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CHAPTER 13

CHAPTER 13. THE COST OF CAPITAL. What sources of long-term capital do firms use?. What types of long-term capital do firms use?. Long-term debt Preferred stock Common equity. Calculating the weighted average cost of capital. WACC = w d k d (1-T) + w p k p + w c k s

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CHAPTER 13

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  1. CHAPTER 13 THE COST OF CAPITAL

  2. What sources of long-term capital do firms use? SITI AISHAH BINTI KASSIM (FM2)

  3. What types of long-term capital do firms use? • Long-term debt • Preferred stock • Common equity SITI AISHAH BINTI KASSIM (FM2)

  4. Calculating the weighted average cost of capital WACC = wdkd(1-T) + wpkp + wcks • The w’s refer to the firm’s capital structure weights. • The k’s refer to the cost of each component. SITI AISHAH BINTI KASSIM (FM2)

  5. 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. SITI AISHAH BINTI KASSIM (FM2)

  6. Should we focus on before-tax or after-tax capital costs? • Tax effects associated with financing can be incorporated either in capital budgeting cash flows or in cost of capital. • Most firms incorporate tax effects in the cost of capital. Therefore, focus on after-tax costs. • Only cost of debt is affected. SITI AISHAH BINTI KASSIM (FM2)

  7. Should we focus on historical (embedded) costs or new (marginal) costs? The cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we should focus on marginal costs. SITI AISHAH BINTI KASSIM (FM2)

  8. How are the weights determined? WACC = wdkd(1-T) + wpkp + wcks • Use accounting numbers or market value (book vs. market weights)? • Use actual numbers or target capital structure? SITI AISHAH BINTI KASSIM (FM2)

  9. Cost of Debt • Method 1: Ask an investment banker what the coupon rate would be on new debt. • Method 2: Find the bond rating for the company and use the yield on other bonds with a similar rating. • Method 3: Find the yield on the company’s debt, if it has any. SITI AISHAH BINTI KASSIM (FM2)

  10. Example:A 15-year, 12% semiannual bond sells for $1,153.72. What’s rd? 0 1 2 30 i = ? ... 60 60 60 + 1,000 -1,153.72 INPUTS 30 -1153.72 60 1000 5.0% x 2 = rd = 10% N I/YR PV PMT FV OUTPUT SITI AISHAH BINTI KASSIM (FM2)

  11. Component Cost of Debt • Interest is tax deductible, so the after tax (AT) cost of debt is: kd AT = kd BT (1-T) = 10%(1 - 0.40) = 6%. • Use nominal rate. • Flotation costs small, so ignore. SITI AISHAH BINTI KASSIM (FM2)

  12. Component Cost of Preferred Stock WACC = wdkd(1-T) + wpkp + wcks • kp is the marginal cost of preferred stock. • The rate of return investors require on the firm’s preferred stock. SITI AISHAH BINTI KASSIM (FM2)

  13. Example:What is the cost of preferred stock? PP = $113.10; 10%Q; Par = $100; F = $2. • Use this formula: SITI AISHAH BINTI KASSIM (FM2)

  14. Note: • Flotation costs for preferred are significant, so are reflected. Use net price. • Preferred dividends are not deductible, so no tax adjustment. Just kps. • Nominal kpsis used. SITI AISHAH BINTI KASSIM (FM2)

  15. Is preferred stock more or less risky to investors than debt? • More risky; company not required to pay preferred dividend. • However, firms try to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, and (3) preferred stockholders may gain control of firm. SITI AISHAH BINTI KASSIM (FM2)

  16. Why is yield on preferred stock lower than kd? • Corporations own most preferred stock, because 70% of preferred dividends are non-taxable to corporations. • Therefore, preferred stock often has a lower B-T yield than the B-T yield on debt. • The A-T yield to an investor, and the A-T cost to the issuer, are higher on preferred stock than on debt. Consistent with higher risk of preferred stock. SITI AISHAH BINTI KASSIM (FM2)

  17. Illustrating the differences between A-T costs of debt and preferred stock Recall, that the firm’s tax rate is 40%, and its before-tax costs of debt and preferred stock are kd = 10% and kp = 9%, respectively. A-T kp = kp – kp (1 – 0.7)(T) = 9% - 9% (0.3)(0.4) = 7.92% A-T kd = 10% - 10% (0.4) = 6.00% A-T Risk Premium on Preferred = 1.92% SITI AISHAH BINTI KASSIM (FM2)

  18. Component Cost of Equity WACC = wdkd(1-T) + wpkp + wcks • ks is the marginal cost of common equity using retained earnings. • The rate of return investors require on the firm’s common equity using new equity is ke. SITI AISHAH BINTI KASSIM (FM2)

  19. 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). SITI AISHAH BINTI KASSIM (FM2)

  20. Why is there a cost for reinvested earnings? • Earnings can be reinvested or paid out as dividends. • Investors could buy other securities, earn a return. • Thus, there is an opportunity cost if earnings are reinvested. SITI AISHAH BINTI KASSIM (FM2)

  21. Opportunity cost: The return stockholders could earn on alternative investments of equal risk. Due to that, • Investors could buy similar stocks and earn ks. • Firm could repurchase its own stock and earn ks. • Therefore, ks is the cost of retained earnings. SITI AISHAH BINTI KASSIM (FM2)

  22. Three ways to determine the cost of common equity, ks • CAPM: ks = kRF + (kM – kRF) β • DCF: ks = D1 / P0 + g • Own-Bond-Yield-Plus-Risk Premium: ks = kd + Bond RP SITI AISHAH BINTI KASSIM (FM2)

  23. Example:What is the cost of equity based on the CAPM?kRF = 7%, RPM = 6%, β = 1.2. ks = kRF + (kM – kRF) β = 7.0% + (6.0%)1.2 = 14.2% SITI AISHAH BINTI KASSIM (FM2)

  24. Example:If D0 = $4.19, P0 = $50, and g = 5%, what is the cost of common equity based upon the DCF approach? D1 = D0 (1+g) D1 = $4.19 (1 + .05) D1 = $4.3995 ks = D1 / P0 + g = $4.3995 / $50 + 0.05 = 13.8% SITI AISHAH BINTI KASSIM (FM2)

  25. Estimating the Growth Rate • Use the historical growth rate if you believe the future will be like the past. • Obtain analysts’ estimates: Value Line, Zack’s, Yahoo!.Finance. • Use the earnings retention model, illustrated on next slide. SITI AISHAH BINTI KASSIM (FM2)

  26. What is the expected future growth rate? Example: Suppose the company has been earning 15% on equity (ROE = 15%) and retaining 35% (dividend payout = 65%), and this situation is expected to continue. SITI AISHAH BINTI KASSIM (FM2)

  27. Solution: g = ( 1 – Payout ) (ROE) = (1 – 0.65) (15%) = 5.25% or g = ROE (Retention Rate) = (0.35) (15%) = 5.25% • Very close to the g that was given before. SITI AISHAH BINTI KASSIM (FM2)

  28. Could DCF methodology be appliedif g is not constant? • Yes, non-constant growth stocks are expected to attain constant growth at some point, generally in 5 to 10 years. • May be complicated to compute. SITI AISHAH BINTI KASSIM (FM2)

  29. 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. SITI AISHAH BINTI KASSIM (FM2)

  30. 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. • Example: Suppose the stock price is $50, there are 3 million shares of stock, the firm has $25 million of preferred stock, and $75 million of debt. SITI AISHAH BINTI KASSIM (FM2)

  31. Solution: • Vce = $50 (3 million) = $150 million. • Vps = $25 million. • Vd = $75 million. • Total value = $150 + $25 + $75 = $250 million. • wce = $150/$250 = 0.6 • wps = $25/$250 = 0.1 • wd = $75/$250 = 0.3 SITI AISHAH BINTI KASSIM (FM2)

  32. Solution: What is the WACC? WACC = wdkd(1 - T) + wpskps + wceks = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1%. SITI AISHAH BINTI KASSIM (FM2)

  33. What are some factors that influence a company’s WACC? • Market conditions, especially interest rates and tax rates. • The firm’s capital structure and dividend policy. • The firm’s investment policy. Firms with riskier projects generally have a higher WACC. SITI AISHAH BINTI KASSIM (FM2)

  34. Why is the cost of retained earnings cheaper than the cost of issuing new common stock? • 1. When a company issues new common stock they also have to pay flotation costs to the underwriter. • 2. Issuing new common stock may send a negative signal to the capital markets, which may depress stock price. SITI AISHAH BINTI KASSIM (FM2)

  35. Example:If issuing new common stock incurs a flotation cost of 15% of the proceeds, what is ke? SITI AISHAH BINTI KASSIM (FM2)

  36. Flotation Costs • Flotation costs depend on the risk of the firm and the type of capital being raised. • The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small. • We will frequently ignore flotation costs when calculating the WACC. SITI AISHAH BINTI KASSIM (FM2)

  37. Example:Ignoring flotation costs, what is the firm’s WACC? WACC = wdkd(1-T) + wpkp + wcks = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1% SITI AISHAH BINTI KASSIM (FM2)

  38. Four Mistakes to Avoid When Using WACC • 1. When estimating the cost of debt, don’t use the coupon rate on existing debt. Use the current interest rate on new debt. • 2. When estimating the risk premium for the CAPM approach, don’t subtract the current long-term T-bond rate from the historical average return on common stocks. • For example, if the historical rM has been about 12.2% and inflation drives the current rRF up to 10%, the current market risk premium is not 12.2% - 10% = 2.2%! SITI AISHAH BINTI KASSIM (FM2)

  39. Don’t use book weights to estimate the weights for the capital structure. • Use the target capital structure to determine the weights. • If you don’t know the target weights, then use the current market value of equity, and never the book value of equity. • If you don’t know the market value of debt, then the book value of debt often is a reasonable approximation, especially for short-term debt. SITI AISHAH BINTI KASSIM (FM2)

  40. Always remember that 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 WACC. • We do adjust for these items when calculating the cash flows of the project, but not when calculating the WACC. SITI AISHAH BINTI KASSIM (FM2)

  41. THE END SITI AISHAH BINTI KASSIM (FM2)

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