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473.32 11 Winter 2014

CF. 473.32 11 Winter 2014. Questions. What cash flows should I consider? How does the market set “r”? How should I set “r”?. Setting “r”. basic idea if project return > cost of money then value of firm should . Cost of Money. firm gets money from 2 sources.

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473.32 11 Winter 2014

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  1. CF 473.32 11 Winter 2014

  2. Questions • What cash flows should I consider? • How does the market set “r”? • How should I set “r”?

  3. Setting “r” • basic idea • if • project return > cost of money • then • value of firm should 

  4. Cost of Money • firm gets money from 2 sources • sources expect benefits back • Debt • payments • value if sold • interim • final • Bonds • coupon • face value •  • Loans • interest • principal • Equity • Preferred shares • dividends •  • Common shares • dividends • 

  5. Cost of Money • 3 ideas to measure this: • dividend growth • earnings retention • WACC

  6. Cost of Money • p0share price now • d1dividend a year from now • g rate of growth • rereturn on equity • dividend growth • remember this formula? • change the labels slightly • rearrange it

  7. Cost of Money • dividend growth • need to know g • dividend history

  8. dividend history • dividend • change • growth • 2007 • $1.10 • 2008 • $1.20 • $0.10 • 9.09% • 2009 • $1.35 • $0.15 • 12.50% • 2010 • $1.50 • $0.15 • 11.11% • 2011 • $1.55 • $0.05 • 3.33% • 9.01% • average • g = .0901

  9. Cost of Money • dividend growth • earnings retention • WACC

  10. Cost of Money • dividend growth • earnings retention • same formula • different method of finding g

  11. Cost of Money • dividend growth • earnings retention • WACC “weighted average cost of capital” • uses ideas from CAPM

  12. WACC • of $ we get from outside world • what do we pay for debt? • what do we pay for equity? • what proportion of each do we have?

  13. WACC • crucial: market prices • corporate tax rate • rate on equity • % market value of equity • weight of equity • weight of debt • rate on debt • % market value of debt • YTM

  14. WACC

  15. Cost of Debt • long-term debt • bonds • YTM • not coupon rate • expected bond ratings

  16. Cost of Debt • ignoring taxes for now • example • current bond issue • $1,000 face value • 2 years to maturity • 10% coupon rate (“embedded cost”) • paid semiannually • currently selling for 107% of face value • what is cost of debt?

  17. Cost of Equity • example • for our firm • $25.00 current stock price • $1.80 last dividend • 7% annual dividend growth • 0.9 β • analysts’ estimates

  18. Cost of Equity • example • current in our market • 8% risk-free rate • 7% market risk premium

  19. 2 More Things on ch 14 • applying WACC’s r • flotation costs

  20. Applying WACC’s r • WACC’s r used to decide • yes or no? • which is best? • appropriate for • project same risk overall firm • core business • otherwise • adaptation needed

  21. Adapting WACC’s r • when • a specific division’s project • outside core business • then • find firms that do these projects • use their average βs • or adjust subjectively

  22. Adapting WACC’s r • adjusting subjectively • example

  23. Flotation Costs • r depends on risk • not how $ raised • however • cost of issuing must be included

  24. Flotation Costs • basic approach: • weighted average flotation cost • Use target weights because firm will issue securities in these percentages over the long term.

  25. Flotation Costs • project • cost • $1 million • after-tax cash flows • $250,000/year • 7 years

  26. Flotation Costs • project • WACC • 15% • firm’s target D/E ratio is .6 • flotation costs • 5% equity • 3% debt

  27. Flotation Costs

  28. Questions • What cash flows should I consider? • How does the market set r? • How should I set r?

  29. What cash flows? • ch 10 • Has it flowed already? • Would it flow without the project?

  30. What cash flows? • Has it flowed “already”? • sunk costs • research costs • decision-making costs • sales to date

  31. What cash flows? • Would it flow without the project? • if so, don’t count it • Incremental only • lost • gained • “The stand-alone principal”

  32. What cash flows? • Incremental only • lost • capital • operating • gained • revenues • CCA tax shield benefits

  33. CCA tax shield • c cost of asset • tCCACCA tax rate • tc corporate tax rate • rdiscount rate • s salvage value • n number of periods in the project

  34. “hurdle rate”

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