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CHAPTER 9 The Cost of Capital

CHAPTER 9 The Cost of Capital. Cost of Capital Components Debt Preferred Common Equity WACC. What types of long-term capital do firms use?. Long-term debt Preferred stock Common equity. Capital components are sources of funding that come from investors.

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CHAPTER 9 The Cost of Capital

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  1. CHAPTER 9 The Cost of Capital • Cost of Capital Components • Debt • Preferred • Common Equity • WACC

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

  3. 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.

  4. Should we focus on before-tax or after-tax capital costs? • Tax effects associated with financing can be incorporated either in capital budgeting cash flows or in cost of capital. • Most firms incorporate tax effects in the cost of capital. Therefore, focus on after-tax costs. • Only cost of debt is affected.

  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 and investing new capital. So, we should focus on marginal costs.

  6. Cost of Debt • Method 1: Ask an investment banker what the coupon rate would be on new debt. • Method 2: Find the bond rating for the company and use the yield on other bonds with a similar rating. • Method 3: Find the yield on the company’s debt, if it has any.

  7. A 15-year, 12% semiannual bond sells for $1,153.72. What’s rd? 0 1 2 30 i = ? ... 60 60 60 + 1,000 -1,153.72 INPUTS 30 -1153.72 60 1000 5.0% x 2 = rd = 10% N I/YR PV PMT FV OUTPUT

  8. Component Cost of Debt • Interest is tax deductible, so the after tax (AT) cost of debt is: rd AT = rd BT(1 - T) = 10%(1 - 0.40) = 6%. • Use nominal rate. • Flotation costs small, so ignore.

  9. What’s the cost of preferred stock? PP = $113.10; 10%Q; Par = $100; F = $2. Use this formula:

  10. Picture of Preferred  0 1 2 rps = ? ... -111.1 2.50 2.50 2.50

  11. Note: • Flotation costs for preferred are significant, so are reflected. Use net price. • Preferred dividends are not deductible, so no tax adjustment. Just rps. • Nominal rps is used.

  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, earn a return. • Thus, there is an opportunity cost if earnings are reinvested.

  14. 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 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-Risk Premium: rs = rd + Bond RP.

  16. What’s the cost of equity based on the CAPM?rRF = 7%, RPM = 6%, b = 1.2. rs = rRF + (rM - rRF )b. = 7.0% + (6.0%)1.2 = 14.2%.

  17. Issues in Using CAPM • Most analysts use the rate on a long-term (10 to 20 years) government bond as an estimate of rRF. For a current estimate, go to www.bloomberg.com, select “U.S. Treasuries” from the section on the left under the heading “Market.” More…

  18. Issues in Using CAPM (Continued) • Most analysts use a rate of 5% to 6.5% for the market risk premium (RPM) • Estimates of beta vary, and estimates are “noisy” (they have a wide confidence interval). For an estimate of beta, go to www.bloomberg.com and enter the ticker symbol for STOCK QUOTES.

  19. What’s the DCF cost of equity, rs?Given: D0 = $4.19;P0 = $50; g = 5%.

  20. Estimating the Growth Rate • Use the historical growth rate if you believe the future will be like the past. • Obtain analysts’ estimates: Value Line, Zack’s, Yahoo!.Finance. • Use the earnings retention model, illustrated on next slide.

  21. 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?

  22. Retention growth rate:g = ROE(Retention rate) g = 0.35(15%) = 5.25%.This is close to g = 5% given earlier.

  23. Find rs using the own-bond-yield-plus-risk-premium method. (rd = 10%, RP = 4%.) • This RP  CAPM RPM. • Produces ballpark estimate of rs. Useful check. rs = rd + RP = 10.0% + 4.0% = 14.0%

  24. What’s a reasonable final estimateof rs? Method Estimate CAPM 14.2% DCF 13.8% rd + RP 14.0% Average 14.0%

  25. 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.

  26. 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...)

  27. Estimating Weights (Continued) • Suppose the stock price is $50, there are 3 million shares of stock, the firm has $25 million of preferred stock, and $75 million of debt. (More...)

  28. Vce = $50 (3 million) = $150 million. • Vps = $25 million. • Vd = $75 million. • Total value = $150 + $25 + $75 = $250 million. • wce = $150/$250 = 0.6 • wps = $25/$250 = 0.1 • wd = $75/$250 = 0.3

  29. What’s the WACC? WACC = wdrd(1 - T) + wpsrps + wcers = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1%.

  30. WACC Estimates for Some Large U. S. Corporations

  31. What factors influence a company’s WACC? • Market conditions, especially interest rates and tax rates. • The firm’s capital structure and dividend policy. • The firm’s investment policy. Firms with riskier projects generally have a higher WACC.

  32. Calculate the after-tax cost of debt under each of the following conditions: a. Interest rate, 13 percent; tax rate, 0 percent. b. Interest rate, 13 percent; tax rate, 20 percent. c. Interest rate, 13 percent; tax rate, 35 percent.

  33. The Bouchard Company’s EPS was $6.50 in 2002 and $4.42 in 1997. The company pays out 40percent of its earnings as dividends, and the stock sells for $36. a. Calculate the past growth rate in earnings. (Hint: This is a 5-year growth period.) b. Calculate the next expected dividend per share, D1. Assume that the past growth rate will continue. c. What is the cost of equity, rs, for the Bouchard Company?

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