VIEWS: 0 PAGES: 26 CATEGORY: Business POSTED ON: 1/10/2009
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