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Fundamentals of Corporate Finance/3e,ch18


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Fundamentals of Corporate Finance/3e,ch18

  1. 1. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-1Chapter EighteenCost of Capital
  2. 2. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-218.1 The Cost of Capital: Some Preliminaries18.2 The Cost of Equity18.3 The Costs of Debt and Preference Shares18.4 The Weighted Average Cost of Capital18.5 Divisional and Project Costs of Capital18.6 Flotation Costs and the Weighted Average Costof Capital18.7 Summary and ConclusionsChapter Organisation
  3. 3. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-3Chapter Objectives• Apply the dividend growth model approach and the SMLapproach 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 theNPV of a project.
  4. 4. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-4The 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 onwhere 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 debtand the cost of equity.
  5. 5. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-5Cost of Equity• The cost of equity is the return required byequity investors given the risk of the cashflows from the firm.• There are two major methods for determining thecost of equity:– Dividend growth model– SML or CAPM.
  6. 6. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-6The Dividend Growth ModelApproach• According to the constant growth model:Rearranging:gRgDPE)(100−+=gPDRE01+=
  7. 7. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-7Example—Cost of Equity Capital:Dividend ApproachReno Co. recently paid a dividend of 15 cents pershare. This dividend is expected to grow at a rateof 3 per cent per year into perpetuity. The currentmarket price of Reno’s shares is $3.20 per share.Determine the cost of equity capital for Reno Co.( )7.8%or0.0780.03$3.201.03$0.15=+=ER
  8. 8. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-8Estimating g( )9.025%/47.6210.537.9510.00rategrowthAverage=+++=One method for estimating the growth rate is to use the historicalaverage.
  9. 9. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-9The Dividend Growth ModelApproachAdvantages• 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. 10. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-10The SML ApproachRequired return on a risky investment is dependent on threefactors:– the risk-free rate, Rf– the market risk premium, E(RM) – Rf– the systematic risk of the asset relative to the average, β[ ]fMEfE RRRR −×+= β
  11. 11. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-11Example—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. 12. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-12Example—Cost of Equity Capital:SML Approach (continued)[ ]( )%.%..%RRRR fMEfE12179474016=×+=−×β+=
  13. 13. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-13The SML ApproachAdvantages• Adjusts for risk.• Accounts for companies that don’t have a constant dividend.Disadvantages• Requires two factors to be estimated: the market riskpremium and the beta co-efficient.• Uses the past to predict the future, which may not beappropriate.
  14. 14. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-14The 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. 15. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-15Example—Cost of DebtIshta Co. sold a 20-year, 12 per cent bond 10 yearsago at par. The bond is currently priced at $86.What is our cost of debt?( )( )( )( )14.4%/2$86$100/10$86$100$12/2NPPV/NPPV=+−+=+−+=nIRDThe yield to maturity is 14.4 per cent, so this is usedas the cost of debt, not 12 per cent.
  16. 16. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-16The 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.0PDRp =
  17. 17. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-17Example—Cost of Preference Shares• An $8 preference share issue was sold 10 years ago. It sellsfor $120 per share today.• The dividend yield today is $8.00/$120 = 6.67 per cent, sothis is the cost of the preference share issue.
  18. 18. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-18The Weighted Average Cost of CapitalLet: E = the market value of equity = no.of outstanding shares × sharepriceD = the market value of debt = no. ofoutstanding bonds × priceThen: V = E + DSo: E/V + D/V = 100%That is: The firm’s capital structure weightsare E/V and D/V.
  19. 19. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-19The Weighted Average Cost ofCapital• Interest payments on debt are tax deductible, so the after-taxcost 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:( )CD TR 1debtofcosttax-After −×=( ) ( ) ( )CDE TRVDRVE 1WACC −××+×=
  20. 20. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-20Example—Weighted Average Cost ofCapitalZeus Ltd has 78.26 million ordinary shares onissue with a book value of $22.40 per share and acurrent market price of $58 per share. Themarket value of equity is therefore $4.54 billion.Zeus has an estimated beta of 0.90. Treasurybills currently yield 4.5 per cent and the marketrisk premium is assumed to be 7.94 per cent.Company tax is 30 per cent.
  21. 21. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-21Example—Weighted Average Cost ofCapital (continued)The firm has four debt issues outstanding:
  22. 22. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-22Example—Cost of Equity(SML Approach)[ ]( )%.%..%.RRRR fMEfE651194790054=×+=−×β+=
  23. 23. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-23Example—Cost of DebtThe weighted average cost of debt is 7.15 per cent.
  24. 24. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-24Example—Capital Structure Weights• Market value of equity = 78.26 million × $58 = $4.539 billion.• Market value of debt = $1.474 billion.( ) ( )9.32%or0.09320.3010.07150.2450.11650.755WACC75.5%or0.755$6.013b$4.539b24.5%or0.245$6.013b$1.474bbillion$6.013billion$1.474billion$4.539=−×+======+=VEVDV
  25. 25. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-25WACC• The WACC for a firm reflects the risk and the target capitalstructure to finance the firm’s existing assets as a whole.• WACC is the return that the firm must earn on its existingassets to maintain the value of its shares.• WACC is the appropriate discount rate to use for cash flowsthat are similar in risk to the firm.
  26. 26. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-26Divisional and Project Costs ofCapital• When is the WACC the appropriate discount rate?– When the project’s risk is about the same as the firm’srisk.• Other approaches to estimating a discount rate:– divisional cost of capital—used if a company has morethan one division with different levels of risk– pure play approach—a WACC that is unique to aparticular project is used– subjective approach—projects are allocated to specificrisk classes which, in turn, have specified WACCs.
  27. 27. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-27The SML and the WACCExpectedreturn (%)BetaSMLWACC = 15%= 8%IncorrectacceptanceIncorrectrejectionBA161514Rf =7A = .60 firm = 1.0 B = 1.2If a firm uses its WACC to make accept/reject decisions for all types of projects, it will have atendency towards incorrectly accepting risky projects and incorrectly rejecting less riskyprojects.
  28. 28. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-28Example—Using WACC for allProjects• What would happen if we use the WACC for allprojects regardless of risk?• Assume the WACC = 15 per centProject Required Return IRR DecisionA 15% 14% RejectB 15% 16% Accept• Project A should be accepted because its risk is low (Beta =0.60), whereas Project B should be rejected because its riskis high (Beta = 1.2).
  29. 29. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-29The SML and the SubjectiveApproachExpectedreturn (%)BetaSML20WACC = 1410Rf = 7Low risk(–4%)Moderate risk(+0%)High risk(+6%)AWith the subjective approach, the firm places projects into one of several risk classes. The discountrate 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.= 8%
  30. 30. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-30Flotation Costs• The issue of debt or equity may incur flotation costs such asunderwriting fees, commissions, listing fees.• Flotation costs are relevant expenses and need to bereflected in any analysis.DEA fVDfVEf ×+×=
  31. 31. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-31Example—Project Cost includingFlotation CostsSaddle Co. Ltd has a target capital structure of 70per cent equity and 30 per cent debt. Theflotation costs for equity issues are 15 per cent ofthe amount raised and the flotation costs for debtissues are 7 per cent. If Saddle Co. Ltd needs$30 million for a new project, what is the ‘truecost’ of this project?( ) ( )12.6%0.070.300.150.70=×+×=AfThe weighted average flotation cost is 12.6 percent.
  32. 32. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-32Example—Project Cost includingFlotation Costs (continued)( )( )million$34.320.1261$30mprojectofcostTruemillion$30costsflotationignoringcostProject=−==
  33. 33. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-33Example—Flotation Costs and NPV• Apollo Co. Ltd needs $1.5 million to finance a new projectexpected to generate annual after-tax cash flows of $195 800forever. The company has a target capital structure of 60 percent equity and 40 per cent debt. The financing optionsavailable are:– An issue of new ordinary shares. Flotation costs of equityare 12 per cent of capital raised. The return on newequity is 15 per cent.– An issue of long-term debentures. Flotation costs of debtare 5 per cent of the capital raised. The return on newdebt is 10 per cent.• Assume a corporate tax rate of 30 per cent.
  34. 34. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-34Example—NPV (No Flotation Costs)( ) ( )322$159000500$10.118800$195NPV11.8%or0.1180.3010.10.415%0.6WACC=−==−×+=
  35. 35. Copyright  2004 McGraw-Hill AustraliaPty Ltd18-35Example—NPV (With Flotation Costs)( ) ( )( )$7340982651$1-0.118800$195NPV982651$10.0921000500$1costTrue9.2%or0.0920.−==×+×=AfFlotation costs decrease a project’s NPV andcould alter an investment decision.