Finance assignment ASPS
mk59
fin_slides_4.pptxCost of Capital
1
1
Announcements & Reminders
Student End-of-Term Evaluations (SETE)
Your opinions are very important and greatly appreciated.
Evaluations are anonymous.
Your evaluations will provide feedback to improve course content and delivery for future semesters.
Please do your evaluation before 6:00 am on Monday, December 8.
Next Week
Final Exam, Room 226 Wednesday, December 10, 5:30-7:30 pm
2
2
Determine initial cost of project
Estimate project’s future net cash flows by year over its expected life (cash inflows minus cash outflows)
Determine appropriate cost of capital based on riskiness of project
Compute values for project evaluation
NPV
IRR
MIRR
Payback period
Discounted payback period
Profitability index
Make decision based on applicable decision rules
Post-audit and ongoing reviews
Capital Budgeting Process Overview
3
Capital
Budgeting
Techniques
(Parrino 9)
Cost of Capital
(Parrino 11)
Capital
Budgeting
Cash Flows
(Parrino 10)
3
What are the three major categories (sections) of cash flows to consider in capital budgeting?
What cash flows are considered in both the initial investment and the terminal cash flow?
Why is depreciation added back when calculating the incremental after-tax project cash flows?
Why do we consider cash flows, and why after-tax cash flows?
How is after-tax salvage value of an asset calculated?
Cash Flows for Capital Budgeting
Chapter 10 Review Questions
4
4
Explain weighted-average cost of capital for a firm
Explain why it is often used as a discount rate to evaluate projects
Calculate cost of debt for a firm
Calculate cost of preferred stock for a firm
Calculate cost of common stock for a firm
Calculate weighted-average cost of capital for a firm
Explain limitations of using a firm’s weighted-average cost of capital as a discount rate when evaluating a project
Discuss alternatives to firm’s weighted-average cost of capital
5
Learning Objectives
Cost of Capital – Chapter 11
5
Firm’s cost of financing (use of investor funds)
Average return required by firm’s investors
What must be paid to attract funds
Base rate of return that a project must earn to increase firm value
WACC = weighted-average cost of capital
Weighted-average cost of types of financing
Weights are percentages of capital structure
Capital structure
Most firms attempt to maintain optimal mix of debt and equity financing
6
Cost of Capital
6
Types of capital used by firms to raise money:
kdebt pretax = EAY = before tax cost of debt
kdebt after-tax = EAY(1-T) = after-tax cost of debt
kps = cost of preferred stock
kcs = cost of common stock
7
Capital Components of WACC
7
8
The Finance Balance Sheet
MV of assets = MV of liabilities + MV of equity (11.1)
8
Cost of debt is weighted-average cost of all of the firm’s debt combined
Consider bonds outstanding and all loans outstanding at market value
Current cost of debt for a publicly traded bond = yield to maturity (YTM) adjusted for effective annual interest rate (EAR or EAY)
Account for float (issue) costs
Current cost of long-term bank or other private debt
Call the banker and ask what rate the bank would charge if they decided to refinance the debt today
9
Estimating Cost of Debt
9
Net proceeds
Funds actually received by the firm
Used to find pretax cost of debt
Issuance costs
Underwriting – investment bankers
Administrative – legal, accounting, etc.
After-tax compounded cost of debt (true cost)
EAY (YTM adjusted for compounding)
10
Cost of Bonds (Long-Term Debt)
10
Company wants to issue $1,000 par value, 9% coupon, 20-year bonds with semi-annual interest payments
Similar risk bonds are being issued at coupon rates > 9% so the company has to sell bonds for $980 each
In addition, the company must pay issuance costs of $30 per bond
Net proceeds to the company: $950 each
Calculate pretax cost of debt (annual YTM and EAY)
11
Calculating Pretax Cost of Bonds
Calculation Example
See YTM/EAY handout
Step 1: Calculate semiannual yield.
PV = -950
FV = 1,000
PMT = 1,000 x 9% coupon / 2 = 45
N = 20 x 2 = 40
I = ?
I = 0.04783
Step 2: Calculate Yield-to-Maturity (YTM)
YTM = Periodic yield x number of periods per year
= 0.04783 x 2 = 0.0478 x 2
= 0.09566 = 0.0956
= 9.57% = 9.56%
Step 3: Calculate Effective Annual Yield (EAY)
Enter: 1 + semiannual yield
Raise to power of number of periods
(1.04783)2 = 1.0979 (1.0478)2 = 1.0979
EAY = 9.79% =9.79%
11
Interest payments are tax deductible
Interest expense reduces firm’s taxable income
This leads to smaller tax liability
This makes debt the cheapest form of financing
After-tax cost of debt
kdebt pretax (or EAY) = pretax cost of debt
T is the firm’s tax rate
kdebt after-tax = EAY(1 – T)
If the firm’s tax rate is 40% and the pretax cost of debt is 9.79%, what is the after-tax cost?
12
After-Tax Cost of Bonds
After-tax cost of debt = 9.79% x (1-0.40) = 0.05874 = 5.87%
12
Cost of Preferred Stock
Rate of return investors require on firm’s preferred stock
Preferred dividend divided by net issuing price
13
kps = Dps (11.6)
Pps
Where:
kps = cost of preferred stock
Dps = constant (fixed) dividend
Pps = per-share net proceeds firm receives from issue or sale
after deducting issue costs
13
Student Investment Co. wants to issue a preferred stock with the following features:
$77 par value (which is what it will sell for)
10% dividend ($7.70/share)
Issue (flotation) costs/share = $3
What are the net proceeds per share?
What is the company’s cost of preferred stock?
14
Cost of Preferred Stock
Calculation Example
kps = Dps (11.6)
Pps
Where:
Dps = constant (fixed) dividend
Pps = per-share net proceeds firm receives from issue or sale
after deducting issue costs
Net proceeds per share = $77 issue price - $3 issue cost = $74 per share
Kps = 7.70 / (77 – 3) = 7.70/74 = 0.104054 = 10.41%
14
Cost of Common Equity
Return required from common equity investors
Based on market values of common stock
Three alternative methods for estimating cost of common stock
Most appropriate method to use depends on what information is available and how reliable the analyst believes it is
Method 1: Using Capital Asset Pricing Model (CAPM)
Method 2: Using Constant-Growth Dividend Model
Method 3: Using Multistage-Growth Dividend Model
15
We will cover the CAPM and constant-growth dividend models shortly.
The multistage-growth dividend model for companies with variable dividend growth rates. It is similar to the supernormal growth common stock valuation method we covered in Parrino chapter 8. Know that it exists, what it is and when to use it, but we will not cover it in detail for this chapter. You may be tested on concepts, but you will not be tested on its calculations.
15
kcs = Rrf + (βcs × market risk premium)
Where:
kcs = cost of common equity
Rrf = risk-free rate of return
βcs = beta coefficient for common stock
Market risk premium = expected market return - risk-free rate
16
The CAPM Approach
Calculating Cost of Common Stock
16
Price and expected rate of return on a share of common stock depends on the dividends expected on the stock.
17
Calculating Cost of Common Stock
Discounted Cash Flow (DCF) Approach*
kcs = D1 + g (11.5)
P0
Where:
kcs = cost of common stock
g = constant growth rate**
D1 = next period’s expected dividend
P0 = current stock price
formula
assumes
constant dividend growth rate
* Expected rate of return
** “g” may need to be calculated
“g” may need to be calculated based on historical dividend patterns and statement about growth expectations.
Example: A company’s dividend has grown at a consistent rate and is expected to continue to do so. The annual dividend was $3.00 three years ago. The company just paid a dividend of $4.00.
What’s the annual dividend growth rate? FV = 4, PV = -3, N = 3, PMT = 0, I = ? = 10.06% g = 10/06%
What’s next year’s dividend (D1) expected to be? $4.00 x 1.1006 = $4.40
17
Assumptions
Current risk-free rate is 2%
Annual market return is 8%
Company’s beta is 1.8
What is the cost of common stock?
18
CAPM Method – Calculation Example
Calculating Cost of Common Stock
kcs = Rrf + (βcs × market risk premium)
kcs = 0.02 + [1.8 x (0.08 – 0.02)]
= 0.02 + 0.108
= 0.128
= 12.8%
18
Assumptions
Dividend in year 1 = $3.50
Current market price = $33.63
Dividends are growing at 2%/yr
What is the cost of common stock?
19
Calculating Cost of Common Stock
Constant Growth Method – Calculation Example
kcs = D1 + g (11.5)
P0
kcs = 3.50/33.63 + 0.02
= 0.10407 + 0.02
= 0.12407
= 12.41%
19
Calculated the same as existing common stock
Difference is in market price
Price will be lower due to flotation/issuance costs
May have to underprice shares to sell
Cost is higher than existing common stock
Usually most expensive type of financing for a company
20
Costs of New Common Stock Issues
20
Capital Structure and WACC
Optimal Capital Structure
% debt, % preferred stock and % common equity in firm’s capital structure that will maximize the price of the firm’s stock
WACC (weighted-average cost of capital)
Weighted average of the component costs of debt, preferred stock and common equity
Based on market values for each type of capital
Why use a weighted average?
Use of debt impacts the ability to use equity, and vice versa
Weighted-average cost must be used to evaluate projects
Regardless of specific financing used to fund a particular project
Required return on the mix of investments (from investors’ perspective)
21
21
WACC = xDebt kDebt pretax (1-t) + xps kps + xcs kcs (11.7)
Where:
t = tax rate
xDebt = proportion of debt in firm’s capital structure
xps = proportion of preferred stock in firm’s capital structure
xcs = proportion of common stock in firm’s capital structure
kDebt pretax = before-tax cost of debt
kps = cost of preferred stock
kcs = cost of common stock
22
Weighted-Average Cost of Capital (WACC)
22
Two important points should be noted for the WACC calculation:
Best to convert the weights into decimal form and leave the individual costs in percentage terms.
The weights must be non-negative and sum to 1.0 or 1.00.
23
Calculating WACC – Important Points
23
We found the costs of the types of capital for Student Investment Co. to be as follows:
Cost of debt, kdebt after-tax = 5.87%
Cost of preferred stock, kps = 10.41%
Cost of new common stock, kcs = 12.80%
The company has the following market values for capital. Use these to determine the weights used in calculating its WACC.
Long-term debt (amount owed) = $399,923
Preferred stock (based on market price) = 1,300 shares outstanding at $77/share
Common stock equity (market price) = 14,867 shares outstanding at $33.63/share
Calculate the WACC based on the above information.
What is the WACC used for?
24
Calculating WACC
Student Investment Co. Calculation Example
WACC = xDebt kDebt pretax (1-t) + xps kps + xcs kcs
Solution on next slide….
24
| Market | Cost | Weighted | |||||||||
| Value | Weight | (given) | Cost | ||||||||
| Debt after-tax | $ 399,923 | [a] | 0.40 | [d] | 5.87% | 2.35% | [h] | ||||
| Preferred stock | 100,100 | [b] | 0.10 | [e] | 10.41% | 1.04% | [i] | ||||
| Common stock | 499,977 | [c] | 0.50 | [f] | 12.80% | 6.40% | [j] | ||||
| Total | $ 1,000,000 | 1.00 | [g] | 9.79% | WACC | ||||||
| [a] given | |||||||||||
| [b] 1,300 shares at $77 per share = $100,100 | |||||||||||
| [c] 14,867 shares at $33.63 per share = $499,977 | |||||||||||
| [d] 399,923/1,000,000 = 0.40 | |||||||||||
| [e] 100,100/1,000,000 = 0.10 | |||||||||||
| [f] 499,977/1,000,00 = 0.50 | |||||||||||
| [g] Make sure weights add to 1.0 or 1.00 | |||||||||||
| [h] 0.40 x 5.87% = 2.35% | |||||||||||
| [i] 0.10 x 10.41% = 1.04% | |||||||||||
| [j] 0.50 x 12.80% = 6.4% | |||||||||||
| Formula: WACC = (0.40)(5.87%) + (0.10)(10.41%) + (0.50)(12.80%) = 9.79% |
Calculating WACC
Student Investment Co. Calculation Example - Solution
25
26
Potential Errors When Using WACC
Two types of problems can arise when a firm’s WACC is used to evaluate individual projects:
A project with a positive NVP may be rejected (green area)
A project with a negative NVP may be accepted (pink area)
Limitations of using WACC as discount rate for evaluating all projects
If WACC used as discount rate is too high, the firm may reject projects that would have positive NPV if correct discount rate were used. (pink area)
WACC-estimated NPV would be negative even though true NPV would be positive.
If WACC used as discount rate is too low, the firm may accept projects that would have negative NPV if correct discount rate were used. (green area)
WACC-estimated NPV would be positive even though true NPV would be negative.
Only really correct to use firm’s WACC to discount cash flows for a project if the following conditions hold:
Condition 1: If the level of systematic risk for an individual project is the same as that of the portfolio of projects that currently comprise the firm
Condition 2: If the individual project uses the same financing mix (proportions of debt, preferred stock and common stock) used to finance the firm as a whole
26
Alternatives to Using WACC
If the discount rate for a project cannot be estimated directly, a financial analyst might try to find a public firm that is in a business that is similar to the project.
“Pure-play” comparable because it is exactly like project
This approach is generally not feasible due to the difficulty of finding a public firm that is only in the business represented by the project.
Financial managers sometimes classify projects into categories based on their systematic risks.
They then specify a discount rate that is to be used to discount the cash flows for all projects within each category.
27
Project or Category Discount Rates
27
28
Potential Errors When Using Multiple Discount Rates
28
Final Exam
Prep Suggestions
29
29
12/4/2014
Wednesday, December 10
5:30-7:30 pm: Final Exam, Room 226
Covers following information:
Parrino Chapters 9-11
WSJ Book Chapters 6-7
Cumulative topics (listed later in slides)
What should you bring?
Financial calculator
Pencils
Erasers
Brain
Final Exam Information
(continued)
30
30
Material that is fair game:
Homework and worksheets
Chapter information from both textbooks
Lecture content, slides and discussion
Format
Multiple choice
Problems (like homework, assignments and worksheets)
Short essay
Formulas will be provided on separate page of exam
Exam Information (cont’d)
31
12/4/2014
31
Do the Practice Exam prepared by the SI’s
Re-work and check against solutions on BbLearn
All homework and worksheet problems
Pre-Exam “In-Class” Assignment
SI Practice Exam
Review lecture slides and class notes
Review Parrino chapter summaries and re-read sections which are still unclear
Review WSJ book chapters
Practice using your financial calculator for TVM, NVP, IRR and regular math
Texas Instruments guides for BAII-Plus and graphing calculators are on BbLearn under “FIN 311 Content”
How Should You Study?
32
12/4/2014
32
Exam review session (including practice exam) with SI’s
Sunday, December 7, 5:00-7:00 pm, Gardner Auditorium
Ask SI’s if you need help (no later than December 7)
Work Parrino “Self-Study” Problems, if you need more practice (solutions in textbook)
More Study Tools
33
12/4/2014
33
Exam Strategies
Answer the questions you are confident that you know first.
Spend more time on the portions of the exam that have higher point values.
If you do skip questions and intend to go back to them later, MAKE SURE YOU GO BACK AND COMPLETE THEM.
If you have time, double-check your answers.
Show your work and calculator inputs with your answers.
34
12/4/2014
34
TVM problems and techniques
What is it you are trying to determine? (i.e., PV, FV, Payment, Interest rate, etc.)
What do you know – what information has been given?
Use this information as your inputs
Growth rates (solving for I)
Show your calculator inputs on your exam
Main goal for a firm and a firm’s management
Cumulative Topics
Exam Content
35
35
WACC (weighted-average cost of capital)
Investor’s required return for each type of capital; determined by market prices for capital
Cost of debt (after-tax)
Cost of preferred stock
Cost of new common stock
Least expensive vs. most expensive financing
Capital structure
Capital Budgeting – WACC
Exam Content
36
36
Capital Budgeting process (steps)
Capital Budgeting cash flows
Determining relevant cash flows
Initial investment, incremental after-tax operating cash flows, terminal cash flows
Net working capital calculation
Include opportunity costs
Ignore sunk costs
Capital Budgeting techniques and decision rules
NPV (use relevant cash flows and WACC)
IRR and MIRR (compare to WACC)
Payback period
Capital Budgeting (cont’d)
Exam Content
37
37
Taxes
Calculation of withholding taxes and take-home pay
Pretax 401(k) contributions and their effect on the marginal tax rate
Insurance
General policy components
Coverage
Premiums
Deductibles
Claims
Effect of changes in components on cost of insurance (premiums)
Taxes and Insurance
Exam Content
38
38
Coming Events
Homework, Assignment & Practice Exam
Due no later than 12 noon Friday, December 5
Parrino Questions & Problems – Chapter 11
Online through WileyPLUS via BbLearn
Due no later than 2:00 pm Friday, December 5
Pre-Exam “In-Class” Assignment #3 (50 points possible)
Individual assignment – not in groups
Via Support Services with label and date-time stamp
Solutions to be posted on BbLearn shortly after deadline
SI Practice Exam and Solutions – expected to be posted by Friday, Dec. 5
Next Week
Sunday, December 7
5:00-7:00 pm, Exam Review Session with SI’s (including practice exam) Gardner Auditorium
Wednesday, December 10
5:30-7:30 pm, Final Exam, Room 226
39
39
Appendix
40
40
Bond Valuation
Semiannual market yield = 8%/2 = 4%
Semiannual coupon payment = par x coupon/2 = $1,000 x 5%/2 = $25
Notice the N: 3 years convert to 6 because semiannual
Remember when calculating semiannual i/2 and n x 2
Enter
Answer
N
i
PMT
PV
FV
6
4
25
1,000
-921.37
Semiannual Compounding Calculation Example
What is the market value of a three-year, 5% coupon bond with a market yield of 8% and semiannual coupon payments?
41
41
Bond Yields
What is it?
Rate that makes present value of bond’s cash flows equal price of bond
Rate a bondholder earns if bond is held to maturity and all coupon and principal payments are made as promised
Changes daily as interest rates change
When using a financial calculator, we are solving for i
Yield-To-Maturity (YTM)
42
42
What is it?
In bond trading, the effective annual interest rate (EAR) is called the effective annual yield (EAY).
Method to annualize a bond yield
Formula EAY = (1 + Quoted Interest Rate/m)m -1 Where: Quoted Interest Rate = simple annual yield (i.e., semiannual yield x 2) m = number of compounding periods per year
Simple annual yield is yield per period multiplied by the number of compounding periods
For bonds with semiannual compounding, simple annual yield = semiannual yield 2
Bond Yields
Effective Annual Yield
43
43
Yield-to-Maturity and Effective Annual Yield Example
An investor buys a 30-year bond with a $1,000 face value for $800. The bond’s coupon rate is 8% and interest payments are made semiannually. What are the bond’s yield-to-maturity and effective annual yield?
Enter
Answer
N
i
PMT
PV
FV
60
5.07
40
1,000
-800
Calculation Example
Step 1: Calculate semiannual yield
(continued)
44
44
Step 2: Calculate Yield-to-Maturity (YTM)
Step 3: Calculate Effective Annual Yield (EAY)
Enter
Answer
x
=
.0507
2
.1014
Enter
Answer
x2
1
1.0507
-
.1040
=
Yield-to-Maturity and Effective Annual Yield
Calculation Example (cont’d)
10.14%
10.40%
45
45
Interest Rates
Anna is charged 1% interest when she borrows $2000 for one week. What is the annual percentage interest rate (APR) on the loan?
Annual Percentage Rate (APR) Example with Equation
46
46
Interest Rates
EAR accounts for number of compounding periods and adjusts annualized interest rate for time value of money
EAR is more accurate measure of rates involved in lending and investing
Calculating Effective Annual Interest Rate (EAR)
47
47
Interest Rates
Anna is charged 1% interest when she borrows $2000 for one week. What is the effective annual interest rate (EAR)?
Effective Interest Annual Rate (EAR) Example with Equation
48
48
Interest Rates
Your credit card has an APR of 12 % (1% per month). What is the EAR?
Effective Interest Annual Rate (EAR) Example with Equation
49
49
52%
or
0.52
52
x
(0.01)
APR
=
=
67.77%
or
0.6777
1
-
1.6777
1
-
0.01)
(1
EAR
52
=
=
+
=
12.68%
or
0.1268
1
-
1.1268
1
-
0.01)
(1
1
-
0.12/12)
(1
EAR
12
12
=
=
+
=
+
=
