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Cost of Capital.pptx
- 1. | COST OF CAPITAL
- 2. LEARNING OBJECTIVES 1 4 5 2 3 How to determine a firm’s cost of equity capital How to determine a firm’s cost of debt How to determine a firm’s overall cost of capital How to correctly include flotation costs in capital budgeting projects Some of the pitfalls associated with a firm’s overall cost of capital & what to do about them
- 3. The Cost of Capital: Some Preliminaries
- 4. The Cost of Equity The Dividend Growth Model Approach The Security Market Line (SML) Approach “The return that equity investors require on their investment in the firm” Approaches to determining the cost of equity
- 5. The Dividend Growth Model Approach 𝐏𝟎 = 𝐃𝟎 ∗ (𝟏 + 𝐠) 𝐑𝐞 − 𝐠 = 𝐃𝟏 𝐑𝐞 − 𝐠 g = Dividend growth rate 𝑃0= Price per share of the stock 𝐷0= Dividend just paid 𝐷1= Next period’s projected dividend 𝑅𝑒= Required return on the stock 𝐑𝐞 = 𝐃𝟏 𝐏𝟎 + 𝐠
- 6. Implementing the Approach Ex: Greater States Public Service, a large public utility, paid a dividend of $4 per share last year. The stock currently sells for $60 per share. You estimate that the dividend will grow steadily at a rate of 6 percent per year into the indefinite future. What is the cost of equity capital for Greater States? • Expected dividend for the coming year 𝑫𝟏 = 𝑫𝟎∗ (𝟏 + 𝒈) $4 *1.06 $4.24 • Given this, the cost of equity, R E , is: 𝑹𝒆 = 𝑫𝟏 𝑷𝟎 + 𝒈 $4.24/60 + .06 13.07% • The cost of equity is 13.07 %.
- 7. Estimating g Use historical growth rates (Arithmetic Average) Use analysts’ forecasts of future growth rate (Geometric Average) Methods of estimating g
- 8. Arithmetic Average Year Dividend 2005 $1.10 2006 $1.2 2007 $1.35 2008 $1.4 2009 $1.55 =$.10/1.10 =9.09% In 2006 for example, the dividend rose from $1.10 to $1.20. Dividends for previous 5 yrs Year Dividend Dollar Change Percentage change 2005 $1.10 - 2006 $1.2 $0.10 9.09% 2007 $1.35 $0.15 12.5% 2008 $1.4 $0.05 3.7% 2009 $1.55 $0.15 10.71% = (9.09+12.5+3.7+10.71)/4 = 9% Average of four growth rates Percentage change in dividend each year
- 9. Geometric Average $1.10 is the present value and $1.55 is the future value. 𝐹𝑉4= 𝑃0 (1+i)4 1.55=1.1(1+i) 4 i=8.95% Average=8.95% $1.10 is the present value and $1.55 is the future value. Time Value of Money Problem 𝑭𝑽𝟒= 𝑷𝟎 (1+i) 4 1.55=1.1(1+i) 4 i=8.95% Average=8.95%
- 10. Advantages & Disadvantages of the Approach Advantages • Simplicity Disadvantages • Applicable only to companies that pay dividends • Estimated cost of equity is very sensitive to the estimated growth rate • Does not explicitly consider risk
- 11. SML Approach 𝑹𝒆 = 𝑹𝒇 + 𝜷𝒆*(𝑹𝒎-𝑹𝒇) 𝑅𝑓 = The risk-free rate (𝑅𝑚-𝑅𝑓) = market risk premium β = The systematic risk of the asset relative to average (beta coefficient) 𝑅𝑒 = Expected return on the company’s equity
- 12. Implementing the Approach Ex: The market risk premium (based on large common stocks) is 7 percent and U.S. treasury bills are paying about 1.83 percent, eBay had an estimated beta of 2.13 .Estimate eBay’s cost of equity. 𝑹𝒆 = 𝑹𝒇 + 𝜷𝒆*(𝑹𝒎-𝑹𝒇) =1.83% 2.13 7% =16.74% • The cost of equity is 16.74 %.
- 13. Advantages & Disadvantages of the Approach Advantages • Explicitly adjusts for risk • Applicable to companies other than steady dividend growth Disadvantages • SML approach depend on market risk premium and the beta coefficient
- 14. Question Ex: Suppose stock in Alpha Air Freight has a beta of 1.2. The market risk premium is 7 percent, and the risk-free rate is 6 percent. Alpha’s last dividend was $2 per share, and the dividend is expected to grow at 8 percent indefinitely. The stock currently sells for $30. What is Alpha’s cost of equity capital?
- 15. The Costs of Debt and Preferred Stock
- 16. The Cost of Debt • The effective rate that company pays on its current debt (Ex: Financial bonds) • Usually focus on the cost of long term debt or bonds • Cost of debt can normally be observed either directly or indirectly • The cost of debt is NOT the coupon rate • The required return is best estimated by computing the yield-to-maturity on the existing debt “The return that lenders require on the firm’s debt. ”
- 17. Question Ex: Company has a $1 million loan with a 5% interest rate & a $200,000 loan with a 6% rate. It has also issued bonds worth $2 million at a 7% rate. Find the Company’s Cost of Debt. Company’s Cost of Debt = Total Interest for the year *100 Total debt for the year 1st loan interest = $ 50,000 2nd loan interest= $ 12,000 Bond interest = $ 140,000 Total interest for the year = $ 202,000 Total debt for the year = $ 3.2 Million • Company’s Cost of Debt is 6.31%
- 18. Cost of Preferred Stock RP = D / P0 • Preferred stock has a fixed dividend paid every period forever (perpetuity) RP = D / P0 D =Fixed Dividend P0 = Current price per share of the preferred stock • Cost of preferred stock is simply equal to the dividend yield on the preferred stock • Cost of preferred stock can estimate by observing the required returns on similarly rated shares of preferred stock
- 19. Question Ex: Company has preferred stock that has an annual dividend of $3. If the current price is $25, what is company’s cost of preferred stock? Ex: Company has 2 issues of ordinary preferred stock. One issue paid $1.30 annually per share sold for $21.05 per share.Other paid $1.46 per share annually sold for $24.35 per share. What is company’s cost of preferred stock? RP = D / P0 company’s cost of preferred stock is 12% = $ 3 / $ 25 RP = D / P0 RP = D / P0 = $ 1.30 / $ 21.05 = $ 1.46 / $ 24.35 = 6.2% = 6% • Company’s cost of preferred stock is 6.1%
- 20. The Weighted Average Cost of Capital
- 21. Capital Structure Weights RP = D / P0 Total Capitalization = Long term debt + Equity E = Market value of firm’s Equity = No. of shares outstanding * Price per share D = Market value of firm’s Debt = No. of bonds outstanding * Market price of a single bond V = Combined market value of debt and equity V = E +D Divide by V, 100% = E/V + D/V Capital Structure Weights
- 22. Capital Structure Weights (cont.) Ex: The total market value of a company’s stock were calculated as $200 million and the total market value of the company’s debt were calculated as $50 million, then the combined value would be $250 million. E = $200 mn D = $50 mn V = E + D = $250 mn E/V = $200mn/$250mn = 80% • Therefore, Debt percentage = 100 – 80 = 20% • So, 80 percent of the firm’s financing would be equity and the remaining 20 percent would be debt
- 23. Taxes and WACC Ex: Suppose a firm borrows $1 million at 9% interest. The corporate tax rate is 34%. What is the after tax interest rate on this loan? • Total interest = $1 mn * 9% = $90 000 • Reduction in tax bill = $90 000 * 34% = $30 600 • After tax interest bill = $90 000 - $30 600 = $50 400 • After tax interest rate = $50 400/$1mn = 5.94%
- 24. Taxes and WACC (Cont.) RP = D / P0 • In general, • 𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 𝑃𝑟𝑒𝑡𝑎𝑥 𝑟𝑎𝑡𝑒 ∗ 1 − 𝑇𝑎𝑥 𝑟𝑎𝑡𝑒 𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 𝑅𝐷 × (1 − 𝑇𝐶) RD = Pretax Rate TC = Corporate tax
- 25. RP = D / P0 Taxes and WACC (Cont.) RP = D / P0 • 𝑊𝐴𝐶𝐶 = 𝐸 𝑉 × 𝑅𝐸 + 𝐷 𝑉 × 𝑅𝐷 × 1 − 𝑇𝐶 𝑅𝐸 = Cost of Equity 𝑅𝐷 = 𝑃𝑟𝑒𝑡𝑎𝑥 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡 𝑅𝑃 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑆𝑡𝑜𝑐𝑘 𝑇𝐶 = 𝐶𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑇𝑎𝑥 If preferred stock is included in the capital structure, 𝑊𝐴𝐶𝐶 = 𝐸 𝑉 × 𝑅𝐸 + 𝑃 𝑉 × 𝑅𝑃 + 𝐷 𝑉 × 𝑅𝐷 × 1 − 𝑇𝐶
- 26. Weighted Average Cost of Capital (WACC) • The overall return the firm must earn on its existing assets to maintain the value of its stock • The required return on any investments by the firm that have essentially the same risks as existing operations
- 27. Question Ex: The B.B. Lean Co. has 1.4 million shares of stock outstanding. The stock currently sells for $20 per share. The firm’s debt is publicly traded and was recently quoted at 93% of face value. It has a total face value of $5 million, and it is currently priced to yield 11%. The risk-free rate is 8%, and the market risk premium is 7%. You’ve estimated that Lean has a beta of .74. If the corporate tax rate is 34%, what is the WACC of Lean Co.?
- 28. Divisional and Project Costs of Capital
- 29. Divisional and Project Cost of Capital The SML and WACC If a firm uses its WACC to make accept–reject decisions for all types of projects, it will have a tendency toward incorrectly accepting risky projects and incorrectly rejecting less risky projects. Expected Return Beta 16 15 14 𝛽𝑓𝑖𝑟𝑚 = 1.0 𝛽𝐴 = 0.6 𝛽𝐵 = 1.2 A B Incorrect Acceptanc e Incorrec t Rejectio n SML WAC C 𝑅𝑓 = 7
- 30. Divisional and Project Cost of Capital (Cont.) Is Project A desirable? Yes Is Project B desirable? NO 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛 = 𝑅𝑓 + 𝛽𝐴 × 𝑅𝑚 − 𝑅𝑓 = 7% + 0.6 × 8% = 11.8% Given its level of systematic risk, its return is inadequate
- 31. Divisional and Project Cost of Capital (Cont.) Divisional Cost of Capital • Imagine, for example, a corporation that has two divisions: a regulated telephone company and an electronics manufacturing operation. The first of these (the phone operation) has relatively low risk; the second has relatively high risk. • In this case, the firm’s overall cost of capital is really a mixture of two different costs of capital, one for each division. If the two divisions were competing for resources, and the firm used a single WACC as a cutoff, which division would tend to be awarded greater funds for investment? • The answer is that the riskier division would tend to have greater returns (ignoring the greater risk), so it would tend to be the “winner.” The less glamorous operation might have great profit potential that would end up being ignored. • Hence, separate divisional costs of capital are developed.
- 32. Divisional and Project Cost of Capital (Cont.) Divisional Cost of Capital Pure Play Approach The use of a WACC that is unique to a particular project, based on companies in similar lines of business. Subjective Approach An approach that involves making subjective adjustments to overall WACC. Firm places projects into one of several risk classes. Discount rate used to value the project is then determined by adding (high risk)/subtracting (low risk) an adjustment factor to or from firm’s WACC. Results fewer incorrect decisions than firm simply used WACC to make
- 33. Divisional and Project Cost of Capital (Cont.) Example: Category Examples Adjustment Factor Discount Rate High Risk New Products +6% 20% Moderate Risk Cost savings. Expansion of existing lines +0 14% Low Risk Replacement of existing equipment -4% 10% Mandatory Pollution Control Equipment n/a n/a Suppose a firm has an overall WACC of 14%.
- 34. Divisional and Project Cost of Capital (Cont.) Low Risk (- 4%) Moderate Risk (+0%) High Risk (+6%) Beta Expected Return 2 0 WACC = 14 10 𝑅𝑓 = 7 A
- 35. Flotation Costs and the Weighted Average Cost of Capital
- 37. THANK YOU
Editor's Notes
- The easiest way to estimate the cost of equity capital Re is the return that the shareholders require on the stock, it can be interpreted as the firm’s cost of equity capital.
- To use the dividend growth model
- observe dividends for the previous, say, fi ve years, calculate the year-to-year growth rates, and average them.
- Geometric average (8.95) is lower than the arithmetic average (9) but the difference here is not likely to be of any practical significance. In general, if the dividend has grown at a relatively steady rate, as we assume when we use this approach, then it can’t make much difference which way we calculate the average dividend growth rate.
- Advantages easy to understand and easy to use Disadvantages 1)Even for companies that pay dividends, the key underlying assumption is that the dividend grows at a constant rate 2)For a given stock price, an upward revision of g by just one percentage point increases the estimated cost of equity by at least a full percentage point 3) here is no allowance for the degree of certainty or uncertainty surrounding the estimated growth rate for dividends. As a result, it is difficult to say whether or not the estimated return is prapotionate with the level of risk
- In Risk,return & security market line chapter Our primary conclusion was that the required or expected return on a risky investment depends on three things: The risk-free rate, R f . 2. The market risk premium, E ( R M ) - R f . 3. The systematic risk of the asset relative to average, which we called its beta coeffi cient, . Using the SML, we can write the expected return on the company’s equity, E ( R E ), as:
- Advantages 1) useful in a wider variety of circumstances. Disadvantages To the extent that estimates are poor, the cost of equity will be inaccurate. For example, our estimate of the market risk premium, 7 percent, is based on about 100 years of returns on particular stock portfolios and markets. Using different time periods or different stocks and markets could result in very different estimates.
- In addition to ordinary equity, firms use debt and, to a lesser extent, preferred stock to finance their investments. As we discuss next, determining the costs of capital associated with these sources of financing is much easier than determining the cost of equity.
- 1)The cost of debt is simply the interest rate the firm must pay on new borrowing, Ex:if the firm already has bonds outstanding, then the yield to maturity on those bonds is the market required rate on the firm’s debt. A alternatively, if we know that the firm’s bonds are rated, say, AA, then we can simply find the interest rate on newly issued AA-rated bonds. Either way, there is no need to estimate a beta for the debt because we can directly observe the rate we want to know . 2)That rate just tells us roughly what the firm’s cost of debt was back when the bonds were issued, not what the cost of debt is today. This is why we have to look at the yield on the debt in today’s marketplace. For consistency with our other notation, we will use the symbol R D for the cost of debt.
- 2) Alternatively, because preferred stocks are rated in much the same way as bonds,
- Advantages easy to understand and easy to use Disadvantages 1)Even for companies that pay dividends, the key underlying assumption is that the dividend grows at a constant rate 2)For a given stock price, an upward revision of g by just one percentage point increases the estimated cost of equity by at least a full percentage point 3) here is no allowance for the degree of certainty or uncertainty surrounding the estimated growth rate for dividends. As a result, it is difficult to say whether or not the estimated return is prapotionate with the level of risk
- Advantages 1) useful in a wider variety of circumstances. Disadvantages To the extent that estimates are poor, the cost of equity will be inaccurate. For example, our estimate of the market risk premium, 7 percent, is based on about 100 years of returns on particular stock portfolios and markets. Using different time periods or different stocks and markets could result in very different estimates.
- Advantages 1) useful in a wider variety of circumstances. Disadvantages To the extent that estimates are poor, the cost of equity will be inaccurate. For example, our estimate of the market risk premium, 7 percent, is based on about 100 years of returns on particular stock portfolios and markets. Using different time periods or different stocks and markets could result in very different estimates.
- observe dividends for the previous, say, fi ve years, calculate the year-to-year growth rates, and average them.
- Advantages 1) useful in a wider variety of circumstances. Disadvantages To the extent that estimates are poor, the cost of equity will be inaccurate. For example, our estimate of the market risk premium, 7 percent, is based on about 100 years of returns on particular stock portfolios and markets. Using different time periods or different stocks and markets could result in very different estimates.