1. CGA Finance 1

2. Learning objectives ( lesson 8) Calculate the component cost of capital for debt, preference shares and ordinary shares. Calculate the component weights Define, explain, and calculate the weighted average cost of capital (WACC) Provide examples and how WACC is used Describe how the choice of capital structure affects WACC

3. CGA Finance 1 Key terms (1) Key terms (1) Chapter 8  Business risk 经营风险  Capital Asset Pricing Model (CAPM) 资本资产定价模型  Capital Structure 资本结构  Financial Policy 财务 ( 融资 ) 政策  Financial risk 财务风险  Flotation cost 筹资费用  Investor’s required rate of return 投资者要求的报酬率  Target capital structure proportions 目标资本结构比例  Weighted average cost of capital 加权平均资本成本 ( 综合 资本成本 )

4. CGA Finance 1 1 Cost of the capital:  Investor ’ s required rate of return: reflects the opportunity cost of the investors.  Firm ’ s cost of raising additional investment. Noteworthy point for the cost of capital  Cost of capital is not a historical number, it should reflect current market cost and values.  Cost of capital is always defined on an after- corporate-tax basis.  Firm or project ’ s cost of capital should be weighted average cost of financing sources (WACC) 1. Definition of cost of capital ( Topic 8.1)

5. CGA Finance 1 1 For the firm ’ s project, the cost of capital is the minimum after tax expected return that allows all investors to receive their demanded rates of return. How to understand? Implication of the cost of capital to the project

6. CGA Finance 1 Cost of Capital - Example Assume your firm wishes to raise $100 for a new Project: $50 will be by new Debt at 8% $50 will be by new Equity at 12% Before-tax rate of return is 14% Tax Rate 40% Therefore After-tax rate of return is 14%*(1-40%)=8.4%

7. CGA Finance 1 Cost of Capital - Example Pre Tax Earnings (100 x 14%) = 14.00 Interest Expense (50X 8%) = 4.00 Earnings before Tax10.00 Tax (40% x 10.00) = 4.00 Earnings After Tax 6.00 –The Debt holders receive $4.00/$50 = 8% (required rate of return) –The Equity Shareholders $6.00 = 6/50 = 12% (required rate of return)

8. CGA Finance 1 Conclusion 8.4% is the minimum after tax expected rate of return needed to give the bond holders and the equity shareholders their required rate of return. 8.4% is the project’s cost of capital. It is the weighted average required rate of return of investors. – 8.4% = 8%*(1-40%)*50% + 12%*50% 8.4% is referred to the hurdle rate ( 可以接受的最低项目期望 收益率 ) –– If the return is = or greater than 8.4% accept the project

9. CGA Finance 1 1 The cost of capital is the minimum after-tax rate of return the firm must earn on new investment (in its own risk class) to just compensate the firm ’ s investors with their required rates of return which reflect the opportunity cost. Summary

10. CGA Finance 1 1 Investment evaluation Choice of capital structure Setting prices in regulated industries 2. Using the Cost of capital ( Topic 8.2)

11. CGA Finance 1 1 For investment evaluation, the cost of capital can be  Hurdle rate for IRR method: only accept the project whose IRR > cost of capital  Discount rate for NPV method: Only accept the project with positive NPV Note:  The firm ’ s cost of capital is based upon investor ’ s perceptions of the risk of the entire firm, thus the firm ’ s cost of capital can only be used to evaluate projects within the firm ’ s risk class.  The cost of capital with a risk that is substantially different from the firm must be determined separately ( Can use CAPM) Investment Evaluation

12. CGA Finance 1 1 Capital Structure: Choice of Capital Structure Assets Liabilities & Equity Current assets Current Liabilities Long-term Debt Preferred Stock Common Equity Assets Liabilities & Equity Current assets Current Liabilities Long-term Debt Preferred Stock Common Equity } Capital Structure (D/E) 1.The firm changes its capital structure, The WACC will change ( why?) 2. The firm should find the capital structure that minimize WACC so that the firm’s value can be maximized.

13. CGA Finance 1 1 In regulated industries, such as public utilities:  regulators must set prices for the products that minimize cost to consumer and at the same time provide “ fair ” rate of return to the investors ( “ fair rate ” = required rate of return of investors) Setting prices in regulated industries

14. CGA Finance 1 1 Major Financing sources:  External Financing sources: Debts: mainly long-term debts ( such as bond) Preferred Stock Common Stock  Internal Financing Source Retained Earnings (Internal common equity) 3. Calculating the component cost of capital (Topic 8.3)

15. CGA Finance 1 1 3.1 Cost of debts For the issuing firm, the cost of debt is: –the rate of return required by investors, –adjusted for flotation costs (any costs associated with issuing new bonds), and –adjusted for taxes. For the issuing firm, the cost of debt is: –the rate of return required by investors, –adjusted for flotation costs (any costs associated with issuing new bonds), and –adjusted for taxes.

16. CGA Finance 1 After-tax Before-tax Marginal % cost of % cost of x tax Debt Debt rate Kd (after tax) = kd (1 - T) -= 1

17. CGA Finance 1 1 Two methods: Observe the required rate of return by investors on existing equivalent-risk securities. Compute the YTM of debt How to get before tax Kd $I t $M (1 + k d ) t (1 + k d ) n P d = + n t = 1 

18. CGA Finance 1 1 See Example 8-2 (LN8.8) Example

19. CGA Finance 1 1 Basic method How to get before tax Kd with flotation cost (1) $I t $M (1 + k d ) t (1 + k d ) n NP d = + n t = 1  Where: NPd is the net proceeds received by the firm from the sale of bond NPd = Pd * ( 1- f) ( f is the after tax flotation rate) NPd = Pd *[1-( 1- t)f ] ( f is the before tax flotation rate)

20. CGA Finance 1 1 Alternative method ( Approximation) How to get before tax Kd with flotation cost (2) Kd (with flotation cost) = Kd/(1-f) or Kd/[1-(1-t)f] This Formula only apply to the situation where the formula in last PPT cannot be used and yield of debt is given.

21. CGA Finance 1 Example 1: Cost of Debt Prescott Corporation issues a $1,000 par, 20 year bond paying the market rate of 10%. Coupons are semiannual. The bond will sell for par since it pays the market rate, but after tax flotation cost rate is 5%. What is the pre-tax and after-tax cost of debt for Prescott Corporation? (Tax Rate 34%)

22. CGA Finance 1 Pre-tax cost of debt: (using TVM) P/Y = 2N = 40 PMT = -50Tax Rate = 34% FV = -1000 After tax Floating cost PV = 950 (1000 – 50 ) solve: I = 10.61% = kd After-tax cost of debt: Kd = kd (1 - T) Kd =.1061 (1 -.34) Kd =.07 = 7% Another method to derive the after tax rate?

23. CGA Finance 1 Example 2: Cost of Debt Prescott Corporation issues a $1,000 par, 10 year bond paying the coupon rate of 8%. Coupons are semiannual. The current market yield on bonds of comparable risk and maturity is 12.36%, and generally the after tax flotation cost rate is 5%. What is the pre-tax and after-tax cost of debt for Prescott Corporation? (Tax Rate 34%)

24. CGA Finance 1 Example 2: Cost of Debt after-tax cost of debt : [12.36% * (1-34%)] / (1-5%) = 8.59%

25. CGA Finance 1 1 See Example 8-2 (LN8.8) Example 3: Cost of debt

26. CGA Finance 1 1 3.2 Cost of preferred shares Finding the cost of preferred stock is similar to find the rate of return, except that we have to consider the flotation costs associated with issuing preferred stock.

27. CGA Finance 1 Cost of preferred shares K = D NPo ps NPo = price – After tax flotation costs !

28. CGA Finance 1 Example 1: Cost of Preferred Shares If A Co Ltd issues preferred stock, and pays a dividend of $8 per year and valued at $75 per share. If flotation costs amount to $1 per share, what is the cost of preferred stock for A Co, Ltd.

29. CGA Finance 1 Solution kp = = = = 10.81% Cost of Preferred to A Co. Ltd. Dividend Net Price D NPo 8.00 74.00 Kp

30. CGA Finance 1 1 See Example 8-2 (LN8.8) Example 2: Cost of Preferred Shares

31. CGA Finance 1 1 3.3 Cost of common equity There are two sources of Common Equity: 1) Internal common equity (retained earnings). 2) External common equity (new common stock issue). Do these two sources have the same cost? There are two sources of Common Equity: 1) Internal common equity (retained earnings). 2) External common equity (new common stock issue). Do these two sources have the same cost?

32. CGA Finance 1 Cost of Internal Equity Since the stockholders own the firm’s retained earnings, the cost is simply the stockholders’ required rate of return ( No need to considering the flotation cost) Why? If managers are investing stockholders’ funds, stockholders will expect to earn an acceptable rate of return.

33. CGA Finance 1 Methods to compute the cost of capital for common equity 1) Dividend Growth Model Dividend k c = + g (growth rate) (Market Price) 2) Capital Asset Pricing Model (CAPM) k c = k rf +  (k m - k rf ) D 1 Po

34. CGA Finance 1 Capital Asset Pricing Model Capital Asset Pricing Model (CAPM) k c = k rf +  (k m - k rf ) k c = Cost of Capital K rf = Risk Free Rate  Risk of Common Stock return relative to market K m = Expected Rate of return for market

35. CGA Finance 1 Capital Asset Pricing Model Two Advantages of CAPM are: Simple and easy to understand and implement  The model variable are available from public sources The model does not rely on dividends or any assumptions about growth rate of dividends

36. CGA Finance 1 Capital Asset Pricing Model Lets look at the variables: K rf Risk Free rate use government securities   Available from investment advisors K m Risk premium available by looking at historical stock returns and the premium earned over (under) the risk free rate of interest. Empirical study has calculated the market risk premium to be 6.4% (Ref Page 413 Text)

37. CGA Finance 1 Cost of External Equity Dividend Growth Model k nc = + g D 1 NPo Net proceeds to the firm after flotation costs!

38. CGA Finance 1 Cost of External Equity CAPM kc = krf + b (km - krf ) Kc (with flotation cost) = Kc / ( 1-f) f: after tax flotation cost rate

39. CGA Finance 1 1 See Example 8-3 See Example 8-2 (LN8.15) Question:  when Using dividend growth model, How to determine g?  How to deal with flotation cost when using dividend model, CAPM to estimate the cost of capital?  How to determine the Final cost of capital when the results from different model is conflicting? Example : cost of common equity

40. CGA Finance 1 1 When you calculate WACC, only use one or the other of these two common equity component. It depends on whether the firm has sufficient available retained earnings to meet the common equity financing needs. See LN8.17 Noteworthy point

41. CGA Finance 1 1 The component weight should be calculated on the basis of market value, rather than the book value. Question:  How to determine the market value for the component? 4. Calculating the component weight ( Topic 8.4)

42. CGA Finance 1 5. Weighted Average Cost of Capital ( Topic 8.5) The weighted average cost of capital is just the weighted average cost of all of the financing sources. See Example 8-2 (LN 8.18) – Note: 3 situations

43. CGA Finance 1 Exercise 1 –A firm has the following balance sheet figures: –The firm’s tax rate is 35%. Interest on a new 12-year bond will be 9% and each €1000 bond will net €970 to the firm. Preference shares can be sold at par to provide a dividend yield of 7.5%. Current market price of ordinary share is €100. The firm will get a net proceeds of €96 from new issues. The dividend is expected to be €10 next year and is anticipated to grow at a constant rate of 5% for ever. The firm does not have internally generated funds for future projects. –Compute the firm’s weighted average cost of capital based on current market value weights. Debt 12%12 years to maturity700,000 Preference shares10% dividend300,000 Ordinary stock8,000 @ €5 each400,000 Retained earnings200,000

44. CGA Finance 1 Exercise 2 –ABC Corporation has the following balance sheet figures (in $ thousands) : –ABC’s preferred shares have a current market price of $8 per share. The long-term bonds consist of a single issue with a remaining term to maturity of 6 years and interest paid semi-annually. The current market yield on bonds of comparable risk and maturity is 12.36%. Finally, ABC has 60 million outstanding common shares; the shares paid a dividend of $0.60 per share recently, which is expected to grow at an average annual rate of 4% for the foreseeable future; and the shares have a current market price of $10 per share. Flotation costs are estimated to be 4% after tax on new debt and common equity, and 5% before tax on new preferred shares. ABC’s marginal tax rate is 40%. The firm does not have internally generated funds for future projects. –Compute the firm’s weighted average cost of capital based on current market value weights. Bonds 11% @ $1,0006 years to maturity500,000 Preference shares10% dividend @ $7.5 par375,000 Ordinary stock$5 par300,000 Retained earnings250,000

45. CGA Finance 1 6. Impact of the capital structure on WACC ( Topic 8.6) See Example 8-2 ( LN8.23) Question:  What happens if the firm still increase the financial leverage?  What conclusion you can get from the Example?

46. CGA Finance 1 Capital Cost and financial leverage See Figure 16-5 (Textbook P563) Question: Why does the relationship between the capital cost and financial leverage like that?

47. CGA Finance 1 Advantage and disadvantage of debt financing Advantage of debt financing:  interest payments are deductible and create a debt tax shield ( single: T*D*R; PV : T*D) Disadvantage of debt financing:  all else equal, borrowing increases the probability (and therefore the expected value) of direct and indirect bankruptcy costs, which in turn cause the cost of debt and cost of equity rise.

48. CGA Finance 1 Direct bankruptcy cost:  those costs directly associated with bankruptcy, such as legal and administrative expenses. Indirect bankruptcy cost :  Impaired ability to conduct business  agency costs Direct and indirect Bankruptcy cost

49. CGA Finance 1 Agency Cost –When a firm has debt, conflicts of interest arise between the shareholders and bondholders. Because of this, the stockholders are tempted to pursue the selfish strategies ( deviating from the normal NPV decision rule): --- Selfish investment strategy 1: Incentive to take large risks. --- Selfish investment strategy 2: Incentive toward underinvestment --- Selfish investment strategy 3: Milking the property – Ultimately the stockholders will pay for the costs of the selfish investment strategies. Recognizing the imminent financial distress, the bondholders will protect themselves against the possible hurt from the shareholders by raising the interest rates they require on the bonds.

50. CGA Finance 1 Between Points 0 and A –The firm issues a small amount of additional debt. –The corporate tax shield created by interest payments, combined with the fact that this would be low risk debt, means Kd will be small. – Ke will rise because of increasing possibility of financial distress, but this rise may be less than the reduction due to a low Kd. – thus WACC will fall

51. CGA Finance 1 Between Points A and B –The firm increase the financial leverage to a moderate level. –The corporate tax shield created by interest payments, are offsetting by the rise of component cost of capital due to the bankruptcy cost. – Between points A and B, WACC is relatively flat. – The optimal range of financial leverage lies between point A and B. – Points B signifies the firm’s debt capacity: maximum proportion of debt can be included in the firm’s capital structure, and still maintain its low WACC

52. CGA Finance 1 Beyond Point B –The firm increase the financial leverage to an excessive level. –The component cost of capital rise at a faster rate, and the tax shield of interest payment are exceeded by the cost. – WACC will rise rapidly.

53. CGA Finance 1 Value of the firm (V L ) Financial leverage Optimal Present value of tax shield on debt Financial distress costs Actual firm value V U = Value of firm with no debt V L = V U + T C  D Maximum firm value V L * VUVU The Optimal Capital Structure and the Value of the Firm Actual firm value = V U + T C  D – Financial distress costs

54. CGA Finance 1 Capital Structure - Some Management Issues cash-flow ability to service debt is critical need to consider volatility of EBIT ( business risk) calculate interest coverage ratio EBIT Interest expense calculate debt service coverage ratio EBIT [ interest expense + principal payments / (1 - tax rate) ] compare capital structure and ratios over time, and with industry standards

55. CGA Finance 1 Appendix Modern capital structure theory (MM theory)

56. CGA Finance 1 End of Lesson Notes 8 This is real value-added time!