0. CF
473.32 11
Winter 2014

1. Questions What cash flows should I consider?
How does the market set “r”?
How should I set “r”?

2. Setting “r” basic idea if then project return > cost of money
value of firm should 

3. Cost of Money firm gets money from 2 sources
sources expect benefits back
Debt
payments
value if sold
interim
final
Bonds
coupon
face value 
Loans
interest
principal
Equity
Preferred shares
dividends 
Common shares
dividends 

4. Cost of Money 3 ideas to measure this: dividend growth
earnings retention
WACC

5. Cost of Money dividend growth p0 share price now
d1 dividend a year from now
g rate of growth
re return on equity
dividend growth
remember this formula?
change the labels slightly
rearrange it

6. Cost of Money
dividend growth
need to know g
dividend history

7. dividend history g = .0901 2007 $1.10 2008 $1.20 $0.10 9.09% 2009
change
growth
2007
$1.10
2008
$1.20
$0.10
9.09%
2009
$1.35
$0.15
12.50%
2010
$1.50
$0.15
11.11%
Our historical growth rates are reasonably close, so we could feel reasonably comfortable that the market will expect our dividend to grow at around 5.1%. Note that when we are computing our cost of equity, it is important to consider what the market expects our growth rate to be, not what we may know it to be internally. The market price is based on market expectations, not our private information.
Another way to estimate the market consensus estimate is to look at analysts’ forecasts and take an average.
2011
$1.55
$0.05
3.33%
average
9.01%
g = .0901

8. Cost of Money
dividend growth
earnings retention
WACC

9. Cost of Money dividend growth earnings retention same formula
different method of finding g

10. Cost of Money dividend growth earnings retention WACC
“weighted average cost of capital”
uses ideas from CAPM

11. WACC of $ we get from outside world what do we pay for debt?
what do we pay for equity?
what proportion of each do we have?

12. WACC crucial: market prices corporate tax rate rate on equity
% market value of equity
weight of equity
weight of debt
rate on debt
% market value of debt
YTM

13. WACC

14. Cost of Debt long-term debt bonds YTM expected bond ratings
not coupon rate
expected bond ratings
Point out that the coupon rate was the cost of debt for the company when the bond was issued. We are interested in the rate we would have to pay on newly issued debt, which could be very different from past rates.

15. Cost of Debt example current bond issue what is cost of debt?
ignoring taxes for now
example
current bond issue
$1,000 face value
2 years to maturity
10% coupon rate (“embedded cost”)
paid semiannually
currently selling for 107% of face value
what is cost of debt?
Remind students that it is a trial and error process to find the YTM if they do not have a financial calculator or spreadsheet.

16. Cost of Equity example for our firm $25.00 current stock price
$1.80 last dividend
7% annual dividend growth
0.9 β
analysts’ estimates
Remind students that it is a trial and error process to find the YTM if they do not have a financial calculator or spreadsheet.

17. Cost of Equity example current in our market 8% risk-free rate
7% market risk premium
Remind students that it is a trial and error process to find the YTM if they do not have a financial calculator or spreadsheet.

19. 2 More Things on ch 14
applying WACC’s r
flotation costs

20. Applying WACC’s r WACC’s r used to decide appropriate for otherwise
yes or no?
which is best?
appropriate for
project same risk overall firm
core business
otherwise
adaptation needed
It is important to point out that the WACC is not very useful for companies that have several disparate divisions.
www: Click on the web surfer icon to go to an index of business owned by General Electric. Ask the students if they think that projects proposed by the “Real Estate Group” should have the same discount rate as projects proposed by “Aviation Services.” You can go through the list and illustrate why the divisional cost of capital is important for a company like GE.
If GE’s WACC was used for every division, then the riskier divisions would get more investment capital and the less risky divisions would lose the opportunity to invest in positive NPV projects.

21. Adapting WACC’s r when then a specific division’s project
outside core business
then
find firms that do these projects
use their average βs
or adjust subjectively
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.

22. Adapting WACC’s r adjusting subjectively example r very low WACC - .08
risk level r
very low
WACC - .08
low
WACC - .03
same as firm
WACC
high
WACC + .05
very high
WACC + .10
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.

23. Flotation Costs r depends on risk however not how $ raised
cost of issuing must be included

24. Flotation Costs basic approach: weighted average flotation cost
Use target weights because firm will issue securities in these percentages over the long term.

25. Flotation Costs project cost after-tax cash flows $1 million
$250,000/year
7 years

26. Flotation Costs project WACC firm’s target D/E ratio is .6
15%
firm’s target D/E ratio is .6
flotation costs
5% equity
3% debt

27. Flotation Costs

28. Questions What cash flows should I consider?
How does the market set r?
How should I set r?

29. What cash flows? Has it flowed already?
ch 10
Has it flowed already?
Would it flow without the project?

30. What cash flows? Has it flowed “already”? sunk costs research costs
decision-making costs
sales to date

31. What cash flows? Would it flow without the project? Incremental only
if so, don’t count it
Incremental only
lost
gained
“The stand-alone principal”

32. What cash flows? Incremental only lost gained capital operating
revenues
CCA tax shield benefits

33. CCA tax shield c cost of asset tCCA CCA tax rate tc corporate tax rate
r discount rate
s salvage value
n number of periods in the project

34. c s n tc d r Equipment cost $100,000 Installation & delivery cost
$10,000
Salvage s
$17,000
when? n 6
Marginal tax rate tc
40%
CCA tax rate d
20%
discount rate r
10%
“hurdle rate”