Chap 012

Chapter 12

Cost of Capital

1 McGraw-Hill/Irwin

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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Chapter Outline • • • • •

The Cost of Capital: Some Preliminaries The Cost of Equity The Costs of Debt and Preferred Stock The Weighted Average Cost of Capital Divisional and Project Costs of Capital

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Why Cost of Capital Is Important? • Capital budgeting • r = interest rate, discount rate, required return, cost of capital, opportunity cost • The required return on asset depends on the risk of the asset • How much return required by investor = cost to the company • How to calculate the cost of capital (r)? – Where the capital being raised – Return required by capital suppliers 3

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Capital Components

3 sources of capital: 1) Common stock (Equity) - RE 2) Debts - RD 3) Preferred stock - RP

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1) Cost of Equity (RE) • The cost of equity is the return required by equity investors • There are two major methods for determining the cost of equity – Dividend growth model – SML or CAPM

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The Dividend Growth Model Approach

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• Start with the dividend growth model formula and rearrange to solve for RE D1 P0 = RE − g RE

D1 = + g P0

Cost of equity = Dividend Yield + Capital gains Yield 6

Dividend Growth Model Example

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• Suppose that your 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?

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Example: Estimating the Dividend Growth Rate

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• One method for estimating the growth rate is to use the historical average Year Dividend Percent Change – 2000 1.23 – 2001 1.30 – 2002 1.36 – 2003 1.43 – 2004 1.50

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Advantages and Disadvantages of Dividend Growth Model • Advantage – easy to understand and use • Disadvantages – 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 9

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The CAPM Approach (SML) • Derived from Capital Asset Pricing Model

R E = R f + β E [E(R M ) − R f ] – Rf = Risk-free rate – E(RM)= Market return – E(RM) – Rf = Market risk premium, β = beta = Systematic risk of asset, 10

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Example - SML • Suppose your 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 your cost of equity capital?

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Advantages and Disadvantages of SML • Advantages – Explicitly adjusts for systematic risk – Applicable to all companies, as long as we can compute beta

• Disadvantages – 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 12

Example – Cost of Equity

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• Suppose our company has a beta of 1.5. The market risk premium is expected to be 9% and the current risk-free rate is 6%. We have used analysts’ estimates to determine that the market believes our dividends will grow at 6% per year and our last dividend was $2. Our stock is currently selling for $15.65. What is our cost of equity?

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2) Cost of Debt (RD) • The cost of debt is the investors’ required return on company’s debt • The cost of long-term debt or bonds • The cost of debt is NOT the coupon rate • Best estimated by using the Yield to maturity (YTM) on the existing debt • YTM is the rate implied by the current bond price • The rate that equals the PV of bond’s cash flows with bond price. 14

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Cost of Debt Example • Suppose 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?

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3) Cost of Preferred Stock (Rp) • Preferred generally pays a constant dividend every period • Dividends are expected to be paid every period forever • Preferred stock is an perpetuity, so we take the perpetuity formula, rearrange and solve for RP • PV = C/r ==> P = D/Rp • RP = D / P0

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Cost of Preferred Stock Example

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• Your company has preferred stock that has an annual dividend of $3. If the current price is $25, what is the cost of preferred stock?

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Capital Structure Weights • We can use the individual costs of capital that we have computed to get our “average” cost of capital for the firm. • Weights according to: – Target capital structure – Current market value of capital structure – Book values of capital structure

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Capital Structure Weights

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• Suppose you have a market value of equity equal to $500mil, market value of debt = $475mil and preferred market value = 25mil:

• Suppose a company has a target debt equity ratio of 0.6:

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Taxes and WACC • After-tax cash flows After-tax cost of capital • Interest expense for debt is tax deductible: – Reduces cost of debt – After-tax cost of debt = RD(1-TC) – TC = corporate tax rate • Dividends for common equity and preferred equity are not tax deductible.

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Weighted Average Cost of Capital (WACC)

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E D P WACC = R E + R D (1 − Tc) + R P V V V where:

E/V = Weight for Equity RE = Cost of Equity D/V = Weight for Debt RD = Cost of Debt Tc = Corporate tax rate P/V = Weight for Preferred Rp = Cost of Preferred

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Example – WACC • Equity Capital: – – – – –

• Debt Capital:

50,000 shares $80 per share Beta = 1.15 Market risk premium = 9% Risk-free rate = 5%

• Preferred Capital:

– $1 million in outstanding debt (at face value) – Current quote = 118.39% – Coupon rate = 9%, semiannual coupons – 15 years to maturity – Tax rate = 40%

– 10,000 shares – $110 per share – Dividend rate of 5.5% 22

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Example – WACC

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Example – WACC

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Divisional and Project Costs of Capital

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• Using the WACC as our discount rate is only appropriate for projects that are the same risk as the firm’s current operations • If we are looking at a project that is NOT the same risk as the firm, then we need to determine the appropriate discount rate for that project • Divisions also often require separate discount rates

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Pure Play Approach • Find one or more companies that specialize in the product or service that we are considering • 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 • Often difficult to find pure play companies

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Subjective Approach • Consider the project’s risk relative to the firm overall • Assume WACC=15% for average risk class • If the project is more risky than the firm, use a discount rate greater than the WACC (r>15%) • If the project is less risky than the firm, use a discount rate less than the WACC (r<15%)

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Subjective Approach - Example Risk Level

Discount Rate

Very Low Risk

WACC – 8% =12%

Low Risk

WACC – 3% = 17%

Same Risk as Firm

WACC = 20%

High Risk

WACC + 5% = 25%

Very High Risk

WACC + 10% = 30% 28

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Quick Quiz • What are the two approaches for computing the cost of equity? • How do you compute the cost of debt and the aftertax 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?

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Tutorial • Problem 4, 10 & 18 from page 397 • Problem 18: - under Debt: “…a quoted price of 108.” change to “…a quoted price of 105.34.”

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