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17-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter.

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Presentation on theme: "17-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter."— Presentation transcript:

1 17-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Seventeen Cost of Capital

2 17-2 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 17.1The Cost of Capital: Some Preliminaries 17.2 The Cost of Equity 17.3 The Costs of Debt and Preference Shares 17.4 The Weighted Average Cost of Capital 17.5 Divisional and Project Costs of Capital 17.6 Flotation Costs and the Weighted Average Cost of Capital Summary and Conclusions Chapter Organisation

3 17-3 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Objectives Apply the dividend growth model approach and the SML approach to determine the cost of equity. Estimate values for the costs of debt and preference shares. Calculate the WACC. Discuss alternative approaches to estimating a discount rate. Understand the effects of flotation costs on WACC and the NPV of a project.

4 17-4 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Cost of Capital: Preliminaries Vocabulary the following all mean the same thing: –required return –appropriate discount rate –cost of capital. The cost of capital depends primarily on the use of funds, not the source. The assumption is made that a firms capital structure is fixeda firms cost of capital then reflects both the cost of debt and the cost of equity.

5 17-5 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Cost of Equity The cost of equity, R E, is the return required by equity investors given the risk of the cash flows from the firm. There are two major methods for determining the cost of equity: –Dividend growth model –SML or CAPM.

6 17-6 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Dividend Growth Model Approach According to the constant growth model: Rearranging:

7 17-7 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan ExampleCost of Equity: Dividend Growth Model Approach Jumbo Co. recently paid a dividend of 20 cents per share. This dividend is expected to grow at a rate of 5 per cent per year into perpetuity. The current market price of Jumbos shares is $7.00 per share. Determine the cost of equity capital for Jumbo Co.

8 17-8 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Estimating g One method for estimating the growth rate is to use the historical average.

9 17-9 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Dividend Growth Model ApproachEvaluation Advantages –Easy to use and understand. Disadvantages –Only applicable to companies paying dividends. –Assumes dividend growth is constant. –Cost of equity is very sensitive to growth estimate. –Ignores risk.

10 17-10 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The SML Approach Required return on a risky investment is dependent on three factors: –the risk-free rate, R f –the market risk premium, E(R M ) – R f –the systematic risk of the asset relative to the average,.

11 17-11 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan ExampleCost of Equity Capital: SML Approach Obtain the risk-free rate (R f ) from financial press many use the 1-year Treasury note rate, say, 6 per cent. Obtain estimates of market risk premium and security beta: –historical risk premium = 7.94 per cent (Officer, 1989) –betahistorical investment information services estimate from historical data Assume the beta is 1.40.

12 17-12 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan ExampleCost of Equity Capital: SML Approach (continued)

13 17-13 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The SML Approach Advantages –Adjusts for risk. –Applicable in a wider range of circumstances (e.g. to companies other than just those with constant dividend growth). Disadvantages –Requires two factors to be estimated: the market risk premium and the beta co-efficient. –Uses the past to predict the future, which may not be appropriate.

14 17-14 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Cost of Debt The cost of debt, R D, is the interest rate on new borrowing. R D is observable: –yields on currently outstanding debt –yields on newly-issued similarly-rated bonds. The historic cost of debt is irrelevantwhy?

15 17-15 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan ExampleCost of Debt Ishta Co. sold a 20-year, 12 per cent bond 10 years ago at par ($100). The bond is currently priced at $86. What is our cost of debt? The yield to maturity is 14.4 per cent, so this is used as the cost of debt, not 12 per cent.

16 17-16 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Cost of Preference Shares Preference shares pay a constant dividend every period. Preference shares are a perpetuity, so the cost is: Notice that the cost is simply the dividend yield.

17 17-17 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan ExampleCost of Preference Shares A preference share issue paying an $8 dividend per share was was sold 10 years ago for $60 per share. It sells for $100 per share today. The dividend yield today is $8.00/$100 = 8 per cent, so this is the cost of preference shares.

18 17-18 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Weighted Average Cost of Capital Let:E = the market value of equity = no. of outstanding shares × share price D = the market value of debt = no. of outstanding bonds × price V = the combined market value of debt and equity Then:V = E + D So:E/V + D/V = 100% That is:The firms capital structure weights are E/V and D/V.

19 17-19 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Weighted Average Cost of Capital Interest payments on debt are tax deductible, so the after-tax cost of debt is: Dividends on preference shares and ordinary shares are not tax-deductible so tax does not affect their costs. The weighted average cost of capital is therefore:

20 17-20 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan ExampleWeighted Average Cost of Capital Gidget Ltd has million ordinary shares on issue with a book value of $22.40 per share and a current market price of $58 per share. Gidget has an estimated beta of Treasury bills currently yield 5 per cent and the market risk premium is assumed to be 7.94 per cent. Company tax is 30 per cent.

21 17-21 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan ExampleWeighted Average Cost of Capital (continued) Gidget Ltd has four debt issues outstanding:

22 17-22 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan ExampleCost of Equity (SML Approach)

23 17-23 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan ExampleCost of Debt The weighted average cost of debt is 7.15 per cent.

24 17-24 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan ExampleCapital Structure Weights and WACC Market value of equity = million × $58 = $4.539 billion. Market value of debt = $1.474 billion.

25 17-25 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan WACC The WACC for a firm reflects the risk and the target capital structure to finance the firms existing assets as a whole. WACC is the return that the firm must earn on its existing assets to maintain the value of its shares. WACC is the appropriate discount rate to use for cash flows that are similar in risk to the firm.

26 17-26 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Divisional and Project Costs of Capital When is the WACC the appropriate discount rate? –When the projects risk is about the same as the firms risk. Other approaches to estimating a discount rate: –divisional cost of capitalused if a company has more than one division with different levels of risk –pure play approacha WACC that is unique to a particular project is used –subjective approachprojects are allocated to specific risk classes which, in turn, have specified WACCs.

27 17-27 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The SML and the WACC Expected return (%) Beta SML WACC = 15% = 8% Incorrect acceptance Incorrect rejection B A R f =7 A =.60 firm = 1.0 B = 1.2 If a firm uses its WACC to make accept/reject decisions for all types of projects, it will have a tendency towards incorrectly accepting risky projects and incorrectly rejecting less risky projects.

28 17-28 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan ExampleUsing WACC for all Projects What would happen if we use the WACC for all projects regardless of risk? Assume the WACC = 15 per cent Project Required ReturnIRRDecision A15%14%Reject B15%16%Accept Project A should be accepted because its risk is low (Beta = 0.60), whereas Project B should be rejected because its risk is high (Beta = 1.2).

29 17-29 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The SML and the Subjective Approach Expected return (%) Beta SML 20 WACC = R f = 7 Low risk (–4%) Moderate risk (+0%) High risk (+6%) A With the subjective approach, the firm places projects into one of several risk classes. The discount rate used to value the project is then determined by adding (for high risk) or subtracting (for low risk) an adjustment factor to or from the firms WACC. = 8%

30 17-30 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Flotation Costs The issue of debt or equity may incur flotation costs such as underwriting fees, commissions, listing fees. Flotation costs are relevant cash flows and need to be included in project analysis. To assist with this, a weighted average flotation cost can be calculated:

31 17-31 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan ExampleProject Cost including Flotation Costs Saddle Co. Ltd has a target capital structure of 70 per cent equity and 30 per cent debt. The flotation costs for equity issues are 15 per cent of the amount raised and the flotation costs for debt issues are 7 per cent. If Saddle Co. Ltd needs $30 million for a new project, what is the true cost of this project? The weighted average flotation cost is 12.6 per cent.

32 17-32 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan ExampleProject Cost including Flotation Costs (continued) Saddle Co. needs to raise $30 million for the project after covering flotation costs.

33 17-33 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan ExampleFlotation Costs & NPV Apollo Co. Ltd needs $1.5 million to finance a new project expected to generate annual after-tax cash flows of $ forever. The company has a target capital structure of 60 per cent equity and 40 per cent debt. The financing options available are: –An issue of new ordinary shares. Flotation costs of equity are 12 per cent of capital raised. The return on new equity is 15 per cent. –An issue of long-term debentures. Flotation costs of debt are 5 per cent of the capital raised. The return on new debt is 10 per cent. Assume a corporate tax rate of 30 per cent.

34 17-34 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan ExampleNPV (No Flotation Costs)

35 17-35 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan ExampleNPV (With Flotation Costs) Flotation costs decrease a projects NPV and could alter an investment decision. Note: If the flotation costs are tax-deductible, we can calculate an after- tax weighted average flotation cost, f AT = f A (1-T C )

36 17-36 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Summary and Conclusions The cost of equity is the return that equity investors require on their investment in the firm. There are two approaches to determine the cost of equity: the dividend growth model approach and the SML approach. The cost of debt is the return that lenders require on the firms debt. WACC is both the required rate of return and the discount rate appropriate for cash flows that are similar in risk to the overall firm. Flotation costs can affect a projects NPV and alter the investment decision.


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