Chapter 14 Cost of Capital Chapter Organization T14.1 Chapter Outline Chapter 14 Cost of Capital Chapter Organization 14.1 The Cost of Capital: Some Preliminaries 14.2 The Cost of Equity 14.3 The Costs of Debt and Preferred Stock 14.4 The Weighted Average Cost of Capital 14.5 Divisional and Project Costs of Capital 14.7 Calculating WACC for Bombardier 14.8 Summary and Conclusions CLICK MOUSE OR HIT SPACEBAR TO ADVANCE copyright © 2002 McGraw-Hill Ryerson, Ltd.-

Cost of Capital The rate of return that compensates investors for the use of the capital needed to finance the firm/project This expected return on the part of the investor in turn represents the firm’s cost for that capital Investors expect higher returns to compensate for higher levels of risk The terms required return, appropriate discount rate and cost of capital are all used interchangeably - they all essentially mean the same thing

Cost of Capital continued A key point is the cost of capital depends primarily on the use of the funds ----not the source so if we were analyzing a ‘risk free’ investment we should use a proxy for a risk free return as the cost of capital for the project as the risk increases - the discount rate should increase because the required return by investors is increasing to compensate them for the higher risk

Financial Policy and Cost of Capital A firm’s capital structure ie its mixture of debt and equity is a function of the firm’s financial policy - it is up to management to decide the capital structure for the firm how that structure is decided is for another class! A firm’s cost of capital is a mixture of returns needed to compensate its creditors and shareholders - it reflects both the cost of debt and equity capital A firm’s weighted average cost of capital (WACC) reflects the respective weighting of the firm’s debt and equity capital in its capital structure

The Cost of Equity ‘The return that equity investors require on their investment in the firm’ This expected return must be estimated - there is no direct means of observing the return that investors are expecting. Two Approaches: The Dividend Growth Model Approach the return that shareholders require on the stock is seen as the firm’s cost of equity capital

The SML or Security Market Line Approach Cost of Equity The SML or Security Market Line Approach The SML essentially tells us the reward (return) for bearing risk in financial markets – what return is expected for a given level of risk required return is a function of 3 things: risk free rate market risk premium systematic risk of the asset relative to the average risk - called the ‘beta’ coefficient

T14.3 The Dividend Growth Model Approach Estimating the cost of equity: the dividend growth model approach According to the constant growth model, D1 P0 = RE - g Rearranging, RE = + g P0

T14.4 Estimating the Dividend Growth Rate –based on historical growth Percentage Year Dividend Dollar Change Change 1990 $4.00 - - 1991 4.40 $0.40 10.00% 1992 4.75 0.35 7.95 1993 5.25 0.50 10.53 1994 5.65 0.40 7.62 Average Growth Rate (10.00 + 7.95 + 10.53 + 7.62)/4 = 9.025%

If we assume the retention ratio remains constant Then: Estimating the Dividend Model Growth Rate - Earnings Retention Approach If we assume the retention ratio remains constant Then: growth in earnings = growth in dividends growth in earnings is a function of both the retained earnings and the return on the retained earnings Using ROE (an historical return) as a proxy for investors expected return g = Retention Ratio * ROE

The Cost of Equity - SML Approach Required return is a function of 3 things risk free rate market risk premium - reflecting the risk associated with the market as a whole e.g the TSE risk systematic risk of the asset relative to the average risk - called the ‘beta’ coefficient - reflecting how the individual stock in question varies with the market as a whole- so if the stock historically is much more volatile (risky) than the market then the return should reflect that incremental risk

T14.5 Example: The SML Approach From the SMl comes the Capital Asset Pricing Model (CAPM) According to the CAPM: RE = Rf + bE  (RM - Rf) Rf = risk free rate of return Rm = market risk Rm-RF = market risk premium BE = estimate of systematic risk, the risk for an individual security relative to the market risk as a whole

2. Get estimates of market risk premium and security beta. SML Approach Get the risk-free rate (Rf ) from financial press—many use the 1- year Treasury bill rate, say 6%. 2. Get estimates of market risk premium and security beta. a. Historical risk premium — RM - Rf = e.g. 7.1% on Canadian equities b. Beta — historical (1) Investment information services - e.g., S&P, Value Line (2) Estimate from historical data 3. Suppose the beta is 1.40, then, using the approach: RE = Rf + bE  (RM - Rf) = 2.5% + 1.40  7.1% = 12.44%

Cost of Equity - Summary The return that equity investors require on their investment in the firm Investor’s expected returns = company’s cost of equity capital 2 approaches in estimating this expected return/ cost Dividend Growth Model SML approach

2. The cost of debt is observable: 1. The cost of debt, RD, is the return the firm’s long term creditors demand on new borrowing. The interest rate on the new borrowing reflects that expected return and is the cost of that capital to the firm 2. The cost of debt is observable: a. Yield on currently outstanding debt. b. Yields on newly-issued similarly-rated bonds. 3. The historic debt cost is irrelevant -- why? Example: We sold a 20-year, 12% bond 10 years ago at par. It is currently priced at 120. What is our cost of debt? The yield to maturity is 8.90%, so this is what we use as the cost of debt, not 12%.

Costs of Preferred Stock 1. Preferred stock is a perpetuity, so the cost is RP = D/P0 2. Notice that cost is simply the dividend yield. Example: We sold an $8 preferred issue 10 years ago. It sells for $120/share today. The dividend yield today is $8.00/120 = 6.67%, so this is what we use as the cost of preferred.

The Weighted Average Cost of Capital Capital structure weights 1. Let: E = the market value of the equity. D = the market value of the debt. Then: V = E + D, so E/ V + D/ V = 100% 2. So the firm’s capital structure weights are E/ V and D/ V. we are using market values for the firm’s debt and equity in determining the ‘weights’- if these are fluctuating widely, then book values would be the alternative. 3. Interest payments on debt are tax-deductible, so the after tax cost of debt is the pretax cost multiplied by (1 - corporate tax rate). After tax cost of debt = RD  (1 - Tc) 4. Thus the weighted average cost of capital is WACC = (E/V)  RE + (D/V)  RD  (1 - Tc)

Example: Eastman Chemical’s WACC Eastman Chemical has 78.26 million shares of common stock outstanding. The book value per share is $22.40 but the stock sells for $58. The market value of equity is $4.54 billion. Eastman’s stock beta is .90. T-bills yield 4.5%, and the market risk premium is assumed to be 9.2%. The firm has four debt issues outstanding. Coupon Book Value Market Value Yield-to-Maturity 6.375% $ 499m $ 501m 6.32% 7.250% 495m 463m 7.83% 7.635% 200m 221m 6.76% 7.600% 296m 289m 7.82% Total $1,490m $1,474m

Example: Eastman Chemical’s WACC (concluded) Cost of equity (SML approach): RE = .045 + .90  (.092) = .045 + .0828 = .1278  12.8% Cost of debt: Multiply the proportion of total debt represented by each issue by its yield to maturity; the weighted average cost of debt = 7.15% Capital structure weights: Market value of equity = 78.26 million  $58 = $4.539 billion Market value of debt = $501m + $463m + $221m + $289m = $1.474 billion V = $4.539 billion + $1.474 billion = $6.013 billion D/V = $1.474b/$6.013b = .2451  25% E/V = $4.539b/$6.013b = .7549  75% WACC = .75 (12.8) + .25  7.15(1 - .35) = 10.76%

Summary of Capital Cost Calculations (Table 14.1) I. The Cost of Equity, RE A. Dividend growth model approach RE = D1 / P0 + g B. SML approach RE = Rf +  E  (RM - Rf) II. The Cost of Debt, RD A. For a firm with publicly held debt, the cost of debt can be measured as the yield to maturity on the outstanding debt. B. If the firm has no publicly traded debt, then the cost of debt can be measured as the yield to maturity on similarly rated bonds.

Summary of Capital Cost Calculations (concluded) III. The Weighted Average Cost of Capital (WACC) A. The WACC is the required return on the firm as a whole. It is the appropriate discount rate for cash flows similar in risk to the firm. B. The WACC is calculated as WACC = (E/V)  RE + (D/V)  RD  (1 - Tc) where Tc is the corporate tax rate, E is the market value of the firm’s equity (common and or preferred, D is the market value of the firm’s debt, and V = E + D. Note that E/V is the percentage of the firm’s financing (in market value terms) that is equity, and D/V is the percentage that is debt. Notice E could be common equity or common and preferred equity

Divisional and Project Costs of Capital When is the WACC the appropriate discount rate? When the project is about the same risk as the firm. The WACC is not appropriate when a company has more than one line of business e.g. Two divisions, and each has a distinctive risk profile. Today’s telecommunications companies with regulated telephone business alongside higher risk e-business ventures

Divisional and Project Costs of Capital Other approaches to estimating a discount rate: Divisional cost of capital - each division’s cost of capital is calculated separately Pure play approach - look externally and find companies that focus on as exclusively as possible the type of project in which we are considering investing. (could be used in estimating the cost of capital for the division Subjective approach - subjective adjustments to the overall WACC

Comments on Bombardier WACC Short-term versus long-term financing in estimating WACC Market versus Book Value WACC = (E/V)  RE + (D/V)  RD  (1 - Tc) YTM on bonds, and the cost of debt: RD The cost of preferred stock in the WACC calculation V = E+P+D WACC = (E/V)  RE + (P/V)  RP+(D/V)  RD  (1 - Tc) …..many factors have now changed for Bombardier!!!!

a. What is the firm’s market value capital structure? Solution to Problem 14.16 Elway Mining Corporation has 8 million shares of common stock outstanding, 1 million shares of 6 percent preferred outstanding, and 100,000 9 percent semiannual coupon bonds outstanding, par value $1,000 each. The common stock currently sells for $35 per share and has a beta of 1.0, the preferred stock currently sells for $60 per share, and the bonds have 15 years to maturity and sell for 89 percent of par. The market risk premium is 8 percent, T-bills are yielding 5 percent, and the firm’s tax rate is 34 percent. a. What is the firm’s market value capital structure? b. If the firm is evaluating a new investment project that has the same risk as the firm’s typical project, what rate should the firm use to discount the project’s cash flows?

Solution to Problem 14.16 (continued) a. MVD = 100,000 ($1,000) (.89) = $89M MVE = 8M($35) = $280M MVp = 1M($60) = $60M V = 89M + 280M + 60M = $429M D/V = 89M/429M = .207, E/V = 280M/429M = .653, and P/V = 60M/429M = .140.

Solution to Problem 14.16 (concluded) b. For projects as risky as the firm itself, the WACC is the appropriate discount rate. So: RE = .05 + 1.0(.08) = .13 = 13% B0 = $890 = $45(PVIFARD,30) + $1,000(PVIFRD,30) RD = 10.474%, and RD (1 - Tc) = (.10474)(1 - .34) = .0691 = 6.91% RP = $6/$60 = .10 = 10% WACC = .653 (13) + .207 (6.91) + .14 (10) = 11.32%

Solution to Problem 14.20 True North, Inc. is considering a project that will result in initial after tax cash savings of $6 million at the end of the first year, and these savings will grow at a rate of 5 percent per year indefinitely. The firm has a target debt/equity ratio of .5, a cost of equity of 18 percent, and an after tax cost of debt of 6 percent. The cost-saving proposal is somewhat riskier than the usual project the firm undertakes; management uses the subjective approach and applies an adjustment factor of +2 percent to the cost of capital for such risky projects. Under what circumstances should True North take on the project?

Solution to Problem 14.20 (concluded) WACC = (.3333)(.06) + (.6666)(.18) = .14 Project discount rate = .14 + .02 = .16 NPV = - cost + PV cash flows PV cash flows = [$6M/(.16 - .05)] = $54.55M So the project should only be undertaken if its cost is less than $54.55M.