Chapter 3 COST OF CAPITAL

LEARNING OBJECTIVES 1.How ROE and the required return by common equity investors are related to a firm’s growth opportunities 2.How to apply the steps involved in estimating a firm’s weighted average cost of capital, including how to estimate the market values of the various components of capital, and how to estimate the various costs of these components 3.How operating and financial leverage affect firms 4.The advantages and limitations of using growth models and/or risk models to estimate the cost of common equity.

THE SHORT STORY OF WACC Purposes/Use The weighted average cost of capital (WACC) serves three primary purposes: 1.To evaluate capital project proposals before-the-fact. 2.To set performance targets in order for management to sustain or grow market values, and 3.to measure management performance after-the-fact.

THE SHORT STORY OF WACC What Costs are Measured? Costs associated with financing the firm’s invested capital including: – Debt Costs: Bank loans Long-term debt – bonds/debentures – Equity Costs: Preferred equity costs Common equity costs

THE SHORT STORY OF WACC Why the Marginal Cost? What capital costs the firm 5 months, 5 years or 5 decades ago is irrelevant. What is relevant is what the next dollar of capital will cost in today’s economic environment for this particular firm.

THE SHORT STORY OF WACC Steps in Solving for the WACC 1.Identify the relevant sources of capital (debt and equity). 2.Estimate the market values for the sources of capital and determine the market value weights. 3.Estimate the marginal, after-tax, for each source of capital. 4.Calculate the weighted average.

THE SHORT STORY OF WACC THE FORMULA Once you have the specific marginal costs of capital (after accounting for taxes and floatation costs) and you have found the appropriate weights to use, the actual calculation of a WACC is a simple matter. The cost of equity times the market value weight of equity The cost of debt after tax times the market value weight of debt

THE SHORT STORY OF WACC THE SPREADSHEET APPROACH WACC is the sum of the weighted specific marginal costs of each source of capital.

THE SHORT STORY OF WACC frequently asked questions 1.Why don’t we include the cost of accruals and accounts payable in the cost of capital? – These are ‘spontaneous’ liabilities that rise and fall with the volume of business activity, and are not subject to formal lending arrangements. – Accruals (wages and taxes), it can be argued, don’t have an explicit cost. – For major corporations, spontaneous liabilities are often a very small part of the overall capitalization of the firm (are immaterial for cost of capital purposes).

THE SHORT STORY OF WACC Frequently Asked Questions 2. Why is the cost of capital an estimate and does this matter? – WACC is calculated based on a current estimate of what it will cost for the next dollar of debt and equity. – To estimate the cost of debt we often assume it is equal to the required rate of return on existing debt outstanding in the markets – Forecasting WACC also requires estimating the cost of equity. – In the end, WACC will still be an estimate. The key thing to ensure is that the NPV of the project be positive over the range of possible WACC’s.

THE SHORT STORY OF WACC Frequently Asked Questions 3.Why is the component cost of capital greater than the investor’s required return ? Investment Dealer Investor buys one new share in a company and pays the investment dealer $20 for it. $20.00 Investment dealer gives the issuing firm $18.00 for the share, and pockets $2.00 for providing underwriting services. Issuing company receives $ $18.00 Investor requires a 10% return on her investment of $20. This is a $2.00 return on invested capital. Conclusion: The cost of external capital is greater than the investor’s required return because of floatation costs. The company must produce $2.00 income on an $18.00 investment to meet the investor’s expectations. This is an 11.1% return.

THE SHORT STORY OF WACC Summary WACC measures the firm’s cost of financing future growth today, based on current capital market conditions, and assuming the firm use a long- term average of financing sources. WACC is an estimate. WACC is used to make capital investment decisions. WACC is used to set performance targets for sales, and ROE. WACC is used to assess management’s performance, answering the question, “has management added value?”

FINANCING SOURCES Capital Structure The Financial Structure Capital Structure

FINANCING SOURCES Capital Structure Table illustrates the basic structure of a firm’s balance sheet: – This is a snapshot of the firm’s financial position at one point in time. – Left-hand side of the Balance Sheet Assets – the things the firm owns Note the structure of assets (relative proportions of current assets and net fixed assets) – Right-hand side of the Balance Sheet Liabilities – the borrowed sources of financing – Note the structure of liabilities (the relative proportions of current versus long-term debt) Shareholders’ equity – owner’s investment in the business – Note the amount of capital invested versus the amount of earnings that have been reinvested in the business

IMPORTANT TERMS Financial Structure – The whole right-hand side of the balance sheet – Includes both short-term and long-term sources of financing (debt and equity) Capital Structure – How the firm finances its invested capital – Excludes accruals and accounts payable – short-term liabilities that are not strictly debt contracts, that spontaneously change in response to the operations of the business. – Includes: Bank Loans Long-term debt Common stock and retained earnings

FINANCING SOURCES Capital Structure Financial Structure = $2,000 Capital Structure = $1,700

FINANCING SOURCES Interpreting Balance Sheets Balance sheets are prepared in accordance with GAAP: – Represent historical costs which may not be relevant for current decision-making purposes. Analysis of reported data should include ratios such as: – Debt – to – Equity: Interest bearing debt to shareholder’s equity plus minority interest – Convert book values to market values This is done by multiplying the market-to-book ratio times the book value. Interpret the ratios again.

FINANCING SOURCES Debt-to-Equity Ratio Debt = Equity =

FINANCING SOURCES Converting Book Value to Market Values Market value of debt will be very close (if not equal) to the book values stated on the balance sheet. This is because these are contractual claims that are not negotiable (traded in secondary markets). The amounts stated are the amounts that are required to satisfy the financial claims of these creditors. The market value of long-term debt will depend on interest rate changes since the debt was originally issued. As the bonds approach maturity, their market price will move progressively to equal their par (face) value. It is the face value of the debt that is presented here. Equity = The market value of equity is greatly affected by management. It is not uncommon to see market-to-book ratios of 2 or more, reflecting the growth prospects the market sees for the firm. Lets convert the book value of equity by a market-to-book ratio of 2.5.

Financing Sources Converting Book Value to Market Values When adjusted for market value effects, the apparent “high” debt to equity ratio (.7) is a much lower This confirms the importance of using relevant data when making decisions.

THE MOST IMPORTANT CORPORATE FINANCE DECISIONS It is the managers job to maximize shareholders’ wealth. The most important ways manager can add value to the firm: – Changing the mix of financing used by the firm (changing the relative proportions of debt and equity), and – Determining the minimum rate of return needed to maintain the current market value.

VALUATION EQUATION FOR A PERPETUITY Three Ways of Using the Valuation Equation you learned how to determine the present value of an infinite stream of equal, periodic cash flows (an infinite annuity). Where: S = the present value of the perpetuity X = the forecast annual earnings K e = the investor’s required return [ 20-1] If the annual cash flow is $2.00 and the investor’s required return is 10%, the present value of the perpetuity is $20.

VALUATION EQUATION FOR A PERPETUITY Three Ways of Using the Valuation Equation The equation can be rearranged to solve for the required return K e also known as the earnings yield: The earnings yield is not normally used as the investor’s required return because it simply measures forecast earnings as a percentage of the market price, ignoring growth opportunities. [ 20-2]

Valuation Equation for a Perpetuity Three Ways of Using the Valuation Equation The perpetuity valuation model can be further rearranged to solve for the forecast earnings given the current market price and investor’s required return. This helps managers determine their earnings target that must be met to support the current market value. If the manager knows the investor requires a 10% rate of return and the market price is $20.00, she knows the firm must generate $2.00 in EPS to sustain the stock price. [ 20-3]

THE COST OF CAPITAL Determining the Weighted Average Cost of Capital (WACC) The equation for WACC including common equity, preferred share financing and debt is: In this case the value of the firm equals the sum of the value of stock, preferred and debt: V = S + P + D [ 20-9]

LEVERAGE The increased volatility in operating income over time, created by the use of fixed costs in lieu of variable costs. – Leverage magnifies profits and losses. There are two types: – Operating leverage – Financial leverage Both types of leverage have the same effect on shareholders but are accomplished in very different ways, for very different purposes strategically.

OPERATING LEVERAGE What is it? How is it Increased? The textbook defines operating leverage as: – The increased volatility in operating income caused by fixed operating costs. You should understand that managers do make decisions affecting the cost structure of the firm. Managers can, and do, decide to invest in assets that give rise to additional fixed costs and the intent is to reduce variable costs. – This is commonly accomplished by a firm choosing to become more capital intensive and less labour intensive, thereby increasing operating leverage.

OPERATING LEVERAGE Advantages and Disadvantages Advantages: – Magnification of profits to the shareholders if the firm is profitable. – Operating efficiencies (faster production, fewer errors, higher quality) usually result increasing productivity, reducing ‘downtime’ etc. Disadvantages: – Magnification of losses to the shareholders if the firm does not earn enough revenue to cover its costs. – Higher break even point – High capital cost of equipment and the illiquidity of such an investment make it: Expensive (more difficult to finance) Potentially exposed to technological obsolescence, etc.

FINANCIAL LEVERAGE What is it? How is it Increased? Your textbook defines financial leverage as: – The increased volatility in operating income caused by fixed financial costs. Financial leverage can be increased in the firm by: – Selling bonds or preferred stock (taking on financial obligations with fixed annual claims on cash flow) – Using the proceeds from the debt to retire equity (if the lenders don’t prohibit this through the bond indenture or loan agreement)

Financial Leverage Advantages and Disadvantages Advantages: – Magnification of profits to the shareholders if the firm is profitable. – Lower cost of capital at low to moderate levels of financial leverage because interest expense is tax-deductible. Disadvantages: – Magnification of losses to the shareholders if the firm does not earn enough revenue to cover its costs. – Higher break even point. – At higher levels of financial leverage, the low after-tax cost of debt is offset by other effects such as: Present value of the rising probability of bankruptcy costs Agency costs Lower operating income (EBIT), etc.

EFFECTS OF OPERATING AND FINANCIAL LEVERAGE Summary Equity holders bear the added risks associated with the use of leverage. The higher the use of leverage (either operating or financial) the higher the risk to the shareholder. Leverage therefore can and does affect shareholders required rate of return, and in turn this influences the cost of capital. HIGHER LEVERAGE = HIGHER COST OF CAPITAL