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1 CHAPTER 10 The Cost of Capital

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2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation Costs

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3 Sources of Long-term Capital Long-Term Capital Long-Term Debt Preferred Stock Common Stock Retained Earnings New Common Stock 10-3 rdrd rsrs r ps r ce rere

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4 WACC Weighted Average Cost of Capital Where: w d = % of debt in capital structure w ps = % of preferred stock in capital structure w ce = % of common equity in capital structure r d = firm’s cost of debt r ps = firm’s cost of preferred stock r s = firm’s cost of equity T = firm’s corporate tax rate Weights Component costs WACC = w d r d (1-T) + w ps r ps + w ce r s (10.10)

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5 Capital Components Capital components = sources of funding from investors Accounts payable, accruals, and deferred taxes ≠ sources of funding from investors Not included in calculation of the cost of capital Adjustments made when calculating project cash flows

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6 Cost of Debt Method 1: Ask an investment banker what the coupon rate would be on new debt Method 2: Find the bond rating for the company and use the yield on other bonds with a similar rating Method 3: Find the yield on the company’s outstanding debt

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7 NCC’s Cost of Debt (r d ) A 22-year, 9% semiannual coupon bond sells for $ Bond pays a semiannual coupon: r d = 5.5% x 2 = 11% Calculator Solution 44, S. 45 / %- = 5.50%

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8 Component Cost of Debt Interest is tax deductible, so the after tax (AT) cost of debt is: r d AT= r d BT(1 - T) r d AT= 11%( ) = 6.6% Use nominal rate

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9 Flotation Costs on New Debt Flotation costs on debt usually low Frequently ignored “Project Financing” Adjusts project’s cash flows for flotation costs of debt Debt has specific claim on the project’s cash flows

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10 Adjusting the Cost of Debt for Flotation Costs Where: M = Bond’s par value (face value) F = Flotation cost as a % N = Number of coupon payments T = Corporate tax rate INT = Dollars of interest per period r d (1-T) = after tax cost of debt adjusted for inflation

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11 NCC’s Cost of Debt (r d ) with Flotation Costs NCC can issue 30-year bonds N = 60 11% annual coupon rate Coupons paid semiannually PMT = [(.11 x 1000)/2]*(1-.40) PMT = $33 Flotation cost = 1% PV = -1000(1-.01) = -990 Face value = M = 1000 Calculator Solution 60, 990 S. 33 / %- = 3.34% Nominal after-tax cost of debt with flotation costs = 6.68%

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12 Preferred Stock Flotation costs for preferred are significant Use net price Preferred dividends are not deductible No tax adjustment Use r ps Nominal r ps is used

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13 NCC’s Cost of preferred stock: P P = $100 $10 Dividend F = 2.5% Where: D ps = Preferred dividend P PS = Preferred stock price F = Flotation cost %

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14 Cost of Common Equity Two Ways to raise equity financing: Directly Issue new shares of common stock Indirectly Reinvesting earnings not paid out as dividends Use retained earnings

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15 Funding with New Common Equity Mature firms rarely issue new equity High flotation costs Negative signal to the market Downward pressure on stock price

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16 Cost of 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 reinvested

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17 Cost for Reinvested Earnings Opportunity cost: The return stockholders could earn on alternative investments of equal risk They could buy similar stocks and earn r s, or company could repurchase its own stock and earn r s r s = the cost of reinvested earnings = the cost of equity

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18 Three ways to determine the cost of equity, r s : 1.CAPM: r s = r RF + (R M - r RF )β = r RF + (RP M )β 2.DCF: r s = D 1 /P 0 + g 3.Own-Bond-Yield-Plus-Risk Premium: r s = r d + Bond RP

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19 Three ways to determine the cost of equity, r s : 1.CAPM: r s = r RF + (R M - r RF )β = r RF + (RP M )β 2.DCF: r s = D 1 /P 0 + g 3.Own-Bond-Yield-Plus-Risk Premium: r s = r d + Bond RP

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20 1. Estimate risk-free rate (r RF ) 2. Estimate market risk premium (RP M ) or expected return on the market (R M ) 3. Estimate beta (β) 4. Substitute into CAPM CAPM Cost of Equity - Steps

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21 Estimating r RF Common stock = long-term security T-Bills more volatile than T-Bonds Most analysts use the rate on a long- term (10 to 30 years) government bond as an estimate of r RF

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22 Estimating RP M or R M Historical - Ibbotson & Associates 1926-most recent year 6.5% arithmetic mean - if constant risk aversion 4.9 % geometric mean – best future estimate Ex Ante = Forward-Looking If market in equilibrium: Historical or analysts’ estimates Value Line or Reuters

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23 RP M Estimate – #1 RP M = 11.73% r M Estimate (Reuters, Spring 2008) Dividend yield on S&P500 = 2.61% Dividend growth rate = 13.20% r M =[0.0261(1+.132)]+0.132=16.15% Forward-looking RP M : Long-term T-Bond rate = 4.42% 16.15% % = 11.73% Problems: Past = future? Growth rates sensitive to period measured

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24 RP M Estimate – #2 RP M = 17.79% r M Estimate (Spring 2008) Reuters S&P500 dividend yield = 2.61% Yahoo Earnings growth rate = 19.1% r M =[0.0261(1+.191)]+0.191=22.21% Forward-looking RP M : 22.21% % = 17.79% Problems: Earnings growth ≠ dividend growth 1-year growth rate ≠ long-term growth Analysts’ accuracy Differing analysts’ opinions

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25 Estimating RP M (or R M ) RP M = Equity risk premium Most analysts use a rate of 5% to 6.5% for the market risk premium R M S&P500 index return =proxy for the market return RP M =R M - r RF Brigham-Daves →RP M = [3.5, 6.5]

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26 Estimating Beta - β Beta estimates vary Beta estimates are “noisy” Wide confidence interval Historical Beta 4-5 years/monthly or 1-2 years/weekly Adjusted Beta Fundamental Beta Multinational issues

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27 NCC’s CAPM Cost of Equity r s = r RF + (R M - r RF )β = 8.0% + (6.0%)1.1 = 14.6% r RF = 8% RP M = 6% β= 1.1

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28 Three ways to determine the cost of equity, r s : 1.CAPM: r s = r RF + (R M - r RF )β = r RF + (RP M )β 2.DCF: r s = D 1 /P 0 + g 3.Own-Bond-Yield-Plus-Risk Premium: r s = r d + Bond RP

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29 DCF Approach: Inputs 1. Current stock price (P 0 ) 2. Current dividend (D 0 ) 3. Growth rate (g)

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30 Estimating the Growth Rate The historical growth rate If you believe future = past The earnings retention model Analysts’ estimates: Value Line, Zack’s, Yahoo.Finance

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31 Earnings Retention Model NCC Data: ROE = 14.5% Dividend payout ratio = 52% Retention ratio = 100% - dividend payout Retention rate = 100% - 52% = 48% Retention growth rate: g = ROE x (Retention rate) g = (14.5%) x 0.48 = 7%

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32 Earnings Retention Assumptions 1. Retention rate is constant 2. ROE on new investments is constant 3. No new common stock will be issued 4. The risk of future projects is very close to the risk of the overall firm

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33 Using Analysts’ Forecasts Analysts’ estimate earnings growth = proxy for dividend growth Sometimes involve non-constant growth Develop a proxy constant rate Analysts’ Estimates for NCC: 10.4% annual growth for 5 years 6.5% growth after 5 years Analysts’ estimates usually best source g = 6.9%

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34 NCC’s DCF Cost of Equity, r s r s = D1D1 P0P0 + g = D 0 (1+g) P0P0 + g = $2.40 $ = = 14.5% D 1 = $2.40 P 0 = $32 g = 7%

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35 Three ways to determine the cost of equity, r s : 1.CAPM: r s = r RF + (R M - r RF )β = r RF + (RP M )β 2.DCF: r s = D 1 /P 0 + g 3.Own-Bond-Yield-Plus-Risk Premium: r s = r d + Bond RP

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36 The Own-Bond-Yield-Plus-Risk-Premium Method: r d = 11%, RP = 3.7% r s = r d + RP r s = 11.0% + 3.7% = 14.7% This RP CAPM RP M Produces ballpark estimate of r s Useful check

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37 Final Estimate of r s MethodEstimateUsed by CAPM14.6%74% - 85% DCF14.5%16% r d + RP14.7%Non-public Average14.6%

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38 Flotation Costs for Equity r e = Cost of New Equity NCC: D 1 = $2.40 P 0 = $32 F = 12.5%

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39 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjusted WACC with Flotation Costs

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40 WACC Weighted Average Cost of Capital Where: w d = % of debt in capital structure w ps = % of preferred stock in capital structure w ce = % of common equity in capital structure r d = firm’s cost of debt r ps = firm’s cost of preferred stock r s = firm’s cost of equity T = firm’s corporate tax rate Weights Component costs WACC = w d r d (1-T) + w ps r ps + w ce r s (10.10)

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41 WACC Weights Weights =percentages of the firm that will be financed by each component If possible, always use the target weights for the percentages of the firm that will be financed with the various types of capital NCC: 30% debt, 10% Preferred, 60% Equity

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42 NCC’s WACC Weighted Average Cost of Capital WACC =0.3(11%)(1-.40)+0.1(10.3%)+0.6(14.6%) WACC = 11.77% Componentwr Debt (before tax) % Preferred Stock % Common equity % WACC = w D r D (1- T)+ w Ps r Ps + w c r s

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43 Cost of Capital Issues Before-tax vs. After-tax Capital Costs Long- and short-term debt affected Historical Costs vs. Marginal Costs Target Weights vs. Annual Financing Choices Target Weights vs. Book Values

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44 Estimating Weights for the Capital Structure Estimate the weights using current market values rather than current book values If market value of debt is not known: Usually reasonable to use the book values of debt, especially if the debt is short-term

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45 Estimating Weights Given: The stock price is $50 There are 3 million shares of stock $25 million of preferred stock $75 million of debt

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46 Estimating Weights V ce = $50 x (3 million) = $150 million V ps = $25 million V d = $75 million Total value = $150 + $25 + $75 = $250 million

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47 Estimating Weights

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48 WACC

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49 Factors that influence a company’s WACC Market conditions Interest rates The market risk premium Tax rates Firm’s capital structure Firm’s dividend policy Firm’s investment policy Firms with riskier projects generally have a higher WACC

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50 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjusted WACC with Flotation Costs

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51 Risk-Adjusted WACC The composite WACC reflects the risk of an average project undertaken by the firm Different divisions/projects may have different risks The division’s or project’s WACC should be adjusted to reflect the appropriate risk and capital structure

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52 Divisional Risk and the Cost of Capital Rate of Return (%) WACC Rejection Region Acceptance Region Risk WACC H L F 0 Risk L H Acceptance Region Rejection Region

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53 Using WACC for All Projects - Example What would happen if we use the WACC for all projects regardless of risk? Assume the WACC = 15%

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54 The Risk-Adjusted Divisional Cost of Capital Estimate the cost of capital that the division would have if it were a stand- alone firm Requires estimating the division’s beta, cost of debt, and capital structure CAPM frequently used

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55 Pure Play Method for Estimating Beta for a Division or a Project 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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56 Huron Steel Example

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57 Subjective Approach Consider the project’s risk relative to the firm overall If project risk > firm risk Project discount rate > WACC If project risk < firm risk Project discount rate < WACC

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58 Subjective Approach - Example Risk LevelDiscount Rate Very Low RiskWACC – 8% 7% Low RiskWACC – 3% 12% Same Risk as FirmWACC 15% High RiskWACC + 5% 20% Very High RiskWACC + 10% 25%

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59 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjusted WACC with Flotation Costs

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60 Flotation Costs Flotation costs depend on the risk of the firm and the type of capital being raised Flotation costs: Highest for common equity Most firms issue equity infrequently Flotation costs frequently ignored when calculating WACC

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61 NCC’s WACC With New Debt WACC = w d r AT d + w ps r ps + w c r e WACC = 0.3(6.68%)+0.1(10.3%) +0.6(14.6%) WACC = 2.004% % % = % Componentwr New Debt (after-tax)d % Preferred Stockps % New Common equityc %

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62 NCC’s WACC With New Debt & New Equity WACC = w d r AT d + w ps r ps + w c r e WACC = 0.3(6.68%)+0.1(10.3%) +0.6(15.6%) WACC = 2.004% % % = % Componentwr New Debt (after-tax)d % Preferred Stockps % New Common equityc %

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63 NCC’s WACC WACC DescriptionWACC No New Issues11.770% With New Debt11.794% With New Debt & New Equity12.394%

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64 Increasing Marginal Cost of Capital Externally raised capital flotation costs Increases the cost of capital Investors often perceive large capital budgets as being risky Drives up the cost of capital If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital

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% Capital Required WACC 1 = 11.77% WACC 2 = % Increasing Marginal Cost of Capital 61 No external funds External debt & equity

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66 Four Mistakes to Avoid Current (YTM) vs. historical (Coupon rate) cost of debt Mixing current and historical measures to estimate the market risk premium Book weights vs. Market Weights Use Target weights Use market value of equity Book value of debt is a reasonable proxy for market value Incorrect cost of capital components Only investor provided funding

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67 CHAPTER 10 The Cost of Capital

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