CF 473.32 11 Winter 2014

Questions What cash flows should I consider? How does the market set “r”? How should I set “r”?

Setting “r” basic idea if then project return > cost of money value of firm should 

Cost of Money firm gets money from 2 sources sources expect benefits back Debt payments value if sold interim final Bonds coupon face value  Loans interest principal Equity Preferred shares dividends  Common shares dividends 

Cost of Money 3 ideas to measure this: dividend growth earnings retention WACC

Cost of Money dividend growth p0 share price now d1 dividend a year from now g rate of growth re return on equity dividend growth remember this formula? change the labels slightly rearrange it

Cost of Money dividend growth need to know g dividend history

dividend history g = .0901 2007 $1.10 2008 $1.20 $0.10 9.09% 2009 change growth 2007 $1.10 2008 $1.20 $0.10 9.09% 2009 $1.35 $0.15 12.50% 2010 $1.50 $0.15 11.11% Our historical growth rates are reasonably close, so we could feel reasonably comfortable that the market will expect our dividend to grow at around 5.1%. Note that when we are computing our cost of equity, it is important to consider what the market expects our growth rate to be, not what we may know it to be internally. The market price is based on market expectations, not our private information. Another way to estimate the market consensus estimate is to look at analysts’ forecasts and take an average. 2011 $1.55 $0.05 3.33% average 9.01% g = .0901

Cost of Money dividend growth earnings retention WACC

Cost of Money dividend growth earnings retention same formula different method of finding g

Cost of Money dividend growth earnings retention WACC “weighted average cost of capital” uses ideas from CAPM

WACC of $ we get from outside world what do we pay for debt? what do we pay for equity? what proportion of each do we have?

WACC crucial: market prices corporate tax rate rate on equity % market value of equity weight of equity weight of debt rate on debt % market value of debt YTM

WACC

Cost of Debt long-term debt bonds YTM expected bond ratings not coupon rate expected bond ratings Point out that the coupon rate was the cost of debt for the company when the bond was issued. We are interested in the rate we would have to pay on newly issued debt, which could be very different from past rates.

Cost of Debt example current bond issue what is cost of debt? ignoring taxes for now example current bond issue $1,000 face value 2 years to maturity 10% coupon rate (“embedded cost”) paid semiannually currently selling for 107% of face value what is cost of debt? Remind students that it is a trial and error process to find the YTM if they do not have a financial calculator or spreadsheet.

Cost of Equity example for our firm $25.00 current stock price $1.80 last dividend 7% annual dividend growth 0.9 β analysts’ estimates Remind students that it is a trial and error process to find the YTM if they do not have a financial calculator or spreadsheet.

Cost of Equity example current in our market 8% risk-free rate 7% market risk premium Remind students that it is a trial and error process to find the YTM if they do not have a financial calculator or spreadsheet.

2 More Things on ch 14 applying WACC’s r flotation costs

Applying WACC’s r WACC’s r used to decide appropriate for otherwise yes or no? which is best? appropriate for project same risk overall firm core business otherwise adaptation needed It is important to point out that the WACC is not very useful for companies that have several disparate divisions. www: Click on the web surfer icon to go to an index of business owned by General Electric. Ask the students if they think that projects proposed by the “Real Estate Group” should have the same discount rate as projects proposed by “Aviation Services.” You can go through the list and illustrate why the divisional cost of capital is important for a company like GE. If GE’s WACC was used for every division, then the riskier divisions would get more investment capital and the less risky divisions would lose the opportunity to invest in positive NPV projects.

Adapting WACC’s r when then a specific division’s project outside core business then find firms that do these projects use their average βs or adjust subjectively Ask students which projects would be accepted if they used the WACC for the discount rate? Compare 15% to IRR and accept projects A and B. Now ask students which projects should be accepted if you use the required return based on the risk of the project? Accept B and C. So, what happened when we used the WACC? We accepted a risky project that we shouldn’t have and rejected a less risky project that we should have accepted. What will happen to the overall risk of the firm if the company does this on a consistent basis? Most students will see that the firm will become riskier.

Adapting WACC’s r adjusting subjectively example r very low WACC - .08 risk level r very low WACC - .08 low WACC - .03 same as firm WACC high WACC + .05 very high WACC + .10 Ask students which projects would be accepted if they used the WACC for the discount rate? Compare 15% to IRR and accept projects A and B. Now ask students which projects should be accepted if you use the required return based on the risk of the project? Accept B and C. So, what happened when we used the WACC? We accepted a risky project that we shouldn’t have and rejected a less risky project that we should have accepted. What will happen to the overall risk of the firm if the company does this on a consistent basis? Most students will see that the firm will become riskier.

Flotation Costs r depends on risk however not how $ raised cost of issuing must be included

Flotation Costs basic approach: weighted average flotation cost Use target weights because firm will issue securities in these percentages over the long term.

Flotation Costs project cost after-tax cash flows $1 million $250,000/year 7 years

Flotation Costs project WACC firm’s target D/E ratio is .6 15% firm’s target D/E ratio is .6 flotation costs 5% equity 3% debt

Flotation Costs

Questions What cash flows should I consider? How does the market set r? How should I set r?

What cash flows? Has it flowed already? ch 10 Has it flowed already? Would it flow without the project?

What cash flows? Has it flowed “already”? sunk costs research costs decision-making costs sales to date

What cash flows? Would it flow without the project? Incremental only if so, don’t count it Incremental only lost gained “The stand-alone principal”

What cash flows? Incremental only lost gained capital operating revenues CCA tax shield benefits

CCA tax shield c cost of asset tCCA CCA tax rate tc corporate tax rate r discount rate s salvage value n number of periods in the project

c s n tc d r Equipment cost $100,000 Installation & delivery cost $10,000 Salvage s $17,000 when? n 6 Marginal tax rate tc 40% CCA tax rate d 20% discount rate r 10% “hurdle rate”