Wk7 DQ - Financial Management

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COST OF CAPITAL

CHAPTER 14

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Determine a firm’s cost of equity capital

Determine a firm’s cost of debt

Determine a firm’s overall cost of capital and how to use it to value a company

Explain how to correctly include flotation costs in capital budgeting projects

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

Key Concepts and Skills

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The Cost of Capital: Some Preliminaries

The Cost of Equity

The Costs of Debt and Preferred Stock

The Weighted Average Cost of Capital

Divisional and Project Costs of Capital

Company Valuation with the WACC

Flotation Costs and the Weighted Average Cost of Capital

Chapter Outline

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We know that the return earned on assets depends on the risk of those assets.

The return to an investor is the same as the cost to the company.

Our cost of capital provides us with an indication of how the market views the risk of our assets.

Knowing our cost of capital can also help us determine our required return for capital budgeting projects.

Why Cost of Capital Is Important

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12.4

Section 14.1

Lecture Tip: Students often find it easier to grasp the intricacies of cost of capital estimation when they understand why it is important. A good estimate is required for: -good capital budgeting decisions – neither the NPV rule nor the IRR rule can be implemented without knowledge of the appropriate discount rate

-financing decisions – the optimal/target capital structure minimizes the cost of capital

-operating decisions – cost of capital is used by regulatory agencies in order to determine the “fair” return in some regulated industries (e.g. utilities)

The required return is the same as the appropriate discount rate and is based on the risk of the cash flows.

We need to know the required return for an investment before we can compute the NPV and make a decision about whether or not to take the investment.

We need to earn at least the required return to compensate our investors for the financing they have provided.

Required Return

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Section 14.1 (A)

12.5

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

Business risk

Financial risk

There are two major methods for determining the cost of equity.

Dividend growth model

SML, or CAPM

Cost of Equity

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Section 14.2

12.6

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

The Dividend Growth Model Approach

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12.7

Section 14.2 (A)

Remind students that D1 = D0(1+g).

You may also want to take this time to remind them that return is comprised of the dividend yield (D1 / P0) and the capital gains yield (g).

Suppose that your company is expected to pay a dividend of $1.50 per share next year.

There has been a steady growth in dividends of 5.1% per year and the market expects that to continue.

The current price is $25. What is the cost of equity?

Example: Dividend Growth Model

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12.8

Section 14.2 (A)

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

Year Dividend Percent Change

2014 1.23 -

2015 1.30

2016 1.36

2017 1.43

2018 1.50

Example: Estimating the Dividend Growth Rate

(1.30 – 1.23) / 1.23 = 5.7%

(1.36 – 1.30) / 1.30 = 4.6%

(1.43 – 1.36) / 1.36 = 5.1%

(1.50 – 1.43) / 1.43 = 4.9%

Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%

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12.9

Section 14.2 (A)

Our historical growth rates are fairly close, so we could feel reasonably comfortable that the market will expect our dividend to grow at around 5.1%. Note that when we are computing our cost of equity, it is important to consider what the market expects our growth rate to be, not what we may know it to be internally. The market price is based on market expectations, not our private information. So, another way to estimate the market consensus estimate is to look at analysts’ forecasts and take an average.

Lecture Tip: It is noted in the text that there are other ways to compute g. Rather than use the arithmetic mean, as in the example, the geometric mean (which implies a compound growth rate) can be used. OLS regression with the log of the dividends as the dependent variable and time as the independent variable is also an option. Another way to estimate g is to assume that the ROE and retention rate are constant. If this is the case, then g = ROE × retention rate.

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 – an increase in g of 1% increases the cost of equity by 1%

Does not explicitly consider risk

Advantages and Disadvantages of Dividend Growth Model

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12.10

Section 14.2 (A)

Point out that there is no allowance for the uncertainty about the growth rate.

Lecture Tip: Some students may question how you value the stock for a firm that doesn’t pay dividends. In the case of growth-oriented, non-dividend-paying firms, analysts often look at the trend in earnings or use similar firms to project the future date of the first expected dividend and its future growth rate. However, such processes are subject to greater estimation error, and when companies fail to meet (or even exceed) estimates, the stock price can experience a high degree of variability. It should also be pointed out that no firm pays zero dividends forever – at some point, every going concern will pay dividends. Microsoft is a good example. Many people believed that Microsoft would never pay dividends, but even it ran out of investments for all of the cash that it generated and began paying dividends in 2003.

Use the following information to compute our cost of equity.

Risk-free rate, Rf

Market risk premium, E(RM) – Rf

Systematic risk of asset, 

You can find data on betas and rates at Yahoo! Finance.

The SML Approach

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12.11

Section 14.2 (B)

You will often hear this referred to as the Capital Asset Pricing Model Approach as well.

www: Click on the link to go to finance.yahoo.com. Both betas and 3-month T-bills are available on this site. To get betas, enter a ticker symbol to get the stock quote, then choose Key Statistics. To get the T-bill rates, click on “Bonds” under Investing on the home page.

Suppose your company has an equity beta of .58, and the current risk-free rate is 6.1%. If the expected market risk premium is 8.6%, what is your cost of equity capital?

RE = 6.1 + .58(8.6) = 11.1%

Since we came up with similar numbers using both the dividend growth model and the SML approach, we should feel good about our estimate.

Example – SML

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12.12

Section 14.2 (B)

The similarity is completely dependent on estimates of the risk-free rate and market risk premium.

Advantages

Explicitly adjusts for systematic risk

Applicable to all companies, as long as we can estimate beta

Disadvantages

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

Have to estimate beta, which also varies over time

We are using the past to predict the future, which is not always reliable.

Advantages and Disadvantages of SML

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12.13

Section 14.2 (B)

A good example to illustrate how beta estimates can lag changes in the risk of equity, consider Citigroup (C), which was used in an example in the slides in the previous chapter. In Sept. 2012, (based on calculations on Yahoo) Citigroup had a beta of 2.6. Yet, its capital gains return from Sept 2002 to Sept 2012 was almost -90%!! On the positive side, in Sept. 2012, APPL had a beta of .88, yet its capital gains return over the past 10 years was over 9,000%!!!!!.

Lecture Tip: Students are often surprised when they find that the two approaches typically result in different estimates. Suggest that it would be more surprising if the results were identical. Why? The underlying assumptions of the two approaches are very different. The constant growth model is a variant of a growing perpetuity model and requires that dividends are expected to grow at a constant rate forever and that the discount rate is greater than the growth rate. The SML approach requires assumptions of normality of returns and/or quadratic utility functions. It also requires the absence of taxes, transaction costs, and other market imperfections.

Suppose our company has a beta of 1.5. The market risk premium is expected to be 9%, and the current risk-free rate is 6%.

We have used analysts’ estimates to determine that the market believes our dividends will grow at 6% per year and our last dividend was $2.

Our stock is currently selling for $15.65. What is our cost of equity?

Using SML: RE = 6% + 1.5(9%) = 19.5%

Using DGM: RE = [2(1.06) / 15.65] + .06 = 19.55%

Example – Cost of Equity

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12.14

Section 14.2

Since the two models are reasonably close, we can assume that our cost of equity is probably around 19.5%. Again, though, this similarity is a function of the inputs selected and is not indicative of the true similarity that could be expected.

The cost of debt is the required return on our company’s debt.

We usually focus on the cost of long-term debt or bonds.

The required return is best estimated by computing the yield-to-maturity on the existing debt.

We may also use estimates of current rates based on the bond rating we expect when we issue new debt.

The cost of debt is NOT the coupon rate.

Cost of Debt

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12.15

Section 14.3 (A)

Point out that the coupon rate was the cost of debt for the company when the bond was issued. We are interested in the rate we would have to pay on newly issued debt, which could be very different from past rates.

Lecture Tip: Consider what happens to corporate bond rates and mortgage rates as the Federal Reserve board changes the fed funds rate. If the Federal Reserve raises the fed funds rate by a quarter point, virtually all bond rates, from government to municipal to corporate, will increase after this action.

Suppose we have a bond issue currently outstanding that has 25 years left to maturity.

The coupon rate is 9%, and coupons are paid semiannually.

The bond is currently selling for $908.72 per $1,000 bond.

What is the cost of debt?

N = 50; PMT = 45; FV = 1000; PV = -908.72; CPT I/Y = 5%; YTM = 5(2) = 10%

Example: Cost of Debt

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12.16

Section 14.3 (A)

Remind students that it is a trial and error process to find the YTM if they do not have a financial calculator or spreadsheet application.

Reminders

Preferred stock generally pays a constant dividend each period.

Dividends are expected to be paid every period forever.

Preferred stock is a perpetuity, so we take the perpetuity formula, rearrange and solve for RP.

RP = D / P0

Cost of Preferred Stock

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Section 14.3 (B)

12.17

Your company has preferred stock that has an annual dividend of $3.

If the current price is $25, what is the cost of preferred stock?

RP = 3 / 25 = 12%

Example: Cost of Preferred Stock

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Section 14.3 (B)

12.18

We can use the individual costs of capital that we have computed to get our “average” cost of capital for the firm.

This “average” is 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.

The Weighted Average Cost of Capital

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Section 14.4

12.19

Notation

E = market value of equity = # of outstanding shares times price per share

D = market value of debt = # of outstanding bonds times bond price

V = market value of the firm = D + E

Weights

wE = E/V = percent financed with equity

wD = D/V = percent financed with debt

Capital Structure Weights

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12.20

Section 14.4 (A)

Note that for bonds we would find the market value of each bond issue and then add them together.

Also note that preferred stock would just become another component of the equation if the firm has issued it.

Finally, we generally ignore current liabilities in our computations. However, if a company finances a substantial portion of its assets with current liabilities, it should be included in the process.

Lecture Tip: It may be helpful to mention and differentiate between the three types of weightings in the capital structure equation: book, market and target. It is also helpful to mention that the total market value of equity incorporates the market value of all three common equity accounts on the balance sheet (common stock, additional paid-in capital and retained earnings).

Lecture Tip: The cost of short-term debt is usually very different from that of long-term debt. Some types of current liabilities are interest-free, such as accruals. However, accounts payable has a cost associated with it if the company forgoes discounts. The cost of notes payable and other current liabilities depends on market rates of interest for short-term loans. Since these loans are often negotiated with banks, you can get estimates of the short-term cost of capital from the company’s bank. The market value and book value of current liabilities are usually very similar, so you can use the book value as an estimate of market value.

Suppose you have a market value of equity equal to $500 million and a market value of debt equal to $475 million.

What are the capital structure weights?

V = 500 million + 475 million = 975 million

wE = E/V = 500 / 975 = .5128 = 51.28%

wD = D/V = 475 / 975 = .4872 = 48.72%

Example: Capital Structure Weights

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12.21

Section 14.4 (A)

We are concerned with aftertax cash flows, so we also need to consider the effect of taxes on the various costs of capital.

Interest expense reduces our tax liability (subject to limitation).

This reduction in taxes reduces our cost of debt.

After-tax cost of debt = RD(1-TC)

Dividends are not tax deductible, so there is no tax impact on the cost of equity.

WACC = wERE + wDRD(1-TC)

Taxes and the WACC

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12.22

Section 14.4 (B)

Point out that if we have other financing that is a significant part of our capital structure, we would just add additional terms to the equation and consider any tax consequences.

The Tax Cuts and Jobs Act of 2017 placed limitations on the amount of interest that can be deducted in certain situations. If there is no deduction, then the pretax and aftertax cost of debt would be equal. If any deduction is allowed, then the aftertax cost would be lower.

Lecture Tip: With a lower tax rate and/or less deductibility, the overall WACC would be higher, which would reduce project/firm value. However, the lower tax rate also increases cash flows, which would increase project/firm value. The latter seems to be the dominant impact.

Lecture Tip: If the firm utilizes substantial amounts of current liabilities, equation 14.7 from the text should be modified as follows: WACC = (E/V)RE + (D/V)RD(1-TC) + (P/V)RP + (CL/V)RCL(1-TC) where CL/V represents the market value of current liabilities in the firm’s capital structure and V = E + D + P + CL.

Equity Information

50 million shares

$80 per share

Beta = 1.15

Market risk premium = 9%

Risk-free rate = 5%

Debt Information

$1 billion in outstanding debt (face value)

Current quote = 110

Coupon rate = 9%, semiannual coupons

15 years to maturity

Tax rate = 21%

Extended Example: WACC - I

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12.23

Section 14.4 (B)

Remind students that bond prices are quoted as a percent of par value.

What is the cost of equity?

RE = 5 + 1.15(9) = 15.35%

What is the cost of debt?

N = 30; PV = -1,100; PMT = 45; FV = 1,000; CPT I/Y = 3.9268

RD = 3.927(2) = 7.854%

What is the after-tax cost of debt?

RD(1-TC) = 7.854(1-.21) = 6.205%

Extended Example: WACC - II

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12.24

Section 14.4 (B)

Point out that students do not have to compute the YTM based on the entire face amount. They can still use a single bond or they could also base everything on 100 (PV = -110; FV = 100; PMT = 4.5).

We assume that the interest expense remains fully deductible.

What are the capital structure weights?

E = 50 million (80) = 4 billion

D = 1 billion (1.10) = 1.1 billion

V = 4 + 1.1 = 5.1 billion

wE = E/V = 4 / 5.1 = .7843

wD = D/V = 1.1 / 5.1 = .2157

What is the WACC?

WACC = .7843(15.35%) + .2157(6.205%) = 13.38%

Extended Example: WACC - III

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12.25

Section 14.4 (B)

Go to Yahoo! Finance to get information on Eastman Chemical (EMN).

Under Profile and Key Statistics, you can find the following information:

# of shares outstanding

Book value per share

Price per share

Beta

Under analysts estimates, you can find analysts estimates of earnings growth (use as a proxy for dividend growth).

The Bonds section at Yahoo! Finance can provide the T-bill rate.

Use this information, along with the CAPM and DGM, to estimate the cost of equity.

Eastman Chemical I

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Section 14.4 (C)

12.26

Go to FINRA to get market information on Eastman Chemical’s bond issues.

Enter “Eastman Ch” to find the bond information.

Note that you may not be able to find information on all bond issues due to the illiquidity of the bond market.

Go to the SEC website to get book value information from the firm’s most recent 10Q.

Eastman Chemical II

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Section 14.4 (C)

12.27

Find the weighted average cost of the debt.

Use market values if you were able to get the information.

Use the book values if market information was not available.

They are often very close.

Compute the WACC.

Use market value weights if available.

Eastman Chemical III

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Section 14.4 (C)

12.28

Find estimates of WACC at ValuePro.

Look at the assumptions.

How do the assumptions impact the estimate of WACC?

Example: Work the Web

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Section 14.4 (C)

12.29

Table 14.1 Cost of Equity

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Section 14.4 (C)

12.30

Table 14.1 Cost of Debt

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Section 14.4 (C)

12.31

Table 14.1 WACC

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Section 14.4 (C)

12.32

Using the WACC as our discount rate is only appropriate for projects that have the same risk as the firm’s current operations.

If we are looking at a project that does NOT have the same risk as the firm, then we need to determine the appropriate discount rate for that project.

Divisions also often require separate discount rates.

Does every GE Business Unit have the same cost?

Divisional and Project Costs of Capital

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12.33

Section 14.5

It is important to point out that a single corporate WACC is not very useful for companies that have several disparate divisions.

www: Click on the link and then go to “GE Businesses” to see an index of businesses owned by General Electric. Ask the students if they think that projects proposed by “GE Capital” should have the same discount rate as projects proposed by the “Energy” group. You can go through the list and illustrate why the divisional cost of capital is important for a company like GE.

If GE’s WACC was used for every division, then the riskier divisions would get more investment capital and the less risky divisions would lose the opportunity to invest in positive NPV projects.

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

Assume the WACC = 15%

Project Required Return IRR

A 20% 17%

B 15% 18%

C 10% 12%

Example: Using WACC for All Projects

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12.34

Section 14.5 (B)

Ask students which projects would be accepted if they used the WACC for the discount rate? Compare 15% to the 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. What will happen to the firm’s cost of capital as the firm becomes riskier? It will increase (adjusting for changes in market returns in general) as well.

Lecture Tip: It may help students to distinguish between the average cost of capital to the firm and the required return on a given investment if the idea is turned around from the firm’s point of view to the investor’s point of view. Consider an investor who is holding a portfolio of T-bills, corporate bonds and common stocks. Suppose there is an equal amount invested in each. The T-bills have paid 5% on average, the corporate bonds 10%, and the common stocks 15%. Thus, the average portfolio return is 10%. Now suppose that the investor has some additional money to invest and they can choose between T-bills that are currently paying 7% and common stock that is expected to pay 13%. What choice will the investor make if he uses the 10% average portfolio return as his cut-off rate? (Invest in common stock 13%>10%, but not in T-bills 7%<10%.) What if he uses the average return for each security as the cut-off rate? (Invest in T-bills 7% > 5%, but not common stock 13%<15%.)

Lecture Tip: You may wish to point out here that the divisional concept is no more than a firm-level application of the portfolio concept introduced in the section on risk and return. And, not surprisingly, the overall firm beta is therefore the weighted average of the betas of the firm’s divisions.

Find one or more companies that specialize in the product or service that we are considering.

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.

Often difficult to find pure play companies

The Pure Play Approach

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12.35

Section 14.5 (C)

Note that technically you need to unlever the beta for each company before computing the average. Once the average of the unlevered beta has been found, you then relever to match the capital structure of the firm. This is done because the equity beta contains both business risk and financial risk – what we really need is the business risk and then we apply our own financial risk.

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

If the project has more risk than the firm, use a discount rate greater than the WACC.

If the project has less risk than the firm, use a discount rate less than the WACC.

You may still accept projects that you shouldn’t and reject projects you should accept, but your error rate should be lower than not considering differential risk at all.

Subjective Approach

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12.36

Section 14.5 (D)

Lecture Tip: Ask the class to consider a situation in which a company maintains a large portfolio of marketable securities. Now ask them to consider the impact this large security balance would have on a company’s current and quick ratios and how this might impact the company’s ability to meet short-term obligations. The students should easily remember that a larger liquidity ratio implies less risk (and less potential profit). Although the revenue realized from the marketable securities would be less than the interest expense on the company’s comparable debt issues, these holdings would result in lowering the firm’s beta and WACC. This example allows students to recognize that the expected return and beta of an investment in marketable securities would be below the company’s WACC, and justification for such investments must be considered relative to a benchmark other than the company’s overall WACC.

International Note: The difficulty in arriving at an appropriate estimate of the cost of capital for project analysis is magnified for firms engaged in multinational investing. In Financial Management for the Multinational Firm, Abdullah suggests that adjustments to foreign project hurdle rates should reflect the effects of the following:

-foreign exchange risk

-political risk

-capital market segmentation

-international diversification effects

Making these adjustments requires a great deal of judgment and expertise, as well as an understanding of the underlying financial theory. Most multinational firms find it expeditious to adjust the hurdle rates subjectively, rather than attempting to quantify precisely the effects of these factors for each foreign project.

Risk Level	Discount Rate
Very Low Risk	WACC – 8%
Low Risk	WACC – 3%
Same Risk as Firm	WACC
High Risk	WACC + 5%
Very High Risk	WACC + 10%

Example: Subjective Approach

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12.37

Section 14.5 (D)

Lecture Tip: What an individual firm considers a risky investment and what the financial market considers a risky investment may not be the same. Recall that the market is concerned with systematic risk, or non-diversifiable risk. If a firm is considering an investment’s total risk in assigning it to a risk category, the risk categories may not line up with the SML.

The WACC can be useful for investment analysts when trying to measure the value of a company.

If an analyst can predict future CFFA for the entire firm, WACC becomes the firm’s discount rate.

To separate financing costs from the cash flows, the tax amount should be the amount that would be paid if the firm used no debt.

With no debt, Adjusted CFFA, or CFA*:

CFA* = EBIT × (1 – TC) + Depreciation – Change in NWC – Capital spending

If these cash flows continue to grow at growth rate g perpetually, the firm value today is:

V0 = CFA*1 / (WACC – g); CFA*1 is next year’s projected value

Company Valuation with the WACC

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Section 14.6

See Example 14.6 in the book for an application of this methodology.

12.38

The required return depends on the risk, not how the money is raised.

However, the cost of issuing new securities should not just be ignored either.

Basic Approach

Compute the weighted average flotation cost.

Use the target weights, because the firm will issue securities in these percentages over the long term.

Flotation Costs

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Section 14.7 (A)

12.39

Your company is considering a project that will cost $1 million. The project will generate aftertax cash flows of $250,000 per year for 7 years. The WACC is 15%, and the firm’s target D/E ratio is .6 The flotation cost for equity is 5%, and the flotation cost for debt is 3%. What is the NPV for the project after adjusting for flotation costs?

fA = (.375)(3%) + (.625)(5%) = 4.25%

PV of future cash flows = 1,040,105

NPV = 1,040,105 - 1,000,000/(1-.0425) = -4,281

The project would have a positive NPV of 40,105 without considering flotation costs.

Once we consider the cost of issuing new securities, the NPV becomes negative.

Example: NPV and Flotation Costs

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12.40

Section 14.7 (B)

D/E = .6; Let E = 1; then D = .6

V = .6 + 1 = 1.6

D/V = .6 / 1.6 = .375; E/V = 1/1.6 = .625

PMT = 250,000; N = 7; I/y = 15; CPT PV = 1,040,105

What are the two approaches for computing the cost of equity?

How do you compute the cost of debt and the after-tax cost of debt?

How do you compute the capital structure weights required for the WACC?

What is the WACC?

What happens if we use the WACC for the discount rate for all projects?

What are two methods that can be used to compute the appropriate discount rate when WACC isn’t appropriate?

How should we factor flotation costs into our analysis?

Quick Quiz

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Section 14.8

12.41

How could a project manager adjust the cost of capital (i.e., appropriate discount rate) to increase the likelihood of having his/her project accepted?

Is this ethical or financially sound?

Ethics Issues

14-‹#›

12.42

A manager could assume that the project is less risky than the typical firm project and therefore apply a lower discount rate, which would increase the NPV. This illustrates the importance of sensitivity analysis for corporate headquarters in evaluating proposed projects.

A corporation has 10,000 bonds outstanding with a 6% annual coupon rate, 8 years to maturity, a $1,000 face value, and a $1,100 market price.

The company’s 100,000 shares of preferred stock pay a $3 annual dividend, and sell for $30 per share.

The company’s 500,000 shares of common stock sell for $25 per share and have a beta of 1.5. The risk free rate is 4%, and the market return is 12%.

Assuming a 21% tax rate, what is the company’s WACC?

Comprehensive Problem

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12.43

Section 14.8

MV of debt = 10,000 × $1,100 = $11,000,000

Cost of debt = YTM: 8 N; -1,100 PV; 60 PMT; 1,000 FV; CPT I/Y = 4.48%

MV of preferred = 100,000 × $30 = $3,000,000

Cost of preferred = 3/30 = 10%

MV of common = 500,000 × $25 = $12,500,000

Cost of common = .04 + 1.5 × (.12 - .04) = 16%

Total MV of all securities = $11M + $3M + $12.5M = 26.5M

Weight of debt = 11M/26.5M = .4151

Weight of preferred = 3M/26.5M = .1132

Weight of common = 12.5M/26.5M = .4717

WACC = .4151 × .0448 × (1 - .21) + .1132 × .10 + .4717 × .16 = .0979 = 10.15%

End of Chapter

Chapter 14

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