Capital components: debt, preferred stock, and common stock. Any increase in total assets must be financed by an increase in one or more of these capital components Kd: the interest rate on the firm’s new debt Kps: the cost of preferred stock Ks: the cost of retained earnings Ke:the cost of common equity (equity obtained by issuing new common stock as apposed to retaining eanings

1. The cost of debt Kd(1-T) is the after tax cost of debt. The relevant cost of new debt, taking into account the tax deductibility of interest. In effect, the government pays part of the cost of debt because interest is deductible. Note that the cost of debt is the interest rate on new debt, not the interest rate paid on existing or old debt.

A 15-year, 12% semiannual bond sells for $1,153.72. What’s kd? 1 2 30 i = ? ... 60 60 60 + 1,000 -1,153.72 30 -1153.72 60 1000 5.0% x 2 = kd = 10% INPUTS N I/YR PV PMT FV OUTPUT

Component Cost of Debt Interest is tax deductible, so kd AT = kd BT(1 – T) = 10%(1 – 0.40) = 6%.

2. The cost of preferred stock (Kp) The rate of return investors require on the firm’s preferred stock. Preferred stock is a perpetuity that pays a fixed dividend (Dp) forever. Kp = Preferred dividend / the current price of the preferred stock

What’s the cost of preferred stock? Pp = $111.10; $10 dividend/share Use this formula:

Note: Preferred dividends are not tax deductible, so no tax adjustment. Just kp. Nominal kp is used. Our calculation ignores flotation costs.

Why is there a cost for retained earnings? Earnings can be reinvested or paid out as dividends. Investors could buy other securities, earn a return. Thus, there is an opportunity cost if earnings are retained.

Opportunity cost: The return stockholders could earn on alternative investments of equal risk. They could buy similar stocks and earn ks. So, ks is the cost of retained earnings. The rate of return required by stockholders on a firm’s common stock

Three ways to determine cost of common equity, ks: 1. CAPM: ks = kRF + (kM – kRF)b. 2. The bond-yield plus risk-premium approach: Ks= bond yield + firm’s risk premium firms with risky, low-rated, and consequently high-interest-rate debt will also have risky, high-cost equity. The risk premium over a firm’s own bond yield has generally ranged from 3 to 5 percentage.

3. Discount Cash Flow model (Constant dividend growth model) Ks = (D1/Po) + g How to estimate g? g = (1- dividend pay out ratio)*ROE

What’s the cost of common equity based on the CAPM What’s the cost of common equity based on the CAPM? kRF = 7%, RPM = 6%, b = 1.2. ks = kRF + (kM – kRF )b. = 7.0% + (6.0%)1.2 = 14.2%.

What’s the DCF cost of common equity, ks. Given: D0 = $4 What’s the DCF cost of common equity, ks? Given: D0 = $4.19; P0 = $50; g = 5%. ks = + g = + g = + 0.05 = 0.088 + 0.05 = 13.8%. D1 P0 D0(1 + g) P0 $4.19(1.05) $50

Suppose the company has been earning 15% on equity (ROE = 15%) and retaining 35% (dividend payout = 65%), and this situation is expected to continue. What’s the expected future g?

Retention growth rate: g = (1 – Payout)(ROE). = 0. 35(15%). = 5. 25% Retention growth rate: g = (1 – Payout)(ROE) = 0.35(15%) = 5.25%. Here (1 – Payout) = Fraction retained.

Find ks using the own-bond-yield-plus-risk-premium method Find ks using the own-bond-yield-plus-risk-premium method. (kd = 10%, RP = 4%.) ks = kd + RP = 10.0% + 4.0% = 14.0% This RP ¹ CAPM RP. Produces ballpark estimate of ks.

What’s a reasonable final estimate of ks? Method Estimate CAPM 14.2% DCF 13.8% kd + RP 14.0% Average 14.0%

Why is the cost of retained earnings (ks) cheaper than the cost of issuing new common stock (ke)? 1. When a company issues new common stock they also have to pay flotation costs to the underwriter. 2. Issuing new common stock may send a negative signal to the capital markets, which may depress stock price.

Two approaches that can be used to account for flotation costs: Include the flotation costs as part of the project’s up-front cost. This reduces the project’s estimated return. Adjust the cost of capital to include flotation costs. This is most commonly done by incorporating flotation costs in the DCF model.

Ke = [D1/Po(1-F) ] + g F is the percentage flotation cost incurred in selling the new stock. So, Po (1-F) is the net price per share received by the company.

New common, F = 15%:

Because of flotation costs, dollars raised by selling new stock must “work harder” than dollars raised by retaining earnings. Moreover, since no flotation costs are involved, retained earnings have a lower cost than new stock. Therefore, the firms should utilize retained earnings to the extent possible to avoid the costs of new common stock. However, if a firm has more good investment opportunities, issuing new common stock is necessary.

The retained earnings breakpoint represents the total amount of financing that can be raised before the firm is forced to sell new common stock. Retained earnings breakpoint = addition to retained earnings/equity fraction

E.g) Suppose a firm estimates its earnings to be $100M next year and has a payout ratio of 40%. Its capital structure consists of 45% debt, 2% preferred, and 53% equity. The break point will be $60M/0.53 = $113.2M; After the firm has raised total capital of $113.2M, the firm will be forced to issue new common stock.

Comments about flotation costs: Flotation costs depend on the risk of the firm and the type of capital being raised. The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small. We will frequently ignore flotation costs when calculating the WACC.

5. Weighted Average Cost of Capital (WACC) If all new equity will come from retained earnings: WACC = Wd [Kd(1-t)] + Wp(Kps) + Wc(Ks) Wd, Ws, Wc are the weights used for debt, preferred stock, and common equity. Assume that the firm has established such a target and will finance all new investments so as to maintain a constant target capital structure. Weights should be based on the market value.

What’s the firm’s WACC (ignoring flotation costs)? WACC = wdkd(1 – T) + wpkp + wcks = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1%.

The company has a target capital structure of 40 percent debt and 60 percent equity Bonds pay 10% coupon (semiannual), mature in 20 years and sell for $849.54 the company stock beta is 1.2 rf = 10%, market risk premium = 5% the company is a constant growth firm that just paid a dividend of $2, sells for $27 per share, and a growth rate of 8% marginal tax rate is 40%.

What factors influence a company’s composite WACC? Market conditions. (the level of interest rates, tax rates…) The firm’s capital structure and dividend policy. The firm’s investment policy. Firms with riskier projects generally have a higher WACC.

WACC Estimates for Some Large U. S. Corporations, Nov. 1999 Company WACC Intel 12.9% General Electric 11.9 Motorola 11.3 Coca-Cola 11.2 Walt Disney 10.0 AT&T 9.8 Wal-Mart 9.8 Exxon 8.8 H. J. Heinz 8.5 BellSouth 8.2

Should the company use the composite WACC as the hurdle rate for each of its projects? NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the “hurdle rate” for a typical project with average risk. Different projects have different risks. The project’s WACC should be adjusted to reflect the project’s risk.

What procedures are used to determine the risk-adjusted cost of capital for a particular project or division? Subjective adjustments to the firm’s composite WACC. Attempt to estimate what the cost of capital would be if the project/division were a stand-alone firm. This requires estimating the project’s beta.

Find the division’s market risk and cost of capital based on the CAPM, given these inputs: Target debt ratio = 40%. kd = 12%. kRF = 7%. Tax rate = 40%. betaDivision = 1.7. Market risk premium = 6%.

Beta = 1.7, so division has more market risk than average. Division’s required return on equity: ks = kRF + (kM – kRF)bDiv. = 7% + (6%)1.7 = 17.2%. WACCDiv. = wdkd(1 – T) + wcks = 0.4(12%)(0.6) + 0.6(17.2%) = 13.2%.

How does the division’s market risk compare with the firm’s overall market risk? Division WACC = 13.2% versus company WACC = 11.1%. Indicates that the division’s market risk is greater than firm’s average project. “Typical” projects within this division would be accepted if their returns are above 13.2%.