1. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-1 Chapter Eighteen Cost of Capital

2. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-2 18.1 The Cost of Capital: Some Preliminaries 18.2 The Cost of Equity 18.3 The Costs of Debt and Preference Shares 18.4 The Weighted Average Cost of Capital 18.5 Divisional and Project Costs of Capital 18.6 Flotation Costs and the Weighted Average Cost of Capital 18.7 Summary and Conclusions Chapter Organisation

3. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-3 Chapter Objectives Apply the dividend growth model approach and the SML approach to determine the cost of equity. Estimate values for the costs of debt and preference shares. Calculate the WACC. Discuss alternative approaches to estimating a discount rate. Understand the effects of flotation costs on WACC and the NPV of a project.

4. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-4 The Cost of Capital: Preliminaries Vocabulary—the following all mean the same thing: – required return – appropriate discount rate – cost of capital. The cost of capital is an opportunity cost—it depends on where the money goes, not where it comes from. The assumption is made that a firm’s capital structure is fixed—a firm’s cost of capital then reflects both the cost of debt and the cost of equity.

5. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-5 Cost of Equity The cost of equity is the return required by equity investors given the risk of the cash flows from the firm. There are two major methods for determining the cost of equity: – Dividend growth model – SML or CAPM.

6. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-6 The Dividend Growth Model Approach According to the constant growth model: Rearranging:

7. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-7 Example—Cost of Equity Capital: Dividend Approach Reno Co. recently paid a dividend of 15 cents per share. This dividend is expected to grow at a rate of 3 per cent per year into perpetuity. The current market price of Reno’s shares is $3.20 per share. Determine the cost of equity capital for Reno Co.

8. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-8 Estimating g One method for estimating the growth rate is to use the historical average.

9. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-9 The Dividend Growth Model Approach Advantages Easy to use and understand. Disadvantages Only applicable to companies paying dividends. Assumes dividend growth is constant. Cost of equity is very sensitive to growth estimate. Ignores risk.

10. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-10 The SML Approach Required return on a risky investment is dependent on three factors: – the risk-free rate, R f – the market risk premium, E(R M ) – R f – the systematic risk of the asset relative to the average, 

11. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-11 Example—Cost of Equity Capital: SML Approach Obtain the risk-free rate (R f ) from financial press— many use the 1-year Treasury note rate, say, 6 per cent. Obtain estimates of market risk premium and security beta: – historical risk premium = 7.94 per cent (Officer, 1989) – beta—historical  investment information services  estimate from historical data Assume the beta is 1.40.

12. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-12 Example—Cost of Equity Capital: SML Approach (continued)

13. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-13 The SML Approach Advantages Adjusts for risk. Accounts for companies that don’t have a constant dividend. Disadvantages Requires two factors to be estimated: the market risk premium and the beta co-efficient. Uses the past to predict the future, which may not be appropriate.

14. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-14 The Cost of Debt The cost of debt, R D, is the interest rate on new borrowing. R D is observable: – yields on currently outstanding debt – yields on newly-issued similarly-rated bonds. The historic cost of debt is irrelevant—why?

15. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-15 Example—Cost of Debt Ishta Co. sold a 20-year, 12 per cent bond 10 years ago at par. The bond is currently priced at $86. What is our cost of debt? The yield to maturity is 14.4 per cent, so this is used as the cost of debt, not 12 per cent.

16. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-16 The Cost of Preference Shares Preference shares pay a constant dividend every period. Preference shares are a perpetuity, so the cost is: Notice that the cost is simply the dividend yield.

17. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-17 Example—Cost of Preference Shares An $8 preference share issue was sold 10 years ago. It sells for $120 per share today. The dividend yield today is $8.00/$120 = 6.67 per cent, so this is the cost of the preference share issue.

18. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-18 The Weighted Average Cost of Capital Let:E = the market value of equity = no. of outstanding shares × share price D = the market value of debt = no. of outstanding bonds × price Then:V = E + D So:E/V + D/V = 100% That is:The firm’s capital structure weights are E/V and D/V.

19. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-19 The Weighted Average Cost of Capital Interest payments on debt are tax deductible, so the after-tax cost of debt is: Dividends on preference shares and ordinary shares are not tax-deductible so tax does not affect their costs. The weighted average cost of capital is therefore:

20. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-20 Example—Weighted Average Cost of Capital Zeus Ltd has 78.26 million ordinary shares on issue with a book value of $22.40 per share and a current market price of $58 per share. The market value of equity is therefore $4.54 billion. Zeus has an estimated beta of 0.90. Treasury bills currently yield 4.5 per cent and the market risk premium is assumed to be 7.94 per cent. Company tax is 30 per cent.

21. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-21 Example—Weighted Average Cost of Capital (continued) The firm has four debt issues outstanding:

22. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-22 Example—Cost of Equity (SML Approach)

23. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-23 Example—Cost of Debt The weighted average cost of debt is 7.15 per cent.

24. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-24 Example—Capital Structure Weights Market value of equity = 78.26 million × $58 = $4.539 billion. Market value of debt = $1.474 billion.

25. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-25 WACC The WACC for a firm reflects the risk and the target capital structure to finance the firm’s existing assets as a whole. WACC is the return that the firm must earn on its existing assets to maintain the value of its shares. WACC is the appropriate discount rate to use for cash flows that are similar in risk to the firm.

26. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-26 Divisional and Project Costs of Capital When is the WACC the appropriate discount rate? – When the project’s risk is about the same as the firm’s risk. Other approaches to estimating a discount rate: – divisional cost of capital—used if a company has more than one division with different levels of risk – pure play approach—a WACC that is unique to a particular project is used – subjective approach—projects are allocated to specific risk classes which, in turn, have specified WACCs.

27. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-27 The SML and the WACC Expected return (%) Beta SML WACC = 15% = 8% Incorrect acceptance Incorrect rejection B A 16 15 14 R f =7 A =.60 firm = 1.0 B = 1.2 If a firm uses its WACC to make accept/reject decisions for all types of projects, it will have a tendency towards incorrectly accepting risky projects and incorrectly rejecting less risky projects.

28. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-28 Example—Using WACC for all Projects What would happen if we use the WACC for all projects regardless of risk? Assume the WACC = 15 per cent Project Required ReturnIRRDecision A15%14%Reject B15%16%Accept Project A should be accepted because its risk is low (Beta = 0.60), whereas Project B should be rejected because its risk is high (Beta = 1.2).

29. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-29 The SML and the Subjective Approach Expected return (%) Beta SML 20 WACC = 14 10 R f = 7 Low risk (–4%) Moderate risk (+0%) High risk (+6%) A With the subjective approach, the firm places projects into one of several risk classes. The discount rate used to value the project is then determined by adding (for high risk) or subtracting (for low risk) an adjustment factor to or from the firm’s WACC. = 8%

30. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-30 Flotation Costs The issue of debt or equity may incur flotation costs such as underwriting fees, commissions, listing fees. Flotation costs are relevant expenses and need to be reflected in any analysis.

31. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-31 Example—Project Cost including Flotation Costs Saddle Co. Ltd has a target capital structure of 70 per cent equity and 30 per cent debt. The flotation costs for equity issues are 15 per cent of the amount raised and the flotation costs for debt issues are 7 per cent. If Saddle Co. Ltd needs $30 million for a new project, what is the ‘true cost’ of this project? The weighted average flotation cost is 12.6 per cent.

32. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-32 Example—Project Cost including Flotation Costs (continued)

33. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-33 Example—Flotation Costs and NPV Apollo Co. Ltd needs $1.5 million to finance a new project expected to generate annual after-tax cash flows of $195 800 forever. The company has a target capital structure of 60 per cent equity and 40 per cent debt. The financing options available are: – An issue of new ordinary shares. Flotation costs of equity are 12 per cent of capital raised. The return on new equity is 15 per cent. – An issue of long-term debentures. Flotation costs of debt are 5 per cent of the capital raised. The return on new debt is 10 per cent. Assume a corporate tax rate of 30 per cent.

34. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-34 Example—NPV (No Flotation Costs)

35. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 18-35 Example—NPV (With Flotation Costs) Flotation costs decrease a project’s NPV and could alter an investment decision.