1 chapter 10 the cost of capital. 2 topics cost of capital components debt preferred common equity...
TRANSCRIPT
![Page 1: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/1.jpg)
1
CHAPTER 10
The Cost of Capital
![Page 2: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/2.jpg)
2
Topics
Cost of Capital Components Debt Preferred Common Equity
WACC Composite Risk Adjustments WACC with Flotation Costs
![Page 3: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/3.jpg)
3
Sources of Long-term Capital
10-3
rd
rsrps
rce re
![Page 4: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/4.jpg)
4
WACCWeighted Average Cost of Capital
Where:
wd = % of debt in capital structurewps = % of preferred stock in capital structurewce = % of common equity in capital structure
rd = firm’s cost of debtrps= firm’s cost of preferred stockrs = firm’s cost of equity
T = firm’s corporate tax rate
Weights
Component costs
WACC = wdrd(1-T) + wpsrps + wcers (10.10)
![Page 5: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/5.jpg)
5
Capital Components Capital components = sources of
funding from investors Accounts payable, accruals, and
deferred taxes ≠ sources of funding from investors Not included in calculation of the
cost of capital Adjustments made when calculating
project cash flows
![Page 6: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/6.jpg)
6
Cost of Debt Method 1: Ask an investment
banker what the coupon rate would be on new debt
Method 2: Find the bond rating for the company and use the yield on other bonds with a similar rating
Method 3: Find the yield on the company’s outstanding debt
![Page 7: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/7.jpg)
7
NCC’s Cost of Debt (rd)
A 22-year, 9% semiannual coupon bond sells for $835.42
Bond pays a semiannual coupon:rd = 5.5% x 2 = 11%
Calculator Solution 44 835.42
45 1000
= 5.50%
![Page 8: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/8.jpg)
8
Component Cost of Debt
Interest is tax deductible, so the after tax (AT) cost of debt is: rd AT = rd BT(1 - T) rd AT = 11%(1 - 0.40) =
6.6% Use nominal rate
![Page 9: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/9.jpg)
9
Flotation Costs on New Debt Flotation costs on debt usually low Frequently ignored
“Project Financing” Adjusts project’s cash flows for
flotation costs of debt Debt has specific claim on the
project’s cash flows
![Page 10: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/10.jpg)
10
Adjusting the Cost of Debt for Flotation Costs
N
1tN
dt
d )]T1(r1[
M
)]T1(r1[
)T1(INT)F1(M 2)-(10
Where:
M = Bond’s par value (face value)
F = Flotation cost as a %
N = Number of coupon payments
T = Corporate tax rate
INT = Dollars of interest per period
rd(1-T) = after tax cost of debt adjusted for inflation
![Page 11: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/11.jpg)
11
NCC’s Cost of Debt (rd) with Flotation Costs
NCC can issue 30-year bonds
N = 60 11% annual coupon rate
Coupons paid semiannually PMT = [(.11 x 1000)/2]*(1-.40) PMT = $33
Flotation cost = 1% PV = -1000(1-.01) = -990
Face value = M = 1000
Calculator Solution 60 990
33 1000
= 3.34%
Nominal after-tax cost of debt with flotation costs = 6.68%
![Page 12: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/12.jpg)
12
Preferred Stock
Flotation costs for preferred are significant Use net price
Preferred dividends are not deductible No tax adjustment Use rps
Nominal rps is used
![Page 13: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/13.jpg)
13
NCC’s Cost of preferred stock: PP = $100 $10 Dividend F =
2.5%
3)-(10 )F1(P
Dr
ps
psps
Where:
Dps = Preferred dividend
PPS = Preferred stock priceF = Flotation cost %
10.3%
)025.1(100$
10$rps
![Page 14: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/14.jpg)
14
Cost of Common Equity
Two Ways to raise equity financing: Directly
Issue new shares of common stock Indirectly
Reinvesting earnings not paid out as dividends
Use retained earnings
![Page 15: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/15.jpg)
15
Funding with New Common Equity
Mature firms rarely issue new equity High flotation costs Negative signal to the market Downward pressure on stock
price
![Page 16: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/16.jpg)
16
Cost of 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 reinvested
![Page 17: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/17.jpg)
17
Cost for Reinvested Earnings
Opportunity cost: The return stockholders could earn on alternative investments of equal risk They could buy similar stocks and earn
rs, or company could repurchase its own stock and earn rs
rs = the cost of reinvested earnings = the cost of equity
![Page 18: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/18.jpg)
18
Three ways to determine the cost of equity, rs:
1. CAPM: rs = rRF + (RM - rRF)β
= rRF + (RPM)β
2. DCF: rs = D1/P0 + g
3. Own-Bond-Yield-Plus-Risk Premium:
rs = rd + Bond RP
![Page 19: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/19.jpg)
19
Three ways to determine the cost of equity, rs:
1. CAPM: rs = rRF + (RM - rRF)β
= rRF + (RPM)β
2. DCF: rs = D1/P0 + g
3. Own-Bond-Yield-Plus-Risk Premium:
rs = rd + Bond RP
![Page 20: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/20.jpg)
20
1. Estimate risk-free rate (rRF)
2. Estimate market risk premium (RPM) or expected return on the market (RM)
3. Estimate beta (β)4. Substitute into CAPM
CAPM Cost of Equity - Steps
![Page 21: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/21.jpg)
21
Estimating rRF
Common stock = long-term security
T-Bills more volatile than T-Bonds Most analysts use the rate on a
long-term (10 to 30 years) government bond as an estimate of rRF
![Page 22: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/22.jpg)
22
Estimating RPM or RM
Historical - Ibbotson & Associates 1926-most recent year 6.5% arithmetic mean - if constant risk
aversion 4.9 % geometric mean – best future
estimate Ex Ante = Forward-Looking
If market in equilibrium: Return Required Return Expected MMRF0
1M RRPrg
P
Dr̂
Historical or analysts’ estimates
Value Line or Reuters
![Page 23: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/23.jpg)
23
RPM Estimate – #1RPM = 11.73%
rM Estimate (Reuters, Spring 2008) Dividend yield on S&P500 = 2.61% Dividend growth rate = 13.20% rM=[0.0261(1+.132)]+0.132=16.15%
Forward-looking RPM: Long-term T-Bond rate = 4.42% 16.15% - 4.42% = 11.73%
Problems: Past = future? Growth rates sensitive to period
measured
gP
)g1(Dr̂
0
0M
![Page 24: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/24.jpg)
24
RPM Estimate – #2 RPM = 17.79%
rM Estimate (Spring 2008) Reuters S&P500 dividend yield = 2.61% Yahoo Earnings growth rate = 19.1% rM=[0.0261(1+.191)]+0.191=22.21%
Forward-looking RPM: 22.21% - 4.42% = 17.79%
Problems: Earnings growth ≠ dividend growth 1-year growth rate ≠ long-term growth Analysts’ accuracy Differing analysts’ opinions
gP
)g1(Dr̂
0
0M
![Page 25: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/25.jpg)
25
Estimating RPM (or RM)
RPM = Equity risk premium Most analysts use a rate of 5% to
6.5% for the market risk premium RM
S&P500 index return =proxy for the market return
RPM=RM- rRF
Brigham-Daves →RPM = [3.5, 6.5]
![Page 26: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/26.jpg)
26
Estimating Beta - β Beta estimates vary Beta estimates are “noisy”
Wide confidence interval Historical Beta
4-5 years/monthly or 1-2 years/weekly
Adjusted Beta Fundamental Beta
Multinational issues
![Page 27: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/27.jpg)
27
NCC’s CAPM Cost of Equity
rs = rRF + (RM - rRF )β
= 8.0% + (6.0%)1.1
= 14.6%
rRF = 8% RPM = 6% β= 1.1
![Page 28: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/28.jpg)
28
Three ways to determine the cost of equity, rs:
1. CAPM: rs = rRF + (RM - rRF)β
= rRF + (RPM)β
2. DCF: rs = D1/P0 + g
3. Own-Bond-Yield-Plus-Risk Premium:
rs = rd + Bond RP
![Page 29: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/29.jpg)
29
DCF Approach: Inputs
1. Current stock price (P0)
2. Current dividend (D0)
3. Growth rate (g)
g expected
5)-(10
o
1ss
s
10
P
Dr̂r
gr
DP̂
![Page 30: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/30.jpg)
30
Estimating the Growth Rate
The historical growth rate If you believe future = past
The earnings retention model Analysts’ estimates:
Value Line, Zack’s, Yahoo.Finance
![Page 31: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/31.jpg)
31
Earnings Retention Model NCC Data:
ROE = 14.5% Dividend payout ratio = 52%
Retention ratio = 100% - dividend payout Retention rate = 100% - 52% = 48%
Retention growth rate: g = ROE x (Retention rate) g = (14.5%) x 0.48 = 7%
![Page 32: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/32.jpg)
32
Earnings Retention Assumptions
1. Retention rate is constant2. ROE on new investments is
constant3. No new common stock will be
issued4. The risk of future projects is very
close to the risk of the overall firm
![Page 33: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/33.jpg)
33
Using Analysts’ Forecasts Analysts’ estimate earnings growth
= proxy for dividend growth Sometimes involve non-constant growth
Develop a proxy constant rate
Analysts’ Estimates for NCC: 10.4% annual growth for 5 years 6.5% growth after 5 years
Analysts’ estimates usually best source
g = 6.9%
![Page 34: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/34.jpg)
34
NCC’s DCF Cost of Equity, rs
rs = D1
P0
+ g =D0(1+g)
P0
+ g
= $2.40
$32+ 0.07
= 0.075 + 0.07
= 14.5%
D1 = $2.40 P0 = $32 g = 7%
![Page 35: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/35.jpg)
35
Three ways to determine the cost of equity, rs:
1. CAPM: rs = rRF + (RM - rRF)β
= rRF + (RPM)β
2. DCF: rs = D1/P0 + g
3. Own-Bond-Yield-Plus-Risk Premium:
rs = rd + Bond RP
![Page 36: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/36.jpg)
36
The Own-Bond-Yield-Plus-Risk-Premium Method: rd = 11%, RP = 3.7%
rs = rd + RP rs = 11.0% + 3.7% = 14.7%
This RP CAPM RPM
Produces ballpark estimate of rs Useful check
![Page 37: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/37.jpg)
37
Final Estimate of rs
Method Estimate
Used by
CAPM 14.6% 74% - 85%
DCF 14.5% 16%
rd + RP 14.7% Non-public
Average 14.6%
![Page 38: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/38.jpg)
38
Flotation Costs for Equityre = Cost of New Equity
9)-(10 g)F1(P
Dr̂r
0
1ee
NCC: D1 = $2.40 P0 = $32 F = 12.5%
15.6%
07.)125.1(32$
40.2$r̂r ee
![Page 39: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/39.jpg)
39
Topics
Cost of Capital Components Debt Preferred Common Equity
WACC Composite Risk Adjusted WACC with Flotation Costs
![Page 40: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/40.jpg)
40
WACCWeighted Average Cost of Capital
Where:
wd = % of debt in capital structurewps= % of preferred stock in capital structurewce= % of common equity in capital structure
rd = firm’s cost of debtrps= firm’s cost of preferred stockrs= firm’s cost of equity
T = firm’s corporate tax rate
Weights
Component costs
WACC = wdrd(1-T) + wpsrps + wcers (10.10)
![Page 41: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/41.jpg)
41
WACC Weights
Weights =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 NCC: 30% debt, 10% Preferred, 60% Equity
![Page 42: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/42.jpg)
42
NCC’s WACCWeighted Average Cost of Capital
WACC =0.3(11%)(1-.40)+0.1(10.3%)+0.6(14.6%)
WACC = 11.77%
Component w r
Debt (before tax)
0.30 11.0%
Preferred Stock 0.10 10.3%
Common equity 0.60 14.6%WACC = wDrD (1- T)+ wPsrPs + wcrs
![Page 43: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/43.jpg)
43
Cost of Capital Issues Before-tax vs. After-tax Capital
Costs Long- and short-term debt affected
Historical Costs vs. Marginal Costs Target Weights vs. Annual Financing
Choices Target Weights vs. Book Values
![Page 44: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/44.jpg)
44
Estimating Weights for the Capital Structure
Estimate the weights using current market values rather than current book values
If market value of debt is not known: Usually reasonable to use the book
values of debt, especially if the debt is short-term
![Page 45: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/45.jpg)
45
Estimating Weights
Given: The stock price is $50 There are 3 million shares of
stock $25 million of preferred stock $75 million of debt
![Page 46: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/46.jpg)
46
Estimating Weights
Vce = $50 x (3 million) = $150 million
Vps = $25 million Vd = $75 million Total value = $150 + $25 + $75 =
$250 million
![Page 47: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/47.jpg)
47
Estimating Weights
Value WeightStock price $50Share O/S 3,000,000
Preferred Stock $25,000,000 $25,000,000 10%
Debt $75,000,000 $75,000,000 30%
$250,000,000 100%
$150,000,000 60%
Total Firm
![Page 48: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/48.jpg)
48
WACC
Tax Rate = 40% Cost of Capital
Stock price $50Share O/S 3,000,000
Preferred Stock $25,000,000 $25,000,000 10% 10.30% 1.03%
Debt $75,000,000 $75,000,000 30% 11.00% 60% 1.98%
$250,000,000 100% 11.77%
WACC
8.76%
Tax Effect
14.60%
Total Firm
Value Weight
$150,000,000 60%
![Page 49: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/49.jpg)
49
Factors that influence a company’s WACC Market conditions
Interest rates The market risk premium Tax rates
Firm’s capital structure Firm’s dividend policy Firm’s investment policy
Firms with riskier projects generally have a higher WACC
![Page 50: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/50.jpg)
50
Topics
Cost of Capital Components Debt Preferred Common Equity
WACC Composite Risk Adjusted WACC with Flotation Costs
![Page 51: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/51.jpg)
51
Risk-Adjusted WACC The composite WACC reflects the
risk of an average project undertaken by the firm
Different divisions/projects may have different risks
The division’s or project’s WACC should be adjusted to reflect the appropriate risk and capital structure
![Page 52: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/52.jpg)
52
Divisional Risk and the Cost of Capital
Rate of Return (%)
WACC
Rejection Region
Acceptance Region
Risk
WACC H
WACC L
WACC F
0 Risk L Risk H
Acceptance Region
Rejection Region
![Page 53: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/53.jpg)
53
Using WACC for All Projects - Example
What would happen if we use the WACC for all projects regardless of risk?
Assume the WACC = 15%Required
Project Return IRR If 15% Risk AdjA 20% 17% Accept RejectB 15% 18% Accept AcceptC 10% 12% Reject Accept
Decision
![Page 54: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/54.jpg)
54
The Risk-Adjusted Divisional Cost of Capital
Estimate the cost of capital that the division would have if it were a stand-alone firm
Requires estimating the division’s beta, cost of debt, and capital structure CAPM frequently used
![Page 55: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/55.jpg)
55
Pure Play Method for Estimating Beta for a Division or a Project
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
![Page 56: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/56.jpg)
56
Huron Steel Example
Riskfree rate = 7%Market risk premium = 6%
Division Beta COC % BusSteel 1.1 13.60% 70%Barge 1.5 16.00% 20%Distrib 0.5 10.00% 10%Overall 1.12 13.72%
Huron Steel Company
![Page 57: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/57.jpg)
57
Subjective Approach Consider the project’s risk
relative to the firm overall If project risk > firm risk
Project discount rate > WACC If project risk < firm risk
Project discount rate < WACC
![Page 58: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/58.jpg)
58
Subjective Approach - Example
Risk Level Discount Rate
Very Low Risk WACC – 8% 7%
Low Risk WACC – 3% 12%
Same Risk as Firm WACC 15%
High Risk WACC + 5% 20%
Very High Risk WACC + 10% 25%
![Page 59: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/59.jpg)
59
Topics
Cost of Capital Components Debt Preferred Common Equity
WACC Composite Risk Adjusted WACC with Flotation Costs
![Page 60: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/60.jpg)
60
Flotation Costs Flotation costs depend on the risk
of the firm and the type of capital being raised
Flotation costs: Highest for common equity Most firms issue equity infrequently
Flotation costs frequently ignored when calculating WACC
![Page 61: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/61.jpg)
61
NCC’s WACC With New Debt
WACC = wdrATd + wpsrps + wcre
WACC = 0.3(6.68%)+0.1(10.3%) +0.6(14.6%)WACC = 2.004% + 1.03% + 9.36% = 11.794%
Component w r
New Debt (after-tax)
d 0.30 6.68%
Preferred Stock ps 0.10 10.3%
New Common equity
c 0.60 14.6%
![Page 62: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/62.jpg)
62
NCC’s WACC With New Debt & New Equity
WACC = wdrATd + wpsrps + wcre
WACC = 0.3(6.68%)+0.1(10.3%) +0.6(15.6%)WACC = 2.004% + 1.03% + 9.36% = 12.394%
Component w r
New Debt (after-tax)
d 0.30 6.68%
Preferred Stock ps 0.10 10.3%
New Common equity
c 0.60 15.6%
![Page 63: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/63.jpg)
63
NCC’s WACC
WACC Description WACC
No New Issues 11.770%
With New Debt 11.794%
With New Debt & New Equity
12.394%
![Page 64: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/64.jpg)
64
Increasing Marginal Cost of Capital Externally raised capital flotation costs
Increases the cost of capital Investors often perceive large capital
budgets as being risky Drives up the cost of capital
If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital
![Page 65: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/65.jpg)
500 700
%
Capital Required
WACC1 = 11.77%
WACC2 = 12.394%
8
9
10
12
13
14
15
16
Increasing Marginal Cost of Capital
61
No external funds
External debt & equity
![Page 66: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/66.jpg)
66
Four Mistakes to Avoid Current (YTM) vs. historical (Coupon rate) cost
of debt Mixing current and historical measures to
estimate the market risk premium Book weights vs. Market Weights
Use Target weights Use market value of equity Book value of debt is a reasonable proxy for market
value Incorrect cost of capital components
Only investor provided funding
![Page 67: 1 CHAPTER 10 The Cost of Capital. 2 Topics Cost of Capital Components Debt Preferred Common Equity WACC Composite Risk Adjustments WACC with Flotation](https://reader035.vdocuments.us/reader035/viewer/2022081513/56649cc95503460f94991713/html5/thumbnails/67.jpg)
67
CHAPTER 10
The Cost of Capital