Ch 14 Cost of Capital. In this chapter, the important fact to note is that the return an investor in a security receives is the cost of that security.

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Presentation transcript:

Ch 14 Cost of Capital

In this chapter, the important fact to note is that the return an investor in a security receives is the cost of that security to the firm that issued it. 1) Cost of Equity (1) Dividend growth model

Estimating g (growth rate): (1) historical growth rate or (2) analyst’ s forecasts of future growth rate. Arithmetic and geometric averages could be used. Problems: -Applicable to firms paying dividends. -Sensitive to growth rate. -Not consider risks. (2) SML approach.

Advantages: - Adjusted for risk - Applicable to firms not paying dividends Disadvantages: - Reliance on estimates. - Reliance on the past in order to estimate beta.

2) Cost of debts Yield to Maturity after Tax Cost of debts = YTM * (1-t) In case that a firm has several debts, book or market value weighted cost of debts is used.

3) Cost of preferred stocks

4) Weighted Average Cost of Capital Hurdle rate to screen projects Minimum rate to maintain the current capital structure Performance evaluation - EVA Weights are market values or book values

WACC is used to screen in projects that supposedly have the similar risk as the firm itself. How to handle a project that has different level of risk from the firm? (1) Pure play approach: using other benchmarking firms that have the similar level of risks as a project (2) Subjective Approach: subjectively classify the level of risks.

5) Flotation costs: cost of issuing securities. Ex) A company A needs to pay 10% to issue new securities of $1000. Thus Company A has to raise; $1000 = X*(1-0.1) X= 1000/0.9 = $ Company A has to raise $

(1) Weighted flotation cost Ex) Company B’ s target capital structure is 60% equity and 40% debt. The flotation cost of Equity is 10% and that of debt is 5%. A company needs $100.

True cost = 100/(1-0.08)=108.7 (2) Flotation costs and NPV

Ex) T-printing company is at its target debt- equity ratio of 100%. It is considering building a new $500,000 printing plant in CA. The new plant is expected to generate after-tax cash flows of $73,150 per year forever. Tax rate is 34%. 1) flotation cost of equity is 10% and required rate of return is 20% 2) flotation cost of debt is 2% and YTM is 10% What is the NPV of the new printing plant?

WACC = 0.5* *0.1*(1-0.34) = PV = 73150/0.133 = 550,000. Flotation costs = 0.5* *0.02 = Total initial cost: 500,000 = X*(1-0.06) X= 500,000/(0.94) = 531,915. NPV = 550, ,915 > 0, accept the project.

(3) Internal equity and floatation costs Flotation cost of internal equity is zero. The use internal equity does not change previous approach to calculate WACC and NPV analysis.