1. 10 - 1 Copyright © 2001 by Harcourt, Inc.All rights reserved. CHAPTER 10 The Cost of Capital Cost of capital components Accounting for flotation costs WACC Adjusting cost of capital for risk Estimating project risk

2. 10 - 2 Copyright © 2001 by Harcourt, Inc.All rights reserved. What types of capital do firms use? Debt Preferred stock Common equity: Retained earnings New common stock

3. 10 - 3 Copyright © 2001 by Harcourt, Inc.All rights reserved. Stockholders focus on A-T CFs. Therefore, we should focus on A-T capital costs, i.e., use A-T costs in WACC. Only k d needs adjustment. Should we focus on before-tax or after-tax capital costs?

4. 10 - 4 Copyright © 2001 by Harcourt, Inc.All rights reserved. The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on today’s marginal costs (for WACC). Should we focus on historical (embedded) costs or new (marginal) costs?

5. 10 - 5 Copyright © 2001 by Harcourt, Inc.All rights reserved. A 15-year, 12% semiannual bond sells for $1,153.72. What’s k d ? 6060 + 1,00060 01230 i = ? 30 -1153.72 60 1000 5.0% x 2 = k d = 10% NI/YRPVFV PMT -1,153.72... INPUTS OUTPUT

6. 10 - 6 Copyright © 2001 by Harcourt, Inc.All rights reserved. Component Cost of Debt Interest is tax deductible, so k d AT = k d BT (1 – T) = 10%(1 – 0.40) = 6%. Use nominal rate. Flotation costs small. Ignore.

7. 10 - 7 Copyright © 2001 by Harcourt, Inc.All rights reserved. What’s the cost of preferred stock? P p = $111.10; 10%Q; Par = $100. Use this formula:

8. 10 - 8 Copyright © 2001 by Harcourt, Inc.All rights reserved. Picture of Preferred Stock 2.50 012 k p = ? -111.1 ... 2.50 $111.10 = =. k Per = = 2.25%; k p(Nom) = 2.25%(4) = 9%. D Q k Per $2.50 k Per $2.50 $111.10

9. 10 - 9 Copyright © 2001 by Harcourt, Inc.All rights reserved. Note: Preferred dividends are not tax deductible, so no tax adjustment. Just k p. Nominal k p is used. Our calculation ignores flotation costs.

10. 10 - 10 Copyright © 2001 by Harcourt, Inc.All rights reserved. Is preferred stock more or less risky to investors than debt? More risky; company not required to pay preferred dividend. However, firms try to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, (3) preferred stockholders may gain control of firm.

11. 10 - 11 Copyright © 2001 by Harcourt, Inc.All rights reserved. Why is yield on preferred lower than k d ? Corporations own most preferred stock, because 70% of preferred dividends are nontaxable to corporations. Therefore, preferred often has a lower B-T yield than the B-T yield on debt. The A-T yield to an investor, and the A-T cost to the issuer, are higher on preferred than on debt. Consistent with higher risk of preferred.

12. 10 - 12 Copyright © 2001 by Harcourt, Inc.All rights reserved. Example: k p = 9% k d = 10% T = 40% k p, AT = k p – k p (1 – 0.7)(T) = 9% – 9%(0.3)(0.4) = 7.92%. k d, AT = 10% – 10%(0.4) = 6.00%. A-T Risk Premium on Preferred = 1.92%.

13. 10 - 13 Copyright © 2001 by Harcourt, Inc.All rights reserved. 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.

14. 10 - 14 Copyright © 2001 by Harcourt, Inc.All rights reserved. Opportunity cost: The return stockholders could earn on alternative investments of equal risk. They could buy similar stocks and earn k s, or company could repurchase its own stock and earn k s. So, k s is the cost of retained earnings.

15. 10 - 15 Copyright © 2001 by Harcourt, Inc.All rights reserved. Three ways to determine cost of common equity, k s : 1.CAPM: k s = k RF + (k M – k RF )b. 2.DCF: k s = D 1 /P 0 + g. 3.Own-Bond-Yield-Plus-Risk Premium: k s = k d + RP.

16. 10 - 16 Copyright © 2001 by Harcourt, Inc.All rights reserved. What’s the cost of common equity based on the CAPM? k RF = 7%, RP M = 6%, b = 1.2. k s = k RF + (k M – k RF )b. = 7.0% + (6.0%)1.2 = 14.2%.

17. 10 - 17 Copyright © 2001 by Harcourt, Inc.All rights reserved. What’s the DCF cost of common equity, k s ? Given: D 0 = $4.19; P 0 = $50; g = 5%. D1P0D1P0 D 0 (1 + g) P 0 $4.19(1.05) $50 k s = + g = + g = + 0.05 = 0.088 + 0.05 = 13.8%.

18. 10 - 18 Copyright © 2001 by Harcourt, Inc.All rights reserved. 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?

19. 10 - 19 Copyright © 2001 by Harcourt, Inc.All rights reserved. Retention growth rate: g = (1 – Payout)(ROE)= 0.35(15%) = 5.25%. Here (1 – Payout) = Fraction retained. Close to g = 5% given earlier. Think of bank account paying 10% with payout = 100%, payout = 0%, and payout = 50%. What’s g?

20. 10 - 20 Copyright © 2001 by Harcourt, Inc.All rights reserved. Could DCF methodology be applied if g is not constant? YES, nonconstant g stocks are expected to have constant g at some point, generally in 5 to 10 years. But calculations get complicated.

21. 10 - 21 Copyright © 2001 by Harcourt, Inc.All rights reserved. Find k s using the own-bond-yield-plus- risk-premium method. (k d = 10%, RP = 4%.) This RP  CAPM RP. Produces ballpark estimate of k s. Useful check. k s = k d + RP = 10.0% + 4.0% = 14.0%

22. 10 - 22 Copyright © 2001 by Harcourt, Inc.All rights reserved. What’s a reasonable final estimate of k s? MethodEstimate CAPM 14.2% DCF 13.8% k d + RP 14.0% Average 14.0%

23. 10 - 23 Copyright © 2001 by Harcourt, Inc.All rights reserved. 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. Why is the cost of retained earnings cheaper than the cost of issuing new common stock?

24. 10 - 24 Copyright © 2001 by Harcourt, Inc.All rights reserved. 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.

25. 10 - 25 Copyright © 2001 by Harcourt, Inc.All rights reserved. New common, F = 15%:

26. 10 - 26 Copyright © 2001 by Harcourt, Inc.All rights reserved. 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.

27. 10 - 27 Copyright © 2001 by Harcourt, Inc.All rights reserved. What’s the firm’s WACC (ignoring flotation costs)? WACC = w d k d (1 – T) + w p k p + w c k s = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1%.

28. 10 - 28 Copyright © 2001 by Harcourt, Inc.All rights reserved. What factors influence a company’s composite WACC? Market conditions. The firm’s capital structure and dividend policy. The firm’s investment policy. Firms with riskier projects generally have a higher WACC.

29. 10 - 29 Copyright © 2001 by Harcourt, Inc.All rights reserved. WACC Estimates for Some Large U. S. Corporations, Nov. 1999 CompanyWACC Intel12.9% General Electric11.9 Motorola11.3 Coca-Cola11.2 Walt Disney10.0 AT&T 9.8 Wal-Mart 9.8 Exxon 8.8 H. J. Heinz 8.5 BellSouth 8.2

30. 10 - 30 Copyright © 2001 by Harcourt, Inc.All rights reserved. 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.

31. 10 - 31 Copyright © 2001 by Harcourt, Inc.All rights reserved. Risk and the Cost of Capital

32. 10 - 32 Copyright © 2001 by Harcourt, Inc.All rights reserved. Divisional Cost of Capital

33. 10 - 33 Copyright © 2001 by Harcourt, Inc.All rights reserved. What are the three types of project risk? Stand-alone risk Corporate risk Market risk

34. 10 - 34 Copyright © 2001 by Harcourt, Inc.All rights reserved. How is each type of risk used? Market risk is theoretically best in most situations. However, creditors, customers, suppliers, and employees are more affected by corporate risk. Therefore, corporate risk is also relevant.

35. 10 - 35 Copyright © 2001 by Harcourt, Inc.All rights reserved. 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. What procedures are used to determine the risk-adjusted cost of capital for a particular project or division?

36. 10 - 36 Copyright © 2001 by Harcourt, Inc.All rights reserved. Methods for Estimating a Project’s Beta 1.Pure play. Find several publicly traded companies exclusively in project’s business. Use average of their betas as proxy for project’s beta. Hard to find such companies.

37. 10 - 37 Copyright © 2001 by Harcourt, Inc.All rights reserved. 2.Accounting beta. Run regression between project’s ROA and S&P index ROA. Accounting betas are correlated (0.5 – 0.6) with market betas. But normally can’t get data on new projects’ ROAs before the capital budgeting decision has been made.

38. 10 - 38 Copyright © 2001 by Harcourt, Inc.All rights reserved. Find the division’s market risk and cost of capital based on the CAPM, given these inputs: Target debt ratio = 40%. k d = 12%. k RF = 7%. Tax rate = 40%. beta Division = 1.7. Market risk premium = 6%.

39. 10 - 39 Copyright © 2001 by Harcourt, Inc.All rights reserved. Beta = 1.7, so division has more market risk than average. Division’s required return on equity: k s = k RF + (k M – k RF )b Div. = 7% + (6%)1.7 = 17.2%. WACC Div. = w d k d (1 – T) + w c k s = 0.4(12%)(0.6) + 0.6(17.2%) = 13.2%.

40. 10 - 40 Copyright © 2001 by Harcourt, Inc.All rights reserved. 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%.