Date post: | 27-Mar-2015 |
Category: |
Documents |
Upload: | stephanie-simpson |
View: | 218 times |
Download: | 1 times |
17-1Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Chapter Seventeen
Cost of Capital
17-2Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
17.1 The Cost of Capital: Some Preliminaries
17.2 The Cost of Equity
17.3 The Costs of Debt and Preference Shares
17.4 The Weighted Average Cost of Capital
17.5 Divisional and Project Costs of Capital
17.6 Flotation Costs and the Weighted Average Cost of Capital
Summary and Conclusions
Chapter Organisation
17-3Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Chapter Objectives• Apply the dividend growth model approach and the
SML approach to determine the cost of equity.
• Estimate values for the costs of debt and preference shares.
• Calculate the WACC.
• Discuss alternative approaches to estimating a discount rate.
• Understand the effects of flotation costs on WACC and the NPV of a project.
17-4Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Cost of Capital: Preliminaries• Vocabulary→ the following all mean the same
thing:– required return– appropriate discount rate– cost of capital.
• The cost of capital depends primarily on the use of funds, not the source.
• The assumption is made that a firm’s capital structure is fixed—a firm’s cost of capital then reflects both the cost of debt and the cost of equity.
17-5Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Cost of Equity
• The cost of equity, RE , 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– SML or CAPM.
17-6Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
The Dividend Growth Model Approach
• According to the constant growth model:
Rearranging:
gR
gDP
E
) (1 0
0
gP
DRE
0
1
17-7Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—Cost of Equity: Dividend Growth Model Approach
Jumbo Co. recently paid a dividend of 20 cents per share. This dividend is expected to grow at a rate of 5 per cent per year into perpetuity. The current market price of Jumbo’s shares is $7.00 per share. Determine the cost of equity capital for Jumbo Co.
8%or 0.08
0.05 $7.00
1.05 $0.20
ER
17-8Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Estimating g
9.025%
/47.62 10.53 7.95 10.00 rategrowth Average
One method for estimating the growth rate is to use the historical average.
17-9Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
The Dividend Growth Model Approach—Evaluation
• Advantages– Easy to use and understand.
• Disadvantages– Only applicable to companies paying dividends.– Assumes dividend growth is constant.– Cost of equity is very sensitive to growth estimate.– Ignores risk.
17-10Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
The SML Approach• Required return on a risky investment is dependent on three
factors:
– the risk-free rate, Rf
– the market risk premium, E(RM) – Rf
– the systematic risk of the asset relative to the average, .
fMEfE RRRR
17-11Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—Cost of Equity Capital: SML Approach
• Obtain the risk-free rate (Rf) from financial press—many use the 1-year Treasury note rate, say, 6 per cent.
• Obtain estimates of market risk premium and security beta:– historical risk premium = 7.94 per cent (Officer, 1989)– beta—historical
investment information services estimate from historical data
• Assume the beta is 1.40.
17-12Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—Cost of Equity Capital: SML Approach (continued)
%.
%. . %
RRRR fMEfE
1217
9474016
17-13Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
The SML Approach• Advantages
– Adjusts for risk.– Applicable in a wider range of circumstances (e.g. to
companies other than just those with constant dividend growth).
• Disadvantages– Requires two factors to be estimated: the market risk
premium and the beta co-efficient.– Uses the past to predict the future, which may not be
appropriate.
17-14Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
The Cost of Debt
• The cost of debt, RD, is the interest rate on new borrowing.
• RD is observable:– yields on currently outstanding debt– yields on newly-issued similarly-rated bonds.
• The historic cost of debt is irrelevant—why?
17-15Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—Cost of Debt
Ishta Co. sold a 20-year, 12 per cent bond 10 years ago at par ($100). The bond is currently priced at $86. What is our cost of debt?
14.4%
/2$86 $100
/10$86 $100 $12
/2NP PV
/NP PV
nI
RD
The yield to maturity is 14.4 per cent, so this is used as the cost of debt, not 12 per cent.
17-16Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
The Cost of Preference Shares• Preference shares pay a constant dividend every
period.
• Preference shares are a perpetuity, so the cost is:
• Notice that the cost is simply the dividend yield.
0 P
DRP
17-17Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—Cost of Preference Shares• A preference share issue paying an $8 dividend per
share was was sold 10 years ago for $60 per share. It sells for $100 per share today.
• The dividend yield today is $8.00/$100 = 8 per cent, so this is the cost of preference shares.
17-18Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
The Weighted Average Cost of Capital
Let: E = the market value of equity = no. of outstanding shares × share price
D = the market value of debt = no. of outstanding bonds × price
V = the combined market value of debt and equity
Then: V = E + D
So: E/V + D/V = 100%
That is: The firm’s capital structure weightsare E/V and D/V.
17-19Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
The Weighted Average Cost of Capital• Interest payments on debt are tax deductible, so
the after-tax cost of debt is:
• Dividends on preference shares and ordinary shares are not tax-deductible so tax does not affect their costs.
• The weighted average cost of capital is therefore:
CD TR 1 debt ofcost tax -After
CDE TRVDRV
E 1 WACC
17-20Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—Weighted Average Cost of Capital
Gidget Ltd has 78.26 million ordinary shares on issue with a book value of $22.40 per share and a current market price of $58 per share. Gidget has an estimated beta of 0.90. Treasury bills currently yield 5 per cent and the market risk premium is assumed to be 7.94 per cent. Company tax is 30 per cent.
17-21Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—Weighted Average Cost of Capital (continued)
Gidget Ltd has four debt issues outstanding:
17-22Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—Cost of Equity(SML Approach)
%.
%..%
RRRR fMEfE
1512
947 900 5
17-23Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—Cost of Debt
The weighted average cost of debt is 7.15 per cent.
17-24Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—Capital Structure Weights and WACC• Market value of equity = 78.26 million × $58 = $4.539 billion.• Market value of debt = $1.474 billion.
10.4%or 0.104
0.30 1 0.0715 0.245 0.1215 0.755 WACC
75.5%or 0.755 $6.013b$4.539b
24.5%or 0.245 $6.013b$1.474b
billion $6.013 billion $1.474 billion $4.539
VE
VD
V
17-25Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
WACC• The WACC for a firm reflects the risk and the target
capital structure to finance the firm’s existing assets as a whole.
• WACC is the return that the firm must earn on its existing assets to maintain the value of its shares.
• WACC is the appropriate discount rate to use for cash flows that are similar in risk to the firm.
17-26Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Divisional and Project Costs of Capital• When is the WACC the appropriate discount rate?
– When the project’s risk is about the same as the firm’s risk.
• Other approaches to estimating a discount rate:– divisional cost of capital—used if a company has more
than one division with different levels of risk– pure play approach—a WACC that is unique to a
particular project is used– subjective approach—projects are allocated to specific
risk classes which, in turn, have specified WACCs.
17-27Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
The SML and the WACCExpectedreturn (%)
Beta
SML
WACC = 15%
= 8%
Incorrectacceptance
Incorrectrejection
B
A
161514
Rf =7
A = .60 firm = 1.0 B = 1.2
If a firm uses its WACC to make accept/reject decisions for all types of projects, it will have a tendency towards incorrectly accepting risky projects and incorrectly rejecting less risky projects.
17-28Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—Using WACC for all Projects• What would happen if we use the WACC for all
projects regardless of risk?
• Assume the WACC = 15 per cent
Project Required Return IRR Decision
A 15% 14% Reject
B 15% 16% Accept
• Project A should be accepted because its risk is low (Beta = 0.60), whereas Project B should be rejected because its risk is high (Beta = 1.2).
17-29Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
The SML and the Subjective Approach
Expectedreturn (%)
Beta
SML
20
WACC = 14
10
Rf = 7
Low risk(–4%)
Moderate risk(+0%)
High risk(+6%)A
With the subjective approach, the firm places projects into one of several risk classes. The discount rate used to value the project is then determined by adding (for high risk) or subtracting (for low risk) an adjustment factor to or from the firm’s WACC.
= 8%
17-30Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Flotation Costs• The issue of debt or equity may incur flotation costs
such as underwriting fees, commissions, listing fees.• Flotation costs are relevant cash flows and need to
be included in project analysis.• To assist with this, a weighted average flotation cost
can be calculated:
DEA fVDfV
Ef
costflotation debt
costflotation equity
costflotation average weighted where
D
E
A
f
f
f
17-31Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—Project Cost including Flotation CostsSaddle Co. Ltd has a target capital structure of 70 per cent equity and 30 per cent debt. The flotation costs for equity issues are 15 per cent of the amount raised and the flotation costs for debt issues are 7 per cent. If Saddle Co. Ltd needs $30 million for a new project, what is the ‘true cost’ of this project?
12.6%
0.07 0.30 0.15 0.70
Af
The weighted average flotation cost is 12.6 per cent.
17-32Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—Project Cost including Flotation Costs (continued)
million $34.32
.1260 1
$30m
1
costs)flotation (ignoringcost Project project ofcost True
Af
• Saddle Co. needs to raise $30 million for the project after covering flotation costs.
17-33Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—Flotation Costs & NPV• Apollo Co. Ltd needs $1.5 million to finance a new
project expected to generate annual after-tax cash flows of $195 800 forever. The company has a target capital structure of 60 per cent equity and 40 per cent debt. The financing options available are:– An issue of new ordinary shares. Flotation costs of equity
are 12 per cent of capital raised. The return on new equity is 15 per cent.
– An issue of long-term debentures. Flotation costs of debt are 5 per cent of the capital raised. The return on new debt is 10 per cent.
• Assume a corporate tax rate of 30 per cent.
17-34Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—NPV (No Flotation Costs)
322 $159
000 500 $1 0.118
800 $195 NPV
11.8%or 0.118
0.30 1 0.1 0.4 15% 0.6 WACC
17-35Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—NPV (With Flotation Costs)
$7340
982 651 $10.118
800 $195 NPV
982 651 $1 0.092 1
000 500 $1 cost True
9.2%or 0.092
0.05 0.4 0.12 0.6
Af
Flotation costs decrease a project’s NPV and could alter an investment decision.
Note: If the flotation costs are tax-deductible, we can calculate an after-tax weighted average flotation cost, fAT = fA(1-TC)
17-36Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Summary and Conclusions• The cost of equity is the return that equity investors
require on their investment in the firm.• There are two approaches to determine the cost of
equity: the dividend growth model approach and the SML approach.
• The cost of debt is the return that lenders require on the firm’s debt.
• WACC is both the required rate of return and the discount rate appropriate for cash flows that are similar in risk to the overall firm.
• Flotation costs can affect a project’s NPV and alter the investment decision.