Basic Corporate Finance 2-208-97 Lecture 10: Cost of Capital

1. Basic Corporate Finance2-208-97 Lecture 10: Cost of Capital

2. 12 April 2012 Tolga Cenesizoglu 2 Outline for Lecture 10 Cost of Capital Cost of Equity Cost of Debt Weighted Average Cost of Capital (WACC) Problems with WACC Floatation Costs

3. 12 April 2012 Tolga Cenesizoglu 3 Cost of Capital We know that discount rates used to evaluate projects should take into account The opportunity cost of capital The riskiness of the project Different sources of capital (equity or debt) As we already know, firms can raise capital for their projects either by issuing debt or issuing equity. These different sources of capital will have different opportunity costs associated. One of the most important measures of cost of capital is Weighted Average Cost of Capital (WACC) which takes into account all the above.

4. 12 April 2012 Tolga Cenesizoglu 4 A Digest on Different Terminology So far, we have used different terminology such as required rate of return, the appropriate discount rate, the cost of capital and the opportunity cost of capital. They all mean essentially the same thing. For example, the yield-to-maturity (YTM) is the return an investor would receive if she holds a bond to maturity. In some sense, YTM is the required rate of return on this bond or the appropriate discount rate for the coupon payments of the bond.

5. 12 April 2012 Tolga Cenesizoglu 5 The Cost of Equity Calculating the cost of equity is more difficult than calculating the cost of debt. There is no way of directly observing the return that the firm�s equity investors (shareholders) require on their investment. Hence, it must be somehow estimated. There are two approaches of estimating the cost of equity from the models of equity we have already analyzed.

6. 12 April 2012 Tolga Cenesizoglu 6 Two Models for Cost of Equity Gordon Dividend Growth Model

7. 12 April 2012 Tolga Cenesizoglu 7 Gordon Growth Model Approach Implementing the Gordon Growth Model Approach requires three pieces of information, P0, D0 and g. For a publicly traded company, we can observe the first two, i.e. the market price and the recent dividend payment. However, the third piece of information, the growth rate of dividend payments needs to be estimated. There are three possible ways of estimating the growth rate: Use historical growth rates to predict the future growth rate Use analysts� forecasts of future growth rates Use earnings retention

8. 12 April 2012 Tolga Cenesizoglu 8 Using Earnings Retention Suppose a company will have the same earnings as earnings this year unless a net investment is made. The net investment will be positive if some earnings are not paid out as dividends, that is, if some earnings are retained. Earnings(+1) = Earnings(0) + Retained Earnings x Return on Retained Earnings Dividend both sides by Earnings this year (0), we get g = Retention Ratio x ROE Use historical ROE numbers to calculate ROE.

9. 12 April 2012 Tolga Cenesizoglu 9 Gordon Growth Model Approach Advantages Easy to understand and easy to use Simplicity Disadvantages Mostly applicable to dividend paying firms Assumes that the dividend growth rate is constant Very sensitive to estimated growth rate Does not consider risk explicitly (No allowance for the uncertainty about the estimated growth rate)

10. 12 April 2012 Tolga Cenesizoglu 10 The CAPM Approach Implementing the CAPM approach to calculate RE requires three pieces of information, the risk free rate (Rf), the beta (�) and the market risk premium (RM � Rf). In practice, one can use a large index of stocks such as S&P500 or TSX Index etc as the market portfolio and the 1 month or 3 month T-Bill rate as the risk free rate and use regression techniques to find beta.

11. 12 April 2012 Tolga Cenesizoglu 11 The CAPM Approach Advantages Explicitly adjusts for risk Does not assume steady dividend growth Disadvantages Sensitive to estimates of the market risk premium and beta Uses past to predict the future

12. 12 April 2012 Tolga Cenesizoglu 12 Which Method is Mostly Used?

13. 12 April 2012 Tolga Cenesizoglu 13 The Cost of Debt The cost of debt is the return that lenders require on a company�s debt. Determining the cost of debt is much easier than determining the cost of equity because the required rate of return is readily available as the YTM on company�s bonds. One can use the YTM calculated using market prices for company�s bonds as the cost of debt. Or alternatively, the YTM on bonds with similar ratings can be used as the cost of debt. Cost of preferred stock

14. 12 April 2012 Tolga Cenesizoglu 14 Weighted Average Cost of Capital (WACC) Having found the cost of equity and the cost of debt, we can calculate the cost of capital for a firm as a weighted average of the two where the weights are the firm�s capital structure weights. Total market value of the firm is the sum of the market value of its equity (E) and the market value of its debt (D), i.e. V = E + D.

15. 12 April 2012 Tolga Cenesizoglu 15 Weighted Average Cost of Capital (WACC) The market value of equity is calculated as the product of the price per share and the number of shares outstanding. The market value of debt is calculated as the sum of the value of every bond issue outstanding where the value of each bond is the product of market price of the bond and the number of bonds outstanding. We generally ignore the short-term liabilities when calculating the firm�s total debt.

16. 12 April 2012 Tolga Cenesizoglu 16 Weighted Average Cost of Capital (WACC) Capital structure weights are calculated as the percentage of the firm�s total value, i.e. E/V and D/V. (e.g. Assume that the market value of the firm�s equity is $300 million and the market value of the firm�s debt is $100 million, then the $300M/($300M+$100M) = 75% of the firm�s financing is equity and the rest 25% is debt.) Then, the unadjusted weighted average cost of capital is

17. 12 April 2012 Tolga Cenesizoglu 17 How to Incorporate Taxes? We are always concerned with after tax cash flows, hence the cost of capital should also be expressed on an after tax basis. Tax implications of issuing debt and equity are different. The cash flow to equity holders (dividend payments) are not tax deductible for the firm. The cash flow to debt holders (interest payments) are tax deductible as operating expense. Hence, we need to use after tax cost of debt in our calculations.

18. 12 April 2012 Tolga Cenesizoglu 18 How to Incorporate Taxes? Example: Assume that a firm borrows $1M at 10% percent interest (EAR) and the tax rate for the firm is 40%. The annual interest payment of the firm is $100K = $1M x 10%. However, this interest expense is tax deductible and the tax saving it provides is $40K= $100K x 40%. Hence, the after tax interest payment is $60K = $100K - $40K. The after tax interest rate is $60K/ $1M = 6% = 10% x (1-0.4). Hence, for a profitable firm the after tax cost of debt is

19. 12 April 2012 Tolga Cenesizoglu 19 Weighted Average Cost of Capital (WACC) For a project that is similar to the firm�s existing projects, the cost of capital is the weighted average cost of capital using the current capital structure weights:

20. 12 April 2012 Tolga Cenesizoglu 20 Weighted Average Cost of Capital (WACC) WACC is the overall return that the firm must earn on its existing assets to maintain the value of its stock. It is also the required rate of return on any investments by the firm that have essentially the same risks as existing operations. So if we were evaluating the cash flows from a proposed investment by this firm, this is the discount rate we would use.

21. 12 April 2012 Tolga Cenesizoglu 21 Weighted Average Cost of Capital (WACC) Market values of the equity and bonds to determine the weights, not book values Use the rates of return investors are currently demanding Use the marginal tax rate

22. 12 April 2012 Tolga Cenesizoglu 22 Finding the WACC Find the after tax required rate of return for each different source of financing. Find the capital structure weights for each type of financing. Calculate the WACC as a weighted average of required rates of return for each source of financing where the weights are the capital structure weights calculated in 2.

23. 12 April 2012 Tolga Cenesizoglu 23 WACC - Example Technology Spying Systems (TSS) is a company that monitors communications between suspected individuals for the government. It is currently considering developing a new advanced system to monitor email exchanges more efficiently. The additional details about the firm are as follows: The common stock of the firm has a beta of 1.2. The average and the marginal tax rates for the firm are 25% and 30%, respectively. The market risk premium and the risk free rate are 8% and 6%, respectively.

24. 12 April 2012 Tolga Cenesizoglu 24 WACC - Example It currently has the following capital structure. 3,000 outstanding 8 percent semiannual-coupon bonds with par value of $1,000 and 20 years to maturity which sells for 103 percent of par. $2,000,000 in 9% APR bank loans with semiannual payments. 90,000 outstanding common shares of stock which sells for $45 per share. 13,000 shares of 7 percent preferred stock outstanding with a face value of $100 which currently sells for $108 per share. Should the firm accept the project if the IRR of the project is 10%?

25. 12 April 2012 Tolga Cenesizoglu 25 Step 1a: Find The Costs of Debt The after tax YTM on the bond is the required rate of return on the debt of the firm from the issuance of this debenture. YTM = 7.703%(APR) Required Rate of Return = 7.85% (EAR) x (1-0.3) = 5.50% The after tax EAR on the bank loan is the required rate of return on the bank loan of the firm. EAR = 9.200% Required Rate of Return = 9.200% x (1-0.3) = 6.442%

26. 12 April 2012 Tolga Cenesizoglu 26 Step 1b: Find The Costs of Equity The required rate of return on the common stock of the firm can be found using CAPM:

27. 12 April 2012 Tolga Cenesizoglu 27 Step 2a: Market Values of Debt The market value of bonds can be found by multiplying the number of debentures outstanding by the price per bond. 3,000 x $1,030 = $3.090M The market value of the bank loan is given in the question. $2.000M

28. 12 April 2012 Tolga Cenesizoglu 28 Step 2b: Market Values of Equity The market value of common stocks can be found by multiplying the number of common stocks outstanding by the price per share. 90,000 x $45 = $4.050M The market value of preferred stocks can be found by multiplying the number of preferred stocks outstanding by the price per share. 13,000 x $108 = $1.404M

29. 12 April 2012 Tolga Cenesizoglu 29 Step 2c: The Capital Structure Weights Total market value of the firm $3.090M + $2.000M + $4.050M + $1.404M = $10.544M The capital structure weights can be found by dividing the market value of each source of financing by the total market value of the firm Bonds $3.090M / $10.544M = 0.293 Bank Loan $2.000M / $10.544M = 0.190 Common Stock $4.050M / $10.544M = 0.384 Preferred Stocks $1.404M / $10.544M = 0.133

30. 12 April 2012 Tolga Cenesizoglu 30 Step 3: WACC Weighted Average Cost of Capital (WACC) = 29.31% x 5.50% + 18.97% x 6.44% + 38.41% x 15.60% + 13.32% x 6.48% = 9.69% TSS should accept this project because IRR (10%) is greater than the required rate of return (WACC) (9.69%).

31. 12 April 2012 Tolga Cenesizoglu 31 Interpreting the WACC Using WACC, if the NPV of a project is greater (less) than zero, then the value of the project�s returns to the market is greater (smaller) than the value of the securities used to finance it. Hence, the project increases (decreases) firm value.

32. 12 April 2012 Tolga Cenesizoglu 32 Problems with WACC Using WACC as the discount rate is only appropriate if the proposed investment is similar to the firm�s existing activities. However, there will be cases where the risk of project will be distinctly different than those of the overall firm.

33. 12 April 2012 Tolga Cenesizoglu 33 Problems with WACC Consider an all-equity firm (i.e. D = 0 and E/V = 100%) with a beta of 1, then the WACC is exactly equal the required rate of return on equity. Suppose this firm uses WACC to evaluate all its projects. Assume that the market risk premium is 8% and the risk-free rate is 7%.

34. 12 April 2012 Tolga Cenesizoglu 34 Problems with WACC Consider the following project: Project A has a beta of 0.6 and an expected return of 14%. The required rate of return according to CAPM is 11.8% = 7% + 0.6 x 8%. The required rate of return according to WACC is 15% = 7% + 1 x 8%. According to CAPM, we should ACCEPT the project (14%>11.8%). According to WACC, we should REJECT the project (14%<15%) WACC results in an INCORRECT REJECTION.

35. 12 April 2012 Tolga Cenesizoglu 35 Problems with WACC Consider another project: Project B has a beta of 1.2 and an expected return of 16%. The required rate of return according to CAPM is 16.6% = 7% + 1.2 x 8%. The required rate of return according to WACC is 15% = 7% + 1 x 8%. According to CAPM, we should REJECT the project (16%<16.6%). According to WACC, we should ACCEPT the project (16%>15%) WACC results in an INCORRECT ACCEPTANCE.

36. 12 April 2012 Tolga Cenesizoglu 36 Problems with WACC

37. 12 April 2012 Tolga Cenesizoglu 37 Problems with WACC WACC tends to reject profitable projects with risks less than the risk of the overall firm. WACC tends to accept unprofitable projects with risks greater than the risk of the overall firm. As a consequence, through time, a firm that uses its WACC to evaluate all projects has a tendency to both accept unprofitable projects and become increasingly risky.

38. 12 April 2012 Tolga Cenesizoglu 38 Problems with WACC The same type of problem arises when the company has more than one line of business (Time Warner Inc. or TimeWarner (NYSE: TWX) (AOL Time Warner Inc. from 2001�2003) is a massive American media conglomerate with major film, television, publishing, Internet and telecommunications divisions.). In this case, the firm�s overall cost of capital is really a mixture of different costs of capital, one for each. If the company uses a single WACC for each division, the riskier division would be awarded greater funds for investment because of higher returns (ignoring the risk).

39. 12 April 2012 Tolga Cenesizoglu 39 Solutions to Problems with WACC The Pure Play Approach Use of a WACC that is unique to a particular project. Assume that we are interested in finding a WACC for the television division of TWX. Find a �pure play company�, that focuses only on a single line of business (in this case television). Calculate the WACC for this pure play company using publicly available data such as the beta, debt-equity ratio, the bond ratings etc.

40. 12 April 2012 Tolga Cenesizoglu 40 Solutions to Problems with WACC The Subjective Approach Categorize the projects into different groups depending on their subjective risk levels. Assign an adjustment factor for each risk group, for example we should use a higher discount rate for projects that are riskier than the overall firm. Calculate the WACC for the overall firm and add the adjustment factors to the WACC of the firm Use these adjusted required rates of returns to evaluate projects in different categories.

41. 12 April 2012 Tolga Cenesizoglu 41 Solutions to Problems with WACC

42. 12 April 2012 Tolga Cenesizoglu 42 Solutions to Problems with WACC

43. 12 April 2012 Tolga Cenesizoglu 43 Floatation Costs The costs associated with the issuance of new securities. Flotation costs include both the underwriting spread and the costs incurred by the issuing company from the offering. Expressed as a portion of gross proceeds, costs generally increase as risks associated with the issue increase, or the size of the offering decreases. We will generally report the floatation costs as a percentage of the total amount to be underwritten.

44. 12 April 2012 Tolga Cenesizoglu 44 Floatation Costs Suppose that we are trying to raise $100M by issuing debt and/or equity. The floatation costs associated with equity and debt are 10% and 5%, respectively. The target capital structure (or target debt-to-equity ratio) is 1/3 (i.e. D/E = 1/3). The weighted average floatation cost can be calculated as

45. 12 April 2012 Tolga Cenesizoglu 45 Floatation Costs Since the floatation costs are the costs associated with raising capital, they should be treated as cash flows relevant for project evaluation and the initial cost must be adjusted accordingly. i.e. to raise $100M with a weighted average floatation cost of 8.75%, the initial cost of the project must be $109.589M = $100M/(1-0.0875). Always use the target capital structure weights, not the actual weights used to raise the current capital.

46. 12 April 2012 Tolga Cenesizoglu 46 Floatation Costs - Example 20th Century Fox considers to develop a sequel of �Borat� after its success in the movie theaters. The sequel will generate $20M exactly two years from today in the movie theaters and $10M from DVD sales exactly three years from today. Its production costs of $20M will occur today. The common stocks of 20th Century Fox are traded in the market for a price of $45 per share. It just paid an annual dividend of $6 per share and the dividend are expected to grow at annual rate of 4%. It is at its target debt-equity ratio of 1.2. It is planning to raise the required amount by issuing 60% equity and 40% debt. 20th Century Fox is raising the debt portion of capital by issuing new 20-year bonds with an annual coupon rate of 9% and they sell at par in the market. The floatation costs associated with equity and debt are 8% and 3%, respectively. The marginal tax rate for 20th Century Fox is 35%. Shall they produce the sequel to Borat?

47. 12 April 2012 Tolga Cenesizoglu 47 Summary Cost of capital, discount rate, and required rate of return all refer to the appropriate rate used for discounting project cash flows. Three steps involved in calculating the weighted average cost of capital (WACC) Find the cost of debt and equity Find the capital structure weights Find the WACC as the weighted average of cost of equity and debt where the weights are the capital structure weights How to incorporate floatation costs associated with issuing debt or equity in our analysis.