Create Presentation
Download Presentation

Download Presentation
## Calculating the Cost of Capital

- - - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - - -

**Calculating the Cost of Capital**Chapter 11 Fin 325, Section 04 – Spring 2010 Washington State University**Weighted Average Cost of Capital**• The WACC formula • E, P, D are market value of equity, preferred stock, and debt, respectively. • are cost of equity, cost of preferred stock, and cost of debt. • is the appropriate corporate tax rate. • Market values reflect investors’ assessment of what they would be willing to pay for various types of securities**Cost of Equity**• Two methods for calculating the cost of equity: • CAPM • Constant Growth Model**Which Model is Better?**• In the CAPM, βE estimates future systematic risk, but we calculate it based on historic data • Needs sufficient historic information • Past level of systematic (market) risk is a good indicator of future risk • Applies more accurately in most cases • The constant growth model assumes constant perpetual growth in dividends • Some type of simple or weighted average of the two methods might be appropriate**Example**• Calculate the cost of equity for ADK Industries given the following information: • ADK common stock price = $32.75 • The next dividend is expected to be $1.54 per share • ADK expects future dividends to grow by 6 percent per year indefinitely • The risk-free rate is 3 percent • The expected return on the market is 9 percent • ADK has a beta of 1.3**Solution**• CAPM method: iE = if + βE[E(iM) – if] = .03 + 1.3[.09 - .03] = 10.80% • Constant growth model: • iE = D1/P0 + g = $1.54/$32.75 + .06 = 10.70% • The best estimate is (10.80%+ 10.70%)/2 = 10.75%**Cost of Preferred Stock**Preferred stock pays constant dividends forever, and so it can be valued as a perpetuity We can rearrange the perpetuity model to solve for iP: Note: this is the same as the constant growth model in which the value of the constant growth is g = 0**Example**• ADK has one million shares of preferred stock outstanding, which pays dividend of $7 per year and currently trades at $72 per share. What is ADK’s cost of preferred equity? iP = D/P0 = $7 / $72 = 9.72%**Cost of Debt**• We estimate the before-tax cost of debt, and then calculate the after-tax cost of debt • Note that interest paid on debt is tax deductible • To find the before-tax cost of debt we find the Yield to Maturity on the firm’s existing debt • YTM takes into account both the interest cash flows and the principal, and reflects debtholders’ required rate of return**Example**ADK has 30,000 20-year, 8 percent bonds outstanding. If the bonds currently sell for 97.5 percent of par and the firm has a marginal tax rate of 35.92 percent, what is the cost of debt for ADK? (assuming annual compounding)**If the before-tax cost of debt is 8.26 percent, then the**after-tax cost of debt is: 8.26% (1 - .3592) = 5.293% • What tax rate do we use in the WACC calculation? • We use the marginal rate.**Calculating the Weights**• We need to use the relevant market values of equity, preferred stock, and debt, represented by E, P, and D • In the ADK example, the firm has 3 million share of common stock outstanding, one million shares of preferred stock, and 30,000 bonds. • What are the relevant weights for ADK?**Equity has a total market value of**3,000,000 x $32.75 = $98,250,000 • Preferred stock has a market value of 1,000,000 x $72 = $72,000,000 • Debt has a market value of 30,000 x $975 = $29,250,000**For common equity:**E/(E+P+D) = $98,250,000 / $199,500,000 = 49.25% • For preferred stock: P/(E+P+D) = $72,000,000 / $199,500,000 = 36.09% • For debt: D/(E+P+D) = $29,250,000 / $199,500,000 = 14.66%**The WACC for ADK Industries:**= (.4925 x 10.75%) + (.3609 x 9.72%) + (.1466 x 8.26%)(1 - .3592) = 9.58%**Firm WACC vs. Project WACC**• We have calculated the firm’s overall weighted average cost of capital • This WACC will be appropriate to use in evaluating “typical” projects • If a new project is similar enough to existing projects, then the firm’s WACC is appropriate • If the new project is riskier than the firm’s average project, then a higher cost of capital should be used • If the new project is safer, then a lower cost of capital should be used to evaluate the project**Divisional WACC**• Ideally, firms would calculate a risk-appropriate WACC for every new project under consideration • Time consuming • Managers must often consider hundreds of new projects each year • Instead, large firms often calculate a divisional WACC, which consumes less time and resources but achieves many of the benefits of project-specific WACCs**Why not use a firm-wide WACC to evaluate all projects**• Incorrect reject / accept decisions • Reject most low-risk projects, both good and bad • Firm becomes riskier over time**Subjective vs. Objective Approaches to Calculating**Divisional WACCs • Subjective approach • If the projects are riskier than the firm average, adjust the WACC upward • If the projects are safer than the firm average, adjust the WACC downward • Biggest disadvantage: the amount of the adjustment is subjective**Objective approach:**• Compute the average beta per division, and use the CAPM to calculate the cost of equity for each division • Use the divisional iE to calculate the divisional WACCs • The subjective approach is used more often than the objective approach because it is easier to implement