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Cost of Capital

FINA 2203 Prof. Rik SEN

This module: where it fits Tool: Discounting
cash-flows
What cash- flows?
What discount rate?
CAPM, WACC Investment:
Capital Budgeting
Bond valuation
Stock valuation

Capital Structure

The relative proportions of debt, equity, and other securities that a firm has outstanding These proportions are often calculated using “market value” or the best estimate thereof

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Balance Sheet: Market value relation Market Value of Equity + Market Value of Preferred Stock + Market Value of Debt =

Total Market Value of Assets

Cost of capital

Average “cost” per dollar of capital

The “cost” to the firm is really the opportunity cost from the investors’ perspective

When investors buy stocks or bonds of a company

they forgo the opportunity to invest elsewhere The firm should offer the investors an expected return equal to what they could earn elsewhere for assuming the same level of risk

Firm’s overall cost of capital is a blend of costs of different sources of its capital

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Weighted Average Cost of Capital

For a firm with only equity,

r WACC = Equity Cost of Capital

For a firm with equity and debt Cost of debt capital

Expected returns on the firm’s debt

Well approximated by yield to maturity on the firm’s debt (both new and existing) for firms

with low credit risk

Actually, the YTM is the maximum return bondholders get if they hold the bond to maturity

If the bond defaults, they get less!

Taxes reduces the effective cost of debt

Effective cost of debt = r D (1 T C )

Cost of preferred stock capital

Typically, holders of preferred stock are promised a fixed dividend, which must be paid “in preference to” any dividend to common

stockholders

When dividend on preferred stock is known and fixed,

Cost of Preferred Stock Capital = Preferred Prefered Stock Dividend Price

Div pfd

P pfd

Example 1

Assume DuPont’s class A preferred stock has a price of \$66.67 and an annual dividend of \$3.50. What is the cost of preferred stock?

Cost of common stock capital

Option 1: Using Capital Asset Pricing Model

1. Estimate the firm’s beta of equity, typically by regressing 60 months of the company’s returns against 60 months of returns for a market proxy such as the S&P 500

2. Determine the risk-free rate, typically by using the yield on Treasury bills or bonds

3. Estimate the market risk premium, typically by comparing historical returns on a market proxy to risk-free rates

4. Apply the CAPM:

Cost of Equity = Risk-Free Rate + Equity Beta × Market Risk Premium

Example 2

Assume the equity beta of DuPont is 1.37, the yield on ten-year Treasury notes is 3%, and you estimate the market risk premium to be

6%. What is DuPont’s cost of equity according

to CAPM?

Cost of common stock capital

Option 2: Constant dividend growth model

Assuming constant growth rate of dividends Example 3

Assume that the average forecast for DuPont’s long-run earnings growth rate is 7.9%. With an expected dividend in one year of \$1.80 and a

price of \$57.66, the CDGM estimate of

DuPont’s cost of equity is:

Cost of Equity =

Div

1

P

E

g

\$1.80

\$57.66

0.079

0.110 or 11.0%

Summary: Estimating the cost of equity WACC formula

r wacc = r E E% + r pfd P% + r D (1 T C )D%

For a company that does not have preferred stock, the

WACC formula condenses to:

r wacc = r E E% + r D (1 T C )D%

Example

The expected return on Target’s equity is 11.5%, and the firm has a yield to maturity on its debt of 6%. Debt accounts for 18% and

equity for 82% of Target’s total market value.

If its tax rate is 35%, what is this firm’s WACC? WACCs for real companies WACC calculations in practice

Using Net Debt

Net Debt = Debt Cash and Risk-Free Securities

r

WACC

= r

E

Market Value of Equity

Enterprise Value

r

D

(1

T )

C

Net Debt

Enterprise Value

Using WACC to value a project

To value a project first calculate incremental free cash flows from the project

Pay attention to amounts as well as timing

Next, discount these cash flows appropriately

using the firm’s WACC

This produces the value of the project which is often called the “levered value”

Since this incorporates the benefit of tax

deduction by using firm’s after-tax cost of capital

Levered value of a project: Key assumptions

Average Risk

The market risk of the project is equivalent to the average market risk of the firm’s investments

Constant Debt-Equity Ratio

The firm adjusts its leverage continuously to maintain a constant ratio of the market value of debt to the market value of equity

Limited Leverage Effects

The main effect of leverage on valuation is the interest tax deduction and that any other factors are not significant at the level of debt chosen

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Are these assumptions true?

These assumptions are reasonable for many projects and firms

The first assumption is likely to fit typical projects of firms with investments concentrated in a single industry

The second assumption reflects the fact that firms tend to increase their levels of debt as they grow larger

The third assumption is especially relevant for firms without very high levels of debt where the interest tax deduction is likely to be the most important factor

affecting the capital budgeting decision

Example: Using WACC to value a project

DuPont is considering an investment that would extend the life of one of its chemical facilities for four years

The project would require upfront costs of

\$6.67 million (in operating expense) plus a \$24 million investment in equipment

The equipment will be obsolete and become

worthless in four years. It will be depreciated

via straight-line over that period

During the next four years, DuPont expects annual sales of \$60 million per year from this facility

Material costs and operating expenses are expected to total \$25 million and \$9 million, respectively, per year

DuPont expects no net working capital requirements for the project, and it pays a tax

rate of 35%.

Assume WACC of Dupont is 10.33% L 19

V

0

1.1033

19

19

19

1.1033

234

1.1033

1.1033

\$59.80 million

NPV = \$59.80 million - \$28.34 million = \$31.46 million

Cost of capital for an acquisition

The company’s WACC is NOT the right one ot use in the following cases

If a company is considering acquiring another

company in a different line of business

Or if a company wants to start a new division in a new line of business

The discount rate (WACC) should be matched to the risk of the cash flows being discounted

Suppose DuPont is considering acquiring Nike, what cost of capital should DuPont use to value this possible acquisition?

Nike faces different market risks than DuPont

Because the risks are different, DuPont’s WACC would be inappropriate for valuing Nike

Instead, DuPont should calculate and use Nike’s WACC of 7.9% when assessing the acquisition

Divisional cost of capital

Now assume DuPont decides to create a similar division internally, rather than buying Nike. What should the cost of capital (WACC)

for the new division be?

Answer: If DuPont plans to finance the division with the same proportion of debt as is used by Nike, then DuPont would use Nike’s WACC as the WACC for its new division

Since the risk of cash flows in this case would be the same as if Dupont acquired Nike

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Costly external financing

Everything we did till now assumed that the project is being financed using internal capital that is already available

However, if money needs to be raised for

financing the project, associated costs should simply be treated as additional cash outflows necessary to the project in the NPV analysis

Issuing new equity or bonds carries a number of costs