# 11 - 1 Copyright © 2002 Harcourt, Inc.All rights reserved. CHAPTER 11 The Cost of Capital Cost of Capital Components Debt Preferred Common Equity WACC.

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11 - 1 Copyright © 2002 Harcourt, Inc.All rights reserved. CHAPTER 11 The Cost of Capital Cost of Capital Components Debt Preferred Common Equity WACC

11 - 2 Copyright © 2002 Harcourt, Inc.All rights reserved. What types of long-term capital do firms use? Long-term debt Preferred stock Common equity

11 - 3 Copyright © 2002 Harcourt, Inc.All rights reserved. Should we focus on before-tax or after-tax capital costs? Tax effects associated with financing can be incorporated either in capital budgeting cash flows or in cost of capital. Most firms incorporate tax effects in the cost of capital. Therefore, focus on after-tax costs. Only cost of debt is affected.

11 - 4 Copyright © 2002 Harcourt, Inc.All rights reserved. Should we focus on historical (embedded) costs or new (marginal) costs? The cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we should focus on marginal costs.

11 - 5 Copyright © 2002 Harcourt, Inc.All rights reserved. A 15-year, 12% semiannual bond sells for \$1,153.72. What’s k d ? 6060 + 1,00060 01230 i = ? 30 -1153.72 60 1000 5.0% x 2 = k d = 10% NI/YRPVFVPMT -1,153.72... INPUTS OUTPUT

11 - 6 Copyright © 2002 Harcourt, Inc.All rights reserved. Component Cost of Debt Interest is tax deductible, so k d AT = k d BT (1 - T) = 10%(1 - 0.40) = 6%. Use nominal rate. Flotation costs small, so ignore.

11 - 7 Copyright © 2002 Harcourt, Inc.All rights reserved. What’s the cost of preferred stock? P P = \$113.10; 10%Q; Par = \$100; F = \$2. Use this formula:

11 - 8 Copyright © 2002 Harcourt, Inc.All rights reserved. Picture of Preferred 2.50 012 k ps = ? -111.1 ... 2.50

11 - 9 Copyright © 2002 Harcourt, Inc.All rights reserved. Note: Flotation costs for preferred are significant, so are reflected. Use net price. Preferred dividends are not deductible, so no tax adjustment. Just k ps. Nominal k ps is used.

11 - 10 Copyright © 2002 Harcourt, Inc.All rights reserved. Is preferred stock more or less risky to investors than debt? More risky; company not required to pay preferred dividend. However, firms want to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, and (3) preferred stockholders may gain control of firm.

11 - 11 Copyright © 2002 Harcourt, Inc.All rights reserved. Why is yield on preferred lower than k d ? 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 investors and A-T cost to the issuer are higher on preferred than on debt, which is consistent with the higher risk of preferred.

11 - 12 Copyright © 2002 Harcourt, Inc.All rights reserved. Example: k ps = 9% k d = 10%T = 40% k ps, AT = k ps - k ps (1 - 0.7)(T) = 9% - 9%(0.3)(0.4) = 7.92% k d, AT = 10% - 10%(0.4)= 6.00% A-T Risk Premium on Preferred = 1.92%

11 - 13 Copyright © 2002 Harcourt, Inc.All rights reserved. Companies can issue new shares of common stock. Companies can reinvest earnings. What are the two ways that companies can raise common equity?

11 - 14 Copyright © 2002 Harcourt, Inc.All rights reserved. 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. Why is there a cost for reinvested earnings?

11 - 15 Copyright © 2002 Harcourt, Inc.All rights reserved. Opportunity cost: The return stockholders could earn on alternative investments of equal risk. They could buy similar stocks and earn k s, or company could repurchase its own stock and earn k s. So, k s, is the cost of reinvested earnings and it is the cost of equity.

11 - 16 Copyright © 2002 Harcourt, Inc.All rights reserved. Three ways to determine the cost of equity, k s : 1.CAPM: k s = k RF + (k M - k RF )b = k RF + (RP M )b. 2.DCF: k s = D 1 /P 0 + g. 3.Own-Bond-Yield-Plus-Risk Premium: k s = k d + RP.

11 - 17 Copyright © 2002 Harcourt, Inc.All rights reserved. What’s the cost of equity based on the CAPM? k RF = 7%, RP M = 6%, b = 1.2. k s = k RF + (k M - k RF )b. = 7.0% + (6.0%)1.2 = 14.2%.

11 - 18 Copyright © 2002 Harcourt, Inc.All rights reserved. What’s the DCF cost of equity, k s ? Given: D 0 = \$4.19;P 0 = \$50; g = 5%.

11 - 19 Copyright © 2002 Harcourt, Inc.All rights reserved. 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?

11 - 20 Copyright © 2002 Harcourt, Inc.All rights reserved. Retention growth rate: g = b(ROE) = 0.35(15%) = 5.25%. Here b = Fraction retained. Close to g = 5% given earlier. Think of bank account paying 10% with b = 0, b = 1.0, and b = 0.5. What’s g?

11 - 21 Copyright © 2002 Harcourt, Inc.All rights reserved. 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. See “Ch 11 Tool Kit.xls”.

11 - 22 Copyright © 2002 Harcourt, Inc.All rights reserved. Find k s using the own-bond-yield- plus-risk-premium method. (k d = 10%, RP = 4%.) This RP  CAPM RP M. Produces ballpark estimate of k s. Useful check. k s = k d + RP = 10.0% + 4.0% = 14.0%

11 - 23 Copyright © 2002 Harcourt, Inc.All rights reserved. What’s a reasonable final estimate of k s? MethodEstimate CAPM14.2% DCF13.8% k d + RP14.0% Average14.0%

11 - 24 Copyright © 2002 Harcourt, Inc.All rights reserved. What’s the WACC? WACC= w d k d (1 - T) + w ps k ps + w ce k s = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1%.

11 - 25 Copyright © 2002 Harcourt, Inc.All rights reserved. WACC Estimates for Some Large U. S. Corporations CompanyWACC Intel12.9% General Electric11.9 Motorola11.3 Coca-Cola11.2 Walt Disney10.0 AT&T 9.8 Wal-Mart 9.8 Exxon 8.8 H. J. Heinz 8.5 BellSouth 8.2

11 - 26 Copyright © 2002 Harcourt, Inc.All rights reserved. What factors influence a company’s WACC? Market conditions, especially interest rates and tax rates. The firm’s capital structure and dividend policy. The firm’s investment policy. Firms with riskier projects generally have a higher WACC.

11 - 27 Copyright © 2002 Harcourt, Inc.All rights reserved. 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.

11 - 30 Copyright © 2002 Harcourt, Inc.All rights reserved. What are the three types of project risk? Stand-alone risk Corporate risk Market risk

11 - 31 Copyright © 2002 Harcourt, Inc.All rights reserved. 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.

11 - 32 Copyright © 2002 Harcourt, Inc.All rights reserved. Subjective adjustments to the firm’s composite WACC. Estimate what the cost of capital would be if the project/division were a stand-alone firm. This requires estimating the project’s beta. What procedures are used to determine the risk-adjusted cost of capital for a particular project or division?

11 - 33 Copyright © 2002 Harcourt, Inc.All rights reserved. Methods for Estimating Beta for a Division or a Project 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.

11 - 34 Copyright © 2002 Harcourt, Inc.All rights reserved. 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.

11 - 35 Copyright © 2002 Harcourt, Inc.All rights reserved. Find the division’s market risk and cost of capital based on the CAPM, given these inputs: Target debt ratio = 10%. k d = 12%. k RF = 7%. Tax rate = 40%. beta Division = 1.7. Market risk premium = 6%.

11 - 36 Copyright © 2002 Harcourt, Inc.All rights reserved. Beta = 1.7, so division has more market risk than average. Division’s required return on equity: k s = k RF + (k M – k RF )b Div. = 7% + (6%)1.7 = 17.2%. WACC Div. = w d k d (1 – T) + w c k s = 0.1(12%)(0.6) + 0.9(17.2%) = 16.2%.

11 - 37 Copyright © 2002 Harcourt, Inc.All rights reserved. How does the division’s WACC compare with the firm’s overall WACC? Division WACC = 16.2% 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 16.2%.

11 - 38 Copyright © 2002 Harcourt, Inc.All rights reserved. 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. Why is the cost of internal equity from reinvested earnings cheaper than the cost of issuing new common stock?

11 - 39 Copyright © 2002 Harcourt, Inc.All rights reserved. Estimate the cost of new common equity: P 0 =\$50, D 0 =\$4.19, g=5%, and F=15%.

11 - 40 Copyright © 2002 Harcourt, Inc.All rights reserved. Estimate the cost of new 30-year debt: Par=\$1,000, Coupon=10%paid annually, and F=15%. Using a financial calculator: N = 30 PV = 1000(1-.02) = 980 PMT = -(.10)(1000)(1-.4) = -60 FV = -1000 Solving for I: 6.15%

11 - 41 Copyright © 2002 Harcourt, Inc.All rights reserved. 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.

11 - 42 Copyright © 2002 Harcourt, Inc.All rights reserved. Four Mistakes to Avoid 1.When estimating the cost of debt, use the current interest rate on new debt, not the coupon rate on existing debt. 2.When estimating the risk premium for the CAPM approach, don’t subtract the current long-term T-bond rate from the historical average return on common stocks. (More...)

11 - 43 Copyright © 2002 Harcourt, Inc.All rights reserved. For example, if the historical k M has been about 12.7% and inflation drives the current k RF up to 10%, the current market risk premium is not 12.7% - 10% = 2.7%! (More...)

11 - 44 Copyright © 2002 Harcourt, Inc.All rights reserved. 3.Use the target capital structure to determine the weights. If you don’t know the target weights, then use the current market value of equity, and never the book value of equity. If you don’t know the market value of debt, then the book value of debt often is a reasonable approximation, especially for short-term debt. (More...)

11 - 45 Copyright © 2002 Harcourt, Inc.All rights reserved. 4.Capital components are sources of funding that come from investors. Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the WACC. We do adjust for these items when calculating the cash flows of the project, but not when calculating the WACC.

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