cost of capital and long-term financial policy
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Chapter 14. Cost of capital and long-term financial policy. Chapter Outline. The Cost of Capital: Introduction The Cost of Equity The Costs of Debt and Preferred Stock The Weighted Average Cost of Capital Divisional and Project Costs of Capital - PowerPoint PPT PresentationTRANSCRIPT
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COST OF CAPITAL AND LONG-TERM FINANCIAL POLICY
Chapter 14
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Chapter OutlineThe Cost of Capital: Introduction
The Cost of Equity
The Costs of Debt and Preferred Stock
The Weighted Average Cost of Capital
Divisional and Project Costs of Capital
Flotation Costs and the Weighted Average Cost of Capital
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Why Cost of Capital is ImportantReturn earned on assets depends on the risk
of those assets
The return to an investor is the same as the cost to the company
Cost of capital provides with an indication of how the market views the risk of assets
Knowing cost of capital can also help determine required return for capital budgeting projects
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Required ReturnThe required return is the same as the
appropriate discount rate and is based on the risk of the cash flows
The required rate of return is used to calculate NPV
We need to earn at least the required return to compensate investors for the financing they have provided
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Cost of EquityThe cost of equity is the return
required by equity investors given the risk of the cash flows from the firm
There are two major methods for determining the cost of equity◦Dividend growth model (Gordon
growth model)◦SML or CAPM
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The Dividend Growth Model ApproachCan be rearranged to solve for RE
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P0 D1
RE g
RE D1
P0
g
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Example Suppose that a company is
expected to pay a dividend of $1.50 per share next year. There has been a steady growth in dividends of 5.1% per year and the market expects that to continue. The current price is $25. What is the cost of equity?
Solution: RE = 11.1%
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Example: Estimating the Dividend Growth Rate
One method for estimating the growth rate is to use the historical average◦Year Dividend Percent Change◦19951.23◦19961.30 5.7%◦19971.36 4.6% Geom. = 5.0864◦19981.43 5.1%◦19991.50 4.9% Ar. Av = 5.0872
Analysts’ forecast can be used
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Alternative Approach to Estimating GrowthIf the company has a stable ROE, a stable
dividend policy and is not planning on raising new external capital, then the following relationship can be used:
A company has a ROE of 15% and payout ratio is 35%. If management is not planning on raising additional external capital, what is its growth rate?
Solution: g= 9.75%9
g = Retention ratio x ROE
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Advantages and Disadvantages of DividendGrowth Model
– easy to understand and use:
◦Only applicable to companies currently paying dividends
◦Not applicable if dividends aren’t growing at a reasonably constant rate
◦Extremely sensitive to the estimated growth rate – an increase in g of 1% increases the cost of equity by 1%
◦Does not explicitly consider risk
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The SML Approach (CAPM)Use the following information to
compute our cost of equity◦Risk-free rate, Rf
◦Market risk premium, E(RM) – Rf
◦Systematic risk of asset,
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E(RA) = Rf + A(E(RM) – Rf)
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SML exampleSuppose the company has an
equity beta of .58 and the current risk-free rate is 6.1%. If the expected market risk premium is 8.6%, what is the cost of equity capital?
Solution: RE = 11.08%
Do both approaches have the same result?
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Advantages and Disadvantages of SML:
◦ Explicitly adjusts for systematic risk◦ Applicable to all companies, as long as
beta can be computed
:◦ Have to estimate the expected market risk
premium, which does vary over time◦ Have to estimate beta, which also varies
over time◦ We are relying on the past to predict the
future, which is not always reliable
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Cost of EquitySuppose the company has a beta of
1.5. The market risk premium is expected to be 9% and the current risk-free rate is 6%. Dividends will grow at 6% per year and last dividend was $2. The stock is currently selling for $15.65. What is our cost of equity?
◦Using SML: RE = 19.5%
◦Using DGM: RE = 19.55%
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Cost of DebtThe cost of debt is the required return on a
company’s debt
Usually the cost of long-term debt or bonds only is taken into account
The required return is best estimated by computing the yield-to-maturity on the existing debt
Estimates of current rates based on the bond rating can be used
The cost of debt is NOT the coupon rate
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Cost of Debt exampleSuppose you have a bond issue
currently outstanding that has 25 years left to maturity. The coupon rate is 9% and coupons are paid semiannually. The bond is currently selling for $908.72 per $1000 bond. What is the cost of debt?
Solution: RD = 10% (YTM)
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Cost of Preferred StockPreferred stock generally pays a
constant dividend every period
Dividends are expected to be paid every period forever
Preferred stock is an annuity
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RP = D / P0
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Cost of Preferred Stock exampleA company has preferred stock
that has an annual dividend of $3. If the current price is $25, what is the cost of preferred stock?
Solution: RPE = = 12%
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The Weighted Average Cost of Capital (WACC)Individual costs of capital are used to
find cost of capital for the firm
WACC is the required return on assets, based on the market’s perception of the risk of those assets
The weights are determined by how much of each type of financing that we use – target D/E ratio
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Capital Structure WeightsV = market value of the firm’s D
+ EWeights
◦wE = E/V = percent financed with equity
◦wD = D/V = percent financed with debt
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Capital Structure Weights exampleSuppose you have a market
value of equity equal to $500 million and a market value of debt = $475 million.◦What are the capital structure
weights?
Solution: WD = =.4872
WE = = .5128
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Taxes and the WACCWe are concerned with after-tax
cash flows, so the effect of taxes on the various costs of capital has to be considered
Interest expense reduces tax liability◦Reduction in taxes reduces cost of
debt◦After-tax cost of debt = RD(1-TC)
Dividends are not tax deductible, so there is no tax impact on the cost of equity 22
WACC = wERE + wDRD(1-TC)
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WACC (1)Equity Information
◦ 50 million shares◦ $80 per share◦ Beta = 1.15◦ Market risk premium
= 9%◦ Risk-free rate = 5%
Debt Information◦ $1 billion in
outstanding debt (face value)
◦ Current quote = 110
◦ Coupon rate = 9%, semiannual coupons
◦ 15 years to maturity
Tax rate = 40%23
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WACC (2)
What is the cost of equity? RE =15.35% (by SML)
What is the cost of debt? RD =7.85 (YTM)
What is the after-tax cost of debt? 7.85*(1-.4)=4.71
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WACC (3)What are the capital structure
weights?E=80*50mil= 4blnD=1.1bln (110% of face)V= 5.1blnWhat is the WACC?WACC=4/5.1*15.35 +
1.1/5.1*4.71== 12.0392% + 1.0159 = 13.0551
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Divisional and Project Costs of Capital Using the WACC as discount rate is only
appropriate for projects that have the same risk as the firm’s current operations
If we are looking at a project that has NOT the same risk as the firm, then the appropriate discount rate for that project has to be determined
Divisions also often require separatediscount rates because they have different levels of risk
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Using WACC for All Projects exampleWhat would happen if we use the
WACC for all projects regardless of risk?
Assume the WACC = 15%Project Required Return IRRA 20% 17%B 15% 18%C 10% 12%
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The Pure Play Approach
1. Find one or more companies that specialize in the product or service that we are considering
2. Compute the beta for each company3. Take an average4. Use that beta along with the CAPM to find the
appropriate return for a project of that risk
Often difficult to find pure play companies
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The pure play approach = use of a WACC that is unique to a particular project
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Subjective ApproachConsider the project’s risk relative to
the firm overallIf the project is more risky than the
firm, use a discount rate greater than the WACC
If the project is less risky than the firm, use a discount rate less than the WACC
You may still accept projects that you shouldn’t and reject projects you should accept, but your error rate should be lower than not considering differential risk at all
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Subjective Approach example
Risk Level Discount Rate
Very Low Risk WACC – 8%
Low Risk WACC – 3%
Same Risk as Firm WACC
High Risk WACC + 5%
Very High Risk WACC + 10%
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Flotation CostsThe required return depends on
the risk, not how the money is raised
However, the cost of issuing new securities should not just be ignored either
Basic Approach◦Compute the weighted average
flotation cost
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DEA fVDfVEf )/()/(
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NPV and Flotation Costs exampleA company is considering a
project that will cost $1 million. The project will generate after-tax cash flows of $250,000 per year for 7 years. The WACC is 15% and the firm’s target D/E ratio is .6 The flotation cost for equity is 5% and the flotation cost for debt is 3%. What is the NPV for the project after adjusting for flotation costs? 32
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Solution
Calculate flotation cost:using system of two linear equations with two unknown (D and E) calculate the $ amounts:
D/E=.6D + E = 1 mil. D=375, 000; E=625,
000fd = 375, 000*.03=11,250
fd = 625, 000*.05=31,250 Add the flotation cost to the PV = (1,
042, 500)PVFCF= 1, 040104.93
NPV=(2,395.07) negative
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