Capital Budgeting and Financial Planning

Capital Budgeting and Financial Planning Course Instructor: M.Jibran Sheikh Contact info: jibransheikh@comsats.edu.pk

2.1.3 Cost of Equity (as well as retained earnings) The cost of common stock (equity) is the rate of return that is required by stockholders. In other words, it is the minimum rate of return that the corporation must earn for its stockholders in order to maintain the market value of its common stock. The return an investor receives takes two forms: the payment of dividends by the company; and the rise in the value of the shares (capital gain). The investor realizes the gain at the time the stock is sold.

2.1.3 Cost of Common Stock (Equity) ....cont For a company to grow, it must retain some of its earnings instead of paying all earnings to investors as dividends. Investors expect that the management of the company will use retained earnings to invest in projects that will enhance the value of the firm, and the cost of equity must include this implicit expectation. Remember: Cost of Retained Earnings = Cost of Equity.Why? Because the firm could avoid part of the cost of common stock outstanding by using retained earnings to buy back shares of its own stock. When they invest retained earnings they forego this opportunity hence incur an opportunity cost equivalent to cost of equity. The cost of equity is the rate of return that investors require in the future, not the rate earned by investors in the past.

2.1.3.1 Estimating cost of equity There are three methods that can be used to estimate the cost of equity: Dividend Valuation/Discount Model (DDM) Capital Asset Pricing Model (CAPM) Bond-yield-plus risk-premium approach i) Dividend Valuation Model If dividends of the company are expected to grow at a constant rate, g, then the current value of the stock can be calculated by the dividend growth model: P0 = D1 / (ke - g) Where: P0 = Current stock price D1 = Next dividend (Current Dividend x 1 + g) ke = Required rate of return on equity g = Estimated growth rate of dividend

Cost of equity (required return) Now, to solve for cost of equity (ke), we use algebra and rearrange the equation: ke = (D1/ P0) + g Example Alpha Company is expecting a 4% growth rate per year for the foreseeable future. The stock is currently selling for $25 per share and the last annual dividend to shareholders was $3. What is the estimated cost of equity for Alpha Company? Before applying the formula, the next dividend (D1) is estimated by multiplying the last dividend by 1+ growth rate ($3 x 1.04 = $3.12). Now the variables can be put into the formula. ke = (D1/ P0) + g ke = (3.I2/25) + 0.04 ke = 0.I648 or I6.48% Alpha’s cost of equity is estimated at 16.48%.

Estimating the expected growth rate of dividends In order to use ke = (D1/P0) +g, you have to estimate the expected growth rate, g. This can be done by: Using the growth rate as projected by security analysts Using the following equation to estimate a firm's sustainable growth rate: g = (retention rate) (return on equity) = (1 - payout rate) (ROE) The difficulty with this model is estimating the firm's future growth rate.

Example 2: Suppose Dexter's stock sells for $21, next year's dividend is expected to be $1, Dexter's expected ROE is 12%, and Dexter is expected to pay out 40% of its earnings. What is Dexter's cost of equity? Answer: ke = (D1/P0) +g g = (ROE)(retention rate) g = (0.12)(1 - 0.4) = 0.072 = 7.2%ke= (1 / 21) + 0.072 = 0.12 or 12%

Comments on Dividend Valuation Model This method is an easy approach to estimating the cost of equity. Stock price and dividend information is relatively easy to obtain for most publicly traded companies. The estimated growth rates may be obtained from published stock analysts’ reports or may be estimated using the equation (see previous slide). However, if a company does not pay dividends, this is not a good method to use. The assumption regarding constant growth of dividends may not be realistic.

ii) Bond yield plus risk premium approach Analysts often use an ad hoc approach to estimate the required rate of return. They add a risk premium (three to five percentage) to the market yield on the firm's long-term debt. i.e. ke = bond yield + risk premium Example: Dexter’s YTM on long-term debt is 8%. Suppose the risk premium is estimated to be 5 %. Dexter’s estimated cost of equity will be: Ke (Dexter) = bond yield (Dexter) + risk premium (Dexter) ke (Dexter) = 8% + 5% = 13%

iii) Capital Asset Pricing Model (CAPM) CAPM is a model that describes the relationship between risk and expected return and is used in the pricing of risky securities. ke = kRF + β (kM - kRF) ke = Cost of equity β = Company’s beta kRF= Risk-free rate (Govt. Treasury securities) kM = Market Return kM - kRF = Market premium The information about Govt. Treasury securities can be obtained easily. The appropriate market rate of return and a company’s beta coefficient can also be found in stock analysts’ reports.

Example: Capital Asset Pricing Model (CAPM) LDM Manufacturing Company wishes to estimate its cost of equity as part of a project analysis. LDM has estimated its beta to be 0.85. Short- term U.S. Treasury bonds are currently paying 3.6% (kRF), and analysts have projected that a stock market portfolio will average an 11% rate of return (kM ) for the next few years. What is LDM’s estimated cost of equity (ke)? ke = kRF + β (kM - kRF) ke = 3.6% + 0.85 (11% - 3.6%) ke = 3.6% + 0.85 x (7.4%) ke = 3.6% + 6.29% ke = 9.89% The estimated cost of equity for LDM Manufacturing Company is 9.89%.

Comparison of different methods of determining Cost of Equity Note that the three models will give three different estimates of ke. You must use your judgment to decide which is most appropriate. The appropriate method for estimating cost of equity may depend on the information that is available. In practice CAPM is most popular method to estimate cost of equity. CAPM is usually preferred over other methods because it incorporates a risk adjustment into the analysis.

2.2 Weighted Average Cost of Capital The appropriate methods for estimating the cost of debt, the cost of preferred stock, and the cost of equity were discussed in the previous section. These are the three major sources of capital available to a company for funding a project. The next step is to combine the costs of each of these components to arrive at the appropriate rate for discounting a stream of future cash flows.

The weighted average cost of capital (WACC) is obtained by combining each of these costs into one discount rate. The formula to calculate the WACC is: ka = Wd kd (I - T) + Wp kp + We ke Where: ka = Weighted average cost of capital Wd = Percentage of capital using debt kd = Cost of debt T = Marginal tax rate of company Wp = Percentage of capital using preferred stock kp = Cost of preferred stock We = Percentage of capital using equity ke = Cost of equity You are simply multiplying the cost of each component by its relative weight in the capital structure of the company.

Example We will illustrate the WACC calculation in this example. XYZ Corporation has a: — Cost of equity of 12.6% — Cost of preferred stock of 9.8% — Cost of debt of 6.5% — Marginal tax rate of 35% XYZ is considering a $1,000,000 project and plans to fund it with $500,000 in debt, $400,000 in equity, and $100,000 in preferred stock. What is the appropriate discount rate that XYZ should use in discounting the expected cash flows from the project? The answer is obtained by using the known values in the WACC formula. ka = Wdkd (I - T) + Wpkp + Weke ka = 0.50 (6.5%)(1 - 0.35) + 0.10 (9.8%) + 0.40 (12.6%) ka = 2.1125% + 0.980% + 5.04% ka = 8.13% The discount rate that XYZ should use to discount the expected cash flows is 8.13%.

Rationale behind WACC The idea of WACC is to account for the costs of all of the capital components. The weights in the calculation of a firm's WACC are the proportions of each source of capital in a firm's capital structure. The weights are “long-run target weights” for each source of capital. Sometimes raising of new capital results in a deviation from firm’s target capital structure but such deviations are short term and in the long run, the firm will adhere to target weights. Therefore each investment decision must be made assuming a WACC, which includes each of the different sources of capital and is based on the long-run target weights. A company creates value by producing a return on assets that is higher than the required rate of return on the capital needed to fund those assets.

Capital Structure The term capital structure refers to the mix of debt, preferred stock, and equity used as funding sources by a company. Many companies have a target capital structure that dictates the ideal percentage of each source of capital to be used in order to maximize the value of the firm. For example, a company may have a target capital structure of 50% debt, 40% equity, and 10% preferred stock. In order to maintain that target structure, new growth comes 50% from debt, 40% from equity, and 10% from preferred. Usually, projects that are part of the core business of a company are financed according to the company’s target capital structure. An acquisition of another company, or some other project that is outside the core business, may have a different capital structure.

Further Comments on WACC Since a firm's WACC reflects the average risk of the projects that make up the firm, it is not appropriate for evaluating all new projects. It should be adjusted upward for projects with greater-than-average risk and downward for projects with less-than-average risk. Many projects may use only one or two of the funding sources to finance a project. A simple rule to remember is that cash flows should be discounted at the rate of the cost of capital that purchased those cash flows. For Instance the appropriate discount rate for a project financed entirely by equity is the cost of equity. The cost of each component is estimated at the margin or future cost - not the historical cost. We often use historical data to forecast future conditions, but it is important to discount future cash flows with a future discount rate.

Limits to the use of debt In the real world, the cost of debt is the least expensive, and the cost of equity the most expensive, of the capital components. Many analysts and managers are tempted to use only debt to finance projects because it is the cheapest. That is not realistic because there is a limit to firms borrowing capacity. To limit their risk, most debt holders will eventually require that the owners contribute some equity capital to the company. More debt will increase the expected bankruptcy costs. More debt will lead to Agency Cost of Debt.

Adjustment for risk Another factor to consider is that a new project may have a different risk than the core business of the firm. It may be necessary to adjust the cost of capital used to discount the cash flows of the new project to represent that risk. This can be accomplished by analysing the beta of companies involved in projects of comparable risk and, if appropriate, changing the cost of equity used for the new project. Once again, the key is to discount the expected cash flows at the discount rate that represents the cost of capital used to obtain those cash flows.

Adjustment for Risk: Beta (β) There are three different concepts of beta: Equity beta (βE)incorporates the effect of operating and financial risk. Equity betas are also referred to as "leveraged" betas or "company" betas. Assets beta (βA)measures the risk of a firm if it were all equity financed. Asset betas are sometimes referred to as “unlevered betas”. For an all equity firm, asset beta and equity beta are the same. Other wise asset betas are not directly observable. Debt beta (βD)is a measure of the risk of debt of the entity. Debt beta would be zero if debt is risk free. Changing financial structure changes equity and debt betas, but not the asset beta.

Capital Budgeting and Financial Planning