Transcript 10 - 1 CHAPTER 10 The Cost of Capital Sources of capital Component costs WACC Adjusting for flotation costs Adjusting for risk Copyright © 2002 by Harcourt, Inc. All.

10 - 1
CHAPTER 10
The Cost of Capital
Sources of capital
Component costs
WACC
Adjusting for flotation costs
Adjusting for risk
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10 - 2
What sources of long-term capital do
firms use?
Long-Term
Capital
Long-Term
Debt
Preferred Stock
Retained
Earnings
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Common Stock
New Common
Stock
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10 - 3
How do you calculate the weighted
average cost of capital?
WACC = wdkd(1 – T) + wpkp + wcks.
The w’s refer to the capital structure
weights.
The k’s refer to the cost of each
component.
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10 - 4
Should we focus on before-tax or
after-tax capital costs?
Stockholders focus on A-T CFs.
Therefore, we should focus on
A-T capital costs, i.e., use A-T
costs in WACC. Only kd needs
adjustment, because interest is
deductible.
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10 - 5
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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10 - 6
How do you determine the weights?
WACC = wdkd(1 – T) + wpkp + wcks.
Use accounting numbers or market
value (book vs. market weights)?
Use actual numbers or target capital
structure?
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10 - 7
Component Cost of Debt
WACC = wdkd(1 – T) + wpkp + wcks.
kd is the marginal cost of debt
capital.
The yield to maturity on outstanding
LT debt is often used as a measure
of kd.
Why tax-adjust, i.e., why kd(1 - T)?
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10 - 8
A 15-year, 12% semiannual bond sells
for $1,153.72. What is 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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10 - 9
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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10 - 10
Component Cost of Preferred Stock
WACC = wdkd(1 – T) + wpkp + wcks.
kp is the marginal cost of preferred
stock.
The rate of return investors require
on the firm’s preferred stock.
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10 - 11
What’s the cost of preferred stock?
Pp = $111.10; 10%Q; Par = $100.
Use this formula:
Dp
$10
=
= 0.090 = 9.0%.
kp =
Pp $111 .10
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10 - 12
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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10 - 13
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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10 - 14
Is preferred stock more or less risky to
investors than debt?
More risky; company not required to
pay preferred dividend.
However, firms try to pay preferred
dividend. Otherwise, (1) cannot pay
common dividend, (2) difficult to
raise additional funds, (3) preferred
stockholders may gain control of
firm.
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10 - 15
Why is yield on preferred lower than kd?
Corporations own most preferred stock,
because 70% of preferred dividends are
nontaxable to corporations.
Therefore, preferred often has a lower
B-T yield than the B-T yield on debt.
The A-T yield to an investor, and the A-T
cost to the issuer, are higher on
preferred than on debt. Consistent with
higher risk of preferred.
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10 - 16
Example:
kp = 9% kd = 10% T = 40%
kp, AT = kp – kp (1 – 0.7)(T)
= 9% – 9%(0.3)(0.4) =
7.92%.
kd, AT = 10% – 10%(0.4) =
6.00%.
A-T Risk Premium on Preferred = 1.92%.
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10 - 17
Component Cost of Equity
WACC = wdkd(1 – T) + wpkp + wcks.
ks is the marginal cost of common
equity using retained earnings.
The rate of return investors require
on the firm’s common equity using
new equity is ke.
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10 - 18
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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10 - 19
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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10 - 20
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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10 - 21
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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10 - 22
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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10 - 23
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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10 - 24
Retention growth rate:
g = (1 – Payout)(ROE) = 0.35(15%)
= 5.25%.
Here (1 – Payout) = Fraction retained.
Close to g = 5% given earlier. Think of
bank account paying 10% with payout
= 100%, payout = 0%, and payout =
50%. What’s g in each case?
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10 - 25
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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10 - 26
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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10 - 27
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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10 - 28
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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10 - 29
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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10 - 30
Suppose new common stock had a
flotation cost of 15%. What is ke?
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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10 - 31
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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10 - 32
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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10 - 33
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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10 - 34
WACC Estimates for Some Large
U.S. Corporations, 1999
Company
Intel
General Electric
Motorola
Coca-Cola
Walt Disney
AT&T
Wal-Mart
Exxon Mobil
H. J. Heinz
BellSouth
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WACC
12.19%
12.47
11.65
12.31
9.28
9.22
10.99
8.16
7.78
7.41
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10 - 35
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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10 - 36
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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10 - 37
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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10 - 38
What are the three types of project
risk?
Stand-alone risk
Corporate risk
Market risk
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10 - 39
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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10 - 40
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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10 - 41
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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10 - 42
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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10 - 43
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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10 - 44
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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10 - 45
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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