Investment Decision Weighted Average Cost of Capital by ramhood4

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```									   Investment Decision:
Weighted Average Cost of
Capital

1/10/2009       Cost of Capital   1
Return on assets must be greater than the cost of capital

Current
Liabilities
Current Assets
What is the cost
of financing?             Long-Term
(What does it               Debt
cost to use the
Fixed Assets     bondholders and
the stockholders
Tangible                              Shareholders’
money?)
Intangible                               Equity

1/10/2009                       Cost of Capital                   2
Why Study Cost of Capital?

1.      Capital budgeting decisions

2.      Regulated industries

3.      Leasing, bond refunding, working capital

4.      Maximize value or minimize cost of inputs, including

capital

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Why a Weighted Average?
Cost of debt     RD = 8%
Cost of equity   RE = 12%

Project A:
IRR = 10%
Financed with all debt

Project B:
IRR = 11%
No debt available
Financed with all equity

1/10/2009                    Cost of Capital   4
Weighted Average Cost of Capital
Assumptions

1)          New project’s risk equals existing
projects’ risk

2)          General financing policies are not
affected by the particular project

1/10/2009                   Cost of Capital      5
Weighted Average Cost of Capital
RA = RD • (1-t) • wtD + RP • wtP + RE • wtE

Where:
RA         = weighted average cost of capital
RD         = cost of debt
RP         = cost of preferred stock
RE         = cost of equity (common stock and retained earnings)
wtD        = weight of debt = D/V
wtP        = weight of preferred stock = P/V
wtE        = weight of equity = E/V
t          = marginal tax rate

1/10/2009                       Cost of Capital                      6
Cost of Debt, RD

1.        Use the marginal cost of debt

2.        A proxy for the marginal cost of debt is the
current yield to maturity (YTM) on bonds*

3.        After tax cost of debt = (YTM)(1-t)

* EAR is best.

1/10/2009                      Cost of Capital             7
Cost of Debt Example

Market value of issue                               18.75 million
Years to maturity                                         8 years
Coupon rate (annual payments)                                 5%
Face value                                          20.00 million

Step 1, Find YTM                                        Step 2, Adjust for taxes
     1 
1-
 (1  r )8      20
18.75  .05(20)                                      R D  6% (1- .4)
   r         (1  r )8

           

YTM  r  6%                                                3.6%

1/10/2009                             Cost of Capital                              8
Cost of Debt with Multiple Issues
(tax rate is 46%)
Mkt value      Years to           Coupon       Face
Issue   (in millions)   Maturity            Rate        Value
a       \$18.85              8              5 %        \$20
b          9.25           10               5            10
c         47.25           20               5            60
75.25
Step 1: YTM’s
a        6%
b        6%                                              RD = 6.6% (1 - .46)
c        7%
= 3.6%
Step 2:     Weighted YTM
9.25         18.75        47.25
YTM              (6%)        (6%)        (7%)  6.6%
75.25        75.25        75.25

1/10/2009                               Cost of Capital                            9
Cost of Preferred Stock

1. RP = return required by investors to invest in
the firm’s preferred stock

Dp   Preferreddividend
2.          RP    
Pp Preferredmarket price

3. No tax savings on dividends

1/10/2009                    Cost of Capital        10
Cost of Preferred Stock Example
Book value of issue                             \$24 million
Market value of issue                           \$20 million
Preferred dividend (annual)                     \$ 2 million
Find RP :
Dp
RP 
Pp
2

20

 10%

1/10/2009                        Cost of Capital                 11
Cost of Preferred Stock with Multiple Issues
Market Value of
Book Value of Issue          Issue                Preferred Dividend
Issue             (in millions)         (in millions)               (in millions)
a              \$24                               \$20               2.0

b               12                                10                .8
\$30
Step 1                                             Step 2
2.0
R a
 10%                                          20        10
RP     (10%)  (8%)
P
20
30        30
.8
RP 
b
 8%                                           9.33%
10

1/10/2009                                  Cost of Capital                                  12
Cost of Equity or Required Return

1.        Cost of Equity is not always a cash outflow; it can be
expected growth (appreciation).

2.        Retained earnings have an opportunity cost--stock
holders could have received the earnings and invested
them in alternative investment of comparable risk--RE

3.        Methods of Calculation
a.   Historical
b.   Gordon Growth
c.   CAPM
d.   McQueen’s Quick and Dirty

1/10/2009                              Cost of Capital               13
The Cost of Equity Capital
Shareholder
Firm with                                   invests in
excess cash     Pay cash dividend             financial
asset
A firm with excess cash can either pay a
dividend or make a capital investment

Shareholder’s
Invest in project       Terminal
Value
Because stockholders can reinvest the dividend in risky financial assets,
the expected return on a capital-budgeting project should be at least as
great as the expected return on a financial asset of comparable risk.

1/10/2009                            Cost of Capital                            14
Cost of Equity--Historical Estimate

Rate of return is made up of dividends and price appreciation:

Pt 1  Pt  Dt 1
RE 
Pt
To get a good historical rate, find the actual rate for several
recent years and arrive at some sort of average.

Implicit assumption: expected return equals past returns

1/10/2009                      Cost of Capital                      15
Cost of Equity -- Historical Estimate Example

Year      Stock Price       Dividend     Return
0        \$10.00
1         11.00              \$1.00      20%
2         12.10                 1.10    20%
3         14.52                 2.42    40%
Questions
• Is the expected required return 40% or 20% or some
average?
• Is the increase to 40% a trend?

1/10/2009                         Cost of Capital                  16
Cost of Equity--Gordon Growth
1. Assumption: dividends will grow at a constant rate “g”

D1
2. RE     g
P0

3. Find g:
a) historical dividend growth
b) sustainable growth

1/10/2009                     Cost of Capital               17
Finding g for ke Calculation
1. Historical approach:
(1993 DPS)(1+g)10 = (2003 DPS)
.56(1+g)10 = 1.75
g  12%*

2. Sustainable growth:          Where:
SG = (ROE)(1-PO)             ROE =             Return on Equity
= (24%)(.5)                     =          NI/OE
= 12%                    PO     =          Payout Ratio
=          Div/NI

*Arithmetic average is better than geometric average when forecasting.

1/10/2009                       Cost of Capital                      18
Finding Cost of Equity--Example
D1
RE     g
P0

\$1.75 (1.12)
               .12
\$49.00

 16%

1/10/2009             Cost of Capital   19
Cost of NEW equity
F = Flotation costs per share of new stock
D1
Rn         g
P0  F

\$1.75 (1.12)
               .12
49.00 - 1.50

 16.1%

1/10/2009                       Cost of Capital          20
Summary of Components
RD  YTM *               *EAR is better
 6%

Dp
RP 
Pp
 10%

D1
RE       g
P0
 16%

Notice RD < RP < RE

1/10/2009                  Cost of Capital                    21
Cost of Capital Weights

1. Best      Proportions of individual source
inputs the firm intends to use in the
future or target weights
2. Proxies--
a) Book value weights
b) Market value weights

1/10/2009               Cost of Capital              22
Weighting the Components
(No new stock issues planned)
Book Value      Market Value (in
Source         Cost      (in millions)      millions)
Debt                    6%          \$20.00          \$18.75
Preferred              10%            24.00          20.00
Common Stock           16%            22.00          55.00
Retained Earnings      16%            18.00
Total                                 84.00          93.75

Market Weights
18.75                 20            55
RA              [(6%)(1 .4)] 
-             (10%)        (16%)  12.24%
93.75                93.75         93.75

Book Weights
20                  24         40
RA      [(6%)(  .4)] 
1             (10%)     (16%)  11.33%
84                  84         84

1/10/2009                             Cost of Capital                       23
Key Assumptions of RA

1.        Same Risk
2.        Same Financing

Goal--    Find the discount rate associated with the risk of
the cash flows

1/10/2009                     Cost of Capital                    24
Fundamental Rules

1. Match investment perspective to:
a. Cash Flows
b. Discount Rate
(i.e., After tax cash flow with RA and
equity cash flows with RE)

2. Discount rate consistent with risk
(i.e., The cost of capital depends primarily on the use
of the funds, not the source.)

1/10/2009                   Cost of Capital                   25
Capital Budgeting & Project Risk

IRR
Project
SML
The SML can tell us why:
Incorrectly accepted
negative NPV projects
Hurdle                                     RF  β FIRM ( R M  RF )
rate
Incorrectly rejected
rf                  positive NPV projects
Firm’s risk (beta)
bFIRM
A firm that uses one discount rate for all projects may over time
increase the risk of the firm while decreasing its value.

1/10/2009                            Cost of Capital                              26

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