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WACC1 wdrd1 T wpsrps wcers WACC2 wdrd1 T wpsrps wcere

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Title: WACC1 wdrd1 T wpsrps wcers WACC2 wdrd1 T wpsrps wcere


1
WACC1 wdrd(1 - T) wpsrps wcers WACC2
wdrd(1 - T) wpsrps wcere
2
CHAPTER 9 The Cost of Capital
  • Cost of capital components
  • Debt
  • Preferred
  • Common equity
  • WACC
  • MCC
  • IOS

MINICASE, Chapter 9 (a-i), p. 340.(See DATA)
3
What sources of capital should be included in a
firms WACC?
  • Long-term debt
  • Preferred stock
  • Common equity
  • Retained earnings
  • New common stock
  • Short term debt?

4
Capital components are sources of funding that
come from investors. Accounts payable, accruals,
and deferred taxes are not sources of funding
that come from investors, so they are not
included in the calculation of the cost of
capital. We do adjust for these items when
calculating the cash flows of a project, but not
when calculating the cost of capital.
5
Should we focus on before-tax or after-tax
capital costs?
  • Tax effects associated with financing can be
    incorporated either in capital budgeting cash
    flows or in cost of capital.
  • Most firms incorporate tax effects in the cost of
    capital. Therefore, focus on after-tax costs.
  • Only cost of debt is affected.

6
Should we focus on before-tax or after-tax
capital costs?
  • Tax effects associated with financing can be
    incorporated either in capital budgeting cash
    flows or in cost of capital.
  • Most firms incorporate tax effects in the cost of
    capital. Therefore, focus on after-tax costs.
  • Only cost of debt is affected.

7
Should we focus on before-tax or after-tax
capital costs?
Only rd needs adjustment rd(1-T) rd - T x rd
where rd cost of debt, and T x rd Tax
savings due to using debt.
8
Should we focus on historical (embedded) costs or
new (marginal) costs?
The cost of capital is used primarily to make
decisions which involve raising new capital. So,
focus on todays marginal costs.
9
Cost of Debt
  • Method 1 Ask an investment banker what the
    coupon rate would be on new debt.
  • Method 2 Find the bond rating for the company
    and use the yield on other bonds with a similar
    rating.
  • Method 3 Find the yield on the companys debt,
    if it has any.
  • Focus on method 3, to start.

10
Whats rd? Coupon 12 semi Price
1,153.72 15 years.
0
1
2
30
rd ?
60
60 1,000
60
-1,153.72
30 -1153.72 60 1000
5.0 x 2 rd 10 EAR ? Should we use it?
INPUTS
I/YR
N
PV
FV
PMT
OUTPUT
11
What should we do if this firm does not have an
outstanding bond?
  • Use rate on bond of a comparable firm (method
    2).
  • Ask investment bankers for their estimate
    (method 1).
  • N.b. If the bond is callable, the YTC rather than
    the YTM may be appropriate.

12
Component cost of debt
  • Interest is tax deductible, so
  • rd AT rd BT(1 - T)
  • 10(1 - 0.40) 6.
  • Use nominal rate. Why?
  • Flotation costs small. Ignore, for now.
  • May need to incorporate yield curve differences.

13
Whats the cost of preferred stock? Pps
113.10 10Q Par 100 F 2.
Use this formula
Dps PNet
0.25(100) 113.10 - 2.00
rps
0.025 2.25. Qtrly.
2.50 111.10
14
Picture of Preferred
ì
0
1
2
kps ?
2.50
2.50
-111.1
2.50
Dps rps
2.50 rPer
111.10 . rPer
2.25 rps(Nom) 2.25(4) 9.
2.50 111.10
15
Note
  • Flotation costs for pfd. are significant, so are
    reflected. Use net price.
  • Preferred dividends are not deductible, so no tax
    adjustment. Just rps.
  • Nominal rps is used.
  • Capital budgeting CFs are nominal.
  • Use nominal values for component costs.

16
Is preferred stock more or less risky to
investors than debt? than equity?
  • Risk Return

Debt
Preferred
Equity
17
Is preferred stock more or less risky to
investors than debt? than equity?
  • Risk Return

Debt
Preferred
Equity
18
Is preferred stock more or less risky to
investors than debt? than equity?
  • More risky company not required to pay preferred
    dividend.
  • However, firms try to pay preferred dividends.
    Otherwise,
  • Cannot pay common dividends.
  • Difficult to raise new capital.
  • Preferred stockholders may gain some control of
    firm.
  • Therefore, does preferred have higher yield than
    debt?

19

Illustration Preferred vs. debt for same company
or similar companies.
Recent data for RJR
rps 9.5 rd 11.4
Is this is as expected?.
20
Why is yield on preferred lower than kd?
  • Corporations own most preferred stock, because
    70 of preferred divi-dends are nontaxable to
    corporations.
  • Therefore, preferred often has a lower B-T yield
    than the B-T yield on debt.
  • But the A-T yield to an investor, and the A-T
    cost to the issuer, are higher on preferred than
    on debt. Consistent with higher risk of
    preferred to investors.

21
Illustration Preferred vs. debt for same company
or similar companies.
Before tax for RJR
rps 9.5 rd 11.4
This looks strange!. Suppose T 40
rps, AT rps - rps (1 - 0.7)(T) 9.5 -
9.5(0.3)(0.4) 8.36 rd, AT 11.4 -
11.4(0.4) 6.84 A-T risk prem. on pfd.
1.52.
This is as expected.
Riskier preferred has higher AT rate.
22
What are the two ways that companies can raise
common equity?
  • .

23
What are the two ways that companies can raise
common equity?
  • Companies can issue new shares of common stock.
  • Companies can reinvest earnings.

24
Why is there a cost for retained earnings?
  • Earnings can be reinvested or paid out as
    dividends.
  • Investors could buy other securities, earn a
    return.
  • Thus, there is an opportunity cost if earnings
    are retained.

25
  • Opportunity cost The return stockholders could
    earn on alternative investments of equal risk.
  • They could buy similar stocks and earn rs, or
    company could repurchase its own stock and earn
    ks. So, rs is the cost of retained earnings.

26
Three ways to determine the cost of equity, rs
1. CAPM rs rRF (rM - rRF)? rRF
(RPM) ? 2. DCF rs D1/P0 g. 3. Own-Bond-Yiel
d-Plus-Risk Premium rs rd Bond RP.
27
Whats the cost of equity based on the CAPM? rRF
7, RPM 6, ß 1.2.
rs rRF (rM - rRF ) ? .
7.0 (6.0)1.2 14.2.
28
Issues in Using CAPM
  • Most analysts use the rate on a long-term (10 to
    20 years) government bond as an estimate of rRF.
    For a current estimate, go to www.bloomberg.com,
    select U.S. Treasuries from the section on the
    left under the heading Market.

More…
29
Issues in Using CAPM (Continued)
  • Most analysts use a rate of 5 to 6.5 for the
    market risk premium (RPM)
  • Estimates of beta vary, and estimates are noisy
    (they have a wide confidence interval). For an
    estimate of beta, go to www.bloomberg.com and
    enter the ticker symbol for STOCK QUOTES.

30
Explain the differences among historical betas,
adjusted betas, and fundamental betas.
  • Historical betas are found by running a linear
    regression between past returns on a stock versus
    a market index.
  • Adjusted betas are historical betas adjusted for
    tendency to move towards 1.0 over
    time.

(More...)
31
  • Fundamental betas are adjusted further to include
    changes in a companys fundamental factors over
    time such as leverage, sales volatility, etc.
    E.g. Adj. ? 0.33(Hist. b) 0.67(1.0) Fund.
    ? f(Hist. b, 1.0, leverage, etc.)
  • Both attempt to overcome the problem that
    historical betas measure past market risk while
    investors are interested in future market risk.

32
How can RPM be measured?
  • Ex post data e.g., Ibottson and Assoc. provides
    this on an annual basis RPM 6.2 for
    1926-1999.
  • Future estimates by financial analysts of market
    minus T-Bond. Could use IBES estimate of firms
    returns, building to rM.

33
Whats the DCF cost of equity, rs? Given D0
4.19P0 50 g 5.
34
Estimating the Growth Rate
  • Use the historical growth rate if you believe the
    future will be like the past.
  • Obtain analysts estimates Value Line, Zacks,
    Yahoo!.Finance.
  • Use the earnings retention model, illustrated on
    next slide.

35
Suppose the company has been earning 15 on
equity (ROE 15) and retaining 35 (dividend
payout 65), and this situation is expected to
continue. Whats the expected future g?
36
Retention growth model g b(ROE) 0.35(15)
5.25. Here b Fraction retained. Close to g
5 given earlier. Intuitive notion Think of
bank account paying 10 with b 0, b 1.0, and
b 0.5. Whats g?
37
Could DCF methodology be applied if g is not
constant?
  • YES, nonconstant g stocks are expected to have
    constant g at some point, generally in 5 to 10
    years.
  • But calculations get a little complicated yet
    still just the PV of all future dividends. See
    FM11 ch.9 Tool Kit.xls

38
Non-Constant growth in Divs
  • P0 D1/(1ks) D2/(1ks)2 D3/(1ks)3 …
    Dn/(1ks)n Dn1/(ks-g)/(1ks)n
  • Dividend Stream

D1 D2 D3
Dn Dn1
Pn Dn1/(ks-g)
PO
39
Find ks using the own-bond-yield-plus-risk-premium
method. (rd 10, RP 4.)
rs rd RP 10.0 4.0 14.0
  • This RP ¹ CAPM RPM.
  • Produces ballpark estimate of rs. Useful check.

40
Whats a reasonable final estimate of rs?
Method
Estimate
CAPM
14.2
DCF
13.8
rd
RP
14.0
Average
14.0
41
How do we find the cost of new common stock, re?
Three steps
Use DCF formula, but adjust P0 for flotation
cost. Compare DCF re with DCF rs to determine
flotation adjustment. Apply flotation adjustment
to final rs estimate.
42
New common F 15 re
g 5.0
5.0 15.4. But, re based solely on
DCF method.
D0(1 g) P0(1 - F)
4.19(1.05) 50(1 - 0.15)
4.40 42.50
43
Flotation adjustment re(DCF) - rs(DCF)
15.4 - 13.8 1.6 . Add the 1.6 flotation
adjustment to final rs 14 to find final
ke re rs Float adjustment 14
1.6 15.6.
44
Comments about flotation costs
  • See Table
  • Flotation costs depend on the risk of the firm,
    the size of the issue, and the type of capital
    being raised.

45
Why is re rs?
  • Investors expect to earn rs.
  • If Company gets money as RE it earns rs
    everythings Cool!
  • But when investors buy new stock F pulled out
    so must earn rs on funds company receives to
    provide rs on money investors put up.

46
Example
1. rs 10 F 20. 2. Investors put up 100,
expect to earn 0.1(100) 10. 3. But, after F,
company nets only 80. (Who gets the
20?) 4 Company needs to earn 12.5 on the 80 to
pay 10 to investors. 5. i.e. Need to earn re
10/0.8 12.5. 6. Conclusion re 12.5 rs
10.0.
47
Estimating Weights for the Capital Structure
  • If you dont know the targets, it is better to
    estimate the weights using current market values
    than current book values.
  • If you dont know the market value of debt, then
    it is usually reasonable to use the book values
    of debt, especially if the debt is short-term.

(More...)
48
Estimating Weights (Continued)
  • Suppose the stock price is 50, there are 3
    million shares of stock, the firm has 25 million
    of preferred stock, and 75 million of debt.

(More...)
49
  • Vce 50 (3 million) 150 million.
  • Vps 25 million.
  • Vd 75 million.
  • Total value 150 25 75 250 million.
  • wce 150/250 0.6
  • wps 25/250 0.1
  • wd 75/250 0.3

50
Whats the WACC1?
WACC1 wdrd(1 - T) wpsrps wcers
0.3(10)(0.6) 0.1(9) 0.6(14) 1.8 0.9
8.4 11.1.
Cost per dollar until Retained earnings are used
up.
51
WACC Estimates for Some Large U. S. Corporations
52
WACC with new CommonStock
WACC2 wdrd(1 - T) wpsrps wcere
0.3(10)(0.6) 0.1(9) 0.6(15.6) 1.8
0.9 9.4 12.1.
53
Summary to this point
re or rs WACC Debt Pfd RE
14.0 11.1 Debt Pfd NCS 15.6 12.1 WACC
rises because equity cost increases. (WHY?)
54
Define the MCC schedule.
  • MCC shows cost of each dollar raised.
  • Each dollar consists of 0.30 of debt, 0.10 of
    Pfd, and 0.60 of equity (RE or new CS).
  • First dollars cost WACC1 11.1, then WACC2
    12.1.
  • Where does the WACC change?

55
How large will capital budget be before company
must issue new CS?
Debt 0.3 Capital raised Preferred 0.1
Capital raised Equity 0.6 Capital raised
1.0 Total capital When only retained
earnings are used for equity Equity RE 0.6
Capital raised, so Capital raised(at BP) RE/0.6.
56
Find retained earnings break point.
Dollars of RE Fraction of equity
BPRE 500,000.
300,000 0.60
500,000 total can be financed with RE, debt, and
preferred.
Alternative explanation
57
(No Transcript)
58
WACC ()
WACC1 11.1
15
WACC2 12.1
10
500 2,000
Dollars of New Capital (in thousands)
How large should our capital budget be?
59
Investment Opportunities (Capital Budgeting
Projects)
A 700,000 17.0 B 500,000 15.0 C
800,000 11.5 2,000,000
Which to accept?
60

A 17
B 15
MCC
12.1
11.1
IOS
C11.5
Cap. budget
500
1,200
2,000
61
  • Projects A and B would be accepted (IRR exceeds
    the MCC).
  • Project C would be rejected (IRR is less than the
    MCC).
  • Capital budget 1.2 million.
  • WACC 12.1

62
Would the MCC (slide 60) remain constant beyond
the RE breakpoint?
  • No. WACC would eventually rise above 12.1.
  • Cost of debt, preferred stock would rise.
  • Large increases in capital budget may also
    increase the perceived risk of the firm,
    increasing WACC.

63
What factors influence a companys WACC?
  • Market conditions, especially interest rates and
    tax rates.
  • The firms capital structure and dividend policy.
  • The firms investment policy. Firms with riskier
    projects generally have a higher WACC.

64
What effect does depreciation have on the MCC
schedule?
  • Depreciation is a noncash expense.
  • Depreciation cash flow is available for dividends
    or retained earnings, e.g., could repurchase debt
    or stock.
  • These funds therefore have an opportunity cost
    equal to the WACC using retained earnings, 11.1.
  • This will shift the MCC schedule outward by the
    of depreciation.

65
Would depreciation affect the acceptability of
proposed capital budgeting projects and the size
of the total capital budget?
Possibly. If the lower cost MCC is shifted to
the right, the cost of capital used to evaluate
projects may be lower. (Slide 49, again)
66
Four Mistakes to Avoid
1. When estimating the cost of debt, use the
current interest rate on new debt, not the coupon
rate on existing debt. 2. When estimating the
risk premium for the CAPM approach, dont
subtract the current long-term T-bond rate from
the historical average return on common stocks
rs rRF (rM - rRF )?
(More ...)
67
  • For example, if the historical rM has been about
    12.7 and inflation drives the current rRF up to
    10, the current market risk premium is not 12.7
    - 10 2.7!

(More ...)
68
WACC1 wdrd(1 - T) wpsrps wcers
3. Use the target capital structure to determine
the weights. If you dont know the target
weights, then use the current market value of
equity, and never the book value of equity. If
you dont know the market value of debt, then the
book value of debt often is a reasonable
approximation, especially for short-term debt.
(More...)
69
4. Capital components are sources of funding that
come from investors. Accounts payable, accruals,
and deferred taxes are not sources of funding
that come from investors, so they are not
included in the calculation of the WACC. We do
adjust for these items when calculating the cash
flows of the project, but not when calculating
the WACC.
70
Should the company use the composite WACC as the
hurdle rate for each of its projects?
  • NO! The composite WACC reflects the risk of an
    average project undertaken by the firm.
    Therefore, the WACC only represents the hurdle
    rate for a typical project with average risk.
  • Different projects have different risks. The
    projects WACC should be adjusted to reflect the
    projects risk.
  • See following case.

71
Risk and the Cost of Capital
72
Divisional Cost of Capital
73
Division or Project Cost of Capital
74
Methods for estimating a divisions or a
projects beta
  • Pure play. Find several publicly traded
    companies exclusively in projects business. Use
    average of their betas as proxy for projects
    beta. Hard to find such companies.

75
  • Accounting beta. Run regression between
    projects ROA and SP index ROA. Accounting
    betas are correlated (0.5-0.6) with market
    betas. But normally cant get data on new
    projects ROAs before the capital budgeting
    decision has been made.

76
Should the company use the composite WACC as the
hurdle rate for each of its divisions?
  • NO! The composite WACC reflects the risk of an
    average project undertaken by the firm.
  • Different divisions may have different risks.
    The divisions WACC should be adjusted to reflect
    the divisions risk and capital structure.

77
What procedures are used to determine the
risk-adjusted cost of capital for a particular
division?
  • Estimate the cost of capital that the division
    would have if it were a stand-alone firm.
  • This requires estimating the divisions beta,
    cost of debt, and capital structure.

78
Methods for Estimating Beta for a Division or a
Project
  • 1. Pure play. Find several publicly traded
    companies exclusively in projects business.
  • Use average of their betas as proxy for
    projects beta.
  • Hard to find such companies.

79
  • 2. Accounting beta. Run regression between
    projects ROA and SP index ROA.
  • Accounting betas are correlated (0.5 0.6) with
    market betas.
  • But normally cant get data on new projects
    ROAs before the capital budgeting decision has
    been made.

80
Find the divisions market risk and cost of
capital based on the CAPM, given these inputs
  • Target debt ratio 10.
  • rd 12.
  • rRF 7.
  • Tax rate 40.
  • betaDivision 1.7.
  • Market risk premium 6.

81
  • Beta 1.7, so division has more market risk than
    average.
  • Divisions required return on equity
  • rs rRF (rM rRF)bDiv.
  • 7 (6)1.7 17.2.
  • WACCDiv. wdrd(1 T) wcrs
  • 0.1(12)(0.6) 0.9(17.2)
  • 16.2.

82
How does the divisions WACC compare with the
firms overall WACC?
  • Division WACC1 16.2 versus company WACC1
    11.1.
  • Typical projects within this division would be
    accepted if their returns are above 16.2.

83
Divisional Risk and the Cost of Capital
84
Recall what are the three types of project risk?
  • Stand-alone risk
  • Corporate risk
  • Market risk

85
How is each type of risk used?
  • Stand-alone risk is easiest to calculate.
  • Market risk is theoretically best in most
    situations.
  • However, creditors, customers, suppliers, and
    employees are more affected by corporate risk.
  • Therefore, corporate risk is also relevant.

86
A Project-Specific, Risk-Adjusted Cost of Capital
  • Start by calculating a divisional cost of
    capital.
  • Estimate the risk of the project using the
    techniques in Chapter 11.
  • Use judgment to scale up or down the cost of
    capital for an individual project relative to the
    divisional cost of capital.

87
Why is the cost of internal equity from
reinvested earnings cheaper than the cost of
issuing new common stock?
1. When a company issues new common stock they
also have to pay flotation costs to the
underwriter. 2. Issuing new common stock may send
a negative signal to the capital markets, which
may depress stock price.
88
Estimate the cost of new common equity P050,
D04.19, g5, and F15.
89
Estimate the cost of new 30-year debt
Par1,000, Coupon10paid annually, and F2.
  • Using a financial calculator
  • N 30
  • PV 1000(1-.02) 980
  • PMT -(.10)(1000)(1-.4) -60
  • FV -1000
  • Solving for I 6.15

90
Part 2 The Optimal Capital Budget Chapter 11,
appendix
  • Weve seen how to evaluate projects.
  • We need cost of capital for evaluation.
  • But corporate cost of capital depends on size of
    capital budget.
  • Must combine MCC and IOS schedules to get
    corporate cost of capital.

91
HANDOUT on Optimal Capital Budget
  • BLUM Industries

92
Blum Industries has 5 potential projects
Project Cost CF Life (N) IRR
A 400,000 119,326 5 15 B 200,000 56,863 5 13
B 200,000 35,397 10 12 C 100,000 27,057 5 11 D
300,000 79,139 5 10
Projects B B are mutually exclusive, the
others are independent. Neither B nor B will be
repeated.
93
Additional information
Interest rate on new debt 8.0 Tax
rate 40.0 Debt ratio 60.0 Current stock
price, P0 20.00 Last dividend, D0 2.00 Expected
growth rate, g 6.0 Flotation cost on CS,
F 19.0 Expected addition to RE
200,000 (NI 500,000, Payout 60.)
For differential project risk, add or sub-tract
2 to WACC.
94
Calculate WACC, then plot IOS and MCC schedules.
Step 1 Estimate the cost of equity
Which method should we use?
D0(1 g) P0
2(1.06) 20
rs g 6
16.6. re g
6 6 19.1.
D1 P0(1 - F)
2(1.06) 20(1 - 0.19)
2.12 16.2
95
Step 2 Estimate the WACCs
WACC1 wdrd(1 - T) wcers (0.6)(8)(0.6)
0.4(16.6) 9.5. WACC2 wdrd(1 - T)
wcere (0.6)(8)(0.6) 0.4(19.1) 10.5.
96
Step 3 Estimate the RE break point
Retained earnings Equity fraction
BPRE 500,000.
200,000 0.4
Each dollar up to 500,000 has 0.40 of RE at
cost of 16.6, then WACC rises.
97
FIGURE 1

16
A
15
14
B
13
B
12
WACC2 10.5
C
11
MCC
WACC1 9.5
10
IOS
D
9
8
7
700
500
New Capital (000s)
98
  • The IOS schedule plots projects in descending
    order of IRR.
  • Two potential IOS schedules--one with A, B, C,
    and D and another with A, B, C, and D.
  • The WACC has a break point at 500,000 of new
    capital.

99
What corporate cost of capital do we use for
capital budgeting, i.e., for calculating NPV?
  • Corporate r WACC that exists where IOS and MCC
    schedules intersect. In this case, Corporate r
    10.5.

100
If all 5 projects are average risk, whats the
optimal capital budget?
  • Corporate r 10.5.
  • IRR and NPV lead to same decisions for
    independent projects. Thus, all independent
    projects with IRRs above 10.5 should be
    accepted.
  • Therefore, accept A and C, reject D, and accept B
    or B.

101
  • NPV and IRR can conflict for mutually exclusive
    projects.
  • NPV method is better, so choose between B and B
    based on NPV at WACC 10.5.
  • NPVB 12,905 NPVB 12,830, so choose B
    over B?.

102
Suppose you arent sure of Corporate k. At what
k would B and B have the same NPV?
Get differences CF0 200,000 - 2000,000
0 CF1- 5 56,863 - 35,397 21,466 CF6-10 0
- 35,397 -35,397 Indifference r IRR
10.52
103
Including Depreciation
  • Suppose that you discovered that 400 of
    depreciation existed, that you hadnt considered
    before. Now what would your decision be?
    (Return to slide 75 to see picture)

104
Adjusting for RISK
The risk-adjusted rates are as follows
Project r 10.5 2
Suppose
Project Risk
Project Req. ret.
Low C, D
8.5
Average B, B
10.5
High A
12.5
105
Now the optimal capital budget consists of A, B
(or B), C, and D, for a total of 1,000,000.
106
(f) Divisional Hurdle rates
  • Companies often have so many projects that you
    cant plot a IOS. Then what?
  • Suppose the company has three divisions L, A and
    H for low risk, average risk and high risk

107
  • Division Proj. Risk Proj k
  • Low 6.5
  • Average 8.5
  • High 10.5
  • Low 8.5
  • Average 10.5
  • High 12.5
  • Low 12.5
  • Average 14.5
  • High 16.5

Low
Average
High
108
ENOUGH!
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