1. Kevin Campbell, University of Stirling, November 2005 1 2008 KOSZT I STRUKTURA KAPITAŁU

2. Kevin Campbell, University of Stirling, November 2005 2 Cost of Capital Cost of Capital - The return the firm’s investors could expect to earn if they invested in securities with comparable degrees of risk Capital Structure - The firm’s mix of long term financing and equity financing

3. Kevin Campbell, University of Stirling, November 2005 3 Cost of Capital The cost of capital represents the overall cost of financing to the firm The cost of capital is normally the relevant discount rate to use in analyzing an investment The overall cost of capital is a weighted average of the various sources: WACC = Weighted Average Cost of Capital WACC = After-tax cost x weights

4. Kevin Campbell, University of Stirling, November 2005 4 Cost of Debt The cost of debt to the firm is the effective yield to maturity (or interest rate) paid to its bondholders Since interest is tax deductible to the firm, the actual cost of debt is less than the yield to maturity: After-tax cost of debt = yield x (1 - tax rate) The cost of debt should also be adjusted for flotation costs (associated with issuing new bonds)

5. Kevin Campbell, University of Stirling, November 2005 5 with stock with debt EBIT 400,000 400,000 - interest expense 0 (50,000) EBT 400,000 350,000 - taxes (34%) (136,000) (119,000) EAT 264,000 231,000 Example: Tax effects of financing with debt Now, suppose the firm pays $50,000 in dividends to the shareholders

6. Kevin Campbell, University of Stirling, November 2005 6 with stock with debt EBIT 400,000 400,000 - interest expense 0 (50,000) EBT 400,000 350,000 - taxes (34%) (136,000) (119,000) EAT 264,000 231,000 - dividends (50,000) 0 Retained earnings 214,000 231,000 Example: Tax effects of financing with debt

7. Kevin Campbell, University of Stirling, November 2005 7 After-tax cost Before-tax cost Tax of Debt of Debt Savings 33,000 = 50,000 - 17,000 OR 33,000 = 50,000 ( 1 -.34) Or, if we want to look at percentage costs: -= Cost of Debt

8. Kevin Campbell, University of Stirling, November 2005 8 After-tax Before-tax Marginal % cost of % cost of x tax Debt Debt rate Kd = kd (1 - T).066 =.10 (1 -.34) - = 1 Cost of Debt

9. Kevin Campbell, University of Stirling, November 2005 9 Prescott Corporation issues a $1,000 par, 20 year bond paying the market rate of 10%. Coupons are annual. The bond will sell for par since it pays the market rate, but flotation costs amount to $50 per bond. What is the pre-tax and after-tax cost of debt for Prescott Corporation? EXAMPLE: Cost of Debt

10. Kevin Campbell, University of Stirling, November 2005 10 Pre-tax cost of debt: 950 = 100(PVIFA 20, K d ) + 1000(PVIF 20, K d ) using a financial calculator: K d = 10.61% After-tax cost of debt: K d = K d (1 - T) K d =.1061 (1 -.34) K d =.07 = 7% EXAMPLE: Cost of Debt So a 10% bond costs the firm only 7% (with flotation costs) because interest is tax deductible

11. Kevin Campbell, University of Stirling, November 2005 11 Cost of New Preferred Stock Preferred stock: has a fixed dividend (similar to debt) has no maturity date dividends are not tax deductible and are expected to be perpetual or infinite Cost of preferred stock = dividend price - flotation cost

12. Kevin Campbell, University of Stirling, November 2005 12 Cost of Preferred stock: Example

13. Kevin Campbell, University of Stirling, November 2005 13 Cost of Equity: Retained Earnings Why is there a cost for retained earnings? Earnings can be reinvested or paid out as dividends Investors could buy other securities, and earn a return. Thus, there is an opportunity cost if earnings are retained

14. Kevin Campbell, University of Stirling, November 2005 14 Cost of Equity: Retained Earnings Common stock equity is available through retained earnings (R/E) or by issuing new common stock: Common equity = R/E + New common stock

15. Kevin Campbell, University of Stirling, November 2005 15 Cost of Equity: New Common Stock The cost of new common stock is higher than the cost of retained earnings because of flotation costs selling and distribution costs (such as sales commissions) for the new securities

16. Kevin Campbell, University of Stirling, November 2005 16 Cost of Equity There are a number of methods used to determine the cost of equity We will focus on two Dividend growth Model CAPM

17. Kevin Campbell, University of Stirling, November 2005 17 The Dividend Growth Model Approach Estimating the cost of equity: the dividend growth model approach According to the constant growth (Gordon) model, D 1 P 0 = R E - g Rearranging D 1 R E = + g P 0

18. Kevin Campbell, University of Stirling, November 2005 18 Example: Estimating the Dividend Growth Rate Percentage Year Dividend Dollar Change Change 1990$4.00-- 19914.40$0.4010.00% 19924.750.357.95 19935.250.5010.53 19945.650.407.62 Average Growth Rate (10.00 + 7.95 + 10.53 + 7.62)/4 = 9.025%

19. Kevin Campbell, University of Stirling, November 2005 19 Dividend Growth Model This model has drawbacks: Some firms concentrate on growth and do not pay dividends at all, or only irregularly Growth rates may also be hard to estimate Also this model doesn’t adjust for market risk Therefore many financial managers prefer the capital asset pricing model (CAPM) - or security market line (SML) - approach for estimating the cost of equity

20. Kevin Campbell, University of Stirling, November 2005 20 Capital Asset Pricing Model (CAPM) Cost of capital Risk-free return Average rate of return on common stocks (WIG) Co-variance of returns against the portfolio (departure from the average) B < 1, security is safer than WIG average B > 1, security is riskier than WIG average

21. Kevin Campbell, University of Stirling, November 2005 21 The Security Market Line (SML) Required rate of return Percent 0.51.01.52.0 SML = R f +  (K m – R f ) Beta (risk) Market risk premium 20.0 18.0 16.0 14.0 12.0 10.0 8.0 5.5 RfRf

22. Kevin Campbell, University of Stirling, November 2005 22 Finding the Required Return on Common Stock using the Capital Asset Pricing Model The Capital Asset Pricing Model (CAPM) can be used to estimate the required return on individual stocks. The formula:  RK R K fmjfj  where j K = Required return on stock j f R = Risk-free rate of return (usually current rate on Treasury Bill). j  = Beta coefficient for stock jrepresents risk of the stock m K = Return in market as measured by some proxy portfolio (index) Suppose that Baker has the following values: f R = 5.5% j  = 1.0 m K = 12%.

23. Kevin Campbell, University of Stirling, November 2005 23 Finding the Required Return on Common Stock using the Capital Asset Pricing Model Then, using the CAPM we would get a required return of  12% 5.5-12 1.0 5.5 K j .

24. Kevin Campbell, University of Stirling, November 2005 24 CAPM/SML approach Advantage: Evaluates risk, applicable to firms that don’t pay dividends Disadvantage: Need to estimate Beta the risk premium (usually based on past data, not future projections) use an appropriate risk free rate of interest

25. Kevin Campbell, University of Stirling, November 2005 25 Estimation of Beta: Measuring Market Risk Market Portfolio - Portfolio of all assets in the economy In practice a broad stock market index, such as the WIG, is used to represent the market Beta - sensitivity of a stock’s return to the return on the market portfolio

26. Kevin Campbell, University of Stirling, November 2005 26 Estimation of Beta Theoretically, the calculation of beta is straightforward: Problems 1.Betas may vary over time. 2.The sample size may be inadequate. 3.Betas are influenced by changing financial leverage and business risk. Solutions Problems 1 and 2 (above) can be moderated by more 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.

27. Kevin Campbell, University of Stirling, November 2005 27 Stability of Beta Most analysts argue that betas are generally stable for firms remaining in the same industry That’s not to say that a firm’s beta can’t change Changes in product line Changes in technology Deregulation Changes in financial leverage

28. Kevin Campbell, University of Stirling, November 2005 28 What is the appropriate risk-free rate? Use the yield on a long-term bond if you are analyzing cash flows from a long-term investment For short-term investments, it is entirely appropriate to use the yield on short-term government securities Use the nominal risk-free rate if you discount nominal cash flows and real risk-free rate if you discount real cash flows

29. Kevin Campbell, University of Stirling, November 2005 29 Survey evidence: What do you use for the risk-free rate? CorporationsFinancial Advisors 90-day T-bill (4%)90-day T-bill (10%) 3-7 year Treasuries (7%)5-10 year Treasuries (10%) 10-year Treasuries (33%)10-30 year Treasuries (30%) 20-year Treasuries (4%)30-year Treasuries (40%) 10-30 year Treasuries (33%)N/A (10%) 10-years or 90-day; depends (4%) N/A (15%) Source: Bruner et. al. (1998)

30. Kevin Campbell, University of Stirling, November 2005 30 Weighted Average Cost of Capital (WACC) WACC weights the cost of equity and the cost of debt by the percentage of each used in a firm’s capital structure WACC=(E/ V) x R E + (D/ V) x R D x (1-T C ) (E/V)= Equity % of total value (D/V)=Debt % of total value (1-Tc)=After-tax % or reciprocal of corp tax rate Tc. The after-tax rate must be considered because interest on corporate debt is deductible

31. Kevin Campbell, University of Stirling, November 2005 31 WACC Illustration ABC Corp has 1.4 million shares common valued at $20 per share =$28 million. Debt has face value of $5 million and trades at 93% of face ($4.65 million) in the market. Total market value of both equity + debt thus =$32.65 million. Equity % =.8576 and Debt % =.1424 Risk free rate is 4%, risk premium=7% and ABC’s β=.74 Return on equity per SML : R E = 4% + (7% x.74)=9.18% Tax rate is 40% Current yield on market debt is 11%

32. Kevin Campbell, University of Stirling, November 2005 32 WACC Illustration WACC = (E/V) x R E + (D/V) x R D x (1-Tc) =.8576 x.0918 + (.1424 x.11 x.60) =.088126 or 8.81%

33. Kevin Campbell, University of Stirling, November 2005 33 Final notes on WACC WACC should be based on market rates and valuation, not on book values of debt or equity Book values may not reflect the current marketplace WACC will reflect what a firm needs to earn on a new investment. But the new investment should also reflect a risk level similar to the firm’s Beta used to calculate the firm’s R E. In the case of ABC Co., the relatively low WACC of 8.81% reflects ABC’s β=.74. A riskier investment should reflect a higher interest rate.

34. Kevin Campbell, University of Stirling, November 2005 34 Final notes on WACC The WACC is not constant It changes in accordance with the risk of the company and with the floatation costs of new capital

35. Kevin Campbell, University of Stirling, November 2005 35 Marginal cost of capital and investment projects 16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0 Percent 10 15 19 5039 Amount of capital ($ millions) 11.23% 70 85 95 Marginal cost of capital K mc A B C D E F G H 10.77% 10.41% ------------------

36. Kevin Campbell, University of Stirling, November 2005 36 The End …. KAPITAŁ - bogactwo zebrane uprzednio w celu podjęcia dalszej produkcji (F. Quesnay, XVIII) wszelki wynik procesu produkcyjnego, który przeznaczony jest do późniejszego wykorzystania w procesie produkcyjnym (MCKenzzie, Nardelli,1991) całokształt zaangażowanych w przedsiębiorstwie wewnętrznych i zewnętrznych, własnych i obcych, terminowych i nieterminowych zasobów (bilans) STRUKTURA KAPITAŁU proporcja udziału kapitału własnego i obcego w finansowaniu działalności przedsiębiorstwa relacja wartości zadłużenia długoterminowego do kapitałów własnych przedsiębiorstwa struktura finansowania – struktura kapitału = zobowiązania bieżące ramy statycznego kompromisu, w którym przedsiębiorstwo ustala docelową wielkość wskaźnika zadłużenia i stopniowo zbliża się do jego osiągnięcia.