Transcript T14.1 Chapter Outline - University of Rhode Island

Cost of Capital
(ch 14&15)

The Cost of Capital: Overview

The Cost of Equity

The Costs of Debt and Preferred Stock

The Weighted Average Cost of Capital

Problems with WACC and Remedies

Basic procedures for going public and issuing
new securities
Cost of Capital (ch15&16)
1
1. The Cost of Capital: Overview
 Preliminaries
1. Vocabulary—the following all mean the same thing:
a. Required return
b. Appropriate discount rate
c. Cost of capital (or cost of money)
2. The cost of capital is an opportunity cost—it primarily
depends on where the money goes, not where it comes from.
3. For now, assume the firm’s capital structure (mix of
debt and equity) is fixed.
Cost of Capital (Ch14&15)
2
2. Cost of Equity
 Different ways to estimate the cost of equity

the dividend growth model

the security market line approach
CAPM: RE = Rf +
E
 (RM - Rf)
Cost of Capital (Ch14&15)
3
A. The Dividend Growth Model Approach
 Estimating the cost of equity: the dividend growth model
approach
According to the constant growth model,
P0 =
D1
RE - g
Rearranging,
RE =
D1
+g
P0
Cost of Capital (Ch14&15)
4
Example: Estimating the Dividend Growth Rate
Dollar Change
Percentage
Change
Year
Dividend
1990
$4.00
1991
4.40
$0.40
10.00%
1992
4.75
0.35
7.95
1993
5.25
0.50
10.53
1994
5.65
0.40
7.62
-
-
Average Growth Rate
(10.00 + 7.95 + 10.53 + 7.62)/4 = 9.025%
Suppose dividend paid in this period is $4, while
stock price = $10, find cost of equity.
Cost of Capital (Ch14&15)
5
B. The SML Approach
 According to the CAPM:
RE = Rf +
E
 (RM - Rf)
1. Get the risk-free rate (Rf ) from financial press—many use the 1-year
Treasury bill rate, say 6%.
2. Get estimates of market risk premium and security beta.
a.
b.
Historical risk premium — _________%
Beta—historical
(1) Investment information services - e.g., S&P, Value Line
(2) Estimate from historical data
3. Suppose the beta is 1.40, then, using the approach:
RE = Rf + E  (RM - Rf)
= 6% + 1.40  ________
= ________
Cost of Capital (Ch14&15)
6
 Cost of debt
1. The cost of debt, RD, is the interest rate on new borrowing.
2. The cost of debt is observable:
a. Yield on currently outstanding debt.
b. Yields on newly-issued similarly-rated bonds.
3. The historic debt cost is irrelevant -- why?
Example: We sold a 20-year, 12% bond 10 years ago at par. It
is currently priced at 86. What is our cost of debt?
The yield to maturity is ____%, so this is what we use as
the cost of debt, not 12%.
Cost of Capital (Ch14&15)
7
 Cost of preferred
1. Preferred stock is a perpetuity, so the cost is
RP = D/P0
2. Notice that cost is simply the dividend yield.
Example: We sold an $8 preferred issue 10 years ago. It
sells for $120/share today.
The dividend yield today is $____/____ = 6.67%, so this
is what we use as the cost of preferred.
Cost of Capital (Ch14&15)
8
4. The Weighted Average Cost of Capital
 Capital structure weights
1. Let:
E = the market value of the equity.
D = the market value of the debt.
Then:
V = E + D, so E/V + D/V = 100%
2. So the firm’s capital structure weights are E/V and D/V.
3. Interest payments on debt are tax-deductible, so the aftertax cost of
debt is the pretax cost multiplied by (1 - corporate tax rate).
Aftertax cost of debt = RD  (1 - Tc)
4. Thus the weighted average cost of capital is
WACC = (E/V)  RE + (D/V)  RD  (1 - Tc)
Cost of Capital (Ch14&15)
9
Example: Eastman Chemical’s WACC
 Eastman Chemical has 78.26 million shares of common stock
outstanding. The book value per share is $22.40 but the stock
sells for $58. The market value of equity is $4.54 billion.
Eastman’s stock beta is .90. T-bills yield 4.5%, and the market
risk premium is assumed to be 9.2%. Tax rate is 35%
 The firm has four debt issues outstanding.
Coupon
Book Value
Market Value
6.375%
$ 499m
$ 501m
6.32%
7.250%
7.635%
7.600%
Total
495m
200m
296m
$1,490m
463m
221m
289m
$1,474m
7.83%
6.76%
7.82%
Cost of Capital (Ch14&15)
Yield-to-Maturity
10
Example: Eastman Chemical’s WACC (concluded)
 Cost of equity (SML approach):
RE =
 Cost of debt:
Multiply the proportion of total debt represented by each issue by its yield to
maturity; the weighted average cost of debt =
 Capital structure weights:
Market value of equity =
Market value of debt =
V=
D/V =
E/V =
 WACC =
Cost of Capital (Ch14&15)
11
5. Problem with WACC and Remedies
 When is the WACC the appropriate discount rate?
When the project is about the same risk as the firm.
 But what if the project risk is different from the firm
 Other approaches to estimating a discount rate:

Divisional cost of capital -- i.e., don’t worry abut WACC

Pure play approach

Subjective approach
Cost of Capital (Ch14&15)
12
The Security Market Line and the Weighted Average Cost of Capital
Cost of Capital (Ch14&15)
13
The Pure Play Approach
 Develop the appropriate cost of capital by looking at the
market-required returns on companies already in that business.
Cost of Capital (Ch14&15)
14
The Security Market Line and the Subjective Approach (Figure 14.2)
Cost of Capital (Ch14&15)
15
6. Going Public and Issuing New Securities -- Basic Procedure
 1. Obtain Approval from the Board of Directors
 2. File Registration Statement with SEC
 3. 20-Day Waiting Period
Provide Preliminary Prospectus
Place Tombstone Ad
file price amendment with SEC
 4. Sell Securities to the Public
Cost of Capital (Ch14&15)
16
Fancy Terminologies
 Prospectus
 red herring
 tombstone
 IPO
 SEO
 general cash offer
 rights offer
Cost of Capital (Ch14&15)
17
Underwriters
 Investment banks that act as intermediaries between a
company selling securities and the investing public
 firm commitment underwriting
 best efforts underwriting
 Green shoe Provision
Cost of Capital (Ch14&15)
18
Methods of Issuing New Securities
Method
Type
Definition
Public
Nontraditional
cash offer
Shelf cash offer
Qualifying companies can
authorize all shares thet expect to
sell over a two year period and sell
them when needed.
Competitive firm
cash offer
Company can elect to award
underwriting contract through a
public auction instead of
negotiation.
Direct placement
Securities are sold directly to
purchaser, who, at least until very
recently, generally could not resell
securities for at least two years.
Private
Private
Cost of Capital (Ch14&15)
19