Week 4 assignment

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Key Concepts and Skills

After studying this chapter, you should be able to:

Determine a firm’s cost of equity capital.

Determine a firm’s cost of debt.

Determine a firm’s overall cost of capital.

Identify some of the pitfalls associated with a firm’s overall cost of capital and what to do about them.

12-2

Chapter Outline

12.1 The Cost of Capital: Some Preliminaries

12.2 The Cost of Equity

12.3 The Costs of Debt and Preferred Stock

12.4 The Weighted Average Cost of Capital

12.5 Divisional and Project Costs of Capital

12.6 Company Valuation with the WACC

12-3

Cost of Capital Basics

The cost to a firm for capital funding = the return to the providers of those funds

The return earned on assets depends on the risk of those assets.

A firm’s cost of capital indicates how the market views the risk of the firm’s assets.

A firm must earn at least the required return to compensate investors for the financing they have provided.

The required return is the same as the appropriate discount rate.

12-4

Cost of Equity

The cost of equity is the return required by equity investors given the risk of the cash flows from the firm.

Two major methods for determining the cost of equity

Dividend growth model

SML or CAPM

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12-5

The Dividend Growth Model Approach

Start with the dividend growth model formula and rearrange to solve for RE.

12-6

Example: The Dividend Growth Model

Your company is expected to pay a dividend of $4.24 per share next year. (D1)

Dividends have grown at a steady rate of 6% per year and the market expects that to continue. (g)

The current stock price is $60. (P0)

What is the cost of equity?

12-7

Example: Estimating the Dividend Growth Rate

One method for estimating the growth rate is to use the historical average

Year Dividend Percent Change

2015 $1.10

2016 1.20

2017 1.35

2018 1.40

2019 1.55

(1.20 – 1.10) / 1.10 = 9.09%

(1.35 – 1.20) / 1.20 = 12.5%

(1.40 – 1.35) / 1.35 = 3.7%

1.55 – 1.40) / 1.40 = 10.71%

Average = (9.09 + 12.5 + 3.7 + 10.71) / 4 = 9.0%

12-8

Advantages and Disadvantages of the Dividend Growth Model

Advantage – easy to understand and use

Disadvantages

Only applicable to companies currently paying dividends

Not applicable if dividends aren’t growing at a reasonably constant rate

Extremely sensitive to the estimated growth rate

Does not explicitly consider risk

12-9

The SML Approach

Use the following information to compute the cost of equity

Risk-free rate, Rf

Market risk premium, E(RM) – Rf

Systematic risk of asset, β

Click on this link for further information.

12-10

Example: SML

Company’s equity beta = 1.15

Current risk-free rate = 7%

Expected market risk premium = 6%

What is the cost of equity capital?

12-11

Advantages and Disadvantages of SML

Advantages

Explicitly adjusts for systematic risk

Applicable to all companies, as long as beta is available

Disadvantages

Must estimate the expected market risk premium, which does vary over time

Must estimate beta, which also varies over time

Relies on the past to predict the future, which is not always reliable

12-12

Example: Cost of Equity

Data:

Beta = 1.2

Market risk premium = 8%

Current risk-free rate = 6%

Analysts’ estimates of growth = 8% per year

Last dividend = $2

Current stock price =$30

Using SML: RE = 6% + 1.2(8%) = 15.6%

Using DGM: RE = [2(1.08) / 30] + .08 = 15.2%

12-13

Cost of Debt

The cost of debt = the required return on a company’s debt

Method 1 = Compute the yield to maturity on existing debt

Method 2 = Use estimates of current rates based on the bond rating expected on new debt

The cost of debt is NOT the coupon rate.

12-14

Example: Cost of Debt

Current bond issue:

22 years to maturity

Coupon rate = 7%

Coupons paid semiannually

Currently bond price = $960

22*2 N

-960 PV

1000 FV

35 PMT

CPT I/Y 3.685%

YTM = 3.685%*2 = 7.37%

12-15

Component Cost of Debt

Use the YTM on the firm’s debt

Interest is tax deductible, so the after-tax (AT) cost of debt is:

If the corporate tax rate = 21%:

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12-16

Cost of Preferred Stock

Preferred pays a constant dividend every period

Dividends expected to be paid forever

Preferred stock is a perpetuity

Example:

Preferred annual dividend = $1.25

Current stock price = $25.85

RP = 1.25 / 25.85 = 4.84%

12-17

Weighted Average Cost of Capital

Use the individual costs of capital to compute a weighted “average” cost of capital for the firm.

This “average” = the required return on the firm’s assets, based on the market’s perception of the risk of those assets

The weights are determined by how much of each type of financing is used.

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12-18

Determining the Weights for the WACC

Weights = percentages of the firm that will be financed by each component

Always use the target weights, if possible.

If not available, use market values

12-19

Capital Structure Weights

Notation

E = market value of equity

= # outstanding shares times price per share

D = market value of debt

= # outstanding bonds times bond price

V = market value of the firm = D + E

Weights

E/V = percent financed with equity

D/V = percent financed with debt

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12-20

WACC (1 of 2)

WACC = (E/V) x RE + (P/V) x RP + (D/V) x RD x (1- TC)

Where:

(E/V) = % of common equity in capital structure

(P/V) = % of preferred stock in capital structure

(D/V) = % of debt in capital structure

RE = firm’s cost of equity

RP = firm’s cost of preferred stock

RD = firm’s cost of debt

TC = firm’s corporate tax rate

Weights

Component costs

12-21

Estimating Weights

Given:

Stock price = $50

3m shares common stock

$25m preferred stock

$75m debt

40% Tax rate

Weights:

E/V = $150/$250 = 0.6 (60%)

P/V = $25/$250 = 0.1 (10%)

D/V = $75/$250 = 0.3 (30%)

Component Values:

VE = $50 × (3 m) = $150m

VP = $25m

VD = $75m

VF = $150+$25+$75=$250m

12-22

WACC (2 of 2)

WACC = 0.6(14%) + 0.1(9%) + 0.3(10%)(1 - .40)

WACC = 8.4% + 0.9% + 1.8% = 11.1%

Component	W	R
Debt (before tax)	0.30	10%
Preferred Stock	0.10	9%
Common equity	0.60	14%

WACC = E/V × RE + P/V × RP + D/V × RD (1 − TC)

12-23

Table 12.1

12-24

Factors That Influence a Company’s WACC

Market conditions, especially interest rates, tax rates, and the market risk premium

The firm’s capital structure and dividend policy

The firm’s investment policy

Firms with riskier projects generally have a higher WACC.

12-25

Eastman Chemical Equity Data

Source: http://finance.yahoo.com

Balance Sheet

Total Cash

(mrq)

227M

Total Cash Per Share

(mrq)

1.62

Total Debt

(mrq)

6.17B

Total Debt/Equity

(mrq)

104.93

Current Ratio

(mrq)

1.82

Book Value Per Share

(mrq)

41.52

12-26

Source: http://finance.yahoo.com

12-27

Eastman Chemical Dividend Growth

Eastman Chemical Beta and Shares Outstanding

Source: http://finance.yahoo.com

12-28

Eastman Chemical Dividends

Source: http://finance.yahoo.com

Growth Estimates EMN Industry Sector S&P 500

Current Qtr. -14.30% N/A N/A -0.01

Next Qtr. 7.70% N/A N/A 0.05

Current Year 7.00% N/A N/A 0.05

Next Year 10.00% N/A N/A 0.11

Next 5 Years (per annum) 9.84% N/A N/A 0.10

Past 5 Years (per annum) 3.53% N/A N/A N/A

12-29

Eastman Chemical Cost of Equity—SML

Beta: Yahoo Finance 0.98

Value Line 1.20

Reuters 1.37

Average of the three is about 1.20

T-Bill rate = 1.98% (Yahoo Finance bonds section)

Market Risk Premium = 7% (assumed)

Cost of Equity (SML) = 1.98% + (7%)(1.20) = 10.38%

12-30

Eastman Chemical Cost of Equity—DCF

Growth rate 6.5%

Last dividend 2.00

Stock price $98.53

Cost of Equity (DCF) =

12-31

Eastman Chemical Cost of Equity

Cost of Equity Method	Estimated Value
SML	9.69%
DCF	10.17%
Average	9.93%

12-32

Eastman Chemical Bond Data

Source: http://www.sec.gov

12-33

Eastman Chemical Cost of Debt

For Eastman, the cost of debt is similar when using either book values or market values.

Coupon Rate	Book Value (in millions)	Percentage of Total	Market Value (in millions)	Percentage of Total	Yield to Maturity	Book Values	Market Values
5.50%	$250	.05	$258.39	.05	2.97%	.14%	.14%
2.70	798	.15	793.00	.15	3.12	.46	.46
4.50	192	.04	192.26	.04	3.49	.12	.13
3.60	753	.14	750.67	.14	3.68	.51	.51
1.25	920	.17	817.38	.15	3.72	.63	.57
7.25	197	.04	230.50	.04	3.85	.14	.17
7.625	43	.01	50.11	.01	4.45	.04	.04
3.80	689	.13	682.10	.13	3.97	.51	.50
7.60	195	.04	242.81	.05	4.20	.15	.19
4.80	493	.09	490.53	.09	4.84	.44	.44
4.65	871	.16	853.84	.16	4.78	.77	.76

12-34

Eastman Chemical WACC

Capital structure weights (market values):

E = $14.066 billion

D =$5.366 billion

V = $14.066 + 5.366 = 19.432 billion

E/V = 14.066 / 19.432 = .72

D/V = 5.366 / 19.432 = .28

Tax rate (assumed) = 21%

WACC = .72(9.58%) + .28(3.92%)(1 - .21)

= 7.79%

12-35

Risk-Adjusted WACC

A firm’s WACC reflects the risk of an average project undertaken by the firm.

“Average”  risk = the firm’s current operations

Different divisions/projects may have different risks.

The division’s or project’s WACC should be adjusted to reflect the appropriate risk and capital structure.

Return to Quick Quiz

12-36

Using WACC for All Projects (1 of 2)

What would happen if we use the WACC for all projects regardless of risk?

Assume the WACC = 15%

12-37

Ask students which projects would be accepted if they used the WACC for the discount rate? Compare 15% to IRR and accept projects A and B.

Now ask students which projects should be accepted if you use the required return based on the risk of the project? Accept B and C.

So, what happened when we used the WACC? We accepted a risky project that we shouldn’t have and rejected a less risky project that we should have accepted. What will happen to the overall risk of the firm if the company does this on a consistent basis? Most students will see that the firm will become riskier.

Using WACC for All Projects (2 of 2)

Assume the WACC = 15%

A project’s required return is calculated using the SML and the project’s Beta.

Adjusting for risk changes the decisions.

12-38

Ask students which projects would be accepted if they used the WACC for the discount rate? Compare 15% to IRR and accept projects A and B.

Now ask students which projects should be accepted if you use the required return based on the risk of the project? Accept B and C.

Divisional Risk & the Cost of Capital

12-39

Pure Play Approach

Find one or more companies that specialize in the product or service being considered.

Compute the beta for each company.

Take an average.

Use that beta along with the CAPM to find the appropriate return for a project of that risk.

Pure play companies can be difficult to find.

Return to Quick Quiz

12-40

Subjective Approach

Consider the project’s risk relative to the firm overall.

If the project is riskier than the firm, use a discount rate greater than the WACC.

If the project is less risky than the firm, use a discount rate less than the WACC.

Return to Quick Quiz

12-41

Example: Subjective Approach

Risk Level	Discount Rate
Very Low Risk	WACC – 8% 6%
Low Risk	WACC – 4% 10%
Same Risk as Firm	WACC 14%
High Risk	WACC + 6% 20%
Very High Risk	WACC + 10% 24%

12-42

Quick Quiz

What are the two approaches for computing the cost of equity? (Slide 12.5)

How do you compute the cost of debt and the after tax cost of debt? (Slide 12.16)

How do you compute the capital structure weights required for the WACC? (Slide 12.20)

What is the WACC? (Slide 12.18)

What happens if we use the WACC as the discount rate for all projects? (Slide 12.36)

What are two methods that can be used to compute the appropriate discount rate when WACC isn’t appropriate? (Slide 12.40 and Slide 12.41)

12-43

END

Chapter 12

1307

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(

RD,AT = RD,BT (1−TC)

D,AT

D,BT

(1-T

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065

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065

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Project A B

IRR Project Beta 14% 0.60 16% 1.20

WACC=15% Reject Accept

Project

IRRProject Beta

14% 0.60

16% 1.20

WACC=15%

Reject

Sheet1

	Required
Project	Return	IRR	Project Beta		WACC=15%
A	20%	14%	0.60		Reject
B	15%	16%	1.20		Accept
				Accept

Sheet2

Sheet3

Required

ProjectIRRReturnWACC=15%Risk Adj

A14%11.8%RejectAccept

B16%16.6%AcceptReject

Decision

Sheet1

		Required	Decision
Project	IRR	Return	WACC=15%	Risk Adj
A	14%	11.8%	Reject	Accept
B	16%	16.6%	Accept	Reject