Ch09 the Cost of Capital

8/20/2019 Ch09 the Cost of Capital

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CHAPTER 9

The Cost of Capital


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Topics in Chapter Cost of capital components

Debt

Preferred stock

Common equit

!ACC

"actors that a#ect !ACC

Ad$ustin% cost of capital for risk


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Value = + + ··· +FCF1 FCF2 FCF∞

(1 + WACC)1 (1 +WACC)∞

(1 + WACC)2

Free cash fow(FCF)

Market interest rates

Firms !usiness risk Market risk a"ersion

Firms #e!t$e%uit& mi'Cost o #e!t

Cost o e%uit&

Weihte# a"erae

cost o ca*ital(WACC)

et o*eratin*ro,t ater ta'es

-e%uire# in"estmentsin o*eratin ca*ital

.

=

/eterminants o 0ntrinsic Valuehe Weihte# A"erae Cost o Ca*ital


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!hat tpes of lon%'term

capital do (rms use) *on%'term debt

Preferred stock

Common equit


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Capital Components Capital components are sources of fundin%

that come from in,estors-

Accounts paable. accruals. and deferredta/es are not sources of fundin% that comefrom in,estors. so the are not included inthe calculation of the cost of capital-

!e do ad$ust for these items 0hencalculatin% the cash o0s of a pro$ect. butnot 0hen calculatin% the cost of capital-


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3efore'ta/ ,s- After'ta/

Capital Costs Ta/ e#ects associated 0ith

(nancin% can be incorporated

either in capital bud%etin% casho0s or in cost of capital-

4ost (rms incorporate ta/ e#ects

in the cost of capital- Therefore.focus on after'ta/ costs- 5nl cost of debt is a#ected-


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Historical 7Embedded8Costs ,s- e0 74ar%inal8Costs The cost of capital is used

primaril to make decisions 0hich

in,ol,e raisin% and in,estin% ne0capital- :o. 0e should focus onmar%inal costs-


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Cost of Debt 4ethod 1< Ask an in,estment

banker 0hat the coupon rate

0ould be on ne0 debt- 4ethod 2< "ind the bond ratin% for

the compan and use the ield on

other bonds 0ith a similar ratin%- 4ethod =< "ind the ield on the

compan>s debt. if it has an-


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A 1+'ear. 12? semiannualbond sells for @1.1+=-62-

!hat>s rd)

B 1.

1 2 =rd )

'1.1+=-62---

= '11+=-62 1

+-? / 2 rd 1?

FR PG "GP4TPT:

5TPT


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Component Cost of Debt nterest is ta/ deductible. so the

after ta/ 7AT8 cost of debt is<

rd AT rd 3T71 I T8

rd AT 1?71 I -&8 ?-

se nominal rate-

"lotation costs small. so i%nore-


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Cost of preferred stock< Pps

@11-9+J 1?KJ Par @1J "

+?

se this formula<

r ps =Dps

Pps (1 – F)=

0.1($100)

$116.95(1 – 0.05)

= $10

$111.10= 0.090 =

9.0%


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Time *ine of Preferred

2-+ 2-+2-+

1 2 Lrps )

'111-1---

@111-1 DK

rPer

@2-+

rPer

rPer @2-+

@111-1 2-2+?J rps7om8 2-2+?7&8

9?


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1=

ote< "lotation costs for preferred are

si%ni(cant. so are reected- se

net price- Preferred di,idends are not

deductible. so no ta/ ad$ustment-

Must rps- ominal rps is used-


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s preferred stock more orless risk to in,estors thandebt) 4ore riskJ compan not required

to pa preferred di,idend-

Ho0e,er. (rms 0ant to papreferred di,idend- 5ther0ise. 718cannot pa common di,idend. 728

diNcult to raise additional funds.and 7=8 preferred stockholders ma%ain control of (rm-


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!h is ield on preferred lo0er than r

d)

Corporations o0n most preferred stock.because 6? of preferred di,idends are

nonta/able to corporations- Therefore. preferred often has a lo0er

3'T ield than the 3'T ield on debt-

The A'T ield to in,estors and A'T cost tothe issuer are hi%her on preferred thanon debt. 0hich is consistent 0ith thehi%her risk of preferred-


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E/ample<r

ps

9?. rd

1?. T

&?

rps. AT rps – rps71 – -687T8

9? – 9?7-=87-&8 6-92?

rd. AT 1? – 1?7-&8 -?

A'T Risk Premium on Preferred 1-92?


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!hat are the t0o 0as thatcompanies can raise common

equit) Directl. b issuin% ne0 shares of

common stock-

ndirectl. b rein,estin% earnin%sthat are not paid out as di,idends7i-e-. retainin% earnin%s8-


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!h is there a cost forrein,ested earnin%s)

Earnin%s can be rein,ested or paidout as di,idends-

n,estors could bu othersecurities. earnin% a return-

Thus. there is an opportunit cost

if earnin%s are rein,ested-


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Cost for Rein,estedEarnin%s 7Continued8

5pportunit cost< The returnstockholders could earn on

alternati,e in,estments of equal risk- The could bu similar stocks and

earn rs. or compan could repurchase

its o0n stock and earn rs- :o. rs. isthe cost of rein,ested earnin%s and itis the cost of common equit-


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Three 0as to determinethe cost of equit. r

s

<

1- CAP4< rs rR" B 7r4 – rR"8b

rR" B 7RP48b-

2- DC"< rs D1P B %-

=- 50n'3ond'Field'Plus' Mud%mental'Risk Premium< rs rd

B 3ond RP-


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CAP4 Cost of Equit< rR" +-?.

RP4 ?. b 1-2

rs rR" B 7RP4 8b

+-? B 7-?81-2 12-;?-


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ssues in sin% CAP4

4ost analsts use the rate ona lon%'term 71 to 2 ears8

%o,ernment bond as anestimate of rR"-

(More…)


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2=

ssues in sin% CAP47Continued8

4ost analsts use a rate of =-+?to ? for the market risk

premium 7RP48 Estimates of beta ,ar. and

estimates are Onois 7the

ha,e a 0ide con(denceinter,al8-


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DC" Cost of Equit. rs<

D @=-2J P @+J %

+-;?

rs

D1

PB %

D71 B %8

PB %

@=-1271-+;8

@+

B -+;

-? B +-;?

12-&?


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Estimatin% the Qro0thRate

se the historical %ro0th rate ifou belie,e the future 0ill be like

the past- 5btain analsts> estimates< Galue

*ine. acks. FahooS"inance-

se the earnin%s retention model.illustrated on ne/t slide-


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Earnin%s Retention 4odel

:uppose the compan has beenearnin% 1+? on equit 7R5E

1+?8 and has been pain% out2? of its earnin%s-

f this situation is e/pected to

continue. 0hat>s the e/pectedfuture %)


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Earnin%s Retention 4odel7Continued8

Qro0th from earnin%s retentionmodel<

% 7Retention rate87R5E8% 71 I Paout rate87R5E8

% 71 I -2871+?8 +-6?-

This is close to % +-;? %i,enearlier-


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Could DC" methodolo%be applied if % is notconstant) FE:. nonconstant % stocks are

e/pected to ha,e constant % at

some point. %enerall in + to 1ears-

3ut calculations %et complicated-

:ee the Web 9A 0orksheet in the(le Ch09 Tool Kit.xls-


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The 50n'3ond'Field'Plus'Mud%mental'Risk'Premium 4ethod< rd 1?. RP =-2?

rs rd B Mud%mental risk premium rs 1-? B =-2? 1=-2?

This o,er'o0n'bond'$ud%mental'riskpremium ≠ CAP4 equit risk

premium. RP4- Produces ballpark estimate of rs-

seful check-


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!hat>s a reasonable (nalestimate of r

s

)

4ethod Estimate

CAP4 12-;?

DC" 12-&?

rd B $ud%ment 1=-2?

A,era%e 12-;?


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Determinin% the !ei%htsfor the !ACC

The 0ei%hts are the percenta%esof the (rm that 0ill be (nanced

b each component- f possible. al0as use the tar%et

0ei%hts for the percenta%es of

the (rm that 0ill be (nanced 0iththe ,arious tpes of capital-


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Estimatin% !ei%hts for theCapital :tructure

f ou don>t kno0 the tar%ets. it isbetter to estimate the 0ei%hts usin%

current market ,alues than currentbook ,alues-

f ou don>t kno0 the market ,alue

of debt. then it is usuall reasonableto use the book ,alues of debt.especiall if the debt is short'term-

(More…)


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Estimatin% !ei%hts7Continued8

:uppose the stock price is @+.there are = million shares of stock.

the (rm has @2+ million ofpreferred stock. and @6+ million ofdebt-

(More…)


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=&


Gs @+7= million8 @1+

million-

Gps @2+ million-

Gd @6+ million-

Total ,alue @1+ B @2+ B @6+ @2+ million-


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=+


0s @1+@2+ -

0ps @2+@2+ -1

0d @6+@2+ -=

The tar%et 0ei%hts for this compan arethe same as these market ,alue 0ei%hts.but often market 0ei%hts temporarilde,iate from tar%ets due to chan%es instock prices-


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!hat>s the !ACC usin%the tar%et 0ei%hts)

!ACC 0drd71 I T8 B 0psrps B 0srs

!ACC -=71?871 -&8 B -179?8

B -712-;?8

!ACC 1-=;? 3 1-&?


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!hat factors inuence acompan>s !ACC)

ncontrollable factors< 4arket conditions. especiall interest rates-

The market risk premium- Ta/ rates-

Controllable factors< Capital structure polic-

Di,idend polic- n,estment polic- "irms 0ith riskier pro$ects

%enerall ha,e a hi%her cost of equit-


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=;

s the (rm>s !ACC correctfor each of its di,isions)

5S The composite !ACC reectsthe risk of an a,era%e pro$ect

undertaken b the (rm- Di#erent di,isions ma ha,e

di#erent risks- The di,ision>s

!ACC should be ad$usted to reectthe di,ision>s risk and capitalstructure-


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=9

The Risk'Ad$ustedDi,isional Cost of Capital

Estimate the cost of capital thatthe di,ision 0ould ha,e if it 0ere

a stand'alone (rm- This requires estimatin% the

di,ision>s beta. cost of debt. and

capital structure-


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Pure Pla 4ethod forEstimatin% 3eta for a Di,ision

or a Pro$ect "ind se,eral publicl traded

companies e/clusi,el in pro$ect>s

business- se a,era%e of their betas as

pro/ for pro$ect>s beta-

Hard to (nd such companies-


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Accountin% 3eta 4ethodfor Estimatin% 3eta

Run re%ression bet0een pro$ect>sR5A and :UP nde/ R5A-

Accountin% betas are correlated7-+ I -8 0ith market betas-

3ut normall can>t %et data on

ne0 pro$ects> R5As before thecapital bud%etin% decision hasbeen made-


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Di,isional Cost of Capitalsin% CAP4

Tar%et debt ratio 1?-

rd 12?-

rR" +-?-

Ta/ rate &?-

betaDi,ision 1-6- 4arket risk premium ?-


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Di,isional Cost of Capitalsin% CAP4 7Continued8

Di,ision>s required return on equit<

rs rR" B 7r4 I rR"8bDi,-

rs +-? B 7?81-6 1+-;?-

!ACCDi,- 0d rd71 I T8 B 0srs -1712?87-8 B -971+-;?8

1&-9&? ≈ 14.9%


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Di,ision>s !ACC ,s- "irm>s5,erall !ACC)

Di,ision !ACC 1&-9? ,ersuscompan !ACC 1-&?-

OTpical pro$ects 0ithin thisdi,ision 0ould be accepted if theirreturns are abo,e 1&-9?-


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!hat are the three tpesof pro$ect risk)

:tand'alone risk

Corporate risk

4arket risk


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Ho0 is each tpe of riskused)

:tand'alone risk is easiest tocalculate-

4arket risk is theoreticall best inmost situations- Ho0e,er. creditors. customers.

suppliers. and emploees are more

a#ected b corporate risk- Therefore. corporate risk is also

rele,ant-

$ i( i k


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A Pro$ect':peci(c. Risk'Ad$usted

Cost of Capital :tart b calculatin% a di,isional

cost of capital-

se $ud%ment to scale up or do0nthe cost of capital for an indi,idualpro$ect relati,e to the di,isional

cost of capital-


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Costs of ssuin% e0Common :tock

!hen a compan issues ne0common stock the also ha,e to

pa otation costs to theunder0riter-

ssuin% ne0 common stock ma

send a ne%ati,e si%nal to thecapital markets. 0hich madepress stock price-

C t f C E it P


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Cost of e0 Common Equit< P

@+. D @=-12. % +-;?. and "

1+?

re D71 B %8

P71 I "8

B %

@=-1271-+;8

@+71 I-1+8

B +-;?

@=-=

@&2-+B +-;? 1=-?

C t f = F D bt P


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Cost of e0 ='Fear Debt< Par @1.. Coupon 1? paid annuall.

and " 2? sin% a (nancial calculator<

=

PG 1.71 I -28 9; P4T '7-1871.871 I -&8 '

"G '1.

:ol,in% for FR< -1+?


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Comments about otationcosts<

"lotation costs depend on the risk of the(rm and the tpe of capital bein% raised-

The otation costs are hi%hest forcommon equit- Ho0e,er. since most(rms issue equit infrequentl. the per'pro$ect cost is fairl small-

!e 0ill frequentl i%nore otation costs0hen calculatin% the !ACC-


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"our 4istakes to A,oid

Current ,s- historical cost of debt

4i/in% current and historical measures

to estimate the market risk premium 3ook 0ei%hts ,s- 4arket !ei%hts

ncorrect cost of capital components

:ee ne/t slides for details-

(More…)

C i i l C


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Current ,s- Historical Costof Debt

!hen estimatin% the cost of debt.don>t use the coupon rate on

e/istin% debt. 0hich represents thecost of past debt-

se the current interest rate on

ne0 debt-

(More…)

E i i h 4 k Ri k


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Estimatin% the 4arket RiskPremium

!hen estimatin% the risk premium for theCAP4 approach. don>t subtract the currentlon%'term T'bond rate from the historicala,era%e return on common stocks-

"or e/ample. if the historical r4 has been

about 12-2? and ination dri,es the

current rR" up to 1?. the current marketrisk premium is not 12-2? I 1? 2-2?S

(More…)


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Estimatin% !ei%hts

se the tar%et capital structure todetermine the 0ei%hts-

f ou don>t kno0 the tar%et 0ei%hts. thenuse the current market ,alue of equit-

f ou don>t kno0 the market ,alue ofdebt. then the book ,alue of debt often is

a reasonable appro/imation. especiallfor short'term debt-

(More…)

Capital components are sources


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Capital components are sourcesof fundin% that come from

in,estors- Accounts paable. accruals. and

deferred ta/es are not sources of

fundin% that come from in,estors. sothe are not included in the calculationof the !ACC-

!e do ad$ust for these items 0hen

calculatin% pro$ect cash o0s. but not0hen calculatin% the !ACC-

Documents

Ch09 the Cost of Capital