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Key Concepts & Skills Calculate & explain A firm’s cost of common equity capital A firm’s cost of preferred stock A firm’s cost of debt A firm’s overall cost of capital Analyze & discuss pitfalls of overall cost of capital & how to manage them Print out the associated PDF for this PowerPoint slideshow to use during the show if you want to! You will find that file where you found this video & slides

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Cost of Capital Basics The cost to a firm for capital funding The return to the providers of those funds The return earned on assets should depend on the risk of those assets In equilibrium WACC = ROA A firm’s cost of capital indicates how the market views the risk of the firm’s assets A firm must earn at least the required return to compensate investors for the financing they have provided The required return is the same as the appropriate discount rate

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IBM Sources of data S&P NetAdvantage Database in the SEU library online Finance.yahoo.com Date: 11/17/2011

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Cost of Common Equity Return required by equity investors given the risk of the cash flows from the firm Two major methods for determining the cost of equity Dividend growth model CAPM

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Dividend Growth Model Approach Start with the dividend growth model formula & rearrange to solve for R E Assumption is that the stock is priced fairly Does this look familiar?

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Dividend Growth Model The current stock price is $185.27 Your company is expected to pay a dividend of $3.00 per share next year D 1 or D 0 ? Dividends have grown at a steady rate of 10.00% per year & the market expects that to continue How long can that really continue? What is the cost of equity?

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Dividend Growth Model The current stock price is $185.27 Your company is expected to pay a dividend of $3.00 per share next year D 1 or D 0 ? Dividends have grown at a steady rate of 10.00% per year & the market expects that to continue How long can that really continue? What is the cost of equity?

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Advantages & Disadvantages of Dividend Growth Model Advantage Easy to understand & use Disadvantages Only applicable to companies currently paying dividends Not applicable if dividends, earnings, stock price are not growing at a reasonably constant rate Sensitive to the estimated growth rate Does not explicitly consider risk Relies on the past to predict the future

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The CAPM (SML) Approach Use the following information to compute the cost of equity Risk-free rate R f Market risk premium E(R M ) – R f Systematic risk of asset

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The CAPM (SML) Approach Company’s equity beta = 0.49 Current risk-free rate = 3.00% Expected market risk premium = 17.00% What is the cost of equity capital?

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The CAPM (SML) Approach Company’s equity beta = 0.49 Current risk-free rate = 3.00% Expected market risk premium = 17.00% What is the cost of equity capital?

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Advantages & Disadvantages of SML Advantages Explicitly adjusts for systematic risk Applicable to all companies, as long as beta is available Disadvantages Must estimate the expected market risk premium Must estimate beta Relies on the past to predict the future

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Cost of preferred stock If IBM had preferred stock Use the current price of the preferred stock Along with its annual dividend And the constant growth model To estimate its cost of preferred stock The growth in dividends is zero

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Cost of Debt The cost of debt Required return on a company’s debt What is the name for that kind of yield? Yield to maturity on existing debt The cost of debt is NOT the coupon rate on OLD or OUTSTANDING DEBT

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Outstanding bond issue 34 years to maturity Coupon rate = 7.00% Coupons paid semiannually Currently bond price = $1,339.71 What is the YTM? CLR TVM Set P/Y = 2 N = 34 years x 2 payments per year = 68 PV = -1339.71 PMT= (0.0700 x 1000.00)/2 = 35 FV = 1000.00 CPT I/Y = 4.93%

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Cost of Debt Outstanding bond issue 34 years to maturity Coupon rate = 7.00% Coupons paid semiannually Currently bond price = $1,339.71 What is the YTM? CLR TVM Set P/Y = N = PV = PMT= FV = CPT I/Y =

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Cost of Debt Use the YTM on the firm’s debt Interest is tax deductible, so the after-tax (AT) cost of debt is If the corporate tax rate = 25.66%

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Cost of Debt Use the YTM on the firm’s debt Interest is tax deductible, so the after-tax (AT) cost of debt is If the corporate tax rate = 25.66%

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Weighted Average Cost of Capital WACC Use the individual (component) costs of capital to compute a weighted average cost of capital for the firm This average The required return on the firm’s assets, based on the market’s perception of the risk of those assets The weights are determined by how much of each type of financing is used

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Determining the Weights for the WACC Weights Proportions of the firm that will be financed by each component Always use the target weights, if possible If not available, use market values If not available, use book values

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Capital Structure Weights: Market From observed prices in the market Notation E = market value of common equity = # outstanding shares of common shares times price per share P = market value of preferred stock = # outstanding shares of preferred shares times price per share D= market value of debt = # outstanding bonds times bond price V = market value of the firm = E + P + D Weights E/V = proportion financed with common equity P/V = proportion financed with preferred stock D/V = proportion financed with debt

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Capital Structure Weights: Book From observed balances on the balance sheet Notation E= book value of common equity = common stock + capital in excess of par + retained earnings – treasury stock P = book value of preferred stock D= book value of typically only long-term debt V = book value of the firm = E + P + D Capital structure weights E/V = proportion financed with common equity P/V = proportion financed with preferred stock D/V = proportion financed with debt

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WACC Capital structure weights Component costs before tax Where ( E/V) = proportion of common equity in capital structure (P/V) = proportion of preferred stock in capital structure (D/V) = proportion of debt in capital structure R E = firm’s cost of equity R P = firm’s cost of preferred stock R D = firm’s cost of debt T C = firm’s corporate tax rate

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Estimating Weights Market value of common equity Market price of the common stock = $185.27 per share 1,178,766,125 shares common stock Market value of equity (E) = $185.27 per share x 1,178,766,125 shares = $218,390,000,000 (a little more than $218 B)

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There is none…so P/V = 0

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Estimating Weights Book value of long-term debt Although we know the market price per bond of the long- term debt, we do not have the number of bonds outstanding So, I will use the book value of long-term debt instead Ok to do if interest rates have not changed or If we do not have all the data from the market Book value of long-term debt from the balance sheet =$21,932,000,000 (almost $22 B)

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Estimating Weights Using market value of equity & book value of debt to calculate the weights Amounts E = $218,390,000,000 P = $0 D = $21,932,000,000 V = $240,322,000,000 Weights E/V = $218,390,000,000/$240,322,000,000 = 0.9087 or 90.87% P/V = $0/$240,322,000,000 = 0.0000 or 0.00% D/V = $21,932,000,000/$240,322,000,000 = 0.0913 or 9.13%

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Estimating Weights Using market value of equity & book value of debt to calculate the weights Amounts E = $218,390,000,000 P = $0 D = $21,932,000,000 V = Weights E/V = = P/V = = D/V = =

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WACC Using market value of equity & book value of debt to calculate the weights

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Estimating Weights Using book value of equity & book value of debt to calculate the weights Amounts E = $22,291,000,000 P = $0 D = $21,932,000,000 V = $44,223,000,000 Weights E/V = $22,291,000,000/$44,223,000,000 = 0.5041 or 50.41% P/V = $0/$44,223,000,000 = 0.0000 or 0.00% D/V = $21,932,000,000/$44,223,000,000 = 0.4959 or 49.59%

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Estimating Weights Using book value of equity & book value of debt to calculate the weights Amounts E = $22,291,000,000 P = $0 D = $21,932,000,000 V = Weights E/V = = P/V = = D/V = =

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WACC Using book value of equity & book value of debt to calculate the weights

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WACC Table for Calculations Big difference!

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WACC Table for Calculations

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Factors that influence a company’s WACC Market conditions, especially interest rates, tax rates & the market risk premium The firm’s capital structure & dividend policy The firm’s investment policy Firms with riskier projects generally have a higher required return

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Risk-adjusted required return A firm’s 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 required return should be adjusted to reflect the appropriate risk & capital structure WACC may not be appropriate

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What would happen if we use the WACC for all projects regardless of risk?

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Using WACC for All Projects Different decisions using WACC = 15% Incorrect decision A risk-adjusted return accounting for the project cash flow risk Correct decision Tend to accept projects that are too risky…like project A Tend to reject projects that are less risky…like project C The risk of the firm will increase over time using RR = WACC Correct decision Incorrect decision

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Key Concepts & Skills Calculate & explain A firm’s cost of common equity capital A firm’s cost of preferred stock A firm’s cost of debt A firm’s overall cost of capital Analyze & discuss pitfalls of overall cost of capital & how to manage them

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© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Cost of Capital Chapter Fourteen.

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