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Principles of Business Finance Fin 510

Principles of Business Finance Fin 510. Dr. Lawrence P. Shao Marshall University Spring 2002. CHAPTER 9 The Cost of Capital. Cost of capital components Accounting for flotation costs WACC Adjusting cost of capital for risk Estimating project risk.

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Principles of Business Finance Fin 510

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  1. Principles of Business FinanceFin 510 Dr. Lawrence P. Shao Marshall University Spring 2002

  2. CHAPTER 9The Cost of Capital • Cost of capital components • Accounting for flotation costs • WACC • Adjusting cost of capital for risk • Estimating project risk

  3. What types of long-term capital do firms use? Long-term debt Preferred stock Common equity: Retained earnings New common stock

  4. Should we focus onbefore-taxorafter-taxcapital costs? Stockholders focus on A-T CFs. Thus, focus on A-T capital costs, i.e., use A-T costs in WACC. Only kd needs adjustment.

  5. Should we focus on historical (embedded) costs or new (marginal) costs? The cost of capital is used primarily to make decisions which involve raising new capital. So, focus on today’s marginal costs (for WACC).

  6. Component Cost of Debt • Interest is tax deductible, so kd AT = kd BT(1 - T) = 10%(1 - 0.40) = 6%. • Use nominal rate. • Flotation costs small. Ignore.

  7. What’s the cost of preferred stock? Pp = $111.10; 10%Q; Par = $100. Use this formula:

  8. Note: • Preferred dividends are not tax deductible, so no tax adjustment. Just kp. • Nominal kp is used. • Our calculation ignores flotation costs.

  9. Is preferred stock more or less risky to investors than debt? • More risky; company not required to pay preferred dividend. • However, firms try to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, (3) preferred stockholders may gain control of firm.

  10. Why is yield on preferred lower than kd? • Corporations own most preferred stock, because 70% of preferred dividends are nontaxable to corporations. • Therefore, preferred often has a lower B-T yield than the B-T yield on debt. • The A-T yield to an investor, and the A-T cost to the issuer, are higher on preferred than on debt. Consistent with higher risk of preferred.

  11. Example: kp = 9% kd = 10% T = 40% kp, AT = kp - kp (1 - 0.7)(T) = 9% - 9%(0.3)(0.4) = 7.92%. kd, AT = 10% - 10%(0.4) = 6.00% A-T Risk Premium on Preferred = 1.92%

  12. Three ways to determine cost of common stock, ks: 1.CAPM: ks = kRF + (kM - kRF)b. 2.DCF: ks = D1/P0 + g. 3.Own-Bond-Yield-Plus-Risk Premium: ks = kd + RP.

  13. What’s the cost of common stock based on the CAPM?kRF = 7%, MRP = 6%, b = 1.2. ks = kRF + (kM - kRF )b. = 7.0% + (6.0%)1.2 = 14.2%.

  14. What’s the DCF cost of commonstock, ks? Given: D0 = $4.19;P0 = $50; g = 5%.

  15. Suppose the company has been earning 15% on equity (ROE = 15%) and retaining 35% (dividend payout = 65%), and this situation is expected to continue.What’s the expected future g?

  16. Retention growth rate:g = b(ROE) = 0.35(15%) = 5.25%.Here b = Fraction retained.Close to g = 5% given earlier. Think of bank account paying 10% with b = 0, b = 1.0, and b = 0.5. What’s g?

  17. Could DCF methodology be applied if g is not constant? • YES, nonconstant g stocks are expected to have constant g at some point, generally in 5 to 10 years. • But calculations get complicated.

  18. Find ks using the own-bond-yield-plus-risk-premium method. (kd = 10%, RP = 4%.) • This RP ¹ CAPM RP. • Produces ballpark estimate of ks. Useful check. ks = kd + RP = 10.0% + 4.0% = 14.0%

  19. What’s a reasonable final estimate of ks?

  20. Why is the cost of retained earnings cheaper than the cost of issuing new common stock? 1. When a company issues new common stock they also have to pay flotation costs to the underwriter. 2. Issuing new common stock may send a negative signal to the capital markets, which may depress stock price.

  21. What’s the firm’s WACC (ignoring flotation costs)? WACC = wdkd(1 - T) + wpkp + wcks = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1%.

  22. What factors influence a company’s composite WACC? • Market conditions. • The firm’s capital structure and dividend policy. • The firm’s investment policy. Firms with riskier projects generally have a higher WACC.

  23. Company WACC Intel 13.6% General Electric 12.7 Walt Disney 12.6 Motorola 11.5 AT&T 10.7 Exxon 10.4 Wal-Mart 9.9 Coca-Cola 9.7 H. J. Heinz 9.5 BellSouth 8.9 WACC Estimates for Some Large U.S. Corporations

  24. Should the company use the composite WACC as the hurdle rate for each of its projects? • NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the “hurdle rate” for a typical project with average risk. • Different projects have different risks. The project’s WACC should be adjusted to reflect the project’s risk.

  25. Risk and the Cost of Capital

  26. Divisional Cost of Capital

  27. How is each type of risk used? • Market risk is theoretically best in most situations. • However, creditors, customers, suppliers, and employees are more affected by corporate risk. • Therefore, corporate risk is also relevant.

  28. Find the division’smarket riskand cost of capital based on theCAPM, given these inputs: • Target debt ratio = 50%. • kd = 12%. • kRF = 7%. • Tax rate = 40%. • betaProject = 1.7. • Market risk premium = 6%.

  29. Beta = 1.7, so project has more market risk than average. • Project’s required return on equity: ks = kRF + (kM - kRF)bp = 7% + (6%)1.7 = 17.2%. WACCp = wdkd(1 - T) + wcks = 0.5(12%)(0.6) + 0.5(17.2%) = 12.2%.

  30. How does the project’s market risk compare with the firm’s overall market risk? • Division WACC = 12.2% versus company WACC = 11.1%. • Indicates that the division’s market risk is greater than firm’s average project. • “Typical” projects within this division would be accepted if their returns are above 12.2%.

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