Presentation is loading. Please wait.

Presentation is loading. Please wait.

Cost of capital Chapter 12. Key concepts and skills Know how to determine a firms cost of equity capital Know how to determine a firms cost of debt Know.

Similar presentations


Presentation on theme: "Cost of capital Chapter 12. Key concepts and skills Know how to determine a firms cost of equity capital Know how to determine a firms cost of debt Know."— Presentation transcript:

1 Cost of capital Chapter 12

2 Key concepts and skills Know how to determine a firms cost of equity capital Know how to determine a firms cost of debt Know how to determine a firms overall cost of capital Understand pitfalls of overall cost of capital and how to manage them 12-2 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

3 Chapter outline The cost of capital: Some preliminaries The cost of equity The costs of debt and preferred stock The weighted average cost of capital Divisional and project costs of capital 12-3 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

4 Why cost of capital is important? We know that the return earned on assets depends on the risk of those assets. The return to an investor is the same as the cost to the company. Our cost of capital provides us with an indication of how the market views the risk of our assets. Knowing our cost of capital can also help us determine our required return for capital budgeting projects Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

5 Required return The required return is the same as the appropriate discount rate and is based on the risk of the cash flows. We need to know the required return for an investment before we can compute the NPV and make a decision about whether or not to take the investment. We need to earn at least the required return to compensate our investors for the financing they have provided Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

6 Cost of equity The cost of equity is the return required by equity investors given the risk of the cash flows from the firm. There are two main methods for determining the cost of equity: 1. Dividend growth model 2. SML or CAPM 12-6 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

7 Dividend growth model method Start with the dividend growth model formula and rearrange to solve for R E 12-7 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

8 Dividend growth model method Example Your company is expected to pay a dividend of $4.40 per share next year. (D 1 ) Dividends have grown at a steady rate of 5.1% per year and the market expects that to continue. (g) The current stock price is $50. (P 0 ) What is the cost of equity? 12-8 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

9 Estimating the dividend growth rateExample 12-9 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh One method for estimating the growth rate is to use the historical average. YearDividend% change (1.30 – 1.23) / 1.23 = 5.7% (1.36 – 1.30) / 1.30 = 4.6% (1.43 – 1.36) / 1.36 = 5.1% (1.50 – 1.43) / 1.43 = 4.9% Average = ( ) / 4 = 5.1%

10 Advantages and disadvantages of dividend growth model method Advantageeasy to understand and use Disadvantages – Only applicable to companies currently paying dividends – Not applicable if dividends arent growing at a reasonably constant rate – Extremely sensitive to the estimated growth rate – Does not explicitly consider risk Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

11 The SML method Compute cost of equity using the SML – Risk-free rate, R f – Market risk premium, E(R M ) – R f – Systematic risk of asset, Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

12 SML approachExample Companys equity beta = 1.2 Current risk-free rate = 7% Expected market risk premium = 6% What is the cost of equity capital? Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

13 Advantages and disadvantages of SML method Advantages – Explicitly adjusts for systematic risk – Applicable to all companies, as long as beta is available Disadvantages – Must estimate the expected market risk premium, which does vary over time – Must estimate beta, which also varies over time – Relies on the past to predict the future, which is not always reliable Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

14 Cost of equityExample 12.1 Data: – Beta = 1.2 – Market risk premium = 8% – Current risk-free rate = 6% – Analysts estimates of growth = 8% per year – Last dividend = $2 – Current stock price = $30 – Using SML: R E = 6% + 1.2(8%) = 15.6% – Using DGM: R E = [2(1.08) / 30] +.08 = 15.2% Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

15 Cost of debt The cost of debt = the required return on a companys debt. We usually focus on the cost of long-term debt or bonds. Method 1 = Compute the yield to maturity on existing debt. Method 2 = Use estimates of current rates based on the bond rating expected on new debt. The cost of debt is NOT the coupon rate Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

16 Cost of debtExample Suppose we have a bond issue currently outstanding that has 25 years left to maturity. The coupon rate is 9% and coupons are paid semiannually. The bond is currently selling for $ per $1000 bond. What is the cost of debt? – 50 [N]; PMT = 45 [PMT]; 1000 [FV]; [+/-][PV] ; [CPT] [I/Y] = 5%; YTM = 5(2) = 10% Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

17 Cost of preference shares Reminders – Preference shares generally pay a constant dividend every period. – Dividends are expected to be paid every period forever. Preference share valuation is an annuity, so we take the annuity formula, rearrange and solve for R P. R P = D/P Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

18 Cost of preference shares Example Your company has preference shares that have an annual dividend of $3. If the current price is $25, what is the cost of a preference share? R P = 3 / 25 = 12% Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

19 Weighted average cost of capital Use the individual costs of capital to compute a weighted average cost of capital for the firm. This average = the required return on the firms assets, based on the markets perception of the risk of those assets. The weights are determined by how much of each type of financing is used Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

20 Determining the weights for the WACC Weights = percentages of the firm that will be financed by each component. Always use the target weights, if possible. – If not available, use market values Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

21 Capital structure weights Notation – E = market value of equity = number of outstanding shares times price per share – D = market value of debt = number outstanding bonds times bond price – V = market value of the firm = D + E Weights – w E = E/V = percentage financed with equity – w D = D/V = percentage financed with debt Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

22 Capital structure weightsExample Suppose you have a market value of equity equal to $500 million and a market value of debt equal to $475 million. – What are the capital structure weights? V = 500 million million = 975 million w E = E/D = 500 / 975 =.5128 = 51.28% w D = D/V = 475 / 975 =.4872 = 48.72% Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

23 Taxes and the WACC Classical tax system We are concerned with after-tax cash flows, so we need to consider the effect of taxes on the various costs of capital. Interest expense reduces our tax liability. – This reduction in taxes reduces our cost of debt. – After-tax cost of debt = R D (1-T C ). Dividends are not tax deductible, so there is no tax impact on the cost of equity Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

24 WACC Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh WACC = (E/V) x R E + (P/V) x R P + (D/V) x R D x (1- T C ) Where: ( E/V) = % of common equity in capital structure (P/V) = % of preferred stock in capital structure (D/V) = % of debt in capital structure R E = firms cost of equity R P = firms cost of preferred stock R D = firms cost of debt T C = firms corporate tax rate

25 WACC I Extended example Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh Equity information – 50 million shares – $80 per share – Beta = 1.15 – Market risk premium = 9% – Risk-free rate = 5% Debt information – $1 billion in outstanding debt (face value) – Current quote = 110 – Coupon rate = 9%, semiannual coupons – 15 years to maturity Tax rate = 40%

26 WACC IIExtended example What is the cost of equity? – R E = (9) = 15.35% What is the cost of debt? – N = 30; PV = -1100; PMT = 45; FV = 1000; CPT I/Y = – R D = 3.927(2) = 7.854% What is the after-tax cost of debt? – R D (1-T C ) = 7.854(1-.4) = 4.712% Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

27 WACC IIIExtended example What are the capital structure weights? – E = 50 million (80) = 4 billion – D = 1 billion (1.10) = 1.1 billion – V = = 5.1 billion – w E = E/V = 4 / 5.1 =.7843 – w D = D/V = 1.1 / 5.1 =.2157 What is the WACC? – WACC =.7843(15.35%) (4.712%) = 13.06% Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

28 Taxes and the WACC Imputation tax system In an imputation system shareholders (if residents) are given a tax credit for the local taxes paid. This will alter the cost of equity for the firm. We have to adjust the WACC formula to take into account the tax advantage of imputation. WACC = w E R E (1-T C ) + w D R D (1-T C ) This adjustment assumes all shareholders can take advantage of the tax credits Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

29 Summary of capital cost calculationsTable Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

30 Summary of capital cost calculationsTable 12.1 (cont.) Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

31 Factors that Influence a companys WACC Market conditions, especially interest rates, tax rates and the market risk premium The firms capital structure and dividend policy The firms investment policy – Firms with riskier projects generally have a higher WACC Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

32 Cost of equityDominos Pizza Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

33 Cost of equityDominos Pizza (cont.) Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

34 Cost of equityDominos Pizza (cont.) Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

35 Cost of equityDominos Pizza (cont.) Cost of equity using CAPM – Assume equity market risk premium= 6% – Risk-free rate= 5.25% (Australian government bond rate) – Beta = 0.85 (from yahoo finance) – R E = (0.06)= or 10.35% Cost of equity using dividend growth model – Growth = 13.8% (using key statistics from yahoo finance) – Last dividend = $0.124 – Current share price = $ 5.07 – R E = 0.124( )/ Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

36 Cost of debtDominos Pizza The following is extracted from Dominos Pizzas corporate website: Overall weighted average debt cost Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

37 WACCDominos Pizza Weights calculated using the total market value – Total market value = $ million – Equity = $ million – Debt = $20.7 million Weights – WE = 0.94; WD = 0.06 WACC – 0.94(0.1315)+0.06(0.082)(1-0.3) = 12.71% Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

38 Divisional and project costs of capital Using the WACC as our discount rate is only appropriate for projects that are the same risk level as the firms current operations. If we are looking at a project that is NOT the same risk level as the firm, we need to determine the appropriate discount rate for that project. Divisions also often require separate discount rates Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

39 Risk-adjusted WACC A firms WACC reflects the risk of an average project undertaken by the firm. – Average risk = the firms current operations Different divisions/projects may have different risks. – The divisions or projects WACC should be adjusted to reflect the appropriate risk and capital structure Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

40 Using WACC for all projects What would happen if we used the WACC for all projects, regardless of risk? Assume the WACC = 15% Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

41 Using WACC for all projects (cont.) Assume the WACC = 15%. Adjusting for risk changes the decisions Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

42 Divisional risk and the cost of capitalFigure Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

43 Pure play approach Find one or more companies that specialise in the product or service being considered. Compute the beta for each company. Take an average. Use that beta along with the CAPM to find the appropriate return for a project of that risk. Pure-play companies are difficult to find Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

44 Subjective approach Consider the projects risk relative to the firm overall. If the project is more risky than the firm, use a discount rate greater than the WACC. If the project is less risky than the firm, use a discount rate less than the WACC. You may still accept projects that you shouldnt and reject projects you should accept, but your error rate should be lower than when not considering differential risk at all Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

45 Subjective approachExample Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh Risk levelDiscount rate Very low riskWACC – 8% Low riskWACC – 3% Same risk as firmWACC High riskWACC + 5% Very high riskWACC + 10%

46 Quick quiz What are the two approaches for computing the cost of equity? How do you compute the cost of debt and the after-tax cost of debt? How do you compute the capital structure weights required for the WACC? What is the WACC? What happens if we use the WACC for the discount rate for all projects? What are two methods that can be used to compute the appropriate discount rate when WACC isnt appropriate? Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

47 END Chapter


Download ppt "Cost of capital Chapter 12. Key concepts and skills Know how to determine a firms cost of equity capital Know how to determine a firms cost of debt Know."

Similar presentations


Ads by Google