Transcript Chapter 9 THE COST OF CAPITAL - Index

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CHAPTER 10
The Cost of Capital
Cost of capital components
Accounting for flotation costs
WACC
Adjusting cost of capital for risk
Estimating project risk
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Coleman Technologies
 Marginal tax rate is 40 percent.
 Current price of its 12 percent coupon,
semiannual bonds with 15 years to
maturity is $1,153.72.
 Current price of 10 percent, $100 par
preferred stock is $111.10.
 Common stock is selling at $50 per share.
Its last dividend was $4.19 and constant 5
percent growth rate.
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Coleman Technologies
Coleman’s beta is 1.2.
The yield on T-bonds is 7 percent.
The market risk premium is
estimated to be 6 percent.
For the bond-yield-plus-risk-premium
approach, the firm uses a 4 percent
risk premium.
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Coleman Technologies
The firm’s target capital structure is:
30 percent long-term debt;
10 percent preferred stock; and
60 percent common equity.
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What are the sources of capital for
firms?
Debt
Preferred stock
Common equity:
Retained earnings
New common stock
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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).
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A 15-year, 12% semiannual bond sells
for $1,153.72. What’s kd?
0
1
2
30
i=?
...
60
-1,153.72
INPUTS
30
N
OUTPUT
60
-1153.72 60
I/YR
PV
PMT
60 + 1,000
1000
FV
5.0% x 2 = kd = 10%
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Component Cost of Debt
Interest is tax deductible, so
kd AT = kd BT(1 – T)
= 10%(1 – 0.40) = 6%.
Use nominal rate.
Flotation costs small.
Ignore.
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What’s the cost of preferred stock?
Pp = $111.10; 10%Q; Par = $100.
Use this formula:
Dp
$10
kp 

 0.090  9.0%.
Pp $111.10
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Picture of Preferred Stock
0
-111.1
kp = ?
1

2
...
2.50
2.50
2.50
DQ
$2.50
$111.10 =
=
.
kPer
kPer
$2.50
kPer =
= 2.25%;
$111.10
kp(Nom) = 2.25%(4) = 9%.
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Note:
Preferred dividends are not tax
deductible, so no tax adjustment.
Just kp.
Nominal kp is used.
Our calculation ignores flotation
costs.
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Why is there a cost for retained
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 retained.
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Opportunity cost: The return
stockholders could earn on
alternative investments of equal
risk.
They could buy similar stocks
and earn ks, or company could
repurchase its own stock and
earn ks. So, ks is the cost of
retained earnings.
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Three ways to determine cost of
common equity, ks:
1. CAPM: ks = kRF + (kM – kRF)b.
2. DCF: ks = D1/P0 + g.
3. Own-Bond-Yield-Plus-Risk
Premium: ks = kd + RP.
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What’s the cost of common equity
based on the CAPM?
kRF = 7%, RPM = 6%, b = 1.2.
ks = kRF + (kM – kRF )b.
= 7.0% + (6.0%)1.2 = 14.2%.
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What’s the DCF cost of common
equity, ks? Given: D0 = $4.19;
P0 = $50; g = 5%.
D1
D0(1 + g)
ks =
+g=
+g
P0
P0
$4.19(1.05)
=
+ 0.05
$50
= 0.088 + 0.05
= 13.8%.
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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?
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Retention growth rate:
g = (1 – Payout)(ROE) = 0.35(15%)
= 5.25%.
Here (1 – Payout) = Fraction retained.
Close to g = 5% given earlier.
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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.
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Find ks using the own-bond-yield-plusrisk-premium method.
(kd = 10%, RP = 4%.)
ks = kd + RP
= 10.0% + 4.0% = 14.0%
This RP  CAPM RP.
Produces ballpark estimate of ks.
Useful check.
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What’s a reasonable final estimate of ks?
Method
Estimate
CAPM
14.2%
DCF
13.8%
kd + RP
14.0%
Average
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14.0%
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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.
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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.
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New common, F = 15%:
D0 (1  g)
ke 
g
P0 (1  F)
$4.191.05 

 5 .0 %
$501  0.15 
$4.40

 5.0%  15.4%.
$42.50
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Comments about flotation costs:
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.
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What’s the firm’s WACC (ignoring
flotation costs)?
WACC = wdkd(1 – T) + wpkp + wcks
= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4% = 11.1%.
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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.
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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
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WACC
12.9%
11.9
11.3
11.2
10.0
9.8
9.8
8.8
8.5
8.2
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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.
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Risk and the Cost of Capital
Rate of Return
(%)
Acceptance Region
W ACC
12.0
H
8.0
0
Rejection Region
A
10.5
10.0
9.5
B
L
Risk L
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Risk A
Risk H
Risk
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Divisional Cost of Capital
Rate of Return
(%)
13.0
Project H
11.0
10.0
9.0
7.0
0
WACC
Division H’s WACC
Project L
Composite WACC
for Firm A
Division L’s WACC
RiskL
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Risk Average
RiskH
Risk
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What are the three types of project
risk?
Stand-alone risk
Corporate risk
Market risk
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How is each type of risk used?
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.
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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.
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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.
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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.
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Find the division’s market risk and cost
of capital based on the CAPM, given
these inputs:
Target debt ratio = 40%.
kd = 12%.
kRF = 7%.
Tax rate = 40%.
betaDivision = 1.7.
Market risk premium = 6%.
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Beta = 1.7, so division has more market
risk than average.
Division’s required return on equity:
ks = kRF + (kM – kRF)bDiv.
= 7% + (6%)1.7 = 17.2%.
WACCDiv. = wdkd(1 – T) + wcks
= 0.4(12%)(0.6) + 0.6(17.2%)
= 13.2%.
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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%.
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