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Cost of Capital

Cost of Capital. Topics. The Cost of Capital: Some Preliminaries The Cost of Equity The Costs of Debt and Preference Shares The Weighted Average Cost of Capital Divisional and Project Costs of Capital Flotation Costs and the Weighted Average Cost of Capital. Learning Objectives.

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Cost of Capital

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  1. Cost of Capital

  2. Topics • The Cost of Capital: Some Preliminaries • The Cost of Equity • The Costs of Debt and Preference Shares • The Weighted Average Cost of Capital • Divisional and Project Costs of Capital • Flotation Costs and the Weighted Average Cost of Capital

  3. Learning Objectives • Apply the dividend growth model approach and the SML approach to determine the cost of equity. • Estimate values for the costs of debt and preference shares. • Calculate the WACC. • Discuss alternative approaches to estimating a discount rate. • Understand the effects of flotation costs on WACC and the NPV of a project.

  4. The Cost of Capital: Preliminaries • Vocabulary—the following all mean the same thing: • required return • appropriate discount rate • cost of capital. • The cost of capital is an opportunity cost—it depends on where the money goes, not where it comes from. • The assumption is made that a firm’s capital structure is fixed—a firm’s cost of capital then reflects both the cost of debt and the cost of equity.

  5. Cost of Equity • The cost of equity is the return required by equity investors given the risk of the cash flows from the firm. • There are two major methods for determining the cost of equity: • Dividend growth model • SML or CAPM.

  6. The Dividend Growth Model Approach • According to the constant growth model: Rearranging:

  7. Example—Cost of Equity Capital: Dividend Approach Reno Co. recently paid a dividend of 15 cents per share. This dividend is expected to grow at a rate of 3 per cent per year into perpetuity. The current market price of Reno’s shares is $3.20 per share. Determine the cost of equity capital for Reno Co.

  8. Estimating g One method for estimating the growth rate is to use the historical average.

  9. The Dividend Growth Model Approach Advantages • Easy to use and understand. Disadvantages • Only applicable to companies paying dividends. • Assumes dividend growth is constant. • Cost of equity is very sensitive to growth estimate. • Ignores risk.

  10. The SML Approach Required return on a risky investment is dependent on three factors: • the risk-free rate, Rf • the market risk premium, E(RM) – Rf • the systematic risk of the asset relative to the average, 

  11. Example—Cost of Equity Capital: SML Approach • Obtain the risk-free rate (Rf) from financial press—many use the 1-year Treasury note rate, say, 6 per cent. • Obtain estimates of market risk premium and security beta: • historical risk premium = 7.94 per cent (Officer, 1989) • beta—historical • investment information services • estimate from historical data • Assume the beta is 1.40.

  12. Example—Cost of Equity Capital: SML Approach (continued)

  13. The SML Approach Advantages • Adjusts for risk. • Accounts for companies that don’t have a constant dividend. Disadvantages • Requires two factors to be estimated: the market risk premium and the beta co-efficient. • Uses the past to predict the future, which may not be appropriate.

  14. The Cost of Debt • The cost of debt, RD, is the interest rate on new borrowing. • RD is observable: • yields on currently outstanding debt • yields on newly-issued similarly-rated bonds. • The historic cost of debt is irrelevant—why?

  15. Example—Cost of Debt Ishta Co. sold a 20-year, 12 per cent bond 10 years ago at par. The bond is currently priced at $86. What is our cost of debt? The yield to maturity is 14.4 per cent, so this is used as the cost of debt, not 12 per cent.

  16. The Cost of Preference Shares • Preference shares pay a constant dividend every period. • Preference shares are a perpetuity, so the cost is: • Notice that the cost is simply the dividend yield.

  17. Example—Cost of Preference Shares • An $8 preference share issue was sold 10 years ago. It sells for $120 per share today. • The dividend yield today is $8.00/$120 = 6.67 per cent, so this is the cost of the preference share issue.

  18. The Weighted Average Cost of Capital Let: E = the market value of equity = no. of outstanding shares × share price D = the market value of debt = no. of outstanding bonds × price Then: V = E + D So: E/V + D/V = 100% That is: The firm’s capital structure weights are E/V and D/V.

  19. The Weighted Average Cost of Capital • Interest payments on debt are tax deductible, so the after-tax cost of debt is: • Dividends on preference shares and ordinary shares are nottax-deductible so tax does not affect their costs. • The weighted average cost of capital is therefore:

  20. Example—Weighted Average Cost of Capital Zeus Ltd has 78.26 million ordinary shares on issue with a book value of $22.40 per share and a current market price of $58 per share. The market value of equity is therefore $4.54 billion. Zeus has an estimated beta of 0.90. Treasury bills currently yield 4.5 per cent and the market risk premium is assumed to be 7.94 per cent. Company tax is 30 per cent.

  21. Example—Weighted Average Cost of Capital (continued) The firm has four debt issues outstanding:

  22. Example—Cost of Equity(SML Approach)

  23. Example—Cost of Debt The weighted average cost of debt is 7.15 per cent.

  24. Example—Capital Structure Weights • Market value of equity = 78.26 million × $58 = $4.539 billion. • Market value of debt = $1.474 billion.

  25. WACC • The WACC for a firm reflects the risk and the target capital structure to finance the firm’s existing assets as a whole. • WACC is the return that the firm must earn on its existing assets to maintain the value of its shares. • WACC is the appropriate discount rate to use for cash flows that are similar in risk to the firm.

  26. Divisional and Project Costs of Capital • When is the WACC the appropriate discount rate? • When the project’s risk is about the same as the firm’s risk. • Other approaches to estimating a discount rate: • divisional cost of capital—used if a company has more than one division with different levels of risk • pure play approach—a WACC that is unique to a particular project is used • subjective approach—projects are allocated to specific risk classes which, in turn, have specified WACCs.

  27. The SML and the WACC Expectedreturn (%) SML = 8% Incorrectacceptance B 16 15 14 WACC = 15% A Incorrectrejection Rf =7 Beta A= .60 firm= 1.0 B= 1.2 If a firm uses its WACC to make accept/reject decisions for all types of projects, it will have a tendency towards incorrectly accepting risky projects and incorrectly rejecting less risky projects.

  28. Example—Using WACC for all Projects • What would happen if we use the WACC for all projects regardless of risk? • Assume the WACC = 15 per cent Project Required Return IRR Decision A 15% 14% Reject B 15% 16% Accept • Project A should be accepted because its risk is low (Beta = 0.60), whereas Project B should be rejected because its risk is high (Beta = 1.2).

  29. The SML and the Subjective Approach Expectedreturn (%) SML = 8% 20 High risk(+6%) A WACC = 14 10 Rf = 7 Moderate risk(+0%) Low risk(–4%) Beta With the subjective approach, the firm places projects into one of several risk classes. The discount rate used to value the project is then determined by adding (for high risk) or subtracting (for low risk) an adjustment factor to or from the firm’s WACC.

  30. Flotation Costs • The issue of debt or equity may incur flotation costs such as underwriting fees, commissions, listing fees. • Flotation costs are relevant expenses and need to be reflected in any analysis.

  31. Example—Project Cost including Flotation Costs Saddle Co. Ltd has a target capital structure of 70 per cent equity and 30 per cent debt. The flotation costs for equity issues are 15 per cent of the amount raised and the flotation costs for debt issues are 7 per cent. If Saddle Co. Ltd needs $30 million for a new project, what is the ‘true cost’ of this project? The weighted average flotation cost is 12.6 per cent.

  32. Example—Project Cost including Flotation Costs (continued)

  33. Example—Flotation Costs and NPV • Apollo Co. Ltd needs $1.5 million to finance a new project expected to generate annual after-tax cash flows of $195 800 forever. The company has a target capital structure of 60 per cent equity and 40 per cent debt. The financing options available are: • An issue of new ordinary shares. Flotation costs of equity are 12 per cent of capital raised. The return on new equity is 15 per cent. • An issue of long-term debentures. Flotation costs of debt are 5 per cent of the capital raised. The return on new debt is 10 per cent. • Assume a corporate tax rate of 30 per cent.

  34. Example—NPV (No Flotation Costs)

  35. Example—NPV (With Flotation Costs) Flotation costs decrease a project’s NPV and could alter an investment decision.

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