1. 1 Prentice Hall, 1998 Chapter 11 Cost of Capital

2. 2 Prentice Hall, 1998 Learning Objectives n Explain why the cost of capital is an opportunity cost, and not the historical cost of funds. n Distinguish among the cost of capital, and the required returns to equity and debt, and identify the major determinants of each. n Identify the important differences between operating and financial leverage, and distinguish between business and financial risk. n Estimate the cost of capital for a capital budgeting project.

3. 3 Prentice Hall, 1998 Cost of Capital and the Principles of Finance n Risk-Return Trade-Off - the project’s risk determines the project’s cost of capital n Time-Value-of-Money - the project’s NPV measures the value it will create n Valuable Ideas - a major source of value n Comparative Advantage - another major source of value

4. 4 Prentice Hall, 1998 Cost of Capital and the Principles of Finance n Incremental Benefits - these are the project’s expected future cash flows n Options - recognize the value of capital budgeting options, such as to expand, postpone, price, abandon, or have a follow- on project n Two-Sided Transactions - consider the other side’s viewpoint n Signaling - consider competitor actions and products

5. 5 Prentice Hall, 1998 The Cost of Capital n The Cost of Capital is the capital budgeting project’s required return. n It is the opportunity cost of investing those funds in the project. n It is the rate of return at which investors are willing to provide financing for the project today. n It reflects the risk of the project. n It is not the historical cost of funds.

6. 6 Prentice Hall, 1998 Corporate Valuation n The market value of the company (or simply, the company value) can be viewed in two ways: n company value equals the sum of the market values of the claims on the company’s assets. n company value equals the sum of the market values of its assets. n This is simply the balance-sheet accounting identity, but in market value terms.

7. 7 Prentice Hall, 1998 Financing Decisions and Company Value n In a perfect capital market, the value of the company does not depend on its capital structure (the way in which its assets are financed). n The mix of debt versus equity is irrelevant in determining company value. n In imperfect capital markets, capital structure can effect the value of the company.

8. 8 Prentice Hall, 1998 Investment Decisions and Company Value n The value of the company does depend on the expected future cash flows to be generated by the company’s assets, and on the required return on these cash flows. n An asset will add value if its expected return (the Internal Rate of Return or IRR) exceeds its required return (that is, its cost of capital).

9. 9 Prentice Hall, 1998 The Market Line for Capital Budgeting Projects n The Capital Asset Pricing Model (CAPM) can be used to obtain the cost of capital for a capital budgeting project. r j = r f +  j (r m - r f ) r j = r f +  j (r m - r f )where r j = cost of capital for project j, r f = riskless return r m = required return on the market portfolio  j = beta of project j

10. 10 Prentice Hall, 1998 Value and the Risk-Return Trade-Off n The value of a project depends on: v its expected future cash flows v its cost of capital n An increase in the expected future cash flows may be offset by a corresponding increase in risk. v An increase in risk increases the project’s cost of capital. n Exact offsetting changes in expected future cash flows and the cost of capital (risk) are simply a risk-return trade-off.

11. 11 Prentice Hall, 1998 Leverage n According to the CAPM, the required return depends only on the project’s non- diversifiable risk. n The non-diversifiable risk borne by shareholders can be split into two parts: v Operating (business) risk v Financial risk n Operating risk results from Operating Leverage. n Financial risk results from Financial Leverage.

12. 12 Prentice Hall, 1998 Operating Leverage n Operating leverage arises from the mix of fixed versus variable costs of production. n High fixed costs (and correspondingly lower variable costs per unit) results in high operating leverage. v The company’s profits are more sensitive to changes in sales. n Conversely, low fixed costs (and correspondingly higher variable costs per unit) results in low operating leverage.

13. 13 Prentice Hall, 1998 Operating Leverage Jewel Plastics, Inc. plans to make plastic jewel cases for CD-ROM disks. Each packet of 10 cases can be sold for $5.00. Two alternative manufacturing technologies are available. Plan A Plan B Annual Fixed Costs Variable Cost (per unit) 60,000 $2.00 $100,000 $1.00 Ignoring taxes, compute the profits under each plan.

14. 14 Prentice Hall, 1998 Operating Leverage n Profit = Sales - Costs = Unit Sales(Selling Price - Variable = Unit Sales(Selling Price - Variable Costs) - Fixed Costs Costs) - Fixed Costs n At a sales level of 50,000 units, the profits under plan A are: 50,000(5.00 - 2.00) - 60,000 = $90,000. n Under Plan B, profits at a sales level of 50,000 units are $100,000.

15. 15 Prentice Hall, 1998 Operating Leverage -$100 -$50 $0 $50 $100 $150 $200 $0$20$40$60$80 Profit ($ thousands) Units Sold (thousands) Plan B Plan A

16. 16 Prentice Hall, 1998 Operating Leverage n Operating leverage affects the risk of the company’s investments, and is unique for each investment. n It affects both the diversifiable as well as the non-diversifiable risk of the investment. n Through its effect on non-diversifiable risk, it also affects the investment’s cost of capital. n The company’s choice of operating leverage may be limited by the number of alternative production methods.

17. 17 Prentice Hall, 1998 Financial Leverage n The presence of fixed costs associated with debt financing results in financial leverage. n As financial leverage increases, the variability of shareholder returns increases. v This increases shareholder’s risk.

18. 18 Prentice Hall, 1998 Financial Leverage Club’s & Stuff is currently all-equity financed. Club’s expected future cash flows are $300 per year in perpetuity, with a minimum annual cash flow of $150. Club’s shareholders currently require a 15% return. Analyze the impact on shareholder returns if Club issues $1,500 of riskless debt with an interest rate of 10%, and uses the funds to pay dividends to the shareholders. Assume perfect markets.

19. 19 Prentice Hall, 1998 Financial Leverage n Currently, the value of Clubs & Stuff is 300 / 0.15 = $2,000 n With $1,000 in debt at 10%, Club’s annual interest expense will be $100. Since Club’s minimum annual cash flow exceeds $100, the debt will be riskless. n Issuing $1,000 of debt and paying the proceeds to the shareholders will result in Club being 50% debt financed. v In perfect markets, company value is independent of capital structure.

20. 20 Prentice Hall, 1998 Financial Leverage n With 50% debt financing, shareholders will demand a higher rate of return since their risk will increase. n As the company’s returns vary, the returns to shareholders will vary more with debt financing than without. v The company has to pay out a fixed cost of $100 per year to the debtholders.

21. 21 Prentice Hall, 1998 Financial Leverage -40% -20% 0% 20% 40% -30%-15%0%15%30% Company’s Return Shareholder’s Return 0% Debt 50% Debt

22. 22 Prentice Hall, 1998 The Weighted Average Cost of Capital n The Weighted Average Cost of Capital, WACC, is the weighted average rate of return required by the suppliers of capital for the company’s investment project. n The suppliers of capital will demand a rate of return that compensates them for the proportional risk they bear by investing in the project.

23. 23 Prentice Hall, 1998 Components of a Financing Package n Consider the case where a project will be financed with 40% debt and 60% equity. n Suppose the project requires an initial investment of $8,000 and has a NPV of $2,000. v The TOTAL value of the project is thus $10,000. n How much debt should the company use? v (40%) $10,000 = $4,000

24. 24 Prentice Hall, 1998 Components of a Financing Package n Since the project requires an initial investment of $8,000, the company will raise the remaining $4,000 by selling stock. n Since the total value of the project is $10,000, the stock will be worth $6,000. v In perfect markets, ALL of the benefits from a project (that is, the project’s NPV) goes to the shareholders.

25. 25 Prentice Hall, 1998 WACC Calculation Let L = the ratio of debt financing to total financing, r e = required return for equity, r e = required return for equity, r d = required return on debt, and r d = required return on debt, and  =marginal corporate tax rate on income from the project. Then, WACC = (1 - L) r e + L(1 -  ) r d WACC = (1 - L) r e + L(1 -  ) r d

26. 26 Prentice Hall, 1998 WACC Calculation Compute the WACC for the Nikko Co. given the following information: Nikko has 8 million common shares outstanding priced at $14.625 each. Next year’s dividend on these shares is expected to be $2.71, and will grow at 5% per year forever. Nikko has 60,000 bonds outstanding, each with a coupon rate of of 12% and are priced at $1,050 each to yield 8% to bondholders. Nikko’s marginal corporate income tax rate is 34%.

27. 27 Prentice Hall, 1998 WACC Calculation n Market value of Nikko’s equity = 8 million x $14.625 per share = $117 million. n Market value of Nikko’s debt = 60,000 x $1,050 per bond = $63 million. n Total market value of Nikko = $117 million + $63 million = $180 million. n Proportion of debt financing used by Nikko = L = $63 M / $180 M = 35%

28. 28 Prentice Hall, 1998 WACC Calculation n To compute the return required by Nikko’s stockholders, we use the constant growth model of stock valuation. r D P g e  1 0 71 625 0052353% $2. $14...

29. 29 Prentice Hall, 1998 WACC Calculation n Since we are interested in measuring the company’s current cost of capital, we use the bond yield currently demanded by the bondholders. n Thus, r d = 8% n Also, the tax rate, , is 34%

30. 30 Prentice Hall, 1998 WACC Calculation WACC = (1 - L)r e + L(1 -  )r d = (0.65)(23.53%) + (0.35)(1 - 0.34)(8%) = 17.14%

31. 31 Prentice Hall, 1998 How Not to Use the WACC n Assume that a company’s existing operations have a risk equal to the average risk of new projects being considered for adoption. n If the company uses its current WACC, it will accept projects of above average risk and reject projects of below average risk. n Thus, the risk of the company will rise.

32. 32 Prentice Hall, 1998 Misapplication of the WACC WACC Risk (beta) Rate of Return

33. 33 Prentice Hall, 1998 How to use the WACC n The correct procedure is to use a cost of capital for each project so that it reflects the risk of that project.

34. 34 Prentice Hall, 1998 Correct Application of the WACC Risk (beta) Rate of Return

35. 35 Prentice Hall, 1998 Financial Risk n Financial risk is due to the presence of debt financing used by the company. v An all-equity financed company has no financial risk. n A company chooses its financial risk with its choice of capital structure and the maturities of its obligations.

36. 36 Prentice Hall, 1998 Financial Leverage and the Cost of Capital n In perfect capital markets, financial leverage has no effect in the WACC. v WACC is independent of the capital structure. n Thus, a project’s value is not affected by the way in which it is financed. n However, financial leverage does alter how the risk of the project is borne by the debtholders and the shareholders.

37. 37 Prentice Hall, 1998 Financial Leverage and the Cost of Capital n As financial leverage increases, the risk that is borne by both the debtholders and the shareholders increases. n In the limit, the debtholders become the stockholders, except for contracting considerations.

38. 38 Prentice Hall, 1998 Required Return Insert Figure 10-7 here. 0.0 1.0 (1 -  ) r f (1 -  ) r d rere WACC L

39. 39 Prentice Hall, 1998 Financial Leverage and Beta n Consider a company with J different assets, each with a beta of  j. n Let w j denote the proportion of company value invested in asset j.

40. 40 Prentice Hall, 1998 Financial Leverage and Beta n Consider a company with J different assets, each with a beta of  j. n Let w j denote the proportion of company value invested in asset j. n The beta of all the assets of the company,  A, is then given by:  Ajj j J w   ه 1

41. 41 Prentice Hall, 1998 Financial Leverage and Beta Using the CAPM, we get WACC = r f +  A (r m - r f ) Thus, we can see that WACC is independent of the capital structure since  A is unaffected by capital structure.

42. 42 Prentice Hall, 1998 Financial Leverage and Beta n How does financial leverage affect the stock’s beta? n Let  d denote the beta of the debt and  denote the beta of the stock. n r d  = r f +  d (r m - r f ) and r e  = r f +  (r m - r f )

43. 43 Prentice Hall, 1998 Financial Leverage and Beta n Recall that WACC = (1 - L) r e + L(1 -  ) r d WACC = r f +  A (r m - r f ) n Pluggin in the CAPM specifications for r e and r d and rearranging the terms, we get: (1 - L  )  A = L  d + (1 - L) 

44. 44 Prentice Hall, 1998 Financial Leverage and Beta n Suppose that debt is riskless. Then  d = 0, and  A = (1 - L)  / (1 -  L)

45. 45 Prentice Hall, 1998 WACC for a Capital Budgeting Project The Evergreen Sprinkler Corp. (ESC) is considering expanding its current operations, and you are asked to estimate the WACC to be used for this project. ESC’s outstanding stock is valued at $16.8 million,while its debt has a market value of $7.2 million. ESC’s stock has a beta of 1.80 and its debt is riskless. ESC’s marginal tax rate is 37%. The riskless rate is 5% and the required return on the market portfolio is 13%.

46. 46 Prentice Hall, 1998 WACC for a Capital Budgeting Project n Since ESC’s debt is worth $7.2 million and its equity is worth $16.8 million, the value of L is $7.2/($7.2 + $16.8) or 0.30. n Further,  = 1.80 and  = 0.37. n Thus, the beta of the assets of ESC is:

47. 47 Prentice Hall, 1998 WACC for a Capital Budgeting Project n Since ESC’s debt is worth $7.2 million and its equity is worth $16.8 million, the value of L is $7.2/($7.2 + $16.8) or 0.30. n Further,  = 1.80 and  = 0.37. n Thus, the beta of the assets of ESC is:  A = (1 - L)  / (1 -  L) = (1 - 0.30)1.80/(1 - (0.37)(0.30) = (1 - 0.30)1.80/(1 - (0.37)(0.30) = 1.42 = 1.42

48. 48 Prentice Hall, 1998 WACC for a Capital Budgeting Project  5%142(13%5%)1636%..

49. 49 Prentice Hall, 1998 WACC for a New Line of Business n Consider a company that intends to expand into a new line of business. What WACC should it use for evaluating this proposal? n If the new line of business is of different risk than the company’s existing assets, the company’s WACC cannot be used. n Estimate  A for other companies in this line of business. n Use the average  A and the CAPM to get the WACC.

50. 50 Prentice Hall, 1998 Operating Leverage and the WACC n Unlike financial leverage, operating leverage affects  A, the beta of the assets. n Higher operating leverage leads to higher asset betas. n This in turn leads to higher WACC. n Given the technology, a company may not have much choice over operating leverage, and thus the WACC.