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Cost of Capital

Cost of Capital

Key Concepts

Know how to determine a firms cost of debt

Know how to determine a firms overall cost of capitalWACC

Divisional and Project Costs of Capital

Flotation Costs and the Weighted Average Cost of

Capital

Understand pitfalls of overall cost of capital and how to

manage them

depends on the risk of those assets

The return to an investor is the same as the cost

to the company

Our cost of capital provides us with an indication

of how the market views the risk of our assets

Knowing our cost of capital can also help us

determine our required return for capital

budgeting projects

Required Return

discount rate and is based on the risk of the cash

flows

We need to know the required return for an investment

before we can compute the NPV and make a decision

about whether or not to take the investment

We need to earn at least the required return to

compensate our investors for the financing they have

provided

Cost of Equity

equity investors given the risk of the cash

flows from the firm

determining the cost of equity

1. Dividend growth model

2. SML based on Capital Asset Pricing Model

formula and rearrange to solve for R E

D1

P0

RE g

RE

D1

g

P0

pay a dividend of $1.50 per share next

year. There has been a steady growth in

dividends of 5.1% per year and the market

expects that to continue. The current price

is $25. What is the cost of equity?

1.50

RE

.051 .111

25

Use the historical growth rate if you

believe the future will be like the past.

Obtain analysts estimates: Value Line,

Zacks, Yahoo.Finance.

Use the earnings retention model,

illustrated on next slide.

to use the historical average

Year

2005

2006

2007

2008

2009

Dividend

1.23

1.30

1.36

1.43

1.50

Percent Change

(1.36 1.30) / 1.30 = 4.6%

(1.43 1.36) / 1.36 = 5.1%

(1.50 1.43) / 1.43 = 4.9%

Second method for estimating the growth

rate is to use sustainable growth rate:

g = RR x ROE

RR= Retention Ratio (the percent of net

income is retained for an vestment).

ROE= Return on Equity (NIAT/Equity)

NIAT=Net Income After Tax

Growth Model

Disadvantages

Only applicable to companies currently paying

dividends

Not applicable if dividends arent growing at a

reasonably constant rate

Extremely sensitive to the estimated growth rate an

increase in g of 1% increases the cost of equity by

1%

Extremely sensitive to stock price volatility

Does not explicitly consider risk

return is the Cost of Equity Capital:

Ri RF i ( RM RF )

To estimate a firms cost of equity capital, we need

to know three things:

1. The risk-free rate, RF

RM R F

Cov ( Ri , RM ) i , M

2

The company beta, i

Var ( RM )

M

3.

Example - SML

58 and the current risk-free rate is 6.1%. If the

expected market risk premium is 8.6%, what is

your cost of equity capital?

RE = 6.1 + .58(8.6) = 11.1%

both the dividend growth model and the SML

approach, we should feel pretty good about our

estimate

(10 to 20 years) government bond as an

estimate of RF.

More

Most analysts use a rate of 5% to 6.5% for

the market risk premium (RPM)

Estimates of beta vary, and estimates are

noisy (they have a wide confidence

interval).

Example

publisher of PowerPoint presentations, has a beta of

2.5. The firm is 100-percent equity financed.

Assume a risk-free rate of 5-percent and a market risk

premium of 10-percent.

What is the appropriate discount rate for an expansion

of this firm?

Ri RF i ( RM RF )

R 5% 2.5 10%

R 30%

Example (continued)

following non-mutually exclusive projects. Each costs

$100 and lasts one year.

Project

Project

IRR

NPV at

30%

2.5

Projects

Estimated Cash

Flows Next

Year

$150

50%

$15.38

2.5

$130

30%

$0

2.5

$110

10%

-$15.38

IRR

Project

Discount Rate for Projects

Good

A

projects

30%

5%

SML

Bad projects

Firms risk (beta)

2.5

An all-equity firm should accept a project whose IRR exceeds the cost of equity

capital and reject projects whose IRRs fall short of the cost of capital.

Estimation of Beta

Problems

Cov ( Ri , RM ) i2

2

Var ( RM )

M

2. The sample size may be inadequate.

3. Betas are influenced by changing financial leverage and business

risk.

Solutions

sophisticated statistical techniques.

Problem 3 can be lessened by adjusting for changes in business

and financial risk.

Look at average beta estimates of comparable firms in the

industry.

Stability of Beta

stable for firms remaining in the same industry.

Thats not to say that a firms beta cant change.

Changes in product line

Changes in technology

Deregulation

Changes in financial leverage

Determinants of Beta

Business

Risk

Cyclicity

of Revenues

Operating Leverage

Financial

Risk

Financial

Leverage

Cyclicality of Revenues

Empirical evidence suggests that retailers and

automotive firms fluctuate with the business cycle.

Transportation firms and utilities are less dependent

upon the business cycle.

Note that cyclicality is not the same as variability

stocks with high standard deviations need not have

high betas.

Movie studios have revenues that are variable,

depending upon whether they produce hits or

flops, but their revenues are not especially

dependent upon the business cycle.

Operating Leverage

a firm (or project) is to its fixed costs.

Operating leverage increases as fixed costs rise and

variable costs fall.

Operating leverage magnifies the effect of cyclicity on beta.

The degree of operating leverage is given by:

EBIT

Q(P - v)

EBIT + F

DOL = EBIT =

=

SALES Q(P - v) - F

EBIT

SALES

Operating Leverage

measures the effect of a change in sales

volume on earnings before interest and

taxes (EBIT). It is defined as the

percentage change in EBIT associated

with a given percentage change in sales:

Gross Profit

=

DOLS =

Sales - Variable cost - Fixed cost

EBIT

Operating leverage increases as fixed costs rise and

variable costs fall.

Financial

a firms fixed costs of financing.

The relationship between the betas of

the firms debt, equity, and assets is

given by:

Asset =

Debt

Equity

Debt +

Equity

Debt + Equity

Debt + Equity

beta relative to the asset beta.

Consider Grand Sport, Inc., which is currently allequity and has a beta of 0.90.

The firm has decided to lever up to a capital

structure of 1 part debt to 1 part equity.

Since the firm will remain in the same industry, its

asset beta should remain 0.90.

However, assuming a zero beta for its debt, its

equity beta would become twice as large:

D

1

Equity = Asset [ 1 + ] 0.9(1 ) 1.80

S

Advantages

Explicitly adjusts for systematic risk

Applicable to all companies, as long as we can

compute beta

Disadvantages

Have to estimate the expected market risk premium,

which does vary over time

Have to estimate beta, which also varies over time

We are relying on the past to predict the future, which

is not always reliable

Cost of Debt

debt

We usually focus on the cost of long-term debt or bonds

The required return is best estimated by computing the

yield-to-maturity on the existing debt

We may also use estimates of current rates based on

the bond rating we expect when we issue new debt

Ask an investment banker what the coupon rate would

be on new debt.

The cost of debt is NOT the coupon rate

After-tax Rd = R d (1-TC)

outstanding that has 25 years left to

maturity. The coupon rate is 9% and

coupons are paid semiannually. The bond

is currently selling for $908.72 per $1000

bond. What is the cost of debt?

T = 50; PMT = 45; FV = 1000; PV = -908.75; CPT

I/Y = 5%; YTM = Rd =5(2) = 10%

25 years/2 = 50 periods = N

HP

$-908.72 = PV

$90/2 = $45 = Payment12-C

(PMT)

YTM = i = ?

$1,000 = FV

5.00

(x2 = 10%)

TI BA II

Plus

25 yrs/2

= 50 payments = N

5%(5 x 2 = 10%

$ -908.72 = PV

$90/2 = $45 (PMT)

$1,000 = FV

YTM = I/Y = ?

1st

2nd

A 15-year, 12% semiannual bond sells for

$1,153.72. Whats Rd?

0

i=?

60

30

N

OUTPUT

30

...

-1,153.72

INPUTS

2

60

-1153.72 60

I/YR

PV

PMT

5.0% x 2 = Rd = 10%

60 + 1,000

1000

FV

(AT) cost of debt is:

dividend every period (DP)

period forever

Preferred stock is an annuity, so we take the

annuity formula, rearrange and solve for R P

R P = D P / P0

Stock

Your company has preferred stock that

has an annual dividend of $3. If the

current price is $25, what is the cost of

preferred stock?

RP = 3 / 25 = 12%

$100.

risky to investors than debt?

More risky; company not required to pay

preferred dividend.

However, firms must pay preferred

dividend before paying common dividend.

can raise common equity?

Directly, by issuing new shares of common

stock.

Indirectly, by reinvesting earnings that are

not paid out as dividends (i.e., retaining

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 reinvested.

Opportunity cost: The return stockholders

could earn on alternative investments of

equal risk.

They could buy similar stocks and earn R E, or

company could repurchase its own stock and

earn RE. So, RE, is the cost of reinvested

earnings and it is the cost of equity.

Capital Structure

capital structure.

If the company is unlevered firm (no debt in the

capital structure, then the cost of capital is based on

cost of equity.

If the company is levered, has debt in its capital

structure, then, the cost of capital is based on

weighted average of each capital in the capital

structure.

weights of each source of funds: namely debt,

preferred stock and equity

We can use the individual costs of capital that

we have computed to get our weighted

average cost of capital for the firm.

The weights are determined by how much of

each type of financing in the capital structure.

Notation

E = market value of equity = # outstanding shares times

price per share

D = market value of debt = # outstanding bonds times

bond price

P=market value of preferred stock=#outstanding shares

times price per share

V = market value of the firm = D + PF+ E

Weights

wE = E/V = percent financed with equity

wd = D/V = percent financed with debt

wP = PF/V = percent financed with preferred stock

WACC = wDRd(1-TC)+wP RP + w E RE

Weights

equity equal to $500 million and a market

value of debt = $475 million.

What

wE = E/V = 500 / 975 = .5128 = 51.28%

we need to consider the effect of taxes on the

various costs of capital

Interest expense reduces our tax liability

This reduction in taxes reduces our cost of

debt

After-tax cost of debt = Rd(1-TC)

Dividends are not tax deductible, so there is no

tax impact on the cost of equity

Equity Information

Debt Information

$1

billion in

outstanding debt (face

value)

Current quote = 110

Coupon rate = 9%,

semiannual coupons

15 years to maturity

50

million shares

$80 per share

Beta = 1.15

Market risk premium =

9%

Risk-free rate = 5%

RE = 5 + 1.15(9%) = 15.35%

T = 30; PV = -1100; PMT = 45; FV = 1000; CPT I/Y =

3.9268

Rd = 3.927(2) = 7.854%

Rd(1-TC) = 7.854(1-.4) = 4.712%

E

D = 1 billion (1.10) = 1.1 billion

V = 4 + 1.1 = 5.1 billion

wE = E/V = 4 / 5.1 = .7843

wd

must raise for a new project. The marginal

cost rises as more and more capital is

raised during a stated time period.

Capital

1. Capital Structure

2. Dividend Policy

3. Investment Policy

Using the WACC as our discount rate is

only appropriate for projects that are the

same risk as the firms current operations

If we are looking at a project that is NOT

the same risk as the firm, then we need to

determine the appropriate discount rate

for that project

Divisions also often require separate

discount rates

What would happen if we use the WACC

for all projects regardless of risk?

Assume the WACC = 15%

Project

A

B

C

Required Return

20%

15%

10%

IRR

17%

18%

12%

Project IRR

The SML can tell us why:

SML

Incorrectly accepted

negative NPV projects

RF FIRM ( RM RF )

Hurdle

rate

Rf

FIRM

Incorrectly rejected

positive NPV projects

Firms risk (beta)

A firm that uses one discount rate for all projects may

over time increase the risk of the firm while decreasing

its value.

Approach

the product or service that we are considering

Compute the beta for each company

Take an average

Use that beta along with the CAPM to find the

appropriate return for a project of that risk

Often difficult to find pure play companies

Subjective Approach

overall

If the project is more risky than the firm, use a

discount rate greater than the WACC

If the project is less risky than the firm, use a

discount rate less than the WACC

You may still accept projects that you shouldnt

and reject projects you should accept, but your

error rate should be lower than not considering

differential risk at all

Risk Level

Discount Rate

WACC 8%

Low Risk

WACC 3%

WACC

High Risk

WACC + 5%

WACC + 10%

Flotation Costs

The required return depends on the risk, not

how the money is raised

However, the cost of issuing new securities

should not just be ignored either

Basic Approach

Compute

Use the target weights because the firm will issue

securities in these percentages over the long term

project will generate after-tax cash flows of $250,000 per year for 7

years. The WACC is 15% and the firms target D/E ratio is .6 The

flotation cost for equity is 5% and the flotation cost for debt is 3%.

What is the NPV for the project after adjusting for flotation costs?

NPV = 1,040,105 - 1,000,000/(1-.0425) = -4,281

flotation costs

Once we consider the cost of issuing new securities, the NPV

becomes negative

Quick Quiz

equity?

How do you compute the cost of debt and the after-tax cost

of debt?

How do you compute the capital structure weights required

for the WACC?

What is the WACC?

What happens if we use the WACC for the discount rate for

all projects?

What are two methods that can be used to compute the

appropriate discount rate when WACC isnt appropriate?

How should we factor in flotation costs to our analysis?

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