Capital Budgeting Overview • Capital Budgeting is the set of valuation techniques for real asset investment decisions. • Capital Budgeting Steps • estimating expected future cash flows for the proposed real asset investment (Chap 10) • estimating the firm’s cost of capital(Chap 12) based on the firm’s optimal capital structure. • using a decision-making valuation technique which depends on the company’s cost of capital to decide whether to accept or reject the proposed investment (Chap 9)
Chapter 12 The Cost of Capital Merck & Co. Jordan Air (#23)
Chapter 12 Learning Objectives • Describe the concepts underlying the firm’s cost of capital (known as weighted average cost of capital) and the purpose for its calculation. • Calculate the after-tax cost of debt, preferred stock and common equity. • Calculate a firm’s weighted average cost of capital. • Adjust the firm’s cost of capital on a by division or by project basis. • Use the cost of capital to evaluate new investment opportunities.
Cost of Capital • The firm’s cost of raising new funds that primarily reflects the investor’s required rate of return. • The weighted average of the cost of individual types of funding to the firm. • Differences between investor’s required rate of return and cost of capital arise from taxes and flotation costs. • One possible decision rule is to compare a project’s expected return (IRR) to the cost of the funds that would be used to finance the purchase of the project. • Accept if : project’s IRR > cost of capital.
Cost of Capital Terms • Capital Component = type of financing such as debt, preferred stock, and common equity • kd = cost of new debt, before tax • kd(1-T) = after-tax component cost of debt • kps = component cost of new preferred stock • kcs or kc = component cost of internal equity (retained earnings), same as what was used Chapters 6 and 8
More Cost of Capital Terms • kncs = cost of new common stock. • WACC or kwacc = the weighted average cost ot capital which is the weighted average of the individual component costs of capital. • wi = the proportion of financing type i used in the firm’s planned capital structure,
Component Cost of Debt • Remember, a corporation can deduct their interest expense for tax purposes. • Therefore, the component cost of debt is the after-tax interest rate on new debt. • kd(1-T). • Where T is the company’s marginal tax rate. • If a company raises new debt capital through bank loans, kd is the interest rate on new debt. • If a company sells new bonds…
Component Cost of Debt • The estimate of kd can be based by finding the expected YTM on the company’s new bonds. • NPd = $It(PVIFA kd,n) + $M(PVIF kd,n) • Where NPd = net proceeds per bond = market value less flotation costs.
Cost of Debt Example • We want to estimate the cost of debt for Merck which has a marginal tax rate of 35%. Let’s assume Merck would issue 10 year bonds at the current market price with flotation costs equal to 1.5% of the par value, and we find the following bond quote. Bond Cur Yld Vol Close Net Chg Merck 6s12 6.1 25 98 +1/4 • Annual coupon rate = 6%, n = 2012-2002 = 10 years , Price = 98% of par value, Semiannual coupons, Assume $1000 par value. • Find YTM = kd
Merck’s cost of debt • Expected Net Proceeds = 98% - 1.5% = 96.5% of par value = 96.5%($1000) = $965 • Annual coupon = 6%($1000) = $60, N = 10. • Semi-annual coupons: • 965 = 60/2 (PVIFAYTM/2,2(10)) +1000(PVIFYTM/2,2(10)) • 965= 30(PVIFAYTM/2,20) +1000(PVIFYTM/2,20) • -965 = PV, 1000 = FV, 30 = PMT, 20 = N, SOLVE FOR I/Y = YTM/2 = 3.24% • YTM = kd = 6.5%, kd(1-T) = 6.5%(1-.35) = 4.2%
Cost of Preferred Stock, kps • Cost of new preferred stock • kps= Dps / NPps • Dp = annual preferred stock dividend • NPps =net proceeds per share from sale of preferred stock • Preferred Stock Characteristics • Par Value, Annual Dividend Rate(% of Par) • generally: no voting rights; must be paid dividends before common dividends can be paid
Cost of Preferred Stock Example • Merck wants to sell new preferred stock. The par value will be $25 a share. Merck decides they will pay an annual dividend yield of 8%. Merck’s advisors say the stock will sell for the $25 par value if the dividend yield is 7.6% and flotation costs will be $1 a share. What is the cost of this new preferred stock. • Dps = .08($25) = $2 • NPps = $25 - $1 = $24 • kps = $2/$24 = 8.3%
Cost of Common Equity (Retained Earnings), kcs • 2 different approaches can be used to estimate the cost of equity. • The two approaches assume that the company’s stock price is in equilibrium. • Theoretically, they should equal each other.
The Dividend Growth Model • The expected return formula derived from the constant growth stock valuation model. • kcs = D1 / Pcs + g = D0(1+g)/Pcs + g • In practice: The tough part is estimating g. • Security analysts’ projections of g can be used. • According to the journal, Financial Management, these projections are a good source for growth rate estimates. • Possible Sources for g: Value Line Investment Survey and Institutional Brokers’ Estimate System (I/B/E/S)
Dividend Growth estimate for the Cost of Common Equity for Merck • Recent Stock Price (P0): $53.60 • Current Dividend (D0): $1.40 • According to Value Line Investment Survey, earnings are expected to grow by 10%, and their dividend growth estimate is 8%. • What to do? Why not go with higher one to be conservative. • Our growth estimate(g): 10% • kcs = ($1.40(1.1)/$53.60) + 10% = 12.9%
Merck’s estimated cost of new common stock, kncs • If Merck decides to sell new common stock to raise additional capital, then • Kncs = D1/NPcs + g = D0(1+g)/NPcs + g • P0: $53.60, D0: $1.40, g = 10% • Assume new stock can be sold at the current market price and Merck will incur a 15% flotation cost per share. NP = $53.60(1-.15) = $45.56 • kncs = $1.40(1.1)/$53.60(1-0.15) + 10% = $1.54/$45.56 + 0.1 = 0.133 = 13.4%
The CAPM Approach to the Cost of Common Equity • The CAPM Approach: is the required rate of return from Chapters 6 and 8. • kc = kRF + β(kM - kRF) • kRF = risk-free rate, • Β = stock’s beta, market risk. • (kM - kRF) = market return minus risk-free rate = market risk premium.
Issues in Implementing CAPM: • Must obtain estimates of kRF, B, and kM – kRF. • Can use Treasuries to estimate kRF. But what time to maturity? • Since capital budgeting involves long-term investments, 10 or 20 year T-bond rates make sense. • Many published sources of B estimates. • Value Line Investment Survey, Standard & Poor’s, and Merrill Lynch. • For kM – kRF, can use historical difference between market return and long-term T-bonds.
Merck’s CAPM Estimate for the Cost of Equity. • Example: The recent 10-yr T-bond rate is 5.2% (risk-free rate ), historical difference between S&P 500 and long-term T-bonds is 7.8% (market risk premium), and Merck’s beta from Value Line is 0.95. What is Merck’s CAPM cost of common equity? • kc = 5.2% + 0.95(7.8%) = 12.6%
Weighted Average Cost of Capital, WACC • WACC = wdkd(1-T) + wps kps + wcs kcs • wi = the fraction of capital component i used in the firm’s capital structure • What is Merck’s WACC if Merck’s target capital structure of 20% debt, 10% preferred stock, and 70% common equity financing through retained earnings?
Merck’s Weighted Average Cost of Capital, WACC with RE • Recall our previous estimates for Merck • kd(1-T) = 4.2% , kps = 8.3% , kcs = 12.9% • wd = 20% or 0.2, wps = 10% or 0.1, wcs = 70% or 0.7 • WACC = wdkd(1-T) + wps kps + wcs kcs • WACC = 0.2(4.2%) + 0.1(8.3%) + 0.7(12.9%) = 10.7%
Merck’s Weighted Average Cost of Capital, WACC with new Common Stock • What if Merck had to sell new common stock to raise common equity financing? • Recall our previous estimates for Merck • kd(1-T) = 4.2% , kps = 8.3% , kncs = 13.4% • wd = 20% or 0.2, wps = 10% or 0.1, wcs = 70% or 0.7 • WACC = wdkd(1-T) + wps kps + wcs kcs • WACC = 0.2(4.2%) + 0.1(8.3%) + 0.7(13.4%) = 11.1%
How to determine when a firm has to sell new common stock. • This depends on the amount of retained earnings (RE) available and the size of the company’s capital budget. • Maximum Capital that can be Raised with RE = RE/proportion of common equity (wcs). • If the firm’s capital budget exceeds this amount, then new common stock has to be sold and the firm incurs a higher WACC for this excess amount of capital.
How to determine when Merck has to sell new common stock. • Merck’s projected net income = $7.2 billion, projected dividend payout ratio = 45% • Merck’s available retained earnings = $7.2B (1-.45) = $4 billion. Target proportion of common equity financing = 70% or 0.7. • Maximum total financing with RE = $4 billion/0.7 = $5.7 billion. • Merck’s WACC for 0 to $5.7 billion of new capital = 10.7%. • Merck’s WACC for more than $5.7 billion of new capital = 11.1%.
Adjusting for project risk • The WACC is for average risk projects. • A company should adjust their WACC upward for more risky projects and downward for less risky projects = project’s Risk-Adjusted Cost of Capital. • A company can also make this adjustment on a divisional basis as well.
Jordan Air Inc.: a Divisional Cost of Capital Example • Jordan Air is a sporting goods apparel company which has recently divested itself from the sports franchise ownership business. • Jordan Air is starting a golf equipment division to go along with its sports apparel division. • The company uses only debt and common equity financing and thinks they should use a different cost of capital for each division.
Jordan Air Inc.: a Divisional Cost of Capital Example • The company has a 40% tax rate and uses the CAPM method for estimating the cost of equity. • Apparel Division: 35% debt and 65% equity financing. Before-tax cost of debt is 8%. Beta = 1.2. • Golf Division: 40% debt and 60% equity financing. Before-tax cost of debt 8.5%. Estimated beta = to Callaway Golf’s beta of 1.6.
Jordan Air’s Apparel Division’s Cost of Capital Calculation • The company has a 40% tax rate and uses the CAPM method for estimating the cost of equity with Krf = 4.5%, Km = 11%. • Apparel Division: 35% debt and 65% equity financing. Before-tax cost of debt is 8%. Beta = 1.2. • Kc = 4.5% + 1.2(11%-4.5%) = 12.3%. • WACC = WdKd(1-T) + WcsKc • WACC = .35(8%)(1-.4) + .65(12.3%) = 9.7%
Jordan Air’s Golf Division’s Cost of Capital Calculation • The company has a 40% tax rate and uses the CAPM method for estimating the cost of equity with Krf = 4.5%, Km = 11%. • Golf Division: 40% debt and 60% equity financing. Before-tax cost of debt 8.5%. Estimated beta = to Callaway Golf’s beta of 1.6. • Kc = 4.5% + 1.6(11%-4.5%) = 14.9% • WACC = WdKd(1-T) + WcsKc • WACC = .4(8.5%)(1-.4) + .6(14.9%) = 11.0%