The Cost of Capital.ppt

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1、,CHAPTER 6The Cost of Capital,Cost of Capital ComponentsDebtPreferredCommon EquityWACC,What types of long-term capital do firms use?,Long-term debtPreferred stockCommon equity,Capital components are sources of funding that come from investors.Accounts payable, accruals, and deferred taxes are not so

2、urces 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.,Should we focus on before-tax or after-tax capital costs?,Tax effects

3、 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.,Should we focus on historical (embedded) costs or new (marginal) c

4、osts?,The cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we should focus on marginal costs.,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 y

5、ield on other bonds with a similar rating.Method 3: Find the yield on the companys debt, if it has any.,A 15-year, 12% semiannual bond sells for $1,153.72. Whats rd?,60,60 + 1,000,60,0,1,2,30,i = ?,30 -1153.72 60 1000 5.0% x 2 = rd = 10%,N,I/YR,PV,FV,PMT,-1,153.72,.,INPUTS,OUTPUT,Component Cost of D

6、ebt,Interest is tax deductible, so the after tax (AT) cost of debt is: rd AT= rd BT(1 - T)= 10%(1 - 0.40) = 6%.Use nominal rate.Flotation costs small, so ignore.,Whats the cost of preferred stock? PP = $113.10; 10%Q; Par = $100; F = $2.,Use this formula:,Picture of Preferred,2.50,2.50,0,1,2,rps = ?,

7、-111.1,.,2.50,Note:,Flotation costs for preferred are significant, so are reflected. Use net price.Preferred dividends are not deductible, so no tax adjustment. Just rps.Nominal rps is used.,Is preferred stock more or less risky to investors than debt?,More risky; company not required to pay preferr

8、ed dividend.However, firms want to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, and (3) preferred stockholders may gain control of firm.,Why is yield on preferred lower than rd?,Corporations own most preferred stock, because 70% of prefe

9、rred dividends are nontaxable to corporations.Therefore, preferred often has a lower B-T yield than the B-T yield on debt.The A-T yield to investors and A-T cost to the issuer are higher on preferred than on debt, which is consistent with the higher risk of preferred.,Example:,rps = 9% rd = 10%T = 4

10、0%,rps, AT = rps - rps (1 - 0.7)(T),= 9% - 9%(0.3)(0.4) = 7.92%,rd, AT = 10% - 10%(0.4)= 6.00%,A-T Risk Premium on Preferred = 1.92%,Directly, by issuing new shares of common stock.Indirectly, by reinvesting earnings that are not paid out as dividends (i.e., retaining earnings).,What are the two way

11、s that companies can raise common equity?,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 reinvested.,Why is there a cost for reinvested earnings?,Opportunity cost: The return stockholders coul

12、d earn on alternative investments of equal risk.They could buy similar stocks and earn rs, or company could repurchase its own stock and earn rs. So, rs, is the cost of reinvested earnings and it is the cost of equity.,Three ways to determine the cost of equity, rs:,1.CAPM: rs= rRF + (rM - rRF)b= rR

13、F + (RPM)b.2.DCF: rs = D1/P0 + g.3.Own-Bond-Yield-Plus-Risk Premium:rs = rd + RP.,Whats the cost of equity based on the CAPM?rRF = 7%, RPM = 6%, b = 1.2.,rs = rRF + (rM - rRF )b.,= 7.0% + (6.0%)1.2 = 14.2%.,Issues in Using CAPM,Most analysts use the rate on a long-term (10 to 20 years) government bo

14、nd as an estimate of rRF. For a current estimate, go to , select “U.S. Treasuries” from the section on the left under the heading “Market.”,More,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”

15、(they have a wide confidence interval). For an estimate of beta, go to and enter the ticker symbol for STOCK QUOTES.,Whats the DCF cost of equity, rs?Given: D0 = $4.19;P0 = $50; g = 5%.,Estimating the Growth Rate,Use the historical growth rate if you believe the future will be like the past.Obtain

16、analysts estimates: Value Line, Zacks, Yahoo!.Finance.Use the earnings retention model, illustrated on next slide.,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?,Retenti

17、on growth rate:g = ROE(Retention rate) g = 0.35(15%) = 5.25%.This is close to g = 5% given earlier. Think of bank account paying 15% with retention ratio = 0. What is g of account balance? If retention ratio is 100%, what is g?,Could DCF methodology be appliedif g is not constant?,YES, nonconstant g

18、 stocks are expected to have constant g at some point, generally in 5 to 10 years.But calculations get complicated. See “Ch 6 Tool Kit.xls”.,Find rs using the own-bond-yield-plus-risk-premium method. (rd = 10%, RP = 4%.),This RP CAPM RPM.Produces ballpark estimate of rs. Useful check.,rs= rd + RP= 1

19、0.0% + 4.0% = 14.0%,Whats a reasonable final estimateof rs?,MethodEstimateCAPM14.2%DCF13.8%rd + RP14.0% Average14.0%,Determining the Weights for the WACC,The weights are the percentages of the firm that will be financed by each component.If possible, always use the target weights for the percentages

20、 of the firm that will be financed with the various types of capital.,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 rea

21、sonable to use the book values of debt, especially if the debt is short-term.,(More.),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.),Vce = $50 (3 million) = $150 million

22、.Vps = $25 million.Vd = $75 million.Total value = $150 + $25 + $75 = $250 million.wce = $150/$250 = 0.6wps = $25/$250 = 0.1wd = $75/$250 = 0.3,Whats the WACC?,WACC= wdrd(1 - T) + wpsrps + wcers= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)= 1.8% + 0.9% + 8.4% = 11.1%.,WACC Estimates for Some Large U. S. Corpo

23、rations,Company WACCGeneral Electric (GE)12.5Coca-Cola (KO)12.3Intel (INTC)12.2Motorola (MOT)11.7Wal-Mart (WMT)11.0Walt Disney (DIS)9.3AT&T (T)9.2Exxon Mobil (XOM)8.2H.J. Heinz (HNZ)7.8BellSouth (BLS)7.4,What factors influence a companys WACC?,Market conditions, especially interest rates and tax rat

24、es.The firms capital structure and dividend policy.The firms investment policy. Firms with riskier projects generally have a higher WACC.,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

25、by the firm.Different divisions may have different risks. The divisions WACC should be adjusted to reflect the divisions risk and capital structure.,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

26、 capital structure.,What procedures are used to determine the risk-adjusted cost of capital for a particular division?,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

27、projects beta.Hard to find such companies.,2.Accounting beta. Run regression between projects ROA and S&P 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.,Find the divisions mark

28、et 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%.,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

29、 = 17.2%.WACCDiv.= wdrd(1 T) + wcrs = 0.1(12%)(0.6) + 0.9(17.2%)= 16.2%.,How does the divisions WACC compare with the firms overall WACC?,Division WACC = 16.2% versus company WACC = 11.1%.“Typical” projects within this division would be accepted if their returns are above 16.2%.,Divisional Risk and

30、the Cost of Capital,What are the three types of project risk?,Stand-alone riskCorporate riskMarket risk,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 affect

31、ed by corporate risk.Therefore, corporate risk is also relevant.,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 8.Use judgment to scale up or down the cost of capital for an individu

32、al project relative to the divisional cost of capital.,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.,Why is the cost of internal equity fro

33、m reinvested earnings cheaper than the cost of issuing new common stock?,Estimate the cost of new common equity: P0=$50, D0=$4.19, g=5%, and F=15%.,Estimate the cost of new 30-year debt: Par=$1,000, Coupon=10%paid annually, and F=2%.,Using a financial calculator:N = 30PV = 1000(1-.02) = 980PMT = -(.

34、10)(1000)(1-.4) = -60FV = -1000Solving for I: 6.15%,Comments about flotation costs:,Flotation costs depend on the risk of the firm and the type of capital being raised.The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fair

35、ly small.We will frequently ignore flotation costs when calculating the WACC.,Four Mistakes to Avoid,1.When estimating the cost of debt, dont use the coupon rate on existing debt. Use the current interest rate on new debt.2.When estimating the risk premium for the CAPM approach, dont subtract the cu

36、rrent long-term T-bond rate from the historical average return on common stocks.,(More .),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 .),Dont use book weights to estimate the w

37、eights for the capital structure.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 reasonabl

38、e approximation, especially for short-term debt.,(More.),4.Always remember that 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.,