FINA2303 Topic 07 Cost of Capital

8/18/2019 FINA2303 Topic 07 Cost of Capital

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Topic 7: Cost of Capital


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Topic 7 Cost of Capital M K Lai Page 2

Learning Outcomes

introduction to cost of capital

cost of debtcost of equityweighted average cost of capital (WACC)WACC and NPVproject-based cost of capital

when raising external capital is costly


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Introduction to Cost of Capital

capital : a firm’s sources of financing including

debt, equity and other securities that it hasoutstanding

capital structure : relative proportions of debt,equity and other securities that a firm hasoutstanding


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to attract investor’s capital, a firm must offer

potential them an expected return equal to whatthey could expect to earn elsewhere for assumingthe same level of risk ( opportunity cost )

cost of capital of a firm = expected return ofinvestor by assuming the same risk of the firm

similarly, the NPV of a project is positive only if itsreturn exceeds what the financial markets offer

on investments with similar risk




the cost of capital is the minimum requiredreturn for an asset given its risk level

common stock : cost of equitypreferred stock : cost of preferred stockdebt : cost of debt

real assets/projects/firms : weighted averagecost of capital (r WACC)

sources

of fundsfor a firm

uses of funds for a firm




long term assets preferred stock

common stock

current assets debt

Statement of Financial Position

uses of funds sources of funds




in other words, rWACC is the discount rate we usein capital budgeting and it reflects

time value of money

risk



Weighted Average Cost of Capital

(WACC): First Lookweighted average cost of capital : average offirm’s equity and debt costs of capital, weightedby fractions of firm’s value that correspond toequity and debt respectivelythe capital asset pricing model shows the positiverelationship between expected return andsystematic risk of a financial security from theperspective of an investorfor a project with positive NPV , the r WACC must lieabove the security market line (SML) (why?)

minimize r WACC so that the firm value can bemaximized (why?)


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Weighted Average Cost of Capital

(WACC): First Lookleverage : the relative amount of debt on a firm’sbalance sheetunlevered firm : a firm that does not have debtoutstanding

rWACC of an unlevered firm is the cost of equitygiven no debt (why?)levered firm : a firm that has debt outstanding

rWACC = fraction of firm financed by equity *cost of equity + fraction of firm financed bydebt * cost of debt = cost of assets (given no

preferred stock)


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Cost of Debt

the cost of debt is the return that lenders requireon a firm’s debt

the prevailing interest rate the firm just pays on

new borrowing

methods to estimate the prevailing interest rate

1.2.3.


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Cost of Debt

the observed or calculated cost of debt r D is on abefore-tax basis, but interest expenses are taxdeductible and hence a firm should consider itsafter-tax (effective) cost of debt = before-tax costof debt*(1-tax rate) or after-tax cost of debt =rD*(1-T C) where T C = corporate tax ratewhich tax rate to use?

marginal tax rate = additional tax paid for per$1 additional taxable incomeeffective tax rate = income tax/pre-tax income

statutory tax rate = rate stated by government


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Example: Cost of Debt

A firm issued a 10-year, 7% bond with annualcoupons 8 years ago. The bond is currentlyselling for 96% of its face value. Given that themarginal tax rate is 35%, what is the after-taxcost of debt of the firm?

6.03%35%) -(1*9.28%debtofcosttax -after

9.28%debtofcosttax -eforeb%28.9yield

)yield1(107

)yield1(7

96 2

==

==

++

+=


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Cost of Preferred Stock

preferred stock has a fixed dividend paid everyyear indefinitely and hence its future cash flowstream is a non-growing perpetuity

rpfd = Divpfd /P pfd

where r pfd = cost of preferred stock; Div pfd = fixed

dividend of preferred stock and P pfd = currentpreferred stock price


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Example: Cost of Preferred Stock

A company had an issue of preferred stock that istraded on the exchange. The issue paid $2.04annually per share and sold for $30.75 per share.What is the company’s cost of preferred stock?

rpdf = $2.04/$30.75 = 6.63%


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Cost of Equity/Common Stock

the cost of equity/common stock is the returnthat common stock investors require on theirinvestment in the firm

two ways to determine the cost of equity

capital asset pricing model

constant dividend growth model


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Cost of Equity/Common Stock: CAPM

where r e = expected return on common stock I orcost of equity; r f = risk-free rate; βE = beta ofcommon stock i; R

Mkt= expected market return

(proxied by stock market index return)in other words, r E depends on

risk free r fmarket/equity risk premium R Mkt– r f

systematic risk βE

)rR(*rr fMktEfE −β+=


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Example: CAPM

The risk-free rate is 2% and the expected marketreturn is 15%. A stock has a beta of 0.95. Whatis the cost of equity?

rE = 2% + 0.95*(15%-2%) = 14.35%


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Cost of Equity/Common Stock: Constant

Growth ModelrE = Div1 /P E + g

where r E = cost of equity; P E = current commonstock price; Div 1 = common stock annualdividend in year 1; g = constant growth rate of

dividendsPE can be observed directly in the stock marketgiven that the firm is listedDiv1 can be estimated as Div 0*(1+g) where Div 0 =current annual dividend assumed to grow at g


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Growth Modelthe most difficult part is to estimate the growthratemethod to estimate the growth rate

1.

2.3.


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Growth Model

source: Reuters


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Example: Constant Growth Model

If the current common stock price is $52, therecently announced dividend per share is $3.25and the expected constant dividend growth rateis 4%, calculate the cost of equity.

rE = $3.25*(1+4%)/52 + 4% = 10.5%


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Comparison Between CAPM and

Constant Dividend Growth Model

constant growthvalid CPMA

growth rate matchesmarket expectations

accurate market riskpremium

correct dividend estimatecorrect estimated beta

assumptions

future dividend growth ratemarket risk premium

expected dividend nextyear

risk-free rate

current stock priceequity beta

inputs

constant dividend growthmodel

CAPM


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WACC: Second Look

rWACC = r E*E% + r pfd *P% + r D*(1-T C)*D%

where r WACC = weighted average cost of capital; r E= cost of equity; r pfd = cost of preferred stock; r D =

(before-tax) cost of debt; E% = fraction of firmfinanced by common stock; P% fraction of firmfinanced by preferred stock; D% fraction of firmfinanced by debt; T C = marginal corporate tax rate

notice: in many cases, P% = 0 (no preferred stock)


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WACC: Second Look

capital structure weights (which to use?)target capital structure announced by firmestimated through market value of debt,preferred stock and common stock

market value of assets = market value ofdebt + market value of preferred stock +market value of common stock

estimated through book value of debt,preferred stock and common stockassets = debt + preferred stock + common

stock (accounting equation)


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Example 1: WACC

Consider the following information about Li &Fung

source: Li & Fung AR


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Example 1: WACC

source: quamnet

source:AsianBondson

line

source: http://pages.stern.nyu.edu/~adamodar/

source: BOCI

average = 6.359%


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Example 1: WACC

effective tax rate = 9.4%optimal debt ratio = 35%beta = 2.17risk-free rate = 1.5647%

market risk premium = 6.35%rE = 1.564% + 2.17*6.35% = 15.15%yield on bond = 6.359%rWACC = 6.359%*(1-9.4%)*35% + 15.15%*(1-35%) = 11.86%


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Example 2: WACC

A company has the following financial data:debt with a book value of $10 million, tradingat 96% at a yield of 6%number of preferred stock outstanding is 1million shares, trading at a price of $5cost of preferred stock = 15%number of common stock outstanding is 5

million shares, trading at a price of $8cost of equity = 18%marginal corporate tax rate = 35%

Calculate the WACC of the company.


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Example 2: WACC

MV of debt = $10 million*96% = $9.6 millionMV of preferred stock = $5*1 million = $5 millionMV of common stock = $8*5 million = $40million

market value of assets = $9.6 million + $5million + $40 million = $54.6 millionD% = $9.6 million/$54.6 million = 0.1758

P% = $5 million/$54.6 million = 0.0916E% = $40 million/$54.6 million = 0.7326rWACC = 18%*0.7326 + 15%*0.0916 + 6%*(1-35%)*0.01758 = 15.25%


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WACC in Practice

use net debt rather than total debt and useenterprise value (EV = equity plus net debt) asbasis for calculating weights

net debt = debt – cash and risk-free securitiesE% = MV of equity/EV and D% = net debt/EV

risk-free rate = yield on government bond but

which maturity?correspond to investment horizon of firm’sinvestors – survey shows that usually 10 year

government bond


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WACC in Practice

market risk premium : some financial managersthat market risk premium has been declining andit is the future market risk premium matters andthey should adjust it downward because of thedownward trend (?)


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WACC in Practice


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Using WACC to Value a Project

use r WACC as discount rate in capital budgetinglevered value : project value includes the benefitof interest tax deduction given the firm’s leveragepolicy (assuming the capital structure is fixed)

WACC method : discount future incremental freecash flows (FCF) using the firm’s r WACC to producethe levered value (V 0 L) of a project with a life of nyears

∑= +

=n

0t

t

WACC

tL0

)r1(

FCFV


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Using WACC to Value a Project

key assumptionsproject risk is the same as firm’s assets (why?)fixed capital structure with constant debt-equity ratio

limited leverage effects, e.g. no financialdistress


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Example: Using WACC to Value a Project

A company is carrying out a capital budgetingexercise on an expansion project by increasingthe size of its production facility. The initialinvestment is $50 million and it is expected togenerate an even cash flow of $12 million in

each of the coming six years. The WACC of thefirm is 16.65%. What is the NPV of the project?


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Example: Using WACC to Value a Project

project.thereject0,NPVAs

m53.6m$50m -$43.47mNPV

m47.43$%)65.16(1$12m

valuelevered

WACC.itsisratediscounteappropriattheandfirm

theofassetsexistingthetosimilarisriskproject

thethatbelieveweproject,expansionanisthisAs

6

1tt

<

−==

=+= ∑=

’


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Project Risk Different from Firm’

s Risk

rWACC does not necessarily reflect the risk of theproject, e.g. launching a new product, entering anew market, etc.in practice, we should look for a firm which hassimilar characteristics as our project and use thesimilar firm’s data to calculate its r WACC whichreflects the risk of the project ( pure playapproach )

furthermore, if the similar firm has a differentcapital structure from the subject firm, need tomake adjustment for the different debt-equityratios (out of scope)

’


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Project Risk Different from Firm’

s Risk

discount rate on project

beta of project

WACC

SML

beta of existingassets of firm


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Exercise

Which is the appropriate discount rate for thefollowing projects? (r e , after-tax r d, own firm’sWACC, similar firm’s WACC)

a company acquires the control over a targetcompanya company carries out a research anddevelopment project for a new producta company expands its business to a newmarketa company invests in the shares of another

company


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Exercise

a company expands its production facilitiesa company carries out a cost reducing programa company uses a new technology to producea product

a company buys the bonds issued by anothercompany

l f


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Example: WACC for a New Acquisition

Company A wants to acquire the control overcompany B which carries out unrelated businessto company A. To determine the NPV of thisacquisition project, company A’s r WACC is notappropriate because it cannot reflect the risk ofcompany B. Given that the two companies havesimilar capital structure, company B’s r WACC

should be used because it reflects the risk of theproject.

Di i i l C f C i l


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Divisional Cost of Capital

consider a company with several divisions ofdifferent risk nature , i.e. a conglomeratethe company’s r WACC reflects its overall risk andcannot accommodate the different risk levels ofthese business linesa divisional cost of capital should be determinedfor each business line with the objective to reflectits risk levelpure play approach : use of r WACC that is unique toa particular project based on companies insimilar lines of business as the project

E l Di i i l C f C i l


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Example: Divisional Cost of Capital

A conglomerate has a division in producinghousehold products. The r WACC of theconglomerate is 20%. The r WACC of a householdproduct manufacturer is 16%. What is the(weighted average) cost of capital of the division?

The divisional cost of capital is 16%.

If the division wants to launch a new householdproduct, is 16% still the appropriate discount ratefor the project?

Wh R i i E t l C it l i C tl


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When Raising External Capital is Costly

flotation costs : costs associated with new issue ofdebt or equity

1.2.

zero flotation costs for internal equity (retainedearnings)

Wh R i i g E t l C it l i C tl


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When Raising External Capital is Costly

how to include them in r WACC

method 1 : adjust r WACC through the weightedaverage cost of flotation

method 2 : when carrying out the capitalbudgeting exercise, consider the flotation cost

as an initial investment

Example: When Raising External Capital


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p g pis Costly

A company decides to issue new equity to financea project. The flotation costs are $456,221. The

present value of the future cash flows generatedby the project is $3,300,000. The estimatedinitial investment (before flotation costs) for the

project is $3,000,000. Calculate the NPV of theproject after adjusting for flotation costs.

projectthereject0,NPVtheas

221,156$ $456,221 -$3,000,000 -$3,300,000NPV

<−=

=

Challenging Questions


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1. What is the relationship between the requiredreturn on an investment and the cost of capitalassociated with that investment?

2. What are the likely consequences if a company

uses its r WACC to evaluate all proposedinvestments from different divisions?3. Discuss whether the CFO of a company should

use the WACC of the company to evaluate thefollowing projects:



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A. An expansion project that the companywill expand its production facilities to enlargeits output level of the existing products inHong Kong. Hopefully, it can take advantageof the economy of scale to reduce theproduction costs.B. An expansion project that the company

will build up new distribution channels inMainland China. Hopefully, it can takeadvantage of the huge population in the

Mainland to enhance its sales revenue.



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4. A company has announced a target capitalstructure of 40% debt and 60% equity. Accordingto the values in the financial market, the capitalstructure is 35% debt and 65% equity. Accordingto the values in the statement of financial position,the capital structure is 45% debt and 55% equity.The company intends to use 100% equity tofinance a project. Given that the project has thesame risk as the existing assets of the company,what weights of debt and equity should be used incalculating the r WACC? Explain.



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5. An investment bank is appointed to be thefinancial advisor to an acquiring company. Theacquiring company wants to take control over atarget company by buying more than 50% of itsshares from the shareholders. If the investmentbank has to determine the value of the targetcompany as a whole , which of the following is

the appropriate discount rate for this“acquisition” project? Explain.



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A. the cost of equity of the acquiringcompanyB. the weighted average cost of capital of theacquiring company

C. the cost of equity of the target companyD. the weighted average cost of capital of thetarget company

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FINA2303 Topic 07 Cost of Capital