Chapter 11

11-1
Fundamentals of Corporate Finance

Second Canadian Edition
prepared by: Carol Edwards BA, MBA, CFA Instructor, Finance British Columbia Institute of Technology
copyright 2003 McGraw Hill Ryerson Limited
11-2
Chapter 11
The Cost of Capital
Chapter Outline

Geothermals Cost of Capital Calculating the Weighted Average Cost of Capital Measuring Capital Structures Calculating Required Rates of Return Big Oils Weighted Average Cost of Capital Interpreting the Weighted Average Cost of Capital Flotation Costs and the Cost of Capital
11-3
Geothermals Cost of Capital

Calculating
the Cost of Capital
The choice of the discount rate can be crucial in the capital budgeting decision.
The
discount rate for a project determines whether NPV will be positive and if the project acceptable. When the project involves huge capital expenditures and/or is long-lived, you want to make the correct decision. Read the Finance In Action box on page 335 of your text to see how important the cost of capital is:
Here the existence of a major investment turned on the choice of the discount rate!
11-4

Calculating
the Cost of Capital
If a firm is financed entirely by equity, its cost of capital equals the return required by investors on the companys stock.
You
can use the CAPM to estimate this return.
However, very few companies are financed entirely by equity.

Instead,
they are financed by a mix of securities, each with its own cost of capital.
11-5

Calculating
the Cost of Capital
When there is a mix of securities, the company cost of capital is no longer the same as the expected return on the common stock.
Instead,
the expected return reflects the weighted after-tax cost of the debt financing plus the cost of the equity financing.
The weights are the fractions of debt and equity in the firms capital structure.
11-6

Example:
Calculating the Cost of Capital
Geothermal is considering an expansion project which will generate $4.5 million annually in perpetuity and costs $30 million. Geothermals return on this proposed investment is 15% ($4.5m / $30m). But, what is this projects cost of capital?
If
it is less than 15%, then the project would be a good deal and would generate net value for Geothermals shareholders.
11-7

Example:
A firms cost of capital will be determined by its capital structure.

Capital
structure is the firms mix of debt and equity financing. We measure the cost of capital using the market value of the financing, not the book value.
11-8

Example:
Calculating the Cost of Capital We measure the cost of capital using the market value of the financing because the
book value of the equity reflects past funding and historic rates of return. But, if investors see the firm as having superior prospects, then the market value of its equity will exceed its book value. This also means the firms debt ratio will be lower than what is recorded on the books.
11-9

Example:
You are told the following about Geothermals capital structure:

It
has bonds with a market value of $194 million. The company also has 22.65 million common shares outstanding, trading at $20 each.
This means the market value of the firms equity is $453 m.
11-10

Example:
Thus, you know the following about Geothermals capital structure:

Market Value of Debt: Market Value of Equity: Total Value of firm: $194 $453 $647 (30%) (70%) (100%)
11-11

Example:
If you were to purchase all of the securities issued by Geothermal, the debt as well as the equity, you would own the entire business.
Thus,
the expected return on this portfolio of securities is the firms cost of capital.
Assume Geothermals bonds are yielding 8% and that its equity returns 14%.
11-12

Example:
To calculate the return on this portfolio, we would:

Get
the weighted average of the returns on the debt and the equity.
The weights would depend on the relative market values of the two securities.
This measure is known as a firms weighted average cost of capital (WACC).

11-13

Example:

(D x rdebt) + (E x requity)
Thus for Geothermal:

V
WACC =
= (D/V x rdebt) + (E/V x requity) = (0.30 x 8%) + (0.70 x 14%) = 12.2%

Note: WACC is also known as rassets
11-14

Example:
The above calculation of WACC assumes that the firm pays no taxes. Taxes are important because interest payments are deducted from income before tax is calculated.
If
Geothermal pays $1 of interest, this will reduce its taxable income by $1. If it is in a 35% tax bracket, then its tax bill will drop by $0.35.
11-15

Example:
In a 35% tax bracket, Geothermals cost of debt is only $0.65 since the government bears 35% of the cost of the interest payments.
The
government doesnt send the firm a cheque for this amount, but the income tax the firm pays is reduced by 35% of its interest expense.
Thus, the cost of the firms debt is not 8%, but:
8% x (1- tax rate) = 8% x (1 - 0.35) = 5.2%

11-16

Example:
Thus if Geothermal is in a 35% tax bracket, its WACC would be calculated as follows:
rassets = [D/V x (1-Tc)rdebt] + (E/V x requity)
= [0.30 x (1-0.35)x8%) + (0.70 x 14%)
= (0.3 x 5.2%) + 9.8%

= 11.4%
11-17
Calculating the WACC
The Steps for Calculating the WACC:

1. Calculate the market value of each of the firms securities. 2. Calculate the market weight of each security as a proportion of the firms total financing. 3. Determine the required rate of return on each security. 4. Calculate the weighted average of these required returns.
Do not forget to adjust the cost of debt for taxes.
11-18

The
Steps for Calculating WACC
If there are three (or more) sources of financing, the general approach to calculating WACC is unchanged!
Just calculate the weighted average after-tax return for each security.
For example, if the firm had preferred shares:
rassets = [D/V x (1-Tc)rdebt] + (P/V x rpreferred) + (E/V x requity)

Practice: Try example 11.1
11-19
What WACC Means
If you discount the expected cash flows from a project at the WACC and you find:
The project has a zero NPV.
Then the projects cash flows are just enough to give each of the security holders the returns they require. Then it will provide each of the security holders with the return they require and it will increase the value of the shareholders equity if accepted. Then the projects cash flows are insufficient to provide the required return to all of the security holders and accepting it will decrease the value of the firm.
The project has a positive NPV.
The project has a negative NPV.
11-20
Measuring Capital Structure

Practical
Problems in Applying WACC
Section 11.3 shows you how to calculate the WACC for a company called Big Oil. Notice that the first place to start is the companys accounts and the book value of its securities.
Using
judgment, research and some work, you convert from book value to market value.
11-21

Practical
If you look at Table 11.1 on page 342, you will see that at book, the firms capital structure is:
50% debt and 50% equity
However, if you look at Table 11.2, you will see that at market, the firms capital structure is:
25% debt and 75% equity
11-22

Practical
Thus, if you had used the book values in the calculation of Big Oils WACC, rather than the market value, your results would have been highly inaccurate!
REMEMBER WACC uses market value not book value!
11-23

Calculating
Market Value of Debt
Most financial managers accept the book value of bank debt as a fair approximation of market value.
This
debt is usually issued at floating rates and if rates change, the payment Big Oil makes will change so as to maintain the loans value.
Long term bonds, though, are usually issued at a fixed rate.

Thus
their market value fluctuates over time.

11-24

Calculating
Market Value of Debt
The market value of a companys bonds is the PV of all coupons, and the par value, discounted at the current interest rate.
Thus,
Big Oil has $200 million in face value of bonds issued at 8%.
Payments are $16 million per year.
There
are 12 years until maturity. Interest rates are currently 9%.
You should be able to calculate that these bonds have a market value of $185.7 million.
11-25

Calculating
Market Value of Equity
The market value of a companys equity is simply the market price per share multiplied by the number of shares outstanding.
Big
Oil has 100 million common shares outstanding. Each share has a market value of $12.
You should be able to calculate that the firms equity has a market value of $1,200 million.
11-26
Calculating Required Rates of Return
You have completed the first two steps for calculating the WACC:
1. Calculate the market value of each of the firms securities. 2. Calculate the market weight of each security as a proportion of the firms total financing.
Now you want to:

3. Determine the required rate of return on each security.
11-27
The Expected Return on Bonds
For most large, healthy firms, financial managers use the yield to maturity on the bonds as the expected return.
But, if a firm is in financial difficulty, beware of assuming that the yield offered by the bonds is the return that investors expect to receive.
Big Oils bonds have a yield to maturity of 9%.
11-28
The Expected Return on Common Stock
You may use the CAPM or the Dividend Discount Model (DDM) to estimate the required rate of return on a firms common equity.
CAPM:
Expected Return = risk-free rate + risk premium rj = rf + (rm - rf)
DDM:
Expected Return = dividend yield + growth rj = DIV1/P0 + g
11-29
The Expected Return on Common Stock
Big Oils expected return on its stock is about 13.5%:

rj = 6% + 0.85(9%) 13.5%
11-30
The Expected Return on Common Stock WARNINGS:
Beware of false precision! Do not expect estimates of the cost of equity to be precise. Remember that the constant-growth formula in the DDM will give you poor results if it is applied to firms with unsustainably high current growth rates.
11-31
The Expected Return on Preferred Stock
A preferred stock pays a fixed annual dividend in perpetuity. Thus, you may use the perpetuity formula to estimate the required rate of return on a firms preferred equity:
Expected Return = dividend yield

rpreferred = Dividend Pricepreferred
11-32
Big Oils Cost of Capital

Calculating
WACC
If Big Oil is in a 35% tax bracket, its WACC would be calculated as follows:

= [0.243 x (1-0.35)x9%) + (0.757 x 13.5%)
= 11.6%
11-33
Interpreting WACC
When
You Can and Cant Use WACC
WACC allows us to measure the cost of capital for companies which issue different types of securities. WACC also adjusts the cost of capital for the tax-deductibility of interest payments. However, its use is restricted to certain types of projects.
11-34
Interpreting WACC
When
The WACC is the rate of return that the firm must expect to earn on its average-risk investments if it is to fairly compensate all its security holders. As such, WACC may be used to value new assets that:
Have
the same risk as the old ones. Will support the same ratio of debt as the firm itself.
In other words, the WACC is an appropriate discount rate if and only if the project is a carbon copy of the firms existing business.
11-35
Interpreting WACC
When
You should know, however, that WACC is sometimes used as a company-wide benchmark discount rate.
This
benchmark will be adjusted upward for unusually risky projects and downwards for unusually safe ones.
11-36
Interpreting WACC
Some Common Mistakes
You calculated Big Oils WACC is 11.6% because the firm uses so little debt (about 25%). But, debt is much less expensive than equity.
Could you lower WACC by issuing more debt and raising its proportion in the firms capital structure?
For example, if you use Big Oils required returns on debt and equity, but change the weights, you can reduce its WACC to 9.7%: rassets = [D/V x (1-Tc)rdebt] + (E/V x requity) = [0.50 x (1-0.35)x9%) + (0.50 x 13.5%) = 9.7%
11-37
Interpreting WACC
Some
Common Mistakes
Do you see what is wrong with the logic? As the firm borrows more, its risk goes up. The consequence:
The
cost of both the companys debt and its equity will go up as investors demand a higher return to compensate them for the increased risk.
11-38
Interpreting WACC
Some
Common Mistakes
When you thought you could reduce Big Oils WACC by borrowing more, you were recognizing only the explicit cost of the debt. However, there is also an implicit cost of using more debt.
Increased
borrowing increases risk, leading security holders to demand a higher rate of return.
11-39
Interpreting WACC
Some Common Mistakes However, despite the increased cost of capital for the companys securities, the overall WACC will remain the same as the fractions of debt and equity change.
This
happens because more weight is put on the debt which costs less than the equity. That is, a change in capital structure must affect the return on the individual securities; however, the return on the package of debt and equity securities is unaffected.
11-40
Interpreting WACC
Revisiting
the Project Cost of Capital
In Chapter 10, you learned that the required rate of return on a project depends on that projects risk level and not the source of funds. Since it will be rare for a project to be financed entirely with equity, we now need to consider ways of calculating a projects WACC.
11-41
Interpreting WACC
Revisiting the Project Cost of Capital

The projects WACC should reflect the projects overall risk and the best securities mix for the project. Thus, calculating a projects cost of capital has two components:
1. Assess the risks of the project by determining its
beta. 2. Determine the best financing mix for the project.
11-42
Floatation Costs and the Cost of Capital

Accounting
for Floatation Costs
Often a firm needs to issue securities to raise the necessary cash for a project. There is a cost associated with issuing securities. These costs, when added to the others of the project, can make the project less attractive.
11-43

Accounting
For example, you are looking at a project for your firm which costs $900,000 and generates $90,000 per year in perpetuity.
If
the opportunity cost of capital on this project is 10%, it is barely acceptable, having a NPV of zero ($90,000/10% - $900,0000).
Now suppose your firm has to issue equity at a cost of $100,000 to finance the project.
The
project would now have a cost of $1 million and a negative NPV, making it unacceptable.
11-44

Accounting
Some companies attempt to account for floatation costs by increasing the discount rate. A better way of handling these costs is to recognize that they are just another cost of undertaking the project. Thus, they should be treated as a negative incremental cash flow when determining the projects NPV.
11-45
Summary of Chapter 11
Firms compute the WACC because they need a standard discount rate for average risk projects.
Average
risk projects have the same risk as the firms existing assets and operations.
If a project is not a carbon copy of the firm (i.e., it is not an average risk project), then the WACC can be used as a benchmark.
It
can be adjusted up for high risk projects, or down for unusually safe projects.
WACC is calculated as follows:

11-46
WACC is the expected rate of return on the portfolio of debt and equity issued by the firm.
The
required rate of return on each security is weighted by its proportion of the firms total market value. The required rate of return is also adjusted for the tax deductibility of interest.
The required return on a firms securities is calculated by:

Using
the yield on the debt. Using the CAPM, or the DDM, for the equity.
11-47
If a firms capital structure changes, the risk of its securities will also change.
For
example, increasing debt will increase the risk borne by both debt and equity holders.
Investors will respond by demanding a higher return.
However,
the overall cost of capital will remain the same as the fractions of debt and equity change.
This happens because more weight is put on the debt which costs less than the equity.
Floatation costs do not affect WACC.

Instead,
they are treated as a negative cash flow in the NPV calculation.


Chapter 11

Transféré par

Informations du document

Copyright

Formats disponibles

Partager ce document

Partager ou intégrer le document

Options de partage

Avez-vous trouvé ce document utile ?

Ce contenu est-il inapproprié ?

Droits d'auteur :

Formats disponibles

Chapter 11

Transféré par

Droits d'auteur :

Formats disponibles

11-1

Fundamentals of Corporate Finance

copyright 2003 McGraw Hill Ryerson Limited

Geothermals Cost of Capital

the Cost of Capital

Geothermals Cost of Capital

the Cost of Capital

can use the CAPM to estimate this return.

However, very few companies are financed entirely by equity.

copyright 2003 McGraw Hill Ryerson Limited

Geothermals Cost of Capital

the Cost of Capital

Geothermals Cost of Capital

Calculating the Cost of Capital

Geothermals Cost of Capital

Calculating the Cost of Capital

A firms cost of capital will be determined by its capital structure.

copyright 2003 McGraw Hill Ryerson Limited

Geothermals Cost of Capital

Geothermals Cost of Capital

Calculating the Cost of Capital

You are told the following about Geothermals capital structure:

This means the market value of the firms equity is $453 m.

copyright 2003 McGraw Hill Ryerson Limited

Geothermals Cost of Capital

Calculating the Cost of Capital

Thus, you know the following about Geothermals capital structure:

copyright 2003 McGraw Hill Ryerson Limited

Geothermals Cost of Capital

Calculating the Cost of Capital

copyright 2003 McGraw Hill Ryerson Limited

Geothermals Cost of Capital

Calculating the Cost of Capital

To calculate the return on this portfolio, we would:

This measure is known as a firms weighted average cost of capital (WACC).

Geothermals Cost of Capital

Calculating the Cost of Capital

Thus for Geothermal:

= (D/V x rdebt) + (E/V x requity) = (0.30 x 8%) + (0.70 x 14%) = 12.2%

Geothermals Cost of Capital

Calculating the Cost of Capital

Geothermals Cost of Capital

Calculating the Cost of Capital

Thus, the cost of the firms debt is not 8%, but:

8% x (1- tax rate) = 8% x (1 - 0.35) = 5.2%

Geothermals Cost of Capital

Calculating the Cost of Capital

= (0.3 x 5.2%) + 9.8%

Calculating the WACC

The Steps for Calculating the WACC:

Calculating the WACC

Steps for Calculating WACC

For example, if the firm had preferred shares:

rassets = [D/V x (1-Tc)rdebt] + (P/V x rpreferred) + (E/V x requity)

Calculating the WACC

What WACC Means

The project has a zero NPV.

The project has a positive NPV.

The project has a negative NPV.

Measuring Capital Structure

Problems in Applying WACC

Measuring Capital Structure

Problems in Applying WACC

Measuring Capital Structure