1. Chapter 14 Cost of Capital 14.1The Cost of Capital: Some Preliminaries 14.2The Cost of Equity 14.3The Costs of Debt and Preferred Stock 14.4The Weighted Average Cost of Capital 14.5Divisional and Project Costs of Capital 14.6Summary and Conclusions Vigdis Boasson Mgf 301, School of Management, SUNY at Buffalo

2. Vigdis Boasson MGF 301, School of Management, SUNY at Buffalo 14.2 The Cost of Capital: Issues Key issues:  What do we mean by “cost of capital”  How can we come up with an estimate? Vocabulary—the following all mean the same thing: a.Required return b.Appropriate discount rate c.Cost of capital (or cost of money) 2.The cost of capital is an opportunity cost—it depends on where the money goes, not where it comes from. 3.For now, assume the firm’s capital structure (mix of debt and equity) is fixed.

3. Vigdis Boasson MGF 301, School of Management, SUNY at Buffalo 14.3 The Dividend Growth Model Approach Estimating the cost of equity: the dividend growth model approach According to the constant growth model, D 1 P 0 = R E - g Rearranging, D 1 R E = + g P 0

4. Vigdis Boasson MGF 301, School of Management, SUNY at Buffalo 14.4 Example: Estimating the Dividend Growth Rate Percentage Year Dividend Dollar Change Change 1990$4.00-- 19914.40$0.4010.00% 19924.750.357.95 19935.250.5010.53 19945.650.407.62 Average Growth Rate (10.00 + 7.95 + 10.53 + 7.62)/4 = 9.025%

5. Vigdis Boasson MGF 301, School of Management, SUNY at Buffalo 14.5 The Dividend Growth Model Approach Advantages and Disadvantages of the Dividend Growth Model Approach:  Approach only works for dividend paying firms.  R E is sensitive to the estimate of g.  Historical dividend rate may not reliably predict future growth rates.  Risk is only indirectly accounted for by the use of price.

6. Vigdis Boasson MGF 301, School of Management, SUNY at Buffalo 14.6 Example: The SML Approach According to the CAPM: R E = R f + E x (R M - R f ) 1.Get the risk-free rate from financial press—many use the 1-year Treasury bill rate, say 5%. 2.Get estimates of market risk premium and security beta. a.Risk premium historical : 8.9% b.Beta—historical (1)Investment information services - e.g., S&P (2)Estimate from historical data 3.Suppose the beta is 1.40, then, using the approach: R E = R f + E x (R M - R f ) = 0.05 + 1.40 x 8.9% = 17.46%

7. Vigdis Boasson MGF 301, School of Management, SUNY at Buffalo 14.6 Costs of Debt and Preferred Stock Cost of debt 1.The cost of debt, R D, is the interest rate on new borrowing. 2.The cost of debt is observable: a.Yield on currently outstanding debt. b.Yields on newly-issued similarly-rated bonds. 3.The historic debt cost is irrelevant -- why?

8. Vigdis Boasson MGF 301, School of Management, SUNY at Buffalo 14.7 Costs of Debt and Preferred Stock (concluded) Cost of preferred 1.Preferred stock is a perpetuity, so the cost is R P = D/P 0 2.Notice that cost is simply the dividend yield. Example: One preferred issue paid $8 annually per share and sold for $120/share. The cost of the preferred stock is: $8 /120 = 6.67%

9. Vigdis Boasson MGF 301, School of Management, SUNY at Buffalo 14.8 The Weighted Average Cost of Capital Capital structure weights 1.Let:E = the market value of the equity. D = the market value of the debt. Then:V = E + D, so E/V + D/V = 100% 2.So the firm’s capital structure weights are E/V and D/V. 3.Interest payments on debt are tax-deductible, so the aftertax cost of debt is the pre-tax cost multiplied by:(1 - corporate tax rate). Aftertax cost of debt = R D x (1 - Tc) 4.Thus the weighted average cost of capital is WACC = (E/V) x R E + (D/V) x R D x (1 - T c )

10. Vigdis Boasson MGF 301, School of Management, SUNY at Buffalo 14.9 Example: Eastman Chemical’s WACC A firm has 80 million shares of common stock outstanding. The book value is $19.10 and the market price is $62.375 per share. T- bills yield 5%, and the market risk premium is assumed to be 8.5%. The stock beta is 1.1. Tax rate is 35%. The firm has three debt issues outstanding. Coupon Book Value Market Value Proportion Yield-to-Maturity 6.375% $499m $521m.40 5.70% 7.250% $495m $543m.42 6.50% 7.625% $200m $226m.18 6.60% $1290m100%

11. Vigdis Boasson MGF 301, School of Management, SUNY at Buffalo 14.9 Example: The firm’s WACC (concluded) Cost of equity (SML approach): R E =.05 + 1.1 x (.085) =.05 +.0935 =.1435  14.4% Cost of debt: Multiply the proportion of total debt represented by each issue by its yield to maturity; the weighted average cost of debt = 6.2% Capital structure weights: Market value of equity = 80 million x $62.375 = $4,990 million Market value of debt = $521m + $543m + $226m = $1,290 million V = $4,990 million + $1,290 million = $6,280 million D/V = $ 1,290 m / $6,280 m=.2054  21% E/V = $4,990 m / $6,280 m =.7946  79% WACC =( (.79 x.144) + (.21 x.062 x (1-.35)) =.1222  12.2%

12. Vigdis Boasson MGF 301, School of Management, SUNY at Buffalo 14.10 Summary of Capital Cost Calculations (Table 14.1) I.The Cost of Equity, R E Dividend growth model approach R E = D 1 / P 0 + g SML approach R E = R f +  E x (R M - R f ) II.The Cost of Debt, R D For a firm with publicly held debt, the cost of debt can be measured as the yield to maturity on the outstanding debt. If the firm has no publicly traded debt, then the cost of debt can be measured as the yield to maturity on similarly rated bonds.

13. Vigdis Boasson MGF 301, School of Management, SUNY at Buffalo 14.10 Summary of Capital Cost Calculations (concluded) III. The Weighted Average Cost of Capital The WACC is the required return on the firm as a whole. It is the appropriate discount rate for cash flows similar in risk to the firm. The WACC is calculated as WACC = (E/V) x R E + (D/V) x R D x (1 - T c ) where T c is the corporate tax rate, E is the market value of the firm’s equity, D is the market value of the firm’s debt, and V = E + D.

14. Vigdis Boasson MGF 301, School of Management, SUNY at Buffalo 14.11 The Security Market Line and the Weighted Average Cost of Capital (Figure 14.1) Expected return (%) Beta SM L WACC = 15% = 8% Incorrect acceptance Incorrect rejection B A 161514161514 R f =7 A =.60 firm = 1.0 B = 1.2 If a firm uses its WACC to make accept/reject decisions for all types of projects, it will have a tendency toward incorrectly accepting risky projects and incorrectly rejecting less risky projects.

15. Vigdis Boasson MGF 301, School of Management, SUNY at Buffalo 14.12 The Security Market Line and the Subjective Approach (Figure 14.2) Expected return (%) Beta SML 20 WACC = 14 10 R f = 7 Low risk (–4%) Moderate risk (+0%) High risk (+6%) A With the subjective approach, the firm places projects into one of several risk classes. The discount rate used to value the project is then determined by adding (for high risk) or subtracting (for low risk) an adjustment factor to or from the firm’s WACC. = 8%

16. Vigdis Boasson MGF 301, School of Management, SUNY at Buffalo 14.13 Chapter 14 Quick Quiz 1. What is the nature of the relationship between cost of capital and the value of the firm? Firm value is maximized when WACC is minimized. 2. In calculating the firm’s WACC, should we use the market value or book value to calculate the weights of debt and equity? Market value 4. What happens if we use the WACC to evaluate all potential investment projects, regardless of their risk? Tendency to reject some projects that should have been accepted and accept projects that should have been rejected.

17. Vigdis Boasson MGF 301, School of Management, SUNY at Buffalo 14.14 Flotation Costs and NPV A. The Basic Approach  flotation cost - financing arrangments and issue costs.  Weighted average flotation cost ( f A ) - sum of all flotation costs as a percent of the amount of security issued, multiplied by the target structure weights.  The multiplier 1/(1- f A ) is used to determine the gross amount of capital to be raised so after-flotation cost amount is sufficient to fund the investment. B. Flotation Costs and NPV  If a project nominally requires an investment of $ I before flotation costs, the procedure is to compute the gross capital requirement as: I x 1/(1 - f A ) and to use this figure as the investment cost in calculating the NPV.

18. Vigdis Boasson MGF 301, School of Management, SUNY at Buffalo 14.15 Flotation Costs and NPV Example: Suppose a firm is considering opening another office. The expansion will cost $50,000 and is expected to generate aftertax cash flows of $10,000 per year in perpetuity. The firm has a target debt/equity ratio of.50. New equity has a flotation cost of 10% and a required return of 15%, while new debt costs 5% to issue and has a required return of 10%. Cost of capital: WACC = (E/V) R E + (D/V) R D (1 - T C ) WACC = 2/3 15% + 1/3 10% (1 -.34) = 12.2%.  Flotation costs: f A = E/V f E + D/V f D f A = 2/3 10% + 1/3 5% f A = 8.33%  NPV: Investment = $50,000/(1 -.083) = $54,526  PV of cash flow = $10,000/.122 = $81,967  NPV = $54,526 + $81,967 = $27,441