1. 1 CHAPTER 9 The Cost of Capital

2. 2 Topics in Chapter Cost of capital components Debt Preferred stock Common equity WACC

3. Value = + + ··· + FCF 1 FCF 2 FCF ∞ (1 + WACC) 1 (1 + WACC) ∞ (1 + WACC) 2 Free cash flow (FCF) Market interest rates Firm’s business risk Market risk aversion Firm’s debt/equity mix Cost of debt Cost of equity Weighted average cost of capital (WACC ) Net operating profit after taxes Required investments in operating capital − = Determinants of Intrinsic Value: The Weighted Average Cost of Capital

4. 4 What types of long-term capital do firms use? Long-term debt Preferred stock Common equity

5. 5 Capital Components Capital components are sources of funding that come from investors. Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the cost of capital. We do adjust for these items when calculating the cash flows of a project, but not when calculating the cost of capital.

6. Tax effects of financing with debt with stock with debt EBIT 400,000 400,000 - interest expense 0 (50,000) EBT 400,000 350,000 - taxes (34%) (136,000) (119,000) EAT 264,000 231,000

7. Example: Tax effects of financing with debt with stock with debt EBIT 400,000 400,000 - interest expense 0 (50,000) EBT 400,000 350,000 - taxes (34%) (136,000) (119,000) EAT 264,000 231,000 Now, suppose the firm pays $50,000 in dividends to the stockholders.

8. Example: Tax effects of financing with debt with stock with debt EBIT 400,000 400,000 - interest expense 0 (50,000) EBT 400,000 350,000 - taxes (34%) (136,000) (119,000) EAT 264,000 231,000 - dividends (50,000) 0 Retained earnings 214,000 231,000

9. 9 A 22-year, 8% semiannual bond sells for $904.91 What’s r d ? 4040 + 1,00040 01244 r d = ? -904.91... 44 -904.91 40 1000 4.5% x 2 = r d = 9% NI/YRPVFVPMT INPUTS OUTPUT

10. 10 Cost of preferred stock: P ps = $100; D ps = $8; F = 2.5% Use this formula: r ps = D ps P ps (1 – F) = $8$8 $100(1 – 0.05) = $8$8 $97.5 =8.2%

11. 11 Is preferred stock more or less risky to investors than debt? More risky; company not required to pay preferred dividend. However, firms want to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds

12. 12 What are the two ways that companies can raise common equity? Directly, by issuing new shares of common stock. Indirectly, by reinvesting earnings that are not paid out as dividends (i.e., retaining earnings).

13. 13 Why is there a cost for reinvested earnings? Earnings can be reinvested or paid out as dividends. Investors could buy other securities, earning a return. Thus, there is an opportunity cost if earnings are reinvested.

14. 14 Cost for Reinvested Earnings (Continued) Opportunity cost: The return stockholders could earn on alternative investments of equal risk. They could buy similar stocks and earn r s, or company could repurchase its own stock and earn r s. So, r s, is the cost of reinvested earnings and it is the cost of common equity.

15. 15 Three ways to determine the cost of equity, r s : 1.CAPM: r s = r RF + (r M – r RF )b = r RF + (RP M )b. 2.DCF: r s = D 1 /P 0 + g. 3.Own-Bond-Yield-Plus-Judgmental- Risk Premium: r s = r d + Bond RP.

16. 16 CAPM Cost of Equity: r RF = 5%, RP M = 5.5%, b = 1.2 r s = r RF + (RP M )b = 5% + (5.5%)1.2 = 11.6%.

17. 17 DCF Cost of Equity, r s : D 1 = $1.82; P 0 = $32; g = 5.5% r s = D1D1 P0P0 + g = = $1.82 $32 + 0.058 =5.7% + 5.5% = 11.2%

18. 18 Estimating the Growth Rate Use the historical growth rate if you believe the future will be like the past. Obtain analysts’ estimates: Value Line, Zacks, Yahoo!Finance. Use the earnings retention model,

19. 19 Earnings Retention Model (Continued) Growth from earnings retention model: g = (Retention rate)(ROE) g = (1 – Payout rate)(ROE)

20. 20 The Own-Bond-Yield-Plus-Judgmental-Risk- Premium Method r s = r d + Judgmental risk premium r s = 9% + 3% = 12%

21. 21 What’s a reasonable final estimate of r s ? MethodEstimate CAPM11.6%11.6% DCF11.2%11.2% r d + judgment12.0%12.0% Average11.6%

22. 22 Determining the Weights for the WACC The weights are the percentages of the firm that will be financed by each component. If possible, always use the target weights for the percentages of the firm that will be financed with the various types of capital.

23. 23 Estimating Weights for the Capital Structure If you don’t know the targets, it is better to estimate the weights using current market values than current book values. If you don’t know the market value of debt, then it is usually reasonable to use the book values of debt, especially if the debt is short-term. (More…)

24. 24 What’s the WACC using the target weights? WACC= w d r d (1 – T) + w ps r ps + w s r s WACC= 0.3(9%)(1 − 0.4) + 0.1(8.2%) + 0.6(11.6%) WACC=9.4%

25. 25 What factors influence a company’s WACC? Uncontrollable factors: Market conditions, especially interest rates. The market risk premium. Tax rates. Controllable factors: Capital structure policy. Dividend policy. Investment policy. Firms with riskier projects generally have a higher cost of equity.