Chapter 14. The Cost of Capital. Chapter 14 Contents

Chapter 14 The Cost of Capital Copyright © 2011 Pearson Prentice Hall. All rights reserved. Chapter 14 Contents 1. The Cost of Capital: An Overview...
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Chapter 14

The Cost of Capital

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Chapter 14 Contents 1. The Cost of Capital: An Overview 2. Determining the Firm’s Capital Structure Weights 3. Estimating the Costs of Individual Sources of Capital 4. Summing Up – Calculating the Firm’s WACC 5. Estimating Project Cost of Capital 6. Floatation costs and Project NPV

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Learning Objectives 1. Understand the concepts underlying the firm’s overall cost of capital and its calculation. 2. Evaluate firm’s capital structure, and determine the relative importance (weight) of each source of financing. 3. Calculate the after-tax cost of debt, preferred stock, and common equity. 4. Calculate firm’s weighted average cost of capital 5. Understand: a)Pros and cons of using multiple, risk-adjusted discount rates; b)divisional cost of capital as alternative for firms with divisions. 6. Adjust NPV for the costs of issuing new securities when analyzing new investment opportunities. Copyright © 2011 Pearson Prentice Hall. All rights reserved.

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Principles Used in Chapter 14 • Principle #1: Money Has a Time Value. • Principle #3: Cash Flows Are the Source of Value. – Estimates of investor’s required rate of return extracted from observed market prices are based on principles #1 and #3. • Principle #2: There Is a Risk-Return Tradeoff. – Investors who purchase a firm’s common stock require a higher expected return than investors who loan money.

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The Cost of Capital: An Overview • The Firm’s Cost of capital is the value-weighted average of the required returns of the securities that are used to finance the firm. – Officially refer to this as the firm’s Weighted Average Cost of Capital, or WACC.

• Most firms raise capital with a combination of debt, equity, and hybrid securities. • WACC incorporates the required rates of return of the firm’s lenders and investors and the particular mix of financing sources that the firm uses.

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The Cost of Capital Overview (cont.) • How does riskiness of firm affect WACC? – Required rate of return on securities will be higher if the firm is riskier. – Risk will influence how the firm chooses to finance i.e. proportion of debt and equity.

• WACC is useful in a number of settings: – – –

WACC is used to value the firm. WACC is used as a starting point for determining the discount rate for projects the firm might undertake. WACC is the appropriate rate to use when evaluating performance, specifically whether or not the firm has created value for its shareholders.

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After-Tax WACC equation (WACCAT)

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3-Step Procedure to Estimate Firm WACC 1.

Define the firm’s capital structure by determining the weight of each source of capital. (see column 2, fig 14-2)

2.

Estimate the opportunity cost of each source of financing. We will use the current market value of each source of capital based on its current, not historical, costs. (see column 3, fig 14-2)

3.

Calculate a weighted average of the costs of each source of financing. (see column 4, fig 14-2)

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Determining Firm’s Capital Structure Weights • The weights are based on the following sources of capital: debt (short-term and long-term), preferred stock and common equity. • Liabilities such as accounts payable and accrued expenses are not included in capital structure. • Ideally, the weights should be based on observed market values. However, not all market values may be readily available. – Hence, we generally use book values for debt and market values for equity.

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Example 1: Calculating the WACC for Templeton Extended Care Facilities, Inc. In the spring of 2010, Templeton was considering the acquisition of a chain of extended care facilities and wanted to estimate its own WACC as a guide to the cost of capital for the acquisition. Templeton’s capital structure consists of the following:

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Example 1 Continued (Info) Templeton contacted the firm’s investment banker to get estimates of the firm’s current cost of financing and was told that if the firm were to borrow the same amount of money today, it would have to pay lenders 8%. However, given the firm’s 25% tax rate, the aftertax cost of borrowing would only be 6% = 8%(1-.25). Preferred stockholders currently demand a 10% rate of return. Common stockholders demand 15% returns. Templeton’s CFO knew that the WACC would be somewhere between 6% and 15% since the firm’s capital structure is a blend of the three sources of capital whose costs are bounded by this range. (Think about the GOOD logic and intuition.)

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Computing the Weights - Finally

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Example 1 – Solution to WACCAT

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Example 2 – Impact of Capital Structure Change on WACC • After completing her estimate of Templeton’s WACC, the CFO decided to explore the possibility of adding more low-cost debt to the capital structure. • With the help of the firm’s investment banker, the CFO learned that Templeton could probably push its use of debt to 37.5% of the firm’s capital structure by issuing more debt and retiring (purchasing) the firm’s preferred shares. • Assume this could be done without increasing the firm’s costs of borrowing or the required rate of return demanded by the firm’s common stockholders. • What is your estimate of the WACC for Templeton under this new capital structure proposal?

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Before Debt Preferred Common

MV 100 50 250

Weight 0.250 0.125 0.625

Total

400

1.000

After Debt Preferred Common

MV 150 0 250

Weight 0.375 0.000 0.625

Total

400

1.000

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AT Rate 6% 10% 15% WACC

AT Rate 6% 10% 15% WACC

W*R 1.500% 1.250% 9.375% 12.125%

W*R 2.250% 0.000% 9.375% 11.625% 14-17

14.3 Estimating the Cost of Individual Sources of Capital

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The Cost of Debt • The cost of debt is the rate of return the firm’s lenders demand when they loan money to firm. • The rate of return is not the same as coupon rate, which is rate contractually set at the time of issue. • Can estimate the market’s required rate of return by examining the yield to maturity on firm’s debt. • After-tax cost of debt = Yield (1-tax rate)

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Example 2: The Cost of Debt Estimate • What will be the yield to maturity on a debt that has par value of $1,000, a coupon interest rate of 5%, time to maturity of 10 years and is currently trading at $900? • What will be the cost of debt if tax rate is 30%?

• Enter: – N = 10; PV = -900; PMT = 50; FV =1000 – I/Y = 6.38% – After-tax cost of Debt = Yield (1-tax rate) = 6.38 (1-.3) = 4.47% Copyright © 2011 Pearson Prentice Hall. All rights reserved.

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The Cost of Debt – Other Approaches • It is not easy to find the market price of a specific bond as most bonds do not trade in the public market. • Because of this, it is a standard practice to estimate the cost of debt using yield to maturity on a portfolio of bonds with similar credit rating and maturity as the firm’s outstanding debt.

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Cost of Preferred Equity Estimates • The cost of preferred equity is the rate of return investors require of the firm when they purchase its preferred stock. • The cost is not adjusted for taxes since dividends are paid to preferred stockholders out of after-tax income.

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Example: Estimate Cost of Preferred Equity • Consider the preferred shares of Relay Company that are trading at $25 per share. What will be the cost of preferred equity if these stocks have a par value of $35 and pay annual dividend of 4%?

• kps = $1.40 ÷ $25 = .056 or 5.6%

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Cost of Common Equity Estimates • The cost of common equity is the rate of return investors expect to receive from investing in firm’s stock. This return comes in the form of cash distributions of dividends and cash proceeds from the sale of the stock. • Cost of common equity is harder to estimate since common stockholders do not have a contractually defined return (unlike bonds or preferred stock). • There are two approaches to estimating the cost of common equity: – Dividend growth model (chapter 10) – CAPM (chapter 8) Copyright © 2011 Pearson Prentice Hall. All rights reserved.

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The Dividend Growth Model – Discounted Cash Flow Approach • Using this approach, estimate the expected stream of dividends as the source of future estimated cash flows. • Use the estimated dividends and current stock price to calculate the internal rate of return on the stock investment. This return is used as an estimate of cost of equity. • Essentially, cost of equity is the I/Y that supports current stock price and our dividend forecast assumptions

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Step 1: Picture the Problem • We are given the following: – Price of common stock (Pcs ) = $10.09 – Growth rate of dividends (g) = 5% and 7.81% – Dividend (D0) = $0.47 per share – Cost of equity is given by dividend yield + growth rate.

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Step 1: Picture the Problem (cont.)

Dividend Yield =D1 ÷ P0

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Growth Rate (g)

Cost of Equity (kcs )

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Step 3: Solve

• At growth rate of 5% • kcs = {$0.47(1.05)/$10.09} + .05 = .0989 or 9.89%

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Step 3: Solve (cont.)

• At growth rate of 7.81% • kcs = {$0.47(1.0781)/$10.09} + .0781 = .1283 or 12.83 %

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Estimating the Rate of Growth, g • The growth rate can be obtained from various websites that post analysts forecasts of growth rates. • We can also estimate the growth rate using the historical data and computing the arithmetic average or geometric average.

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Estimating the Rate of Growth, g (cont.)

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Pros and Cons of the Dividend Growth Model Approach • While dividend growth model is easy to use, it is severely dependent upon the quality of growth rate estimates. – When you look at real dividend policies, you will see that dividends don’t grow smoothly but are a “stair-stepped” function. – This means using smooth g-function systematically over and under estimates any given future dividend

• Furthermore, not all firms pay dividends. Copyright © 2011 Pearson Prentice Hall. All rights reserved.

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The Capital Asset Pricing Model • CAPM was used to determine the expected or required rate of return for risky investments.

• Previous Equation illustrates that the expected return on common stock is determined by three key ingredients: – The risk-free rate of interest, – The beta or systematic risk of the common stock returns, – The market risk premium. Copyright © 2011 Pearson Prentice Hall. All rights reserved.

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Advantages of the CAPM approach 1. The model is simple to understand and use. 2. The model does not depend on dividends or growth rate so it can be applied to companies that do not currently pay dividends or are not expected to experience a constant rate of growth in dividends.

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Disadvantages of the CAPM Approach 1. CAPM does not offer any guidance on the appropriate choice for the risk-free rate. Risk-free rate may vary widely depending on the Treasury security chosen. 2. Estimates of beta can vary widely depending upon the market index and time period chosen. 3. Estimates of market risk premium will also vary depending on the time period and security chosen.

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Example: Estimating Cost of Common Equity using the CAPM At the end of March 2009, the 10-year U.S. Treasury Bond yield that we will use to measure the risk-free rate was 2.81% Estimated market risk premium at the time is 6.5%, and the beta for Pearson’s common stock is 1.20 Determine Pearson’s cost of common equity using the CAPM, as of March 2009. Ke =

Rf + Beta * MRP

=

2.81% + 1.2*6.5%

=

2.81% + 7.8%

=

10.61%

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14.5 Estimating Project Cost of Capital

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Estimating Project Cost of Capital • Should the firm-wide (overall) WACC be used to evaluate all new investments? – Appropriate only if the risk of the new project is equal to the overall risk of the firm. – When not be the case, need a unique cost of capital for each project. • Recent survey found that more than 50% of the firms tend to use single, company-wide discount rate to evaluate all of their investment proposals. • There are advantages and costs associated with estimating a unique discount rate for each project. Copyright © 2011 Pearson Prentice Hall. All rights reserved.

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Rationale for Multiple Discount Rates • Multiple discount rates is consistent with finance theory that suggests that unique discount rate will reflect the unique risk of the investment. • Figure 14-6 illustrates the problems that arise when a single discount rate is used to evaluate investment projects with different levels of risk. • A conglomerate would have a menu of risk profiles for various elements of the economy in which they operate. – This would lead to considering divisional WACC’s

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Why Firms Don’t Use Project Cost of Capital 1. It may be difficult to trace the source of financing for individual project since most firms raise money in bulk for all the projects. 2. It adds to the time and cost in getting approval for new projects.

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Estimating Divisional WACCs • If firm undertakes investment with very different risks, it will try to estimate divisional WACCs. • Divisions are generally defined by geographical regions (e.g., Asian region versus European region) or industry. • Advantages of a divisional WACC: – The discount rate reflects the risk of projects evaluated by different divisions. – Requires estimating only one cost of capital estimate for entire division (rather than one for each project). – Limits managerial latitude and attendant influence costs.

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Using Pure Play Firms to Estimate Divisional WACCs • Here a firm with multiple divisions may identify a comparable firm with only one division (called a pure play firm). • The estimate of pure play firm’s cost of capital can then be used as a proxy for that particular division’s cost of capital.

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Divisional WACC – Issues and Limitations 1. The sample of firms in a given industry may include firms that are not good matches for the firm or one of its divisions. 2. The division being analyzed may not have a capital structure that is similar to the sample of firms in the industry data. 3. The firms in the chosen industry that are used to proxy for divisional risk may not be good reflections of project risk. 4. Good comparison firms for a particular division may be difficult to find.

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WACC, Floatation Costs and Project NPV • Floatation costs are costs incurred by a firm when it raises money to finance new investments by selling bonds and stocks. – Costs may include fees paid to an investment banker, and costs incurred when securities are sold at a discount to the current market price. • Because of floatation costs, the firm will have to raise more than the amount it needs.

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Floatation Costs Example • Firm needs $100 million to finance its new project and the floatation cost is expected to be 5.5%. – How much should the firm raise by selling securities?

$105.82 million = $100 million ÷ (1-.055) • Thus the firm will raise $105.82 million, which includes floatation cost of $5.82 million. Copyright © 2011 Pearson Prentice Hall. All rights reserved.

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Comprehensive Floatation Cost Example 1 Flotation Cost Impact on NPV The Tricon is considering a $100 million investment that would allow it to develop fiber optic high-speed Internet connectivity. Investment will be financed using the firm’s desired mix of debt and equity with 40% debt financing and 60% common equity financing. Firm’s investment banker advised the CFO the issue costs associated with debt would be 2% while the equity issue costs would be 10%. Tricon uses a 10% cost of capital to evaluate its telecom investments and has estimated that the new fiber optic project will yield future cash flows with present value of $115 million. Account for the effect of the costs of raising the financing for the project or flotation costs. Should the firm go forward with the investment in light of the flotation costs?

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Checkpoint 14.4

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Example 2 – Change Float Costs • Stock market conditions changed such that new stock became more expensive to issue. Tricon’s floatation costs rose to 15% of new equity issued and the cost of debt rose to 3%. – Is the project still viable (assume the present value of future cash flows remain unchanged at $115)?

NPV = PV(inflows) – Initial outlay – Floatation costs

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Solution Strategy Steps • First, estimate the average floatation costs that Tricon will incur when raising the funds.

= .40 × .03 + .60 × .15 = .102 or 10.2% • Next, estimate the “grossed up” initial outlay for $100 million project: $111.36 million = $100 million ÷ (1- 0.102) • Thus, floatation costs is equal to $11.36 million and NPV = 115-111.36 = 3.64 and accept. Copyright © 2011 Pearson Prentice Hall. All rights reserved.

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