6/11/2015Cost of Capital1 Investment Decision: Weighted Average Cost of Capital

6/11/2015Cost of Capital2 Return on assets must be greater than the cost of capital Current Assets What is the cost of financing? (What does it cost to use the bondholders and the stockholders money?) Fixed Assets Tangible Intangible Current Liabilities Long-Term Debt Shareholders’ Equity

6/11/2015Cost of Capital3 Why Study Cost of Capital? 1.Capital budgeting decisions 2.Regulated industries 3.Leasing, bond refunding, working capital 4.Maximize value or minimize cost of inputs, including capital

6/11/2015Cost of Capital4 Why a Weighted Average? Cost of debtR D = 8% Cost of equityR E = 12% Project A: IRR = 10% Financed with all debt Project B: IRR = 11% No debt available Financed with all equity

6/11/2015Cost of Capital5 Weighted Average Cost of Capital Assumptions 1)New project’s risk equals existing projects’ risk 2)General financing policies are not affected by the particular project

6/11/2015Cost of Capital6 Weighted Average Cost of Capital R A = R D (1-t) wt D + R P wt P + R E wt E Where: R A = weighted average cost of capital R D = cost of debt R P = cost of preferred stock R E = cost of equity (common stock and retained earnings) wt D = weight of debt = D/V wt P = weight of preferred stock = P/V wt E = weight of equity = E/V t= marginal tax rate

6/11/2015Cost of Capital7 Cost of Debt, R D 1. Use the marginal cost of debt 2. A proxy for the marginal cost of debt is the current yield to maturity (YTM) on bonds* 3. After tax cost of debt = (YTM)(1-t) * EAR is best.

6/11/2015Cost of Capital8 Cost of Debt Example Market value of issue Years to maturity Coupon rate (annual payments) Face value million 8 years 5% million

6/11/2015Cost of Capital9 Cost of Debt with Multiple Issues (tax rate is 46%) Step 1: YTM’s a6% b6% c7% Step 2:Weighted YTM Step 3: Tax Adjustment R D = 6.6% (1 -.46) = 3.6% Issue Mkt value (in millions) Years to Maturity Coupon Rate Face Value a$ %$20 b c

6/11/2015Cost of Capital10 Cost of Preferred Stock 1. R P = return required by investors to invest in the firm’s preferred stock No tax savings on dividends

6/11/2015Cost of Capital11 Cost of Preferred Stock Example Book value of issue $24 million Market value of issue $20 million Preferred dividend (annual) $ 2 million

6/11/2015Cost of Capital12 Cost of Preferred Stock with Multiple Issues Step 1 Step 2 Issue Book Value of Issue (in millions) Market Value of Issue (in millions) Preferred Dividend (in millions) a$24$202.0 b $30

6/11/2015Cost of Capital13 Cost of Equity or Required Return 1. Cost of Equity is not always a cash outflow; it can be expected growth (appreciation). 2. Retained earnings have an opportunity cost--stock holders could have received the earnings and invested them in alternative investment of comparable risk--R E 3. Methods of Calculation a. Historical b. Gordon Growth c. CAPM d. McQueen’s Quick and Dirty

6/11/2015Cost of Capital14 The Cost of Equity Capital Pay cash dividend Shareholder invests in financial asset A firm with excess cash can either pay a dividend or make a capital investment Shareholder’s Terminal Value Because stockholders can reinvest the dividend in risky financial assets, the expected return on a capital-budgeting project should be at least as great as the expected return on a financial asset of comparable risk. Firm with excess cash Invest in project

6/11/2015Cost of Capital15 Cost of Equity--Historical Estimate Rate of return is made up of dividends and price appreciation: To get a good historical rate, find the actual rate for several recent years and arrive at some sort of average. Implicit assumption: expected return equals past returns

6/11/2015Cost of Capital16 Cost of Equity -- Historical Estimate Example Questions Is the expected required return 40% or 20% or some average? Is the increase to 40% a trend? YearStock PriceDividendReturn 0$ $1.0020% % %

6/11/2015Cost of Capital17 Cost of Equity--Gordon Growth 1. Assumption: dividends will grow at a constant rate “g” Find g: a) historical dividend growth b) sustainable growth

6/11/2015Cost of Capital18 Finding g for k e Calculation 1. Historical approach: (1993 DPS)(1+g) 10 = (2003 DPS).56(1+g) 10 = 1.75 g 12%* 2. Sustainable growth:Where: SG = (ROE)(1-PO)ROE = Return on Equity = (24%)(.5)=NI/OE = 12%PO=Payout Ratio =Div/NI *Arithmetic average is better than geometric average when forecasting.

6/11/2015Cost of Capital19 Finding Cost of Equity--Example

6/11/2015Cost of Capital20 Cost of NEW equity F = Flotation costs per share of new stock

6/11/2015Cost of Capital21 Summary of Components Notice R D < R P < R E *EAR is better

6/11/2015Cost of Capital22 Cost of Capital Weights 1. Best Proportions of individual source inputs the firm intends to use in the future or target weights 2.Proxies-- a)Book value weights b)Market value weights

6/11/2015Cost of Capital23 Weighting the Components (No new stock issues planned) Market Weights Book Weights SourceCost Book Value (in millions) Market Value (in millions) Debt6%$20.00$18.75 Preferred10% Common Stock16% Retained Earnings16%18.00 Total

6/11/2015Cost of Capital24 Key Assumptions of R A 1.Same Risk 2.Same Financing Goal--Find the discount rate associated with the risk of the cash flows

6/11/2015Cost of Capital25 Fundamental Rules 1.Match investment perspective to: a.Cash Flows b.Discount Rate (i.e., After tax cash flow with R A and equity cash flows with R E ) 2.Discount rate consistent with risk (i.e., The cost of capital depends primarily on the use of the funds, not the source.)

6/11/2015Cost of Capital26 Capital Budgeting & Project Risk Project IRR The SML can tell us why: Incorrectly accepted negative NPV projects Hurdle rate Incorrectly rejected positive NPV projects rfrf Firm’s risk (beta)  FIRM A firm that uses one discount rate for all projects may over time increase the risk of the firm while decreasing its value.