Discussion 4
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Ch10-CostofCapital.pptxChapter 10. Cost of Capital
1
What sources of capital do firms use?
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Capital
Debt
Preferred Stock
Common Equity
Retained Earnings
New Common Stock
Short-Term Debt
Long-Term Debt
Calculating the Weighted Average Cost of Capital
WACC = wdrd(1 – T) + wprp + wcrs
The w’s refer to the firm’s capital structure weights:
wd=weight of the debt
wp=weight of the preferred stock
wc=weight of the common equity
The r’s refer to the cost of each component:
rd=before-tax cost of the debt
rp =cost of the preferred stock
rs =cost of the common equity
3
Before-tax or after-tax capital costs?
Stockholders focus on after-tax CFs. Therefore, we should focus on after-tax capital costs; i.e., use after-tax costs of capital in WACC. Only rd needs adjustment, because interest is tax deductible.
After-tax cost of debt=Interest rate on debt - Tax saving
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Cost of Debt
WACC = wdrd(1 – T) + wprp + wcrs
rd is the marginal cost of debt capital.
The yield to maturity on outstanding long-term debt is often used as a measure of rd.
5
Cost of Preferred Stock
WACC = wdrd(1 – T) + wprp + wcrs
rp is the marginal cost of preferred stock, which is the return investors require on a firm’s preferred stock.
D is the preferred dividend.
P is the current price of the preferred stock.
Preferred dividends are not tax-deductible, so no tax adjustments necessary.
6
The Cost of Common Equity
Cost of equity is more challenging to estimate than the cost of debt or the cost of preferred stock because common stockholder’s rate of return is not fixed as there is no stated coupon rate or dividend.
The costs will vary for two sources of equity:
Retained earnings (No flotation costs)
Note retained earnings are not a free source of capital. There is an opportunity cost.
rs=cost of the retained earning
New issue (incurs flotation costs)
re=cost of new common stock
Cost estimation techniques
Three Ways to Determine the Cost of Common Equity, rs
The Dividend Growth Model: rs = (D1/P0) + g
The Capital Asset Pricing Model: rs = rf + β(rM – rf )
Bond-Yield-Plus-Risk-Premium:
rs = Bond yield + risk premium= rd + RP
The Dividend Growth Model
Investors’ required rate of return (For Retained Earnings):
D1 = Dividend expected one year hence
P0 = Current price of common stock
g = growth rate
The Dividend Growth Model
Investors’ required rate of return (For new issues)
D1 = Dividends expected one year hence
NP = Net proceeds per share
= Stock price – flotation cost per share
F=the percentage flotation cost required to sell the new stock
g = growth rate
The Dividend Growth Model
Example: A company expects dividends this year to be $1.10, based upon the fact that $1 were paid last year. The firm expects dividends to grow 10% next year and into the foreseeable future. Stock is trading at $35 a share.
Cost of retained earnings:
Cost of new stock (with a $3 floatation cost per share):
The Capital Asset Pricing Model
CAPM: rs = rf + β(rM – rf )
rf = Risk Free rate
= stock Beta
rm =market risk return
rm – rf = Market Risk Premium
Capital Asset Pricing Model
Example: If beta is 1.25, risk-free rate is 1.5% and expected return on market is 10%
rs = rf + (rm – rf)
= .015 + 1.25(.10 – .015)
= 12.125%
Capital Asset Pricing Model Variable estimates
CAPM is easy to apply. Also, the estimates for model variables are generally available from public sources.
Risk Free Rate: Wide range of US government securities on which to base risk-free rate
Beta: Estimates of beta are available from a wide range of services, or can be estimated using regression analysis of historical data.
Market risk premium: It can be estimated by looking at history of stock returns and premium earned over risk-free rate.
Bond-Yield-Plus-Risk-Premium Approach
rd = 10% and RP = 4%.
This RP(risk premium) is not the same as the CAPM RPM.
This method produces a ballpark estimate of rs, and can serve as a useful check.
rs = rd + RP
rs = 10.0% + 4.0% = 14.0%
15
What factors influence a company’s composite WACC?
Market conditions.
The firm’s capital structure and dividend policy.
The firm’s investment policy. Firms with riskier projects generally have a higher WACC.
16
Should the company use the composite WACC as the hurdle rate for each of its projects?
NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the “hurdle rate” for a typical project with average risk.
Different projects have different risks. The project’s WACC should be adjusted to reflect the project’s risk.
17
Divisional Cost of Capital
p
r
D
=
P
P
D
r
p
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