9 - 1 Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. CHAPTER 7 The Cost of Capital Cost of capital components Accounting for flotation costs WACC Adjusting cost of capital for risk Estimating project risk

9 - 2 Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. What’s the firm’s cost of capital ? Opportunity cost of capital Capital components Target capital structure Weighted average cost of capital :marginal cost

9 - 3 Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. What types of long-term capital do firms use? Long-term debt Preferred stock Common equity: Retained earnings New common stock

9 - 4 Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. Should we focus on before-tax or after-tax capital costs? Stockholders focus on A-T CFs. Thus, focus on A-T capital costs, i.e., use A-T costs in WACC. Only k d needs adjustment.

9 - 5 Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. Should we focus on historical (embedded) costs or new (marginal) costs? The cost of capital is used primarily to make decisions which involve raising new capital. So, focus on today ’ s marginal costs (for WACC).

9 - 6 Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. A 15-year, 12% semiannual bond sells for $1, What ’ s k d ? , i = ? % x 2 = k d = 10% NI/YRPVFV PMT -1, INPUTS OUTPUT

9 - 7 Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. Component Cost of Debt Interest is tax deductible, so k d AT = Interest rate - Tax saving = k d BT - k d BT *T = k d BT (1 - T) = 10%( ) = 6%. Use nominal rate,new debt cost,marginal cost Kd:outstanding debt cost (YTM,YTC) no publicly traded debt=>similar co.’s YTM Flotation costs small. Ignore.

9 - 8 Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. What ’ s the cost of preferred stock? P p = $111.10; 10%Q; Par = $100. Use this formula:

9 - 9 Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. Picture of Preferred k p = ? ¥

Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. Note: Preferred dividends are not tax deductible, so no tax adjustment. Just k p. Nominal k p is used. Our calculation ignores flotation costs.

Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. Is preferred stock more or less risky to investors than debt? More risky; company not required to pay preferred dividend. However, firms try to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, (3) preferred stockholders may gain control of firm.

Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. Why is yield on preferred lower than k d ? Corporations own most preferred stock, because 70% of preferred dividends are nontaxable to corporations. Therefore, preferred often has a lower B-T yield than the B-T yield on debt. The A-T yield to an investor, and the A-T cost to the issuer, are higher on preferred than on debt. Consistent with higher risk of preferred.

Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. Example: k p = 9% k d = 10%T = 40% k p, AT = k p - k p ( )(T) = 9% - 9%(0.3)(0.4) = 7.92%. k d, AT = 10% - 10%(0.4) = 6.00% A-T Risk Premium on Preferred = 1.92%

Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. Why is there a cost for retained earnings? Earnings can be reinvested or paid out as dividends. Investors could buy other securities, earn a return. Thus, there is an opportunity cost if earnings are retained.

Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. Opportunity cost: The return stockholders could earn on alternative investments of equal risk. They could buy similar stocks and earn k s, or company could repurchase its own stock and earn k s. So, k s is the cost of common stock.

Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. Three ways to determine cost of common stock, k s : 1.CAPM: k s = k RF + (k M - k RF )b. 2.DCF: k s = D 1 /P 0 + g. 3.Own-Bond-Yield-Plus-Risk Premium: k s = k d + RP.

Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. What ’ s the cost of common stock based on the CAPM? k RF = 7%, MRP = 6%, b = 1.2. k s = k RF + (k M - k RF )b. = 7.0% + (6.0%)1.2 = 4.2%.

Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. Note: estimating Ks based on CAPM Krf:T-Bond rate. Beta: 專業投顧公司 Km=T-Bill rate + inflation + economic growth rate+ stock risk premium. Several problems with the CAPM 1. 若股東未能達到最佳風險分散的狀態, 則尚有 個別股票的風險存在, 則公司真正的風險無法由 beta 反映出 ; 2.even if the CAPM is valid,it’s hard to estiamte Beta : Krf, Beta,marktet premium.

Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. What ’ s the DCF cost of common stock, k s ? Given: D 0 = $4.19; P 0 = $50; g = 5%.

Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. Note: g 難以估計, g 的估計 1. 證券分析師之預測 2. 保留成長分析法 : (the retention growth rate method. Suppose the company has been earning 15% on equity (ROE = 15%) and retaining 35% (dividend payout = 65%), and this situation is expected to continue. What ’ s the expected future g?

Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. Retention growth rate: g = b(ROE) = 0.35(15%) = 5.25%. Here b = Fraction retained. Close to g = 5% given earlier. Think of bank account paying 10% with b = 0, b = 1.0, and b = 0.5. What ’ s g?

Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. Could DCF methodology be applied if g is not constant? YES, nonconstant g stocks are expected to have constant g at some point, generally in 5 to 10 years. But calculations get complicated.

Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. Find k s using the own-bond-yield-plus- risk-premium method. (k d = 10%, RP = 4%.) This RP ¹ CAPM RP. Produces ballpark estimate of k s. Useful check. RP=CS-LR Bonds (judgmental RP) Empirical evidence:RP are between 4 to 7% Too subjective k s = k d + RP = 10.0% + 4.0% = 14.0%

Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. What ’ s a reasonable final estimate of k s?

Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. 1.When a company issues new common stock they also have to pay flotation costs to the underwriter. 2.Issuing new common stock may send a negative signal to the capital markets, which may depress stock price. Why is the cost of retained earnings cheaper than the cost of issuing new common stock?

Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. Two approaches that can be used to account for flotation costs: Include the flotation costs as part of the project ’ s up-front cost. This reduces the project ’ s estimated return. Adjust the cost of capital to include flotation costs. This is most commonly done by incorporating flotation costs in the DCF model.

Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. New common, F = 15%:

Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. Comments about flotation costs: Flotation costs depend on the risk of the firm and the type of capital being raised. The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small. We will frequently ignore flotation costs when calculating the WACC.

Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. What ’ s the firm ’ s WACC (ignoring flotation costs)? WACC= w d k d (1 - T) + w p k p + w c k s = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1%.

Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. What factors influence a company ’ s composite WACC? Market conditions: interest rate and tax. The firm’s capital structure and dividend policy. The firm’s investment policy. Firms with riskier projects generally have a higher WACC.

Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. WACC Estimates for Some Large U.S. Corporations CompanyWACC Intel13.6% General Electric12.7 Walt Disney12.6 Motorola11.5 AT&T10.7 Exxon10.4 Wal-Mart9.9 Coca-Cola9.7 H. J. Heinz9.5 BellSouth8.9

Copyright © 1999 by Harcourt Brace & CompanyAll rights reserved. Should the company use the composite WACC as the hurdle rate for each of its projects? NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the “ hurdle rate ” for a typical project with average risk. Different projects have different risks. The project ’ s WACC should be adjusted to reflect the project ’ s risk.