1. COST OF CAPITAL
Chapter 14

2. Required return VS cost of capital
Any returns for investors are costs for the company
NPV
What is the required rate of return? What does it mean?
What is the difference between: required rate of return / appropriate discount rate and cost of capital?

3. Capital structure
Common stock
Debt
Preferred stock

4. Cost of equity
Cost of common equity (Re) is the rate of return that an investor requires when investing in common shares of a company
The cost of common equity is the return required by equity investors given the risk of the cash flows from the firm
Business risk
Financial risk

5. Cost of equity
There are two major methods for determining the cost of common equity
Dividend growth model
SML

6. Reminder Interest Preferred dividends Dividends Capital gain Debt
Preferred stock
Preferred dividends
Common stock
Dividends
Capital gain

7. Cost of equity Dividend growth model
D1: expected dividend for upcoming year Po: current share price g: growth rate

8. Cost of equity
Suppose STC paid a dividend of 4$ per share last year. The stock is currently sells for 60 $ per share. You estimate that the dividend will grow steadily at a rate if 6% per year into the infinite future. What is the cost of equity for STC?

9. Cost of equity
Suppose that your company is expected to pay a dividend of $1.50 per share next year. You bought the common stock for 20 and expect to sell it next year worth $25. What is your required rate of return?

10. Cost of equity Estimating g: There are two ways of estimating g
Use historical growth rates
Use analysts’ forecasts of future growth rates
dividend
Year
1.10$
2005
1.20
2006
1.35
2007
1.40
2008
1.55
2009

11. Cost of equity Only applicable to companies currently paying dividends
Advantages and Disadvantages of Dividend Growth Model
Advantages: simplicity
Disadvantages:
Only applicable to companies currently paying dividends
Not applicable if dividends aren’t growing at a reasonably constant rate
Extremely sensitive to the estimated growth rate – an increase in g of 1% increases the cost of equity by 1%
Does not explicitly consider risk

12. Cost of equity The Security Market Line Approach (SML)
The SML essentially tells us the reward (return) for bearing risk in financial markets – what return is expected for a given level of risk
required return is a function of 3 things:
risk free rate
market risk premium
systematic risk of the asset relative to the average risk - called the ‘beta’ coefficient

13. Cost of equity risk free rate: return on a risk free asset
market risk premium - reflecting the return associated with the market as a whole e.g. the Saudi market return
systematic risk of the asset relative to the average risk called the ‘beta’ coefficient : A measure of the systematic risk, of a security or a portfolio in comparison to the market as a whole - so if the stock historically is much more volatile (risky) than the market then the return should reflect that incremental risk

14. Cost of equity
From the SML comes the Capital Asset Pricing Model (CAPM)
According to the CAPM:
RE = Rf + bE  (ERM - Rf)
Rf = risk free rate of return
Rm = expected market return
Rm-RF = market risk premium
BE = estimate of systematic risk, the risk for an individual security relative to the market risk as a whole

15. Cost of equity
Get the risk-free rate (Rf ) from financial press—many use the 1-year Treasury bill rate, T-bond rates
Get estimates of market risk premium and security beta.
Historical risk premium — RM - Rf = Beta — historical (1) Investment information services (2) Estimate from historical data

16. Cost of equity
Suppose your company has an equity beta of .58 and the current risk-free rate is 6.1%. If the expected market risk premium is 8.6%, what is your cost of equity capital?

17. Cost of equity Advantages and Disadvantages of SML Advantages
Explicitly adjusts for systematic risk
Applicable to all companies, as long as we can estimate beta
Disadvantages
Have to estimate the expected market risk premium, which does vary over time
Have to estimate beta, which also varies over time
We are using the past to predict the future, which is not always reliable

18. Ex 1 Page 465
The Down and Out Co. just issued a dividend of 2.40$ per share on its common stock. The company is expected to maintain a constant 5.5 percent growth rate in its dividends indefinitely. If the stock sells for 52$ a share , what is the company’s cost of capital?

19. Ex3 Page 465
Stock in Country Road Industries has a beta of the market risk premium is 8 percent, and T-bills are currently yielding 5 percent. The company’s most recent dividend was 1.6$ per share, and dividends are expected to grow at a 6 percent annual rate indefinitely. If the stock sells for 37$ per share, what is your best estimate of the company’s cost of capital?

20. Ex4 Page 465
Suppose In a Found Ltd. Just issued a dividend of 1.43$ per share on its common stocks. The company paid dividends of 1.05$ , 1.12$, 1.19$, and 1.30$ per share in the last four years. If the stock currently sells for 45$, what is your best estimate of the company’s cost of equity?

21. Reminder
Debt
Bank loans
Bonds
Equity
Preferred stock
Common stock

22. Cost of Debt
Cost of capital is the rate that must be earned to satisfy the required rate of return of the firm's investors ( fund providers)
Cost
Required return

23. Cost of Debt What is rate of return?
Required rate of return versus expected rate of return
RRR : The minimum annual percentage earned by an investment that will induce individuals or companies to put money into a particular security or project.

24. Cost of Debt
Do you accept the project?
ERR 20%
RRR 25%

25. Cost of Debt
Do you accept the project?
ERR 30%
RRR 25%

26. Cost of Debt What is required rate of return based on?
The required rate of return is used to determine if the reward is worth the risk.
Risk free rate is required return on a risk-free asset, it is implied that any additional risk taken by an investor should be rewarded with an interest rate higher than the risk-free rate

27. Cost of Debt
Cost of debt is simply the interest rate the firm must pay on new borrowing.
The current interest rate in the market
The cost of debt is the required return on a company’s liabilities

28. Cost of Debt
Loans: Decreasing interest
Bonds: Fixed interest

29. Cost of debt Loans Ki= 2mD/ P(n+1) m= number of payments per-year
D= total interest amount
P= value of loan
n= total number of payments throughout loan period

30. Example
You borrowed 10m$ with a 5% interest rate for 5 years from a bank were you will be repaying the loan as fixed payments. These payments include the principal and interest of the loan. What is the cost of your debt if you are to pay the payments every 3 months across the 5 year period.

31. Bonds Bond: is an interest only loan Bonds features and prices:
For example: suppose the Beck Corporation wants to borrow 1,000$ for 30 years. The interest rate on similar corporation is 12 percent.

32. Bonds
Features:
Coupon: the stated interest payment made on a bond (120$)
Face value: the principle amount of a bond that is repaid at the end of the term. Also called par value (1,000$)
Coupon rate: the annual coupon divided by the face value of a bond. 120$/ 1,000$ = (12%)
Maturity: the specified date on which the principle amount of a bond is paid.

33. Bond values and yields
There is an inverse relation ship between interest rates and the present value of a bond
To determine the value of a bond we need to know:
The number of periods left to maturity
Par value
Interest rate
coupon

34. Bond values and yields
Yield to maturity (YTM): the rate required in the market on a bond

35. Bond values and yields
Example: suppose a company were to issue a bond with 10 years to maturity. This company has an annual coupon of 80$. Similar bonds have a yield of maturity of 8%. What will the bond sell for?
Suppose a year has gone by. And interest rate has risen to 10 percent, what will the bond be worth?
What would the bond sell for if interest rates had dropped by 2 percent?

36. Cost of debt
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
What is the cost of new debt Rd for a company if the current interest rate is 12%?

37. Cost of debt Trial and Error
Suppose we have a bond issue currently outstanding that has 10 years left to maturity and a face value of $1,000. The coupon rate is 10% and coupons are paid annually. The bond is currently selling for $941. What is the cost of debt Rd?

38. If the Price is lower than face value
Cost of debt
If the Price is lower than face value
Rd= YTM = int +( d/n)
(p+FV) / 2
int= interest payment
d= decrease in value of bond
n= years to maturity
p= market value of bond
FV= face value of bond

39. Cost of debt Trial and Error
Suppose we have a bond issue currently outstanding that has 10 years left to maturity and a face value of $1,000. The coupon rate is 10% and coupons are paid annually. The bond is currently selling for $1,134. What is the cost of debt Rd?

40. If the Price is Higher than face value
Cost of debt
If the Price is Higher than face value
Rd= YTM = int - ( rs/n)
(p+FV) / 2
int= interest payment
rs= raise in value of bond
n= years to maturity
p= market value of bond
FV= face value of bond

41. Cost of debt
Suppose we are interested in a six-year , 8 percent coupon bond that is paid annually with a face value of 1,000$. The current price is $. What is the yield to maturity on this bond?
Suppose that the current price for the bond is 1250$. What is the yield to maturity on this bond?

42. Cost of debt Tax Deduction:
An item or expense subtracted from gross income to reduce the amount of income subject to tax.
Interest expense is tax deductible
Therefore, when a company pays interest, the actual cost is less than the expense

43. Cost of debt
Note that Rd is not the appropriate cost of debt to use in calculating the WACC, instead we should use the after-tax cost of debt
Rdt = Rd ( 1- T)

44. Cost of preferred stocks
Reminders
Preferred stock generally pays a constant dividend each period
Dividends are expected to be paid every period forever
Preferred stock is a perpetuity, so we take the perpetuity formula, rearrange and solve for RP
 po = Dp/Rp
Rp = required return on preferred stock

45. Cost of preferred stocks
RP = DP / P0
Rp cost of preferred stock
Dp dividends paid
Po current price not face value

46. Example 14.3
On May 30,2008 Alabama Power Co. had two issues of ordinary preferred stock with a 25$ par value that traded on the NYSE. One issue paid 1.30$ annually per share and sold for 21.05$ per share. The other paid 1.46$ per share annually and sold for 24.35$ per share. What is Alabama Power’s cost of preferred stock?

47. Ex5 Page 465
Holdup bank has an issue of preferred stock with a 6$ stated dividend that just sold for 96$ per share. What is the bank’s cost of preferred stock?

48. Why Cost of Capital Is Important
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
Our cost of capital provides us with an indication of how the market views the risk of our assets

49. Reminder
We said previously that the capital of a company composes of different elements, debt – preferred stock – common stock
As we have seen, a given firm may have more than one provider of capital, each with its own required return
The question here is what is the total cost of capital for a firm putting into consideration all the types of capital that a firm uses

50. The Weighted Average Cost of Capital
We can use the individual costs of capital that we have computed to get our “average” cost of capital for the firm.
This “average” is the required return on the firm’s assets, based on the market’s perception of the risk of those assets
The weights are determined by how much of each type of financing is used

51. WACC
A calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation.
The WACC is the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere
When we talk about the “cost” of capital, we are talking about the required rate of return on invested funds

52. WACC
The weights are determined by how much of each type of financing is used
The weights that we use to calculate the WACC will obviously affect the result
Therefore, the obvious question is: “where do the weights come from?”
There are two possibilities:
Book-value weights
Market-value weights

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

54. Example: Capital Structure Weights
Suppose you have a market value of equity equal to $500 million and a market value of debt equal to $475 million.
What are the capital structure weights?

55. Book value weights
One potential source of these weights is the firm’s balance sheet, since it lists the total amount of long-term debt, preferred equity, and common equity
We can calculate the weights by simply determining the proportion that each source of capital is of the total capital

56. Book value weights
What are the weights if you had the following balance sheet

57. Market-value Weights
The problem with book-value weights is that the book values are historical, not current, values
The market recalculates the values of each type of capital on a continuous basis. Therefore, market values are more appropriate
Calculation of market-value weights is very similar to the calculation of the book-value weights
The main difference is that we need to first calculate the total market value (price times quantity) of each type of capital

58. Market-value Weights
What are the weights if you had the following market values?

59. Market versus book values
It is important to note that market-values is always preferred over book-value
The reason is that book-values represent the historical amount of securities sold, whereas market-values represent the current amount of securities outstanding
For some companies, the difference can be much more dramatic than others

60. WACC = wERE + wPRP+ wDRD(1-TC)
Taxes and the WACC
We are concerned with after-tax cash flows, so we also 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 = RD(1-TC)
Dividends are not tax deductible, so there is no tax impact on the cost of equity
WACC = wERE + wPRP+ wDRD(1-TC)

61. Example
The capital structure of a certain firm consists of 30% debt, 10% preferred stock and 60% common stock . The cost of debt is 10%, preferred stock 12% and 15% for common stock. What is the weighted average cost of capital if you knew that the company pays 40% in taxes?

62. Example
Company A has issued 10,000 bonds and 200,000 common stocks with face values 1000, 50 respectively. The coupon rate for the bonds is 10% and has a 8 year maturity date. The company just paid $6 in dividends which are expected to grow 5% in the upcoming years. The current price for the bonds are $800 and $60 for the common stock. What is the WACC of the company if it pays 35% in taxes?

63. Ex 14.4
The B.B Lean Co. has 1.4 million shares of stocks outstanding. The stock currently sells for 20$ per share. The firm’s debt is publicly traded and was recently quoted at 93 percent of face value. It has a total face value of 5$ million, and is currently priced to yield 11 percent. The risk free rate is 8 percent, and the market risk premium is 7 percent. You’ve estimated that Lean has a beta of .74. if the corporate tax rate is 34 percent, what is the WACC of Lean Coo?

64. What is WACC used for
It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm
Evaluate projects and investments
Evaluation of firm

65. Drawbacks
Using the WACC as our discount rate is only appropriate for projects that have the same risk as the firm’s current operations
If we are looking at a project that does NOT have the same risk as the firm, then we need to determine the appropriate discount rate for that project

66. Flotation Costs- Basic Approach
The required return depends on the risk, not how the money is raised
However, the cost of issuing new securities should not just be ignored either
Basic Approach
Compute the weighted average flotation cost
Use the target weights because the firm will issue securities in these percentages over the long term

67. Example
The Spatt Company, an all equity firm, has a cost of equity of 20 percent. What is the WACC for this company?
The Spatt is considering a large-scale expansion of 100$ million, this expansion is going to be funded by selling new stocks with flotation costs of 10 percent. What is the amount that Spatt should raise?
Suppose that Spatt’s target capital structure is 60 percent equity, 40 percent debt. The flotation cost of equity is still 10percent while the flotation cost of debt is 5 percent. What is the amount that Spatt should raise?

68. Example
ABC co. has a target capital structure that is 80% common equity, 20% debt. The flotation cost for equity issues are 20% of the amount raised; the flotation costs for debt issues are 6%. If the company needs $65 million for a new manufacturing facility, what is the true cost once flotation costs are considered?

69. Flotation Costs & NPV
Suppose the Tripleday Printing company is currently at its target debt-ratio of 100 percent. It is considering building a new 500,000 printing plant in Kansas. This new plant is expected to generate after-tax cash flows of 73,150$ per year forever. The tax rate is 34 percent. There are two financing options:
A 500,000$ new issue of common stock: the issuance costs of the new common stock would be about 10 percent of the amount raised. The required return on the company’s new equity is 20 percent.
A 500,000$ issue of 30-year bonds: the issuance costs of the new debt would be 2 percent of the proceeds. The company can raise new debt at 10 percent.
What is the NPV of the new printing plant?

70. Ex 9 Page 465
Mullineaux Corporation has a target capital structure of 60 percent common stocks, 5 percent preferred stocks, and 35 percent debt. Its cost of equity is 14 percent, the cost of preferred stock is 6 percent, and the cost of debt is 8 percent. The relevant tax rate is 35 percent
What is the WACC?
The company’s president has approached you about Mullineaux’s capital structure. He wants to know why the company doesn’t use more preferred stock financing because its costs less than debt. What would you tell the president?

71. Ex 10 Page466
Sixx AM Manufacturing has a target debt-equity ratio of its cost of equity is 15 percent, and its cost of debt is 9 percent. If the tax rate is 35 percent, what is the company’s WACC?

72. Ex 11 Page 466
Fama’s Llamas has a WACC of 8.9 percent. The company’s cost of equity is 12 percent, and its pretax cost of debt is 7.9 percent. The tax rate is 35 percent. What is the company’s target debt-equity ratio?

73. EX 12 Page 466
Filer Manufacturing has 11 million shares of common stock out standing. The current share price is 68$, and the book value per share is 6$. Filer Manufacturing also has two bond issues outstanding. The first bond issue has a face value of 70$ million, has a 7 percent coupon, and sells for 93 percent of par. The second issue has a face value of 55$ million, has an 8 percent coupon, and sells for 104 percent of par. The first issue matures in 21 years, the second in 6 years.
What are Filer’s capital structure weights on a book value biases?
What are Filer’s capital structure weights on a market value biases?
Which are more relevant, the book or market value weights? Why?

74. Ex 18 Page 467
Suppose your company needs 20$million to build a new assembly line. Your target debt-equity ratio is .75. the flotation cost for new equity is 8 percent, but the flotation cost for debt is only 5 percent. Your boss decided to fund the project by borrowing money because the flotation costs are lower and the needed fund are relatively small.
What do you think about the rationale behind borrowing the entire amount?
What is your company weighted average flotation costs, assuming all equity is raised externally?
What is the true cost of building the new assembly line after taking flotation costs into account? Does it matter in this case that the entire amount is being raised from debt?

75. Ex 23 Page 468
Floyd industries stock has a beta of 1.5. the company just paid a dividend of .8$, and the dividends are expected to grow at 5 percent. The expected return of the market is 12 percent, and the Treasury bill are yielding 5.5 percent. The most recent stock price for Floyd is 61$.
Calculate the cost of equity using DCF method
Calculate the cost of equity using SML method
Why do you think your estimates in (a) and (b) are so different?