1. COST OF CAPITAL Chapter 7

2. Chapter Outline The Cost of Capital: Introduction The Cost of Equity (CAPM and DDM) The Costs of Debt and Preferred Stock The Weighted Average Cost of Capital Divisional and Project Costs of Capital 1

3. Why Cost of Capital is Important 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 Cost of capital provides with an indication of how the market views the risk of assets Knowing cost of capital can also help determine required return for capital budgeting projects 2

4. Required Return The required return is the same as the appropriate discount rate and is based on the risk of the cash flows The required rate of return is used to calculate NPV We need to earn at least the required return to compensate investors for the financing they have provided 3

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 (Gordon growth model) ◦ SML or CAPM 4

6. The Dividend Growth Model Approach Can be rearranged to solve for R E 5

7. Example Suppose that a company is expected to pay a dividend of $1.50 per share next year. There has been a steady growth in dividends of 5.1% per year and the market expects that to continue. The current price is $25. What is the cost of equity? Solution: R E = 11.1% 6

8. Example: Estimating the Dividend Growth Rate One method for estimating the growth rate is to use the historical average ◦ YearDividendPercent Change ◦ 19951.23 ◦ 19961.305.7% ◦ 19971.364.6% Geom. = 5.0864 ◦ 19981.435.1% ◦ 19991.504.9% Ar. Av = 5.0872 Analysts’ forecast can be used 7

9. Alternative Approach to Estimating Growth If the company has a stable ROE, a stable dividend policy and is not planning on raising new external capital, then the following relationship can be used: A company has a ROE of 15% and payout ratio is 35%. If management is not planning on raising additional external capital, what is its growth rate? Solution: g= 9.75% 8 g = Retention ratio x ROE

10. Advantages and Disadvantages of Dividend Growth Model – easy to understand and use  : ◦ 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% ◦ Does not explicitly consider risk 9

11. The SML Approach (CAPM) Use the following information to compute our cost of equity ◦ Risk-free rate, R f ◦ Market risk premium, E(R M ) – R f ◦ Systematic risk of asset,  10 E(R A ) = R f +  A (E(R M ) – R f )

12. SML example Suppose the 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 the cost of equity capital? Solution: R E = 11.08%  Do both approaches have the same result? 11

13. Advantages and Disadvantages of SML : ◦ Explicitly adjusts for systematic risk ◦ Applicable to all companies, as long as beta can be computed  : ◦ 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 12

14. Cost of Equity Suppose the company has a beta of 1.5. The market risk premium is expected to be 9% and the current risk-free rate is 6%. Dividends will grow at 6% per year and last dividend was $2. The stock is currently selling for $15.65. What is our cost of equity? ◦ Using SML: R E = 19.5% ◦ Using DGM: R E = 19.55% 13

15. Cost of Debt The cost of debt is the required return on a company’s debt Usually the cost of long-term debt or bonds only is taken into account The required return is best estimated by computing the yield-to-maturity on the existing debt Estimates of current rates based on the bond rating can be used  The cost of debt is NOT the coupon rate 14

16. Cost of Debt example Suppose you 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? Solution: R D = 10% (YTM) 15

17. Cost of Preferred Stock Preferred stock generally pays a constant dividend every period Dividends are expected to be paid every period forever Preferred stock is an annuity 16 R P = D / P 0

18. Cost of Preferred Stock example 17

19. The Weighted Average Cost of Capital (WACC) Individual costs of capital are used to find cost of capital for the firm WACC is the required return 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 – target D/E ratio 18

20. Capital Structure Weights V = market value of the firm’s D + E Weights ◦ w E = E/V = percent financed with equity ◦ w D = D/V = percent financed with debt 19

21. Capital Structure Weights example 20

22. Taxes and the WACC We are concerned with after-tax cash flows, so the effect of taxes on the various costs of capital has to be considered Interest expense reduces tax liability ◦ Reduction in taxes reduces 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 21 WACC = w E R E + w D R D (1-T C )

23. WACC (1) 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% 22

24. WACC (2) What is the cost of equity? R E =15.35% (by SML) What is the cost of debt? R D =7.85 (YTM) What is the after-tax cost of debt? 7.85*(1-.4)=4.71 23

25. WACC (3) WACC (3) What are the capital structure weights? E=80*50mil= 4bln D=1.1bln (110% of face) V= 5.1bln What is the WACC? WACC=4/5.1*15.35 + 1.1/5.1*4.71= = 12.0392% + 1.0159 = 13.0551 24

26. Divisional and Project Costs of Capital  Using the WACC as discount rate is only appropriate for projects that have the same risk as the firm’s current operations  If we are looking at a project that has NOT the same risk as the firm, then the appropriate discount rate for that project has to be determined Divisions also often require separate discount rates because they have different levels of risk 25

27. 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% 26

28. The Pure Play Approach 1. Find one or more companies that specialize in the product or service that we are considering 2. Compute the beta for each company 3. Take an average 4. 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 27 The pure play approach = use of a WACC that is unique to a particular project

29. 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 28

30. Subjective Approach example Risk LevelDiscount Rate Very Low RiskWACC – 8% Low RiskWACC – 3% Same Risk as FirmWACC High RiskWACC + 5% Very High RiskWACC + 10% 29