2 Key Concepts and Skills Know how to determine:A firm’s cost of equity capitalA firm’s cost of debtA firm’s overall cost of capitalUnderstand pitfalls of overall cost of capital and how to manage them
3 Cost of Capital BasicsThe cost to a firm for capital funding = the return to the providers of those fundsThe return earned on assets depends on the risk of those assetsA firm’s cost of capital indicates how the market views the risk of the firm’s assetsA firm must earn at least the required return to compensate investors for the financing they have providedThe required return is the same as the appropriate discount rate
4 Cost of EquityThe cost of equity is the return required by equity investors given the risk of the cash flows from the firmTwo major methods for determining the cost of equity- Dividend growth model- SML or CAPMReturn to Quick Quiz
5 The Dividend Growth Model Approach Start with the dividend growth model formula and rearrange to solve for RE
6 Example: Dividend Growth Model Your company is expected to pay a dividend of $4.40 per share next year. (D1)Dividends have grown at a steady rate of 5.1% per year and the market expects that to continue. (g)The current stock price is $50. (P0)What is the cost of equity?
7 Example: Estimating the Dividend Growth Rate One method for estimating the growth rate is to use the historical averageYear Dividend Percent Change(1.30 – 1.23) / 1.23 = 5.7%(1.36 – 1.30) / 1.30 = 4.6%(1.43 – 1.36) / 1.36 = 5.1%(1.50 – 1.43) / 1.43 = 4.9%Average = ( ) / 4 = 5.1%
8 Advantages and Disadvantages of Dividend Growth Model Advantage – easy to understand and useDisadvantagesOnly applicable to companies currently paying dividendsNot applicable if dividends aren’t growing at a reasonably constant rateExtremely sensitive to the estimated growth rateDoes not explicitly consider risk
9 The SML ApproachUse the following information to compute the cost of equityRisk-free rate, RfMarket risk premium, E(RM) – RfSystematic risk of asset,
10 Example: SML Company’s equity beta = 1.2 Current risk-free rate = 7% Expected market risk premium = 6%What is the cost of equity capital?
11 Advantages and Disadvantages of SML Explicitly adjusts for systematic riskApplicable to all companies, as long as beta is availableDisadvantagesMust estimate the expected market risk premium, which does vary over timeMust estimate beta, which also varies over timeRelies on the past to predict the future, which is not always reliable
12 Example: Cost of Equity Data:Beta = 1.5Market risk premium = 9%Current risk-free rate = 6%.Analysts’ estimates of growth = 6% per yearLast dividend = $2.Currently stock price =$15.65Using SML: RE = 6% + 1.5(9%) = 19.5%Using DGM: RE = [2(1.06) / 15.65] = 19.55%
13 Cost of DebtThe cost of debt = the required return on a company’s debtMethod 1 = Compute the yield to maturity on existing debtMethod 2 = Use estimates of current rates based on the bond rating expected on new debtThe cost of debt is NOT the coupon rate
14 Example: Cost of Debt Current bond issue: 15 years to maturity PV1000 FV60 PMTCPT I/Y %YTM = 4.45%*2 = 8.9%Current bond issue:15 years to maturityCoupon rate = 12%Coupons paid semiannuallyCurrently bond price = $1,253.72
15 Component Cost of Debt Use the YTM on the firm’s debt Interest is tax deductible, so the after-tax (AT) cost of debt is:If the corporate tax rate = 40%:Return to Quick Quiz
16 Cost of Preferred Stock Preferred pays a constant dividend every periodDividends expected to be paid foreverPreferred stock is a perpetuityExample:Preferred annual dividend = $10Current stock price = $111.10RP = 10 / = 9%
17 Weighted Average Cost of Capital Use the individual costs of capital to compute a weighted “average” cost of capital for the firmThis “average” = the required return on the firm’s assets, based on the market’s perception of the risk of those assetsThe weights are determined by how much of each type of financing is usedReturn to Quick Quiz
18 Determining the Weights for the WACC Weights = percentages of the firm that will be financed by each componentAlways use the target weights, if possibleIf not available, use market values
19 Capital Structure Weights NotationE = market value of equity= # outstanding shares times price per shareD = market value of debt= # outstanding bonds times bond priceV = market value of the firm = D + EWeightsE/V = percent financed with equityD/V = percent financed with debtReturn to Quick Quiz
20 WACC = (E/V) x RE + (P/V) x RP + (D/V) x RD x (1- TC) Where:(E/V) = % of common equity in capital structure(P/V) = % of preferred stock in capital structure(D/V) = % of debt in capital structureRE = firm’s cost of equityRP = firm’s cost of preferred stockRD = firm’s cost of debtTC = firm’s corporate tax rateWeightsComponent costs
24 Factors that Influence a Company’s WACC Market conditions, especially interest rates, tax rates and the market risk premiumThe firm’s capital structure and dividend policyThe firm’s investment policyFirms with riskier projects generally have a higher WACC
35 Risk-Adjusted WACCA firm’s WACC reflects the risk of an average project undertaken by the firm“Average” risk = the firm’s current operationsDifferent divisions/projects may have different risksThe division’s or project’s WACC should be adjusted to reflect the appropriate risk and capital structureReturn to Quick Quiz
36 Using WACC for All Projects What would happen if we use the WACC for all projects regardless of risk?Assume the WACC = 15%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.
37 Using WACC for All Projects Assume the WACC = 15%A project’s required return is calculated using the SML and the project’s BetaAdjusting for risk changes the decisionsAsk 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.
39 Pure Play ApproachFind one or more companies that specialize in the product or service being consideredCompute the beta for each companyTake an averageUse that beta along with the CAPM to find the appropriate return for a project of that riskPure play companies can be difficult to findReturn to Quick Quiz
40 Subjective ApproachConsider the project’s risk relative to the firm overallIf the project is riskier than the firm, use a discount rate greater than the WACCIf the project is less risky than the firm, use a discount rate less than the WACCReturn to Quick Quiz
41 Subjective Approach - Example Risk LevelDiscount RateVery Low RiskWACC – 8% %Low RiskWACC – 4% %Same Risk as FirmWACC %High RiskWACC + 6% %Very High RiskWACC + 10% %
42 Quick QuizWhat are the two approaches for computing the cost of equity? (Slide 12.5)How do you compute the cost of debt and the after tax cost of debt? (Slide 12.16)How do you compute the capital structure weights required for the WACC? (Slide 12.20)What is the WACC? (Slide 12.18)What happens if we use the WACC as the discount rate for all projects? (Slide 12.36)What are two methods that can be used to compute the appropriate discount rate when WACC isn’t appropriate? (Slide and Slide 12.41)