47
Cost of capital Chapter 12
Cost of capitalChapter 12
Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh
Key concepts and skillsKnow how to determine a firms cost of equity capitalKnow how to determine a firms cost of debtKnow how to determine a firms overall cost of capitalUnderstand pitfalls of overall cost of capital and how to manage them
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Chapter outlineThe cost of capital: Some preliminariesThe cost of equityThe costs of debt and preferred stockThe weighted average cost of capitalDivisional and project costs of capital
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Why cost of capital is important?We know that the return earned on assets depends on the risk of those assets.The return to an investor is the same as the cost to the company.Our cost of capital provides us with an indication of how the market views the risk of our assets.Knowing our cost of capital can also help us determine our 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.We need to know the required return for an investment before we can compute the NPV and make a decision about whether or not to take the investment.We need to earn at least the required return to compensate our 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 main methods for determining the cost of equity:1. Dividend growth model2. SML or CAPM
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Dividend growth model methodStart with the dividend growth model formula and rearrange to solve for RE
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Dividend growth model methodExampleYour company is expected to pay a dividend of $4.40 per share next year. (D1)Dividends have grown at a steady rate of 5.1% per year and the market expects that to continue. (g)The current stock price is $50. (P0)What is the cost of equity?
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Estimating the dividend growth rateExample12-* Copyright 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. SinghOne method for estimating the growth rate is to use the historical average.YearDividend% change20031.2320041.3020051.3620061.4320071.50(1.30 1.23) / 1.23 = 5.7%(1.36 1.30) / 1.30 = 4.6%(1.43 1.36) / 1.36 = 5.1%(1.50 1.43) / 1.43 = 4.9%Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%
Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh
Advantages and disadvantages of dividend growth model methodAdvantageeasy to understand and useDisadvantagesOnly applicable to companies currently paying dividendsNot applicable if dividends arent growing at a reasonably constant rateExtremely sensitive to the estimated growth rate Does not explicitly consider risk
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The SML methodCompute cost of equity using the SMLRisk-free rate, RfMarket risk premium, E(RM) RfSystematic risk of asset,
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SML approachExample Companys equity beta = 1.2 Current risk-free rate = 7% Expected market risk premium = 6% What is the cost of equity capital?12-* Copyright 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
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Advantages and disadvantages of SML methodAdvantagesExplicitly adjusts for systematic riskApplicable to all companies, as long as beta is availableDisadvantagesMust estimate the expected market risk premium, which does vary over timeMust estimate beta, which also varies over timeRelies on the past to predict the future, which is not always reliable
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Cost of equityExample 12.1 Data:Beta = 1.2 Market risk premium = 8% Current risk-free rate = 6% Analysts estimates of growth = 8% per year Last dividend = $2 Current stock price = $30
Using SML: RE = 6% + 1.2(8%) = 15.6%Using DGM: RE = [2(1.08) / 30] + .08 = 15.2%
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Cost of debtThe cost of debt = the required return on a companys debt.We usually focus on the cost of long-term debt or bonds.Method 1 = Compute the yield to maturity on existing debt.Method 2 = Use estimates of current rates based on the bond rating expected on new debt.The cost of debt is NOT the coupon rate.
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Cost of debtExampleSuppose we 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?50 [N]; PMT = 45 [PMT]; 1000 [FV]; 908.75[+/-][PV] ; [CPT] [I/Y] = 5%; YTM = 5(2) = 10%
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Cost of preference sharesRemindersPreference shares generally pay a constant dividend every period.Dividends are expected to be paid every period forever.Preference share valuation is an annuity, so we take the annuity formula, rearrange and solve for RP.RP = D/P0
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Cost of preference shares ExampleYour company has preference shares that have an annual dividend of $3. If the current price is $25, what is the cost of a preference share?RP = 3 / 25 = 12%
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Weighted average cost of capitalUse the individual costs of capital to compute a weighted average cost of capital for the firm.This average = the required return on the firms assets, based on the markets perception of the risk of those assets.The weights are determined by how much of each type of financing is used.
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Determining the weights for the WACCWeights = percentages of the firm that will be financed by each component.Always use the target weights, if possible.If not available, use market values.12-* Copyright 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
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Capital structure weightsNotationE = market value of equity = number of outstanding shares times price per shareD = market value of debt = number outstanding bonds times bond priceV = market value of the firm = D + EWeightswE = E/V = percentage financed with equitywD = D/V = percentage financed with debt
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Capital structure weightsExample Suppose you have a market value of equity equal to $500 million and a market value of debt equal to $475 million.What are the capital structure weights?V = 500 million + 475 million = 975 millionwE = E/D = 500 / 975 = .5128 = 51.28%wD = D/V = 475 / 975 = .4872 = 48.72%
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Taxes and the WACC Classical tax systemWe are concerned with after-tax cash flows, so we need to consider the effect of taxes on the various costs of capital.Interest expense reduces our tax liability.This reduction in taxes reduces our 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.
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WACC12-* Copyright 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. SinghWACC = (E/V) x RE + (P/V) x RP + (D/V) x RD x (1- TC)Where:
(E/V) = % of common equity in capital structure(P/V) = % of preferred stock in capital structure(D/V) = % of debt in capital structure
RE = firms cost of equityRP = firms cost of preferred stockRD = firms cost of debtTC = firms corporate tax rate
Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh
WACC IExtended example 12-* Copyright 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. SinghEquity information50 million shares$80 per shareBeta = 1.15Market risk premium = 9%Risk-free rate = 5%Debt information$1 billion in outstanding debt (face value)Current quote = 110Coupon rate = 9%, semiannual coupons15 years to maturityTax rate = 40%
Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh
WACC IIExtended example What is the cost of equity?RE = 5 + 1.15(9) = 15.35%What is the cost of debt?N = 30; PV = -1100; PMT = 45; FV = 1000; CPT I/Y = 3.9268RD = 3.927(2) = 7.854%What is the after-tax cost of debt?RD(1-TC) = 7.854(1-.4) = 4.712%
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WACC IIIExtended example What are the capital structure weights?E = 50 million (80) = 4 billionD = 1 billion (1.10) = 1.1 billionV = 4 + 1.1 = 5.1 billionwE = E/V = 4 / 5.1 = .7843wD = D/V = 1.1 / 5.1 = .2157What is the WACC?WACC = .7843(15.35%) + .2157(4.712%) = 13.06%
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Taxes and the WACC Imputation tax systemIn an imputation system shareholders (if residents) are given a tax credit for the local taxes paid. This will alter the cost of equity for the firm.We have to adjust the WACC formula to take into account the tax advantage of imputation.WACC = wERE(1-TC) + wDRD(1-TC)This adjustment assumes all shareholders can take advantage of the tax credits.
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Summary of capital cost calculationsTable 12.112-* Copyright 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
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Summary of capital cost calculationsTable 12.1 (cont.)12-* Copyright 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
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Factors that Influence a companys WACCMarket conditions, especially interest rates, tax rates and the market risk premiumThe firms capital structure and dividend policyThe firms investment policy Firms with riskier projects generally have a higher WACC
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Cost of equityDominos Pizza12-* Copyright 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
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Cost of equityDominos Pizza (cont.)12-* Copyright 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
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Cost of equityDominos Pizza (cont.)12-* Copyright 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
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Cost of equityDominos Pizza (cont.)Cost of equity using CAPMAssume equity market risk premium= 6%Risk-free rate= 5.25% (Australian government bond rate)Beta = 0.85 (from yahoo finance)RE=0.0525+ 0.85(0.06)=0.1035 or 10.35%Cost of equity using dividend growth model Growth = 13.8% (using key statistics from yahoo finance)Last dividend = $0.124Current share price = $ 5.07RE= 0.124(1+0.138)/5.07
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Cost of debtDominos PizzaThe following is extracted from Dominos Pizzas corporate website:
Overall weighted average debt cost
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WACCDominos PizzaWeights calculated using the total market valueTotal market value = $366.88 millionEquity = $346.18 millionDebt = $20.7 millionWeights WE = 0.94; WD = 0.06WACC 0.94(0.1315)+0.06(0.082)(1-0.3) = 12.71%12-* Copyright 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
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Divisional and project costs of capitalUsing the WACC as our discount rate is only appropriate for projects that are the same risk level as the firms current operations.If we are looking at a project that is NOT the same risk level as the firm, we need to determine the appropriate discount rate for that project.Divisions also often require separate discount rates.
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Risk-adjusted WACCA firms WACC reflects the risk of an average project undertaken by the firm.Average risk = the firms current operationsDifferent divisions/projects may have different risks. The divisions or projects WACC should be adjusted to reflect the appropriate risk and capital structure.
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Using WACC for all projectsWhat would happen if we used the WACC for all projects, regardless of risk?Assume the WACC = 15%
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Using WACC for all projects (cont.)Assume the WACC = 15%.Adjusting for risk changes the decisions.
12-* Copyright 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh Megan Maniscalco - Author: Should the notes to this slide not reflect adjusting for risk? They are the same as for the previous slide at the moment.
Divisional risk and the cost of capitalFigure 12.112-* Copyright 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
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Pure play approachFind one or more companies that specialise in the product or service being considered.Compute the beta for each company.Take an average.Use that beta along with the CAPM to find the appropriate return for a project of that risk.Pure-play companies are difficult to find.
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Subjective approachConsider the projects risk relative to the firm overall.If 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 shouldnt and reject projects you should accept, but your error rate should be lower than when not considering differential risk at all.
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Subjective approachExample12-* Copyright 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Risk levelDiscount rateVery low riskWACC 8%Low riskWACC 3%Same risk as firmWACCHigh riskWACC + 5%Very high riskWACC + 10%
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Quick quizWhat are the two approaches for computing the cost of equity?How do you compute the cost of debt and the after-tax cost of debt?How do you compute the capital structure weights required for the WACC?What is the WACC?What happens if we use the WACC for the discount rate for all projects?What are two methods that can be used to compute the appropriate discount rate when WACC isnt appropriate?12-* Copyright 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
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ENDChapter 1212-46
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***We meaning the firm here.***Remind students that D1 = D0 g.
You may also want to take this opportunity to remind them that return comprises the dividend yield (D1 / P0) and the capital gains yield (g).
*So investors are currently requiring a return of 13.9% on our equity capital.
*Our historical growth rates are reasonably close, so we may feel reasonably confidently that the market will expect our dividend to grow at around 5.1%. Note that when we are computing our cost of equity, it is important to consider what the market expects our growth rate to be, not what we might know it to be internally. The market price is based on market expectations, not our private information.
Another way to estimate the market consensus estimate is to look at analysts forecasts and take an average.
**You will often also hear this referred to as the capital asset pricing model approach.
www: Click on the information icon to go to Bloombergs website. Both betas and 3-month T-bills are available on this site. To get betas, enter a ticker symbol to get the stock quote, then choose profile. To get the T-bill rates, go to Markets and then US Treasuries. is an another site providing similar quotes.***Since the two models are reasonably close, we can assume that our cost of equity is probably about 15.4% (an average).
*Point out that the coupon rate was the cost of debt for the company when the bond was issued. We are interested in the rate we would have to pay on newly issued debt, which could be very different from past rates.
*Remind students that it is a process of trial and error to find the YTM if they do not have a financial calculator or spreadsheet.
*****Note that for bonds we would find the market value of each bond issue and then add them together.
Also note that preferred stock would simply become another component of the equation if the firm has issued it.
Finally, we generally ignore current liabilities in our computations. However, if a company finances a substantial portion of its assets with current liabilities, it should be included in the process.****Remind students that bond prices are quoted as a percentage of par value.
*Point out that students do not have to compute the YTM based on the entire face amount. They can still use a single bond.
******The information is available at the Sydney Morning Herald website or at .
Click on the information icon to reach the Sydney Morning Herald page, which gives the current quote for Dominos .*This data in the textbook is taken from . *Dominos earning summary from yahoo finance.**The complete example is from the textbook; we advise you to refer to textbook for details of the assumptions behind the calculations.*Tax rate of 30% is taken. *It is important to point out that the WACC is not very useful for companies that have several disparate divisions.
**Ask students which projects would be accepted if they used the WACC for the discount rate? Compare 15% to IRR and accept projects A and B.
Now ask students which projects should be accepted if you use the required return based on the risk of the project? Accept B and C.
So, what happened when we used the WACC? We accepted a risky project that we shouldnt have and rejected a less risky project that we should have accepted. What will happen to the overall risk of the firm if the company does this on a consistent basis? Most students will see that the firm will become riskier.*Ask students which projects would be accepted if they used the WACC for the discount rate? Compare 15% to IRR and accept projects A and B.
Now ask students which projects should be accepted if you use the required return based on the risk of the project? Accept B and C.
So, what happened when we used the WACC? We accepted a risky project that we shouldnt have and rejected a less risky project that we should have accepted. What will happen to the overall risk of the firm if the company does this on a consistent basis? Most students will see that the firm will become riskier.
*******
