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Financial Analysis, Planning and Forecasting Theory and Application. Chapter 11 . Alternative Cost of Capital Analysis and Estimation. By Alice C. Lee San Francisco State University John C. Lee J.P. Morgan Chase Cheng F. Lee Rutgers University. Outline. 11.1 Introduction
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Financial Analysis, Planning and ForecastingTheory and Application Chapter 11 Alternative Cost of Capital Analysis and Estimation By Alice C. Lee San Francisco State University John C. Lee J.P. Morgan Chase Cheng F. Lee Rutgers University
Outline • 11.1 Introduction • 11.2 Average earnings yield vs. current earnings yield method • 11.3 Discounting cash-flow method • 11.4 Weighted average cost of capital • 11.5 The CAPM method • 11.6 M&M’s cross-sectional method • 11.7 Chase cost of capital • 11.8 Summary and conclusion remarks • Appendix 11A. Derivative of the basic equilibrium market price of stock and its implications • Appendix 11B. Cummins and Lee’s composite cost of capital estimation model
11.2 Average earnings yield vs. current earnings yield method (11.1) (11.2) (11.3)
11.3 Discounting cash-flow method (11.4) (11.5)
11.3 Discounting cash-flow method log EPSt = 0.910 + 0.015T, (0.026) (0.004) log DPSt = -0.137 + 0.022T (0.145) (0.020)*
11.3 Discounting cash-flow method TABLE 11.1 EPS and DPS of Johnson & Johnson (1995-2006) * Standard errors are in parentheses.
11.4 Weighted average cost of capital • Theoretical justification of the WACC
11.4 Weighted average cost of capital (11.6) (11.6′)
11.4 Weighted average cost of capital (11.6′′) where M = Price at which the bond is sold in the market: M′= Issue price of the bond (the price actually received by the issuing company); (M - M′) = Flotation cost; n = Life of the bond; Ct= Interest expense per period on one bond.
11.4 Weighted average cost of capital (11.6′′′)
11.4 Weighted average cost of capital (11.8) where MC= Market price of the convertible bond; Ct = Interest payment on the convertible bond in period t; N = Time to conversion; V = Forecast value of the bond on termination.
11.4 Weighted average cost of capital PN = P0(1 - Cf) (11.9) where PN= Net price of the stock, P0 = Market price of the new stock, Cf= Percentage flotation cost. PN = 22(1 - 0.05) = 20.90.
11.4 Weighted average cost of capital TABLE 11.2 XYZ financing
11.4 Weighted average cost of capital (11.11) (11.11a) (11.12)
11.4 Weighted average cost of capital (11.13) (11.14) (11.15)
11.4 Weighted average cost of capital (11.15′) (11.16)
11.4 Weighted average cost of capital (6.32) where VU = Market value of unlevered firm, = Corporate tax rate, = Capital gains tax rate, = Tax rate on ordinary income, D = Market value of debt.
11.5 The CAPM method Fig. 11.1 Application of the asset-expansion criterion.
11.5 The CAPM method (11.17) (11.18) where Rj, Rm, and ßj are defined in Chapter 6, E( )= The risk premium on a portfolio having a zero beta and zero dividend yield, E( ) = Expected rate of return on a hedge portfolio having zero beta and dividend yield of unity, di = Dividend yield on stock i, and dm = Dividend yield on the market portfolio.
11.5 The CAPM method TABLE 11.3 Means and standard deviations for three estimates of the cost of equity for the electric utility industry (standard deviations in parentheses)
11.6 M&M’s cross-sectional method • The cost of capital • Regression formulation and empirical results
11.6 M&M’s cross-sectional method (11.19) where V = Sum of the market value of all securities issued by the firm, = Expected level of average annual earnings generated by current assets, = Corporate tax rate, = Cost of unlevered equity capital in a certain designated risk class, D = Market value of a firm’s debt.
11.6 M&M’s cross-sectional method V = S + D + P, (11.20) where S = Common equity, D = Debt, P = Preferred equity,
11.6 M&M’s cross-sectional method (11.21) where = Change of market value of a firm, = Sn + P + D = New investment in real asset, S0 = Change in the market value of the shares held by the current owners of the firm, Sn = Value of any new common stock issued, P = Value of any new preferred stock issued, D = Value of any new debt issued.
11.6 M&M’s cross-sectional method (11.22) (11.23) (11.24)
11.6 M&M’s cross-sectional method (11.25) (11.26) (11.27)
11.6 M&M’s cross-sectional method (11.28a) (11.28b) (11.28c)
11.6 M&M’s cross-sectional method (11.29) (11.30) (11.31)
11.6 M&M’s cross-sectional method (11.32) (11.33)
11.6 M&M’s cross-sectional method (11.34) (11.35)
11.6 M&M’s cross-sectional method (11.37) (11.38) (11.39)
11.7 Chase cost of capital (11.40) V = E + D (11.41) (11.42)
11.7 Chase cost of capital NOPAT = C(E + D - cD) (11.43) (11.44) (11.45)
11.7 Chase cost of capital (11.46) (11.47) Y = R + ß(P) = 8% + 0.95(5%) = 12.75%.
11.7 Chase cost of capital (11.48) where = Marginal tax rate over the past five years; b = Interest rate on all debt over the past five years; D/E = Average total debt to total equity over the past five years. (Debt included capitalized leases, and equity includes deferred items and minority interest.)
11.8 Summary and conclusion remarks Based upon the valuation models and capital-structure theories presented earlier, six alternative cost-of-capital determination and estimation methods are discussed in detail. These methods are (i) average earnings yield method, (ii) DCF method, (iii) WACC method, (iv) CAPM method, (v) M&M’s cross-section method, and (vi) Chase’s method. The interrelationship among different cost-of-capital estimation methods were explored in some detail. The relative advantages between different estimation methods were also indirectly explored. The six cost-of-capital estimation methods that were discussed in this chapter give managers enough background to choose the appropriate cost-of-capital estimation method for utility-regulation determination, capital-budgeting decisions, and financial planning and forecasting.
Appendix 11A. Derivative of the basic equilibrium market price of stock and its implications yd + d ln Pt/dt = kt (11.A.1) where
Appendix 11A. Derivative of the basic equilibrium market price of stock and its implications (11.A.2)
Appendix 11A. Derivative of the basic equilibrium market price of stock and its implications (11.A.4)
Appendix 11A. Derivative of the basic equilibrium market price of stock and its implications (11.A.5) (11.A.6)
