Q13.10 from textbook 1

Chapter 14 Cost of Capital 2

Learning Objectives Calculate a firm’s cost of debt Calculate a firm’s cost of preferred equity Calculate a firm’s cost of common equity Calculate a firm’s overall cost of capital Account for issuing costs Understand pitfalls of overall cost of capital and how to manage them 3

Valuing Projects A project’s contribution to firm value is the net present value of expected cash flows  Discount cash flows using the ____________ Required rate of return for firm’s projects  ______________ (from financial side of firm) is indication of investors’ view of: Riskiness of a firm’s projects (from operations side of firm) Rate of return currently available on investments of similar risk (current market conditions) 4

Assumptions for Use of WACC 1 The risk of projects under consideration matches typical risk of firm’s projects 2 The mixture of debt and equity to fund the projects matches the current capital structure of the firm 5

Measuring Cost of Capital Use after-tax costs to the firm Weight by the proportions in the capital structure 6

Cost of Debt: Required vs Market Yield Investors lend money to the firm when they buy the firm’s bonds Investors in new debt will judge the ability of the firm to pay the coupons and the principal  The required yield to maturity will reflect the market’s judgement of risk Outstanding bonds will differ by:  coupon rate  years to maturity  bond rating 7

Measuring Cost of Debt Firm can deduct interest payments on debt After-tax Cost of Debt = R d ( 1 - T ) Firm’s Marginal Tax Rate Yield on Firm’s Debt 8

Example: Measuring Cost of Debt - 1 Pogo Petroleum Company can issue debt yielding 9%. The company is paying a 42% tax rate. What is the after-tax cost of debt? 9

Example: Cost of Debt Suppose we have a bond issue that has 25 years left to maturity. The coupon rate is 9% and coupons are paid semiannually. The bond is currently selling for $ per $1000 bond. The corporate tax rate is 35%. What is the after-tax cost of debt? 10

Cost of Preferred Stock: Market Yield Determining yield is simpler than for debt  No maturity issue (for vanilla preferred)  Dividends not tax deductible, so no tax adjustment Use the market yield on the firm’s outstanding preferred stock 11

Measuring Cost of Preferred Stock R p = D p / P Current Share Price Preferred Dividend 12

Example: Cost of Preferred Stock 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? 13

Cost of Common Equity: Discounted Cash Flows Determining yield is complicated:  CF’s (dividends) are not guaranteed  Growth rate hard to forecast  Current price can be volatile 14

Example: Dividend Growth Model Suppose that your company is expected to pay a dividend of $1.50 per share next year. Dividends have had a steady growth of 5.1% per year and the market expects that to continue. The current price is $25. What is the cost of equity? 15

Example: Estimating the Dividend Growth Rate – Arithmetic Average One method for estimating the growth rate is to use the historical average  YearDividendPercent Change      (1.30 – 1.23) / 1.23 = % (1.36 – 1.30) / 1.30 = % (1.43 – 1.36) / 1.36 = % (1.50 – 1.43) / 1.43 = % 16

Example: Estimating the Dividend Growth Rate – Geometric Average One method for estimating the growth rate is to use the historical average  YearDividend     

Cost of Common Equity - CAPM Using the CAPM to determine the required yield on equity 18

CAPM: What is the required yield on a security? How risky is stock j relative to the well- diversified market portfolio? 19

Advantages and Disadvantages of Dividend Growth Model Advantage  Dividends and current price usually are easy to observe 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 account for risk 20

Advantages and Disadvantages of CAPM Advantages  Explicitly adjusts for systematic risk  Applicable to all companies, as long as we can compute beta Disadvantages  Have to estimate the expected market risk premium, which does vary over time  Have to estimate beta 21

Weighted Average Cost of Capital - WACC Use the individual costs of capital to get our “average” cost of capital for the firm. This “average” is the required return on our assets, using the market’s perception of the risk of those assets The weights are determined by how much of each type of financing that we use 22

Capital Structure Weights E= market value of common equity = # outstanding shares price per share P= market value of preferred equity = # outstanding shares price per share D= market value of debt = # outstanding bonds bond price V= market value of the firm = D + E + P Weights  w E = E / V = percent financed with common equity  w P = P / V = percent financed with preferred equity  w D = D / V = percent financed with debt 23

Example: Capital Structure Weights 1 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? 24

Example: Capital Structure Weights 2 Suppose you have a market value of the firm equal to $975 M and a target D/E ratio of 1/2.  What are the capital structure weights? 25

WACC WACC = w E R E + w P R P + w D R D (1-T C ) Interest is tax deductible, but dividends are not 26

Example: WACC 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%, semi- annual coupons  15 years to maturity Tax rate = 40% 27

Managing Business & Financial Risks Debt / equity tends to be higher when cash flow uncertainty is lower  Utility high D/E° Mining low D/E Debt / equity tends to be higher when firm’s assets are tangible  Real estate high° R&D firm low 28

Flotation Costs Compute the weighted average flotation cost  Add this to the project cost Use the target weights because the firm will issue securities in these percentages over the long term Weighted Average Flotation Cost: 29

Example: NPV and Flotation Costs Your company is considering a project that will cost $1 million. The project will generate after-tax cash flows of $250,000 per year for 7 years. The WACC is 15% and the firm’s target D/E ratio is 0.6. 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? 30

Chapter 15 Raising Capital 31

Learning Objectives Describe the financing for early-stage businesses Describe how securities are sold to the public and the role of investment bankers Describe initial public offerings and the costs of going public Perform calculations associated with rights offerings 32

Start-Up Financing Personal investment Love money Angel investors Venture capital 33

Venture Capital Private financing for relatively new businesses in exchange for stock Usually entails some hands-on guidance Usual goal is to take the company public  VC benefits from the capital raised in the IPO Many VC firms are formed from a group of investors that pool capital and then have partners in the firm decide which companies will receive financing 34

Small Business Financing Venture capital Business incubators Government grants Bank loans 35

Issuing Securities to the Public Public issue – the creation and sale of securities that are intended to be traded on the public markets All companies listed on the Toronto Stock Exchange come under the Ontario Securities Commission’s jurisdiction  Securities regulation is provincial 36

Advantages of Going Public Current stockholders can diversify Liquidity is increased Easier to raise capital in the future Larger pool of capital may decrease cost of capital Going public establishes firm value Facilitate merger negotiations Increases customer recognition 37

Disadvantages of Going Public Must file numerous reports, with costs involved Operating data must be disclosed Officers must disclose holdings Special “deals” to insiders will be more difficult A small new issue may not be actively traded, so market-determined price may not reflect true value Managing investor relations is time-consuming 38

Selling Securities to the Public Management must obtain permission from the Board of Directors Prepare and distribute copies of a preliminary prospectus (red herring) to the OSC and to potential investors OSC studies the preliminary prospectus and notifies the company of required changes (usually 2 weeks) Once the prospectus is approved, the price is determined and security dealers can begin selling the new issue 39

First and Later Public Issues IPO  Initial Public Offering (or unseasoned new issue).  A company’s first equity issue made available to the public. SEO  Seasoned Equity Offering.  A new issue for a company that has previously issued securities to the public. 40

Alternative Issue Methods – Cash Offer New securities offered for sale to the general public on a cash basis through an investment bank  Firm Commitment  Best Efforts  Bought Deal 41

IPO Under Pricing May be difficult to price an IPO because there isn’t a current market price available Additional asymmetric information associated with companies going public Underwriters want to ensure that their clients earn a good return on IPOs on average Underpricing causes the issuer to “leave money on the table” 42

The Cost of Issuing Securities Direct expenses:  Spread  Legal fees, filing fees Indirect expenses  Management time spent working on issue  Must share control with outsiders  Abnormal returns Price of existing stock tends to decline when new equity is issued  IPO Underpricing  Over allotment (Green Shoe) option Additional shares that the syndicate can purchase after the issue has gone to market 43

Alternative Issue Methods – Rights Offering New securities offered first to existing shareholders. More common outside North America. Allows current shareholders to avoid the dilution that can occur with a new stock issue “Rights” given to the shareholders specify:  Number of shares that can be purchased  Purchase price  Time frame Rights usually trade on the same exchange as the company’s stock 44

Valuing Rights The price specified in a rights offering is generally less than the current market price  The share price will adjust based on the number of new shares issued and the subscription price 45

Example: Rights Offering by Walton Corporation How many rights should be needed to purchase one new share? What is the monetary value of these rights? 46

Quick Quiz: Rights Offering Suppose a company wants to raise $10 M. The subscription price is $20 and the current stock price is $25. The firm currently has 5,000,000 shares outstanding.  How many shares have to be issued?  How many rights will it take to purchase one share?  What is the value of a right? 47

Timing of Rights Issue Shares go ex-rights 2 business days before record date.  Price decreases by value of right on ex-rights day 48

Example: Valuing Rights - 1 Madonna Fashions, Inc. has issued rights to its shareholders. Five rights are needed along with the $45 subscription price to buy one new share. The stock is selling for $54 rights-on. a) What would be the value of one right? b) What would be the new share price once the stock goes ex-rights? 49

Example: Valuing Rights - 2 Brandi Wines is planning a rights offering to raise funds for a $3.8 million project. The price of the 600,000 shares currently outstanding is $47. Brandi’s underwriter is charging a 5% spread. The subscription price is $40. You have decided not to purchase any of the new shares. If you own 4,000 shares, for how much can you sell your rights? 50

Advantages of Rights Offerings Shareholders maintain proportionate ownership Taps firm’s built-in market for new issues Issue costs are lower than straight public issue Trading of shares plus rights can increase interest in firm 51

Types of Long-term Debt Bonds – public issue of long-term debt Private issues  Term loans Direct business loans from commercial banks, insurance companies, etc. Maturities 1 – 5 years Repayable during life of the loan  Private placements Similar to term loans with longer maturity Easier to renegotiate than public issues Lower costs than public issues 52

Q14.21 from textbook Knight, Inc. recently issued new securities to finance a new TV show. The project cost $2.1 million and the company paid $128,000 in flotation costs. In addition, the equity issued had a flotation cost of 8% of the amount raised, whereas the debt issued had a flotation cost of 3% of the amount raised. If Knight issued new securities in the same proportion as its target capital structure, what is the company’s target debt-equity ratio? 53