Transcript Cost Of capital

Chapter 3
COST OF CAPITAL
LEARNING OBJECTIVES
1.
How ROE and the required return by common equity investors are
related to a firm’s growth opportunities
2.
How to apply the steps involved in estimating a firm’s weighted average
cost of capital, including how to estimate the market values of the
various components of capital, and how to estimate the various costs of
these components
3.
How operating and financial leverage affect firms
4.
The advantages and limitations of using growth models and/or risk
models to estimate the cost of common equity.
THE SHORT STORY OF WACC
Purposes/Use
• The weighted average cost of capital (WACC)
serves three primary purposes:
1. To evaluate capital project proposals before-the-fact.
2. To set performance targets in order for management
to sustain or grow market values, and
3. to measure management performance after-the-fact.
THE SHORT STORY OF WACC
What Costs are Measured?
• Costs associated with financing the firm’s
invested capital including:
– Debt Costs:
• Bank loans
• Long-term debt – bonds/debentures
– Equity Costs:
• Preferred equity costs
• Common equity costs
THE SHORT STORY OF WACC
Why the Marginal Cost?
• What capital costs the firm 5 months, 5 years
or 5 decades ago is irrelevant.
• What is relevant is what the next dollar of
capital will cost in today’s economic
environment for this particular firm.
THE SHORT STORY OF WACC
Steps in Solving for the WACC
1. Identify the relevant sources of capital (debt and
equity).
2. Estimate the market values for the sources of
capital and determine the market value weights.
3. Estimate the marginal, after-tax, for each source
of capital.
4. Calculate the weighted average.
THE SHORT STORY OF WACC
THE FORMULA
Once you have the specific marginal costs of capital (after accounting for taxes
and floatation costs) and you have found the appropriate weights to use, the
actual calculation of a WACC is a simple matter.
WACC  K a
S 
D
 K e    K d (1  T )  
V 
V 
The cost of equity times
the market value weight
of equity
The cost of debt after
tax times the market
value weight of debt
THE SHORT STORY OF WACC
THE SPREADSHEET APPROACH
(1)
Type of
Capital
Long-Term Debt
Preferred Stock
Common Stock
(2)
(3)
(4) = (2)*(3)
Specific
Marginal Cost
Weighted
after tax and Market Specific
floatation
Value
Marginal
costs
Weights
Cost
5.5%
11.4%
12.9%
43.0%
11.0%
46.0%
WACC =
0.02365
0.01254
0.05934
9.55%
WACC is the sum of the weighted specific
marginal costs of each source of capital.
THE SHORT STORY OF WACC
frequently asked questions
1. Why don’t we include the cost of accruals and
accounts payable in the cost of capital?
– These are ‘spontaneous’ liabilities that rise and fall
with the volume of business activity, and are not
subject to formal lending arrangements.
– Accruals (wages and taxes), it can be argued, don’t
have an explicit cost.
– For major corporations, spontaneous liabilities are
often a very small part of the overall capitalization of
the firm (are immaterial for cost of capital purposes).
THE SHORT STORY OF WACC
Frequently Asked Questions
2.
Why is the cost of capital an estimate and does this matter?
– WACC is calculated based on a current estimate of what it
will cost for the next dollar of debt and equity.
– To estimate the cost of debt we often assume it is equal
to the required rate of return on existing debt
outstanding in the markets
– Forecasting WACC also requires estimating the cost of
equity.
– In the end, WACC will still be an estimate. The key thing
to ensure is that the NPV of the project be positive over
the range of possible WACC’s.
THE SHORT STORY OF WACC
Frequently Asked Questions
3.
Why is the component cost of capital greater than the investor’s required
return ?
Table 20-1 Main Balance Sheet Accounts
Cash and marketable securities
Accruals
Accounts receivable
Accounts payable
Inventory
Short-term debt
Prepaid expenses
Total current assets
Net fixed assets
Total assets
Total current liabilities
$18.00
Investment
Dealer
$20.00
Long-term debt
Shareholders' equity
Total liabilities and shareholders' equity
The
company
must produce $2.00
Issuing
company
income
an $18.00 investment to
receiveson
$18.00.
meet the investor’s expectations.
This is an 11.1% return.
Investment dealer
gives the issuing firm
$18.00 for the share,
and pockets $2.00 for
providing
underwriting
services.
Conclusion: The cost of external capital is greater than the
investor’s required return because of floatation
costs.
Investor requires
buys onea
new return
10%
share inona her
company and
investment
of pays
$20.
the investment
This
is a $2.00 return
dealer
on
invested
$20 for
capital.
it.
THE SHORT STORY OF WACC
Summary
•
WACC measures the firm’s cost of financing future growth today, based
on current capital market conditions, and assuming the firm use a longterm average of financing sources.
•
WACC is an estimate.
•
WACC is used to make capital investment decisions.
•
WACC is used to set performance targets for sales, and ROE.
•
WACC is used to assess management’s performance, answering the
question, “has management added value?”
FINANCING SOURCES
Capital Structure
Table 20-1 Main Balance Sheet Accounts
Cash and marketable securities
Accruals
Accounts receivable
Accounts payable
Inventory
Short-term debt
Prepaid expenses
Total current assets
Net fixed assets
Total assets
Total current liabilities
Long-term debt
Shareholders' equity
Total liabilities and shareholders' equity
Capital Structure
The Financial
Structure
FINANCING SOURCES
Capital Structure
• Table 20 - 1 illustrates the basic structure of a firm’s balance sheet:
– This is a snapshot of the firm’s financial position at one point in time.
– Left-hand side of the Balance Sheet
• Assets – the things the firm owns
• Note the structure of assets (relative proportions of current assets and
net fixed assets)
– Right-hand side of the Balance Sheet
• Liabilities – the borrowed sources of financing
– Note the structure of liabilities (the relative proportions of current versus
long-term debt)
• Shareholders’ equity – owner’s investment in the business
– Note the amount of capital invested versus the amount of earnings that have
been reinvested in the business
IMPORTANT TERMS
• Financial Structure
– The whole right-hand side of the balance sheet
– Includes both short-term and long-term sources of financing (debt and
equity)
• Capital Structure
– How the firm finances its invested capital
– Excludes accruals and accounts payable – short-term liabilities that are
not strictly debt contracts, that spontaneously change in response to
the operations of the business.
– Includes:
• Bank Loans
• Long-term debt
• Common stock and retained earnings
FINANCING SOURCES
Capital Structure
Table 20-2 A "Simplified" Balance Sheet
Cash and marketable securities
Accounts receivable
Inventory
Prepaid expenses
Total current assets
Net fixed assets
Total assets
$50
200
250
0
500
1,500
$2,000
Accruals
Accounts payable
Short-term debt
Total current liabilities
Long-term debt
Shareholders' equity
Total liabilities and shareholders' equity
Financial
Capital Structure
Structure==$1,700
$2,000
$100
200
50
350
650
1,000
$2,000
FINANCING SOURCES
Interpreting Balance Sheets
• Balance sheets are prepared in accordance with GAAP:
– Represent historical costs which may not be relevant for current
decision-making purposes.
• Analysis of reported data should include ratios such as:
– Debt – to – Equity:
• Interest bearing debt to shareholder’s equity plus minority interest
– Convert book values to market values
• This is done by multiplying the market-to-book ratio times the book value.
• Interpret the ratios again.
FINANCING SOURCES
Debt-to-Equity Ratio
Table 20-2 A "Simplified" Balance Sheet
Cash and marketable securities
Accounts receivable
Inventory
Prepaid expenses
Total current assets
Net fixed assets
Total assets
$50
200
250
0
500
1,500
$2,000
Accruals
Accounts payable
Short-term debt
Debt =
Total current liabilities
Long-term debt
Equity =
Shareholders' equity
Total liabilities and shareholders' equity
Debt - to - Equity Ratio 
$50  $650
$ 1, 000
 0 . 70
$100
200
50
350
650
1,000
$2,000
FINANCING SOURCES
Converting Book Value to Market Values
Table 20-2 A "Simplified" Balance Sheet
Cash and marketable securities
Accounts receivable
Inventory
Prepaid expenses
Total current assets
Net fixed assets
Total assets
$50
200
250
0
500
1,500
$2,000
Book Values
Accruals
$100
Accounts payable
200
Short-term debt
50
Total current liabilities
350
Long-term debt
650
Equity =
Shareholders' equity
1,000
Total liabilities and shareholders' equity
$2,000
Market
valuevalue
of debt
will beisvery
close
(ifdepend
not equal)
to the book
The market
market
value
of
of long-term
equity
greatly
debt
will
affected
byon
management.
interest
rate values
It is
stated
onsince
the balance
This is because
contractual
changes
not
uncommon
the
todebt
seesheet.
market-to-book
was originally
issued.
ratios these
As
of 2the
orare
bonds
more,
approach
reflecting
claims
that
are
not negotiable
in
Thethe
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growth
their
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the
price
market
will(traded
move
seesprogressively
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convert
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amounts
stated
required
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(face)
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isare
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ofthat
theare
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that of
is presented
2.5.satisfy the
here.
financial claims of these creditors.
Financing Sources
Converting Book Value to Market Values
Table 20-2 A "Simplified" Balance Sheet
Cash and marketable securities
Accounts receivable
Inventory
Prepaid expenses
Total current assets
Net fixed assets
Total assets
$50
200
250
0
500
1,500
$2,000
Accruals
Accounts payable
Short-term debt
Total current liabilities
Long-term debt
Shareholders' equity
Total liabilities and shareholders' equity
Book Values Market Values
$100
$100
200
200
50
50
350
350
650
650
1,000
2,500
$2,000
$3,500
When adjusted for market value effects, the apparent “high”
$50  $650
debt" to
equity
ratio
(.7)- tois- aEquity
muchRatio
lower
Market
val ued"
Debt
 0.28.
 0 . 28
$ 2 ,500
This confirms the importance of using relevant data when
making decisions.
THE MOST IMPORTANT
CORPORATE FINANCE DECISIONS
• It is the managers job to maximize shareholders’ wealth.
• The most important ways manager can add value to the firm:
– Changing the mix of financing used by the firm (changing the relative
proportions of debt and equity), and
– Determining the minimum rate of return needed to maintain the
current market value.
VALUATION EQUATION FOR A
PERPETUITY
Three Ways of Using the Valuation Equation
• you learned how to determine the present value of an infinite
stream of equal, periodic cash flows (an infinite annuity).
X
$ 2 . 00
S

[ 20-1] [ 20-1]
S 
 $20.00
Ke
0 . 10
• Where:
S = the present value of the perpetuity
X = the forecast annual earnings
Ke = the investor’s required return
If the annual cash flow
is
$2.00 and the
investor’s required
return is 10%, the
present value of the
perpetuity is $20.
VALUATION EQUATION FOR A
PERPETUITY
Three Ways of Using the Valuation Equation
• The equation can be rearranged to solve for the required return Ke
also known as the earnings yield:
[ 20-2]
X X $2.00
K e Ke  
 10%
S S $20.00
• The earnings yield is not normally used as the investor’s required
return because it simply measures forecast earnings as a
percentage of the market price, ignoring growth opportunities.
Valuation Equation for a
Perpetuity
Three Ways of Using the Valuation Equation
• The perpetuity valuation model can be further rearranged to solve
for the forecast earnings given the current market price and
investor’s required return.
[ 20-3]
K ee  S  0.10  $20.00  $2.00
XX  K
• This helps managers determine their earnings target that must be
met to support the current market value.
• If the manager knows the investor requires a 10% rate of return and
the market price is $20.00, she knows the firm must generate $2.00
in EPS to sustain the stock price.
THE COST OF CAPITAL
Determining the Weighted Average Cost of Capital (WACC)
• The equation for WACC including common equity, preferred share
financing and debt is:
[ 20-9]
WACC  K e
S
V
Kp
P
V
 K d ( 1-T)
D
V
• In this case the value of the firm equals the sum of the value of
stock, preferred and debt:
V=S+P+D
LEVERAGE
• The increased volatility in operating income over
time, created by the use of fixed costs in lieu of
variable costs.
– Leverage magnifies profits and losses.
• There are two types:
– Operating leverage
– Financial leverage
• Both types of leverage have the same effect on
shareholders but are accomplished in very
different ways, for very different purposes
strategically.
OPERATING LEVERAGE
What is it? How is it Increased?
• The textbook defines operating leverage as:
– The increased volatility in operating income caused by fixed operating
costs.
• You should understand that managers do make decisions affecting
the cost structure of the firm.
• Managers can, and do, decide to invest in assets that give rise to
additional fixed costs and the intent is to reduce variable costs.
– This is commonly accomplished by a firm choosing to become more
capital intensive and less labour intensive, thereby increasing
operating leverage.
OPERATING LEVERAGE
Advantages and Disadvantages
Advantages:
– Magnification of profits to the shareholders if the firm is profitable.
– Operating efficiencies (faster production, fewer errors, higher quality)
usually result increasing productivity, reducing ‘downtime’ etc.
Disadvantages:
– Magnification of losses to the shareholders if the firm does not earn
enough revenue to cover its costs.
– Higher break even point
– High capital cost of equipment and the illiquidity of such an
investment make it:
• Expensive (more difficult to finance)
• Potentially exposed to technological obsolescence, etc.
FINANCIAL LEVERAGE
What is it? How is it Increased?
• Your textbook defines financial leverage as:
– The increased volatility in operating income caused by
fixed financial costs.
• Financial leverage can be increased in the firm by:
– Selling bonds or preferred stock (taking on financial
obligations with fixed annual claims on cash flow)
– Using the proceeds from the debt to retire equity (if
the lenders don’t prohibit this through the bond
indenture or loan agreement)
Financial Leverage
Advantages and Disadvantages
Advantages:
– Magnification of profits to the shareholders if the firm is profitable.
– Lower cost of capital at low to moderate levels of financial leverage
because interest expense is tax-deductible.
Disadvantages:
– Magnification of losses to the shareholders if the firm does not earn
enough revenue to cover its costs.
– Higher break even point.
– At higher levels of financial leverage, the low after-tax cost of debt is
offset by other effects such as:
• Present value of the rising probability of bankruptcy costs
• Agency costs
• Lower operating income (EBIT), etc.
EFFECTS OF OPERATING AND FINANCIAL
LEVERAGE
Summary
• Equity holders bear the added risks associated
with the use of leverage.
• The higher the use of leverage (either operating
or financial) the higher the risk to the
shareholder.
• Leverage therefore can and does affect
shareholders required rate of return, and in turn
this influences the cost of capital.
HIGHER LEVERAGE = HIGHER COST OF CAPITAL