12.0 Chapter 12 Cost of Capital

12.1 Issues in Chapter 12 What is cost of capital? Why is cost of capital important? Know how to determine a firm’s cost of equity Common stock Preferred stock Know how to determine a firm’s cost of debt Know how to determine a firm’s overall cost of capital, or weighted average of cost of capital (WACC)

12.2 Cost of Capital: Georgia Pacific Co. “On a market-value basis, our debt-to-capital ratio was 47 percent. By employing this capital structure, we believe that our weighted average cost of capital is nearly optimized – at approximately 10 percent …..” from Annual Report

12.3 The Cost of Capital: What is it? Simply speaking, it refers to the opportunity cost that a firm incurs in raising capital to finance new projects. Ways to finance new project “GE issued 6% 20-year bonds and borrowed capital from JP Morgan to invest on new technology for its electronic division.” “eBay paid 0.39 share to acquire each of the approximately 68 million fully diluted shares of PayPal. Based on eBay's closing price Thursday of $51.90 in 4 p.m. on the Nasdaq Stock Market trading, the deal was valued at $1.4 billion.” (from WSJ, October 14, 2002)

12.4 What types of long-term capital do firms use? Debt  Long-term debt (e.g., bond) Equity  Preferred stock  Common stock Note: Accounting identity: Assets = Liabilities + Equity

12.5 The Cost of Capital What the firm must pay for capital in the capital markets More specifically, minimum rate of return required on new investments Depends on the risk associated with the firm’s activities Equal to the equilibrium rate of return demanded by investors in the capital markets for securities of that degree of risk

12.6 Why Cost of Capital is Important We know that the return earned on assets depends on the risk of those assets (risk and return trade-off) Our cost of capital provides us with an indication of how the market views the risk of our assets

12.7 Why Cost of Capital is Important Knowing our cost of capital can also help us determine our discount rate for capital budgeting projects The firm uses it to discount future cash flows from investment to be made by the firm. That is, a rate in computing NPV. We need to earn at least the cost of capital to compensate our investors for the financing they have provided

12.8 For example, suppose a firm considers an investment proposal that requires an initial investment of $1 million. The investment will generate $400,000 per year for next three years. Find NPV. The cost of capital is 8%. CF0 = -1,000,000, CF1 = 400,000, CF2 = 400,000, CF3 = 400,000, I = 8, NPV = +30,839, Accept it! Had the cost of capital been 10%, the NPV would’ve been -$5,259, so we reject the investment proposal

12.9 Why Cost of Capital is Important Conclusion: Acceptance of new investment depends on the cost of capital (or discount rate) Cost of capital = Discount rate

12.10 Why Cost of Capital is Important Conclusion: The return to an investor is the same as the cost to the company (opportunity cost concept) Cost of capital = required rate of return

12.11 Final conclusion Cost of capital to fund investments = Required return from investments = Discount rate for computing NPVs

12.12 Weighted Average of Cost of Capital WACC = R D (1-t)(D/V) + R E (E/V) where V = value of the firms = debt + equity = D + E R D = the cost of debt R E = the cost of equity Cost of common stock Cost of preferred stock t = the firm’s marginal tax rate

12.13 WACC: The Cost of Debt The cost of debt is the return that the firm’s creditors demand on new borrowing. We usually focus on the cost of long-term debt or bonds The required return is best estimated by computing the yield-to-maturity on the existing debt The cost of debt is NOT the coupon rate

12.14 Example: Cost of Debt Suppose Greenspan Co. has 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 $1,000 bond. What is the cost of debt? N = 50; PMT = 45; FV = 1000; PV = ; I/Y = 5%; YTM = 5(2) = 10%

12.15 Taxes and the WACC 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) Dividends are not tax deductible, so there is no tax impact on the cost of equity WACC = w E R E + w D R D (1-t)

12.16 WACC: Cost of Equity The cost of equity is the return required by equity investors given the risk of the cash flows from the firm 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 The cost of equity is the return required by equity investors given the risk of the cash flows from the firm

12.17 WACC: Cost of Equity There are two methods for determining the cost of equity Dividend Growth Model Security Market Line (SML) / Capital Asset Pricing Model (CAPM)

12.18 The Dividend Growth Model Approach Start with the dividend growth model formula and rearrange to solve for R E

12.19 The CAPM or SML Approach Use the following information to compute our cost of equity Risk-free rate, R f Market risk premium, E(R M ) – R f Systematic risk of asset, 

12.20 Example: Cost of Equity Suppose Greenspan Co. has a beta of 1.5. The market return is expected to be 15% and the current risk-free rate is 6%. We have used analysts’ estimates to determine that the market believes our dividends will grow at 6% per year and our last dividend was $2. Our stock is currently selling for $ What is our cost of equity? Using SML: R E = 6% + 1.5(9%) = 19.5% Using DGM: R E = [2(1.06) / 15.65] +.06 = 19.55%

12.21 So we have two numbers. We simply take an average of these two measurements to get the final cost of equity. Average = (19.5%+19.55%)/2 = %

12.22 Now we are ready to compute WACC. We can use the individual component costs of capital to get our “average” cost of capital for the firm. The weights are determined by how much of each type of financing that we use

12.23 Capital Structure Weights Notation E = market value of equity = # outstanding shares times price per share D = market value of debt = # outstanding bonds times bond price V = market value of the firm = D + E Weights w E = E/V = percent financed with equity w D = D/V = percent financed with debt

12.24 Example: Capital Structure Weights Suppose Greenspan Co. has a total 10 million shares of outstanding common stock with the current market price of $47.5 per share and a total 400,000 shares of corporate bonds with the market price of $1,250 per share. What are the market values of equity and debt? MV E = 10 million shares * $47.5 = $475 million MV D = 400,000 shares * $1,250 = $500 million What are the capital structure weights? V = 500 million million = 975 million w E = E/D = 475 / 975 =.4872 = % w D = D/V = 500 / 975 =.5128 = 51.28%

12.25 WACC: Greenspan Co. Suppose t = 30%. WACC = R D (1-t)(D/V) + R E (E/V) = 10%(1-.3)(.5128) %(.4872) =.1310 or 13.10%

12.26 Example: WACC Highfield Industries must make an estimate of the weighted average cost of capital (WACC). The stock of Highfield Industries has an expected dividend next year of $1.56, an estimated growth rate of 4%, and the stock is currently selling for $26. The beta of Highfield Industries is Debt similar to Highfield’s is selling in the bond market at a price of $1, The bonds have a 10% annual coupon, paid semiannually, 15 years to maturity and a par value of $1,000. The risk free rate is 4% and the expected return on the market is 12%. Highfield has a corporate tax rate of 35%. Currently Highfield has the optimal capital structure with 45% of debt and 55% of equity. Find the WACC.

12.27 What if your company has outstanding preferred stock? Reminders Preferred generally pays a constant dividend every period Dividends are expected to be paid forever Preferred stock pays perpetuity, so we take the perpetuity formula, rearrange and solve for R P. R P = D / P 0

12.28 Example: Cost of Preferred Stock Your company has preferred stock that has an annual dividend of $3. If the current price is $25, what is the cost of preferred stock? R P = 3 / 25 = 12%

12.29 Example: IBM IBM needs an estimate of the weighted average of cost of capital for their firm. The firm has just paid a dividend of $1.27, a current stock price of $20.00, and an expected growth rate in dividends of 10%. The IBM’s beta is The risk free rate is 5% and the expected return on the market portfolio is 13%. The company has bonds outstanding with a par value of $1,000, coupon rate of 8% paid semiannually, and 5 years until maturity. These bonds are selling in the market of $ IBM also carries preferred stocks on its balance sheet. The preferred stocks sell for $30 per share and they pay a dividend of $3 per share. IBM faces 30% marginal tax rate, and has 40% debt, 10% preferred stock, and 50% common stock in its capital structure.

12.30 IBM example, Continued 1. Calculate the cost of debt. 2. Calculate the cost of common stock, using Gordon Growth Model and Capital Asset Pricing Model (CAPM). Take an average. 3. Calculate the cost of preferred stock. 4. Calculate the weighted average of cost of capital.

12.31 IBM example, Continued IBM currently considers producing a new mainframe computer. The financial analysts of the company agree that this new project will carry the same level of risk as the average risk of the company. The new investment will require $1,000,000 and expected cash inflows will be $250,000 annually for five years (net of tax). Should IBM take on this project?  Compute Net Present Value (NPV) using the cost of capital we just computed.

12.32 Divisional and Project Costs of Capital Using the WACC as our discount rate is only appropriate for projects that are the same risk as the firm’s current operations If we are looking at a project that is NOT the same risk as the firm, then we need to determine the appropriate discount rate for that project Different projects or divisions often require separate discount rates. Why? See the next slide.

12.33 Example Suppose you are a financial analyst of “Headache Free, Co.,” a leading pain relief drug manufacturer. Currently, the WACC of the company to be 10%. The CEO of the company just announced that the company will invest in anti-AIDS drug research. Would you recommend that the company use the same 10% as a hurdle rate for anti-AIDS research project? No! The anti-AIDS research project is potentially riskier than the average of typical projects for a pain relief drug company. Should use a higher rate than 10%. Company WACC ≠ Individual Project WACC

12.34 General Electric and its subsidiaries

12.35 Subjective Approach - Example Risk LevelDiscount Rate Very Low RiskWACC – 8% Low RiskWACC – 3% Same Risk as FirmWACC High RiskWACC + 5% Very High RiskWACC + 10%

12.36 WACC Estimates for Some Large U. S. Corporations CompanyWACC Intel12.9% General Electric11.9 Motorola11.3 Coca-Cola11.2 Walt Disney10.0 AT&T 9.8 Wal-Mart 9.8 Exxon 8.8 H. J. Heinz 8.5 BellSouth 8.2

12.37 Costs of Capital for various industries by Value Line Our cost of capital provides us with an indication of how the market views the risk of our assets!