1. The Cost of Capital

2. Cost of Capital Key Concepts Know how to determine a firm’s cost of equity capital Know how to determine a firm’s cost of debt Know how to determine a firm’s overall cost of capital- WACC Divisional and Project Costs of Capital Flotation Costs and the Weighted Average Cost of Capital Understand pitfalls of overall cost of capital and how to manage them

3. Value = + + ··· + FCF 1 FCF 2 FCF ∞ (1 + WACC) 1 (1 + WACC) ∞ (1 + WACC) 2 Free cash flow (FCF) Market interest rates Firm’s business risk Market risk aversion Firm’s debt/equity mix Cost of debt Cost of equity Weighted average cost of capital (WACC ) Net operating profit after taxes Required investments in operating capital − = Determinants of Intrinsic Value: The Weighted Average Cost of Capital

4. Why Cost of Capital Is Important We know that the return earned on assets depends on the risk of those assets The return to an investor is the same as the cost to the company Our cost of capital provides us with an indication of how the market views the risk of our assets Knowing our cost of capital can also help us determine our required return for capital budgeting projects and valuation of the companies.

5. Required Return The required return is the same as the appropriate discount rate and is based on the risk of the cash flows We need to know the required return to value a company We need to know the required return for an investment before we can compute the NPV and make a decision about whether or not to take the investment We need to earn at least the required return to compensate our investors for the financing they have provided

6. 6 Capital Components Capital components are sources of funding that come from investors. Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the cost of capital. We do adjust for these items when calculating the cash flows of a project, but not when calculating the cost of capital.

7. 7 Before-tax vs. After-tax Capital Costs Tax effects associated with financing can be incorporated either in capital budgeting cash flows or in cost of capital. Most firms incorporate tax effects in the cost of capital. Therefore, focus on after- tax costs. Only cost of debt is affected.

8. 8 Historical (Embedded) Costs vs. New (Marginal) Costs The cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we should focus on marginal costs. Cost of additional dollar that the company must raise for a new project. The marginal cost rises as more and more capital is raised during a stated time period.

9. Weighted Average Cost of Capital Capital Components:  Short-term debtLong-term debt  Preferred StockCommon stock WACC = R std (1-T) W std +R d (1-T)W d + R pf W pf + R E W E Where W’s are the weights of each source of financing and R std = interest rate on short-term debt such as notes payable. R d = required return on a bond, for previously issued bonds it is the equal to yield to maturity. R pf and R E are required returns on preferred and common stock

10. Cost of Equity The cost of equity is the return required by equity investors given the risk of the cash flows from the firm

11. Estimation of the Cost Of Equity There are two major methods for determining the cost of equity 1. Dividend growth model 2.SML based on Capital Asset Pricing Model

12. The Dividend Growth Model Approach Start with the dividend growth model formula and rearrange to solve for R E

13. Estimating the Growth Rate Use the historical growth rate if you believe the future will be like the past. Obtain analysts’ estimates: Value Line, Zack’s, Yahoo.Finance. Use the sustainable growth (earnings retention) model.

14. Example: Estimating the Dividend Growth Rate One method for estimating the growth rate is to use the historical average  YearDividendPercent Change  20051.23  20061.30  20071.36  20081.43  20091.50 (1.30 – 1.23) / 1.23 = 5.7% (1.36 – 1.30) / 1.30 = 4.6% (1.43 – 1.36) / 1.36 = 5.1% (1.50 – 1.43) / 1.43 = 4.9% Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%

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

16. Estimating the Dividend Growth Rate Second method for estimating the growth rate is to use sustainable growth rate: g = RR x ROE RR= Retention Ratio (the percent of net income is retained for an vestment). ROE= Return on Equity (NIAT/Equity) NIAT=Net Income After Tax

17. 17 Estimating the Dividend Growth Rate Growth from earnings retention model: g = (Retention rate)(ROE) g = (1 – Payout rate)(ROE) g = (1 – 0.66)(15%) = 5.1%. This is the same as g = 5.1% given earlier.

18. Advantages and Disadvantages of Dividend Growth Model Advantage – easy to understand and use 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 – an increase in g of 1% increases the cost of equity by 1%  Extremely sensitive to stock price volatility  Does not explicitly consider risk

19. The Cost of Equity SML Approach From the firm’s perspective, the expected return is the Cost of Equity Capital: To estimate a firm’s cost of equity capital, we need to know three things: 1.The risk-free rate, R F 2.The market risk premium, 3.The company beta,

20. Example - SML Suppose your company has an equity beta of.58 and the current risk-free rate is 6.1%. If the expected market risk premium is 8.6%, what is your cost of equity capital? R E = 6.1 +.58(8.6) = 11.1% Since we came up with similar numbers using both the dividend growth model and the SML approach, we should feel pretty good about our estimate

21. Issues in Using CAPM Most analysts use the rate on a long-term (10 to 20 years) government bond as an estimate of R F. More…

22. Issues in Using CAPM (Continued) Most analysts use a rate of 5% to 6.5% for the market risk premium (RPM) Estimates of beta vary, and estimates are “noisy” (they have a wide confidence interval).

23. Example Suppose the stock of Stansfield Enterprises, a publisher of PowerPoint presentations, has a beta of 2.5. The firm is 100-percent equity financed. Assume a risk-free rate of 5-percent and a market risk premium of 10-percent. What is the appropriate discount rate for an expansion of this firm?

24. Example (continued) Suppose Stansfield Enterprises is evaluating the following non-mutually exclusive projects. Each costs $100 and lasts one year. Project Project  Project’s Estimated Cash Flows Next Year IRRNPV at 30% A2.5$15050%$15.38 B2.5$13030%$0 C2.5$11010%-$15.38

25. Using the SML to Estimate the Risk-Adjusted Discount Rate for Projects An all-equity firm should accept a project whose IRR exceeds the cost of equity capital and reject projects whose IRRs fall short of the cost of capital. Project IRR Firm’s risk (beta) 5% Good projects Bad projects 30% 2.5 A B C

26. Estimation of Beta Theoretically, the calculation of beta is straightforward: Problems 1.Betas may vary over time. 2.The sample size may be inadequate. 3.Betas are influenced by changing financial leverage and business risk. Solutions –Problems 1 and 2 (above) can be moderated by more sophisticated statistical techniques. –Problem 3 can be lessened by adjusting for changes in business and financial risk. –Look at average beta estimates of comparable firms in the industry.

27. Stability of Beta Most analysts argue that betas are generally stable for firms remaining in the same industry. That’s not to say that a firm’s beta can’t change.  Changes in product line  Changes in technology  Deregulation  Changes in financial leverage

28. Determinants of Beta Business Risk  Cyclicity of Revenues  Operating Leverage Financial Risk  Financial Leverage

29. Cyclicality of Revenues Highly cyclical stocks have high betas.  Empirical evidence suggests that retailers and automotive firms fluctuate with the business cycle.  Transportation firms and utilities are less dependent upon the business cycle. Note that cyclicality is not the same as variability— stocks with high standard deviations need not have high betas.  Movie studios have revenues that are variable, depending upon whether they produce “hits” or “flops”, but their revenues are not especially dependent upon the business cycle.

30. Operating Leverage The degree of operating leverage measures how sensitive a firm (or project) is to its fixed costs. Operating leverage increases as fixed costs rise and variable costs fall. Operating leverage magnifies the effect of cyclicity on beta. The degree of operating leverage is given by:

31. Operating Leverage The degree of operating leverage (DOL) measures the effect of a change in sales volume on earnings before interest and taxes (EBIT). It is defined as the percentage change in EBIT associated with a given percentage change in sales: Operating leverage increases as fixed costs rise and variable costs fall.

32. Financial Leverage and Beta Financial leverage is the sensitivity of a firm’s fixed costs of financing. The relationship between the betas of the firm’s debt, equity, and assets is given by: Financial leverage always increases the equity beta relative to the asset beta.  Asset = Debt + Equity Debt ×  Debt + Debt + Equity Equity ×  Equity

33. Financial Leverage and Beta: Example Consider Grand Sport, Inc., which is currently all- equity and has a beta of 0.90. The firm has decided to lever up to a capital structure of 1 part debt to 1 part equity. Since the firm will remain in the same industry, its asset beta should remain 0.90. However, assuming a zero beta for its debt, its equity beta would become twice as large:

34. Advantages and Disadvantages of SML 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, which also varies over time  We are relying on the past to predict the future, which is not always reliable

35. Cost of Equity Based on Risk Premium The bond yield plus risk premium approach: R E = R D + ERP ERP=Equity risk premium

36. Cost of Debt The cost of debt is the required return on our company’s debt We usually focus on the cost of long-term debt or bonds The required return is best estimated by computing the yield-to-maturity on the existing debt We may also use estimates of current rates based on the bond rating we expect when we issue new debt Ask an investment banker what the coupon rate would be on new debt. The cost of debt is NOT the coupon rate After-tax R d = R d (1-TC)

37. Example: Cost of Debt Suppose we have a bond issue currently outstanding that has 25 years left to maturity. The coupon rate is 9% and coupons are paid semiannually. The bond is currently selling for $908.72 per $1000 bond. What is the cost of debt? T = 50; PMT = 45; FV = 1000; PV = -908.75; CPT I/Y = 5%; YTM = R d =5(2) = 10%

38. Example: Cost of Debt A 15-year, 12% semiannual bond sells for $1,153.72. What’s r d ? 6060 + 1,00060 01230 i = ? -1,153.72... 30 -1153.72 60 1000 5.0% x 2 = R d = 10% NI/YRPVFVPMT INPUTS OUTPUT

39. Component Cost of Debt Interest is tax deductible, so the after tax (AT) cost of debt is:  After-Tax R d = Before –Tax R d (1 - T)  After-Tax R d = 10%(1 - 0.40) = 6%.

40. Cost of Preferred Stock Preferred generally pays a constant dividend every period (D P ) Dividends are expected to be paid every period forever Preferred stock is an annuity, so we take the annuity formula, rearrange and solve for R P R P = D P / P 0

41. 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? R P = 3 / 25 = 12%

42. Is preferred stock more or less risky to investors than debt? More risky; company not required to pay preferred dividend. However, firms want to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, and (3) preferred stockholders may gain control of firm.

43. What are the two ways that companies can raise common equity? Directly, by issuing new shares of common stock. Indirectly, by reinvesting earnings that are not paid out as dividends (i.e., retaining earnings).

44. Why is there a cost for reinvested 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 reinvested.

45. Cost for Reinvested Earnings (Continued) Opportunity cost: The return stockholders could earn on alternative investments of equal risk. They could buy similar stocks and earn r s, or company could repurchase its own stock and earn r s. So, r s, is the cost of reinvested earnings and it is the cost of equity.

46. The Weighted Average Cost of Capital We can use the individual costs of capital that we have computed to get our “average” cost of capital for the firm. This “average” is the required return on our assets, based on 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

47. Capital Structure Weights Notation E = market value of equity = # outstanding shares times price per share D = market value of debt = # outstanding bonds times bond price P=market value of preferred stock=#outstanding shares times price per share V = market value of the firm = D + E Weights  w E = E/V = percent financed with equity  w d = D/V = percent financed with debt WACC = w D R d (1-T C )+w P R P + w E R E

48. Example: Capital Structure Weights Suppose you have a market value of equity equal to $500 million and a market value of debt = $475 million.  What are the capital structure weights? V = 500 million + 475 million = 975 million w E = E/D = 500 / 975 =.5128 = 51.28% w d = D/V = 475 / 975 =.4872 = 48.72%

49. Taxes and the WACC We are concerned with after-tax cash flows, so we need to consider the effect of taxes on the various costs of capital Interest expense reduces our tax liability  This reduction in taxes reduces our cost of debt  After-tax cost of debt = R d (1-T C ) Dividends are not tax deductible, so there is no tax impact on the cost of equity WACC = w E R E + w d R d (1-T C )

50. 50 Determining the Weights for the WACC The weights are the percentages of the firm that will be financed by each component. If possible, always use the target weights for the percentages of the firm that will be financed with the various types of capital.

51. 51 Estimating Weights for the Capital Structure If you don’t know the targets, it is better to estimate the weights using current market values than current book values. If you don’t know the market value of debt, then it is usually reasonable to use the book values of debt, especially if the debt is short-term.

52. Extended Example – WACC - I 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%, semiannual coupons  15 years to maturity Tax rate = 40%

53. Extended Example – WACC - II What is the cost of equity? R E = 5 + 1.15(9%) = 15.35% What is the cost of debt? T = 30; PV = -1100; PMT = 45; FV = 1000; CPT I/Y = 3.9268 R d = 3.927(2) = 7.854% What is the after-tax cost of debt? R d (1-T C ) = 7.854(1-.4) = 4.712%

54. Extended Example – WACC - III What are the capital structure weights?  E = 50 million (80) = 4 billion  D = 1 billion (1.10) = 1.1 billion  V = 4 + 1.1 = 5.1 billion  w E = E/V = 4 / 5.1 =.7843  w d = D/V = 1.1 / 5.1 =.2157 What is the WACC? WACC =.7843(15.35%) +.2157(4.712%) = 13.06%

55. 55 What factors influence a company’s WACC? Uncontrollable factors:  Market conditions, especially interest rates.  The market risk premium.  Tax rates. Controllable factors:  Capital structure policy.  Dividend policy.  Investment policy. Firms with riskier projects generally have a higher cost of equity.

56. 56 Is the firm’s WACC correct for each of its divisions? NO! The composite WACC reflects the risk of an average project undertaken by the firm. Different divisions may have different risks. The division’s WACC should be adjusted to reflect the division’s risk and capital structure.

57. Divisional and Project Costs of Capital Using the WACC as the discount rate is only appropriate for projects that are the same risk as the firm’s current operations If we are looking at a project that is NOT the same risk as the firm, then we need to determine the appropriate discount rate for that project Divisions also often require separate discount rates

58. The Pure Play (Comparable Companies) Approach Find one or more companies that specialize in the product or service that we are considering Compute the beta for each company Take an average Use that beta along with the CAPM to find the appropriate return for a project of that risk Often difficult to find pure play companies

59. 59 The Risk-Adjusted Divisional Cost of Capital Estimate the cost of capital that the division would have if it were a stand- alone firm. This requires estimating the division’s beta, cost of debt, and capital structure.

60. Using WACC for All Projects - Example What would happen if we use the WACC for all projects regardless of risk? Assume the WACC = 15% ProjectRequired ReturnIRR A20%17% B15%18% C10%12%

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

62. Subjective Approach Consider the project’s risk relative to the firm overall If the project is more risky than the firm, use a discount rate greater than the WACC If the project is less risky than the firm, use a discount rate less than the WACC You may still accept projects that you shouldn’t and reject projects you should accept, but your error rate should be lower than not considering differential risk at all

63. Subjective Approach - Example Risk LevelDiscount Rate Very Low RiskWACC – 8% Low RiskWACC – 3% Same Risk as FirmWACC High RiskWACC + 5% Very High RiskWACC + 10%

64. Flotation Costs The required return depends on the risk, not how the money is raised However, the cost of issuing new securities should not just be ignored either Basic Approach  Compute the weighted average flotation cost  Use the target weights because the firm will issue securities in these percentages over the long term

65. NPV and Flotation Costs - Example 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.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?  f A = (.375)(3%) + (.625)(5%) = 4.25%  PV of future cash flows = 1,040,105  NPV = 1,040,105 - 1,000,000/(1-.0425) = -4,281 The project would have a positive NPV of 40,105 without considering flotation costs Once we consider the cost of issuing new securities, the NPV becomes negative

66. 66 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.

67. Quick Quiz What are the two approaches for computing the cost of equity? How do you compute the cost of debt and the after- tax cost of debt? How do you compute the capital structure weights required for the WACC? What is the WACC? What happens if we use the WACC for the discount rate for all projects? What are two methods that can be used to compute the appropriate discount rate when WACC isn’t appropriate? How should we factor in flotation costs to our analysis?