvested.
9 - 14
Opportunity cost: The return
stockholders could earn on
alternative investments of equal
risk.
They could buy similar stocks
and earn rs, or company could
repurchase its own stock and
earn rs. So, rs, is the cost of
reinvested earnings and it is the
cost of equity.
9 - 15
Three ways to determine the
cost of equity, rs:
1. CAPM: rs = rRF + (rM - rRF)b
= rRF + (RPM)b.
2. DCF: rs = D1/P0 + g.
3. Own-Bond-Yield-Plus-Risk
Premium:
rs = rd + Bond RP.
9 - 16
What’s the cost of equity
based on the CAPM?
rRF = 7%, RPM = 6%, b = 1.2.
rs = rRF + (rM - rRF )b.
= 7.0% + (6.0%)1.2 = 14.2%.
9 - 17
Issues in Using CAPM
Most analysts use the rate on a longterm (10 to 20 years) government
bond as an estimate of rRF. For a
current estimate, go to
www.bloomberg.com, select “U.S.
Treasuries” from the section on the
left under the heading “Market.”
More…
9 - 18
Issues in Using CAPM (Continued)
Most analysts use a rate of 5% to 6.5%
for the market risk premium (RPM)
Estimates of beta vary, and estimates
are “noisy” (they have a wide
confidence interval). For an estimate
of beta, go to www.bloomberg.com
and enter the ticker symbol for STOCK
QUOTES.
9 - 19
What’s the DCF cost of equity, rs?
Given: D0 = $4.19;P0 = $50; g = 5%.
D0 1  g 
D1
rs 
g
g
P0
P0
$4.191.05

 0.05
$50
 0.088  0.05
 13.8%.
9 - 20
Estimating the Growth Rate
Use the historical growth rate if you
believe the future will be like the
past.
Obtain analysts’ estimates: Value
Line, Zack’s, Yahoo!.Finance.
Use the earnings retention model,
illustrated on next slide.
9 - 21
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?
9 - 22
Retention growth rate:
g = ROE(Retention rate)
g = 0.35(15%) = 5.25%.
This is close to g = 5% given earlier.
9 - 23
Find rs using the own-bond-yieldplus-risk-premium method.
(rd = 10%, RP = 4%.)
rs = rd + RP
= 10.0% + 4.0% = 14.0%
 This RP  CAPM RPM.
 Produces ballpark estimate of rs.
Useful check.
9 - 24
What’s a reasonable final estimate
of rs?
Method
CAPM
DCF
rd + RP
Average
Estimate
14.2%
13.8%
14.0%
14.0%
9 - 25
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.
9 - 26
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.
(More...)
9 - 27
Estimating Weights (Continued)
Suppose the stock price is $50, there
are 3 million shares of stock, the firm
has $25 million of preferred stock,
and $75 million of debt.
(More...)
9 - 28
Vce = $50 (3 million) = $150 million.
Vps = $25 million.
Vd = $75 million.
Total value = $150 + $25 + $75 = $250
million.
wce = $150/$250 = 0.6
wps = $25/$250 = 0.1
wd = $75/$250 = 0.3
9 - 29
What’s the WACC?
WACC = wdrd(1 - T) + wpsrps + wcers
= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4% = 11.1%.
9 - 30
WACC Estimates for Some Large
U. S. Corporations
Company
WACC
Intel (INTC)
16.0
Dell Computer (DELL) 12.5
BellSouth (BLS)
10.3
Wal-Mart (WMT)
8.8
Walt Disney (DIS)
8.7
Coca-Cola (KO)
6.9
H.J. Heinz (HNZ)
6.5
Georgia-Pacific (GP)
5.9
wd
2.0%
9.1%
39.8%
33.3%
35.5%
33.8%
74.9%
69.9%
9 - 31
What factors influence a company’s
WACC?
Market conditions, especially interest
rates and tax rates.
The firm’s capital structure and
dividend policy.
The firm’s investment policy. Firms
with riskier projects generally have a
higher WACC.
9 - 32
Calculate the after-tax cost of debt
under each of the following
conditions:
a. Interest rate, 13 percent; tax rate, 0 percent.
b. Interest rate, 13 percent; tax rate, 20 percent.
c. Interest rate, 13 percent; tax rate, 35 percent.
9 - 33
The Bouchard Company’s EPS was $6.50 in 2002
and $4.42 in 1997. The company pays out
40percent of its earnings as dividends, and the
stock sells for $36.
a. Calculate the past growth rate in earnings.
(Hint: This is a 5-year growth period.)
b. Calculate the next expected dividend per
share, D1. Assume that the past growth rate
will continue.
c. What is the cost of equity, rs, for the Bouchard
Company?