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

 1/10/2009                     Cost of Capital                 3
 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
                                                          Step 3: Tax Adjustment
 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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