1 / 25

CHAPTER 9

CHAPTER 9. The Cost of Capital. Topics in Chapter. Cost of capital components Debt Preferred stock Common equity WACC. Determinants of Intrinsic Value: The Weighted Average Cost of Capital. Net operating profit after taxes. Required investments in operating capital. −. Free cash flow

rue
Download Presentation

CHAPTER 9

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. CHAPTER 9 The Cost of Capital

  2. Topics in Chapter • Cost of capital components • Debt • Preferred stock • Common equity • WACC

  3. Determinants of Intrinsic Value:The Weighted Average Cost of Capital Net operating profit after taxes Required investments in operating capital − Free cash flow (FCF) = FCF1 FCF2 FCF∞ Value = + + ··· + (1 + WACC)1 (1 + WACC)2 (1 + WACC)∞ Weighted average cost of capital (WACC) Firm’s debt/equity mix Market interest rates Cost of debt Cost of equity Firm’s business risk Market risk aversion

  4. What types of long-term capital do firms use? • Long-term debt • Preferred stock • Common equity

  5. Capital Components • 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.

  6. Tax effects of financing with debt with stockwith debt EBIT 400,000 400,000 - interest expense 0(50,000) EBT 400,000 350,000 - taxes (34%) (136,000)(119,000) EAT 264,000 231,000

  7. Example: Tax effects of financing with debt with stockwith debt EBIT 400,000 400,000 - interest expense 0(50,000) EBT 400,000 350,000 - taxes (34%) (136,000)(119,000) EAT 264,000 231,000 • Now, suppose the firm pays $50,000 in dividends to the stockholders.

  8. Example: Tax effects of financing with debt with stockwith debt EBIT 400,000 400,000 - interest expense 0(50,000) EBT 400,000 350,000 - taxes (34%) (136,000)(119,000) EAT 264,000 231,000 - dividends (50,000) 0 Retained earnings 214,000 231,000

  9. 0 1 2 44 rd = ? ... -904.91 40 40 40+ 1,000 44-904.91401000 4.5% x 2 = rd = 9% INPUTS N I/YR PV PMT FV OUTPUT A 22-year, 8% semiannual bond sells for $904.91 What’s rd?

  10. Use this formula: Dps $8 rps = = $100(1 – 0.05) Pps (1 – F) $8 = = 8.2% $97.5 Cost of preferred stock: Pps = $100; Dps= $8; F = 2.5%

  11. Is preferred stock more or less risky to investors than debt? • More risky; company not required to pay preferred dividend. • However, firms want to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds

  12. 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).

  13. Why is there a cost for reinvested earnings? • Earnings can be reinvested or paid out as dividends. • Investors could buy other securities, earning a return. • Thus, there is an opportunity cost if earnings are reinvested.

  14. Cost for Reinvested Earnings (Continued) • Opportunity cost: The return stockholders could earn on alternative investments of equal risk. • They could buy similar stocks and earn rs, or company could repurchase its own stock and earn rs. So, rs, is the cost of reinvested earnings and it is the cost of common equity.

  15. Three ways to determine the cost of equity, rs: 1. CAPM: rs = rRF + (rM– rRF)b = rRF + (RPM)b. 2. DCF: rs = D1/P0 + g. 3. Own-Bond-Yield-Plus-Judgmental-Risk Premium: rs = rd + Bond RP.

  16. rs = rRF + (RPM )b = 5% + (5.5%)1.2 = 11.6%. CAPM Cost of Equity: rRF = 5%, RPM = 5.5%, b = 1.2

  17. D1 rs = + g = P0 $1.82 = + 0.058 $32 = 5.7% + 5.5% = 11.2% DCF Cost of Equity, rs: D1 = $1.82; P0 = $32; g = 5.5%

  18. Estimating the Growth Rate • Use the historical growth rate if you believe the future will be like the past. • Obtain analysts’ estimates: Value Line, Zacks, Yahoo!Finance. • Use the earnings retention model,

  19. Earnings Retention Model (Continued) • Growth from earnings retention model:g = (Retention rate)(ROE) g = (1 – Payout rate)(ROE)

  20. The Own-Bond-Yield-Plus-Judgmental-Risk-Premium Method • rs = rd + Judgmental risk premium • rs = 9% + 3% = 12%

  21. What’s a reasonable final estimate of rs?

  22. 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.

  23. 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. (More…)

  24. What’s the WACC using the target weights? WACC = wdrd(1 – T) + wpsrps + wsrs WACC = 0.3(9%)(1 − 0.4) + 0.1(8.2%) + 0.6(11.6%) WACC =9.4%

  25. What factors influence a company’s WACC? • Uncontrollable factors: • Market conditions, especially interest rates. • The market risk premium. • Tax rates. • Controllable factors: • Capital structure policy. • Dividend policy. • Investment policy. Firms with riskier projects generally have a higher cost of equity.

More Related