3. the cost of capital
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cost of capitalTRANSCRIPT
No Slide TitleCopyright © 2003 by The McGraw-Hill Companies, Inc.
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Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
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Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
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Weighted Average Cost of Capital (WACC)
Capital Structure
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
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Cost of Capital
Cost of Capital - The return the firm’s investors could expect to earn if they invested in securities with comparable degrees of risk.
Capital Structure - The firm’s mix of long term financing and equity financing.
3
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
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Cost of Capital
Example - Geothermal Inc. has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company Cost of Capital?
5
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
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Cost of Capital
Example - Geothermal Inc. has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company Cost of Capital?
6
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Cost of Capital
Example - Geothermal Inc. has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company Cost of Capital?
Interest is tax deductible. Given a 35% tax rate, debt only costs us 5.2% (i.e. 8 % x .65).
6
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
WACC
Weighted Average Cost of Capital (WACC) - The expected rate of return on a portfolio of all the firm’s securities.
Company cost of capital = Weighted average of debt and equity returns.
7
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
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Three Steps to Calculating Cost of Capital
1. Calculate the value of each security as a proportion of the firm’s market value.
2. Determine the required rate of return on each security.
3. Calculate a weighted average of these required returns.
11
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
WACC
Taxes are an important consideration in the company cost of capital because interest payments are deducted from income before tax is calculated.
12
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
WACC
Example - Executive Fruit has issued debt, preferred stock and common stock. The market value of these securities are $4mil, $2mil, and $6mil, respectively. The required returns are 6%, 12%, and 18%, respectively.
Q: Determine the WACC for Executive Fruit, Inc.
14
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
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Step 2
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Measuring Capital Structure
In estimating WACC, do not use the Book Value of securities.
In estimating WACC, use the Market Value of the securities.
Book Values often do not represent the true market value of a firm’s securities.
19
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Measuring Capital Structure
Market Value of Bonds - PV of all coupons and par value discounted at the current interest rate.
Market Value of Equity - Market price per share multiplied by the number of outstanding shares.
21
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
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Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Perpetuity Growth Model =
solve for re
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Price of Preferred Stock =
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Irwin/McGraw Hill
Flotation Costs
The cost of implementing any financing decision must be incorporated into the cash flows of the project being evaluated.
Only the incremental costs of financing should be included.
This is sometimes called Adjusted Present Value.
28
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
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Problems
Q1) Cost of Debt. Micro Spinoffs, Inc., issued 20-year debt a year ago at par value with a coupon rate of 8 percent, paid annually. Today, the debt is selling at $1,050. If the firm’s tax bracket is 35 percent, what is its after-tax cost of debt?
Q2) Cost of Preferred Stock. Micro Spinoffs also has preferred stock outstanding. The stock pays a dividend of $4 per share, and the stock sells for $40. What is the cost of preferred stock?
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
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Problems
Q3) Calculating WACC. Suppose Micro Spinoffs’s cost of equity is 12 percent. What is its WACC if equity is 50 percent, preferred stock is 20 percent, and debt is 30 percent of total capital?
Q4) Calculating WACC. Reactive Industries has the following capital structure. Its corporate tax rate is 35 percent. What is its WACC?
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Problems
Q5 Calculating WACC. Find the WACC of William Tell Computers. The total book value of the firm’s equity is $10 million; book value per share is $20. The stock sells for a price of $30 per share, and the cost of equity is 15 percent. The firm’s bonds have a par value of $5 million and sell at a price of 110 percent of par. The yield to maturity on the bonds is 9 percent, and the firm’s tax rate is 40 percent.
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Problems
Long street communications Inc (LCI) has the following capital structure, which it considers to be optimal:
Debt = 25%
Preferred Stocks = 15%
Common stocks = 60%
LCI’s net income expected this year is $ 17,142.86, its established dividend payout ratio is 30 percent, its tax rate is 40 percent and investors expect earning and dividends to grow at a constant rate of 9 percent in the future. LCI paid a dividend of $ 3.60 per share last year and its stock currently sells at a price of $ 60 per share. Treasury bonds yield 11 percent and average stock beta has a 14 percent expected rate of return and LCI’s beta is 1.51. These terms will apply to new offerings:
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Problems
Common: New common stock would have a floating cost of 10 percent.
Preferred: New preferred could be sold to the public at a price of $ 100 per share with the dividend of $11, Floating cost of $ 5 would be incurred.
Debt: New debt could be sold at an interest rate of 12 percent.
Find the component cost debt, preferred stock, retained earnings and new common stocks?
What is the WACC?
12- *
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
2
1
1
1
1
1
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Weighted Average Cost of Capital (WACC)
Capital Structure
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Cost of Capital
Cost of Capital - The return the firm’s investors could expect to earn if they invested in securities with comparable degrees of risk.
Capital Structure - The firm’s mix of long term financing and equity financing.
3
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Cost of Capital
Example - Geothermal Inc. has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company Cost of Capital?
5
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Cost of Capital
Example - Geothermal Inc. has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company Cost of Capital?
6
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Cost of Capital
Example - Geothermal Inc. has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company Cost of Capital?
Interest is tax deductible. Given a 35% tax rate, debt only costs us 5.2% (i.e. 8 % x .65).
6
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
WACC
Weighted Average Cost of Capital (WACC) - The expected rate of return on a portfolio of all the firm’s securities.
Company cost of capital = Weighted average of debt and equity returns.
7
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Three Steps to Calculating Cost of Capital
1. Calculate the value of each security as a proportion of the firm’s market value.
2. Determine the required rate of return on each security.
3. Calculate a weighted average of these required returns.
11
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
WACC
Taxes are an important consideration in the company cost of capital because interest payments are deducted from income before tax is calculated.
12
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
WACC
Example - Executive Fruit has issued debt, preferred stock and common stock. The market value of these securities are $4mil, $2mil, and $6mil, respectively. The required returns are 6%, 12%, and 18%, respectively.
Q: Determine the WACC for Executive Fruit, Inc.
14
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Step 2
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Measuring Capital Structure
In estimating WACC, do not use the Book Value of securities.
In estimating WACC, use the Market Value of the securities.
Book Values often do not represent the true market value of a firm’s securities.
19
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Measuring Capital Structure
Market Value of Bonds - PV of all coupons and par value discounted at the current interest rate.
Market Value of Equity - Market price per share multiplied by the number of outstanding shares.
21
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Perpetuity Growth Model =
solve for re
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Price of Preferred Stock =
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Irwin/McGraw Hill
Flotation Costs
The cost of implementing any financing decision must be incorporated into the cash flows of the project being evaluated.
Only the incremental costs of financing should be included.
This is sometimes called Adjusted Present Value.
28
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Problems
Q1) Cost of Debt. Micro Spinoffs, Inc., issued 20-year debt a year ago at par value with a coupon rate of 8 percent, paid annually. Today, the debt is selling at $1,050. If the firm’s tax bracket is 35 percent, what is its after-tax cost of debt?
Q2) Cost of Preferred Stock. Micro Spinoffs also has preferred stock outstanding. The stock pays a dividend of $4 per share, and the stock sells for $40. What is the cost of preferred stock?
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Problems
Q3) Calculating WACC. Suppose Micro Spinoffs’s cost of equity is 12 percent. What is its WACC if equity is 50 percent, preferred stock is 20 percent, and debt is 30 percent of total capital?
Q4) Calculating WACC. Reactive Industries has the following capital structure. Its corporate tax rate is 35 percent. What is its WACC?
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Problems
Q5 Calculating WACC. Find the WACC of William Tell Computers. The total book value of the firm’s equity is $10 million; book value per share is $20. The stock sells for a price of $30 per share, and the cost of equity is 15 percent. The firm’s bonds have a par value of $5 million and sell at a price of 110 percent of par. The yield to maturity on the bonds is 9 percent, and the firm’s tax rate is 40 percent.
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Problems
Long street communications Inc (LCI) has the following capital structure, which it considers to be optimal:
Debt = 25%
Preferred Stocks = 15%
Common stocks = 60%
LCI’s net income expected this year is $ 17,142.86, its established dividend payout ratio is 30 percent, its tax rate is 40 percent and investors expect earning and dividends to grow at a constant rate of 9 percent in the future. LCI paid a dividend of $ 3.60 per share last year and its stock currently sells at a price of $ 60 per share. Treasury bonds yield 11 percent and average stock beta has a 14 percent expected rate of return and LCI’s beta is 1.51. These terms will apply to new offerings:
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
12- *
Problems
Common: New common stock would have a floating cost of 10 percent.
Preferred: New preferred could be sold to the public at a price of $ 100 per share with the dividend of $11, Floating cost of $ 5 would be incurred.
Debt: New debt could be sold at an interest rate of 12 percent.
Find the component cost debt, preferred stock, retained earnings and new common stocks?
What is the WACC?