fundamentals of corporate finance/3e,ch18

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

18-1

Chapter Eighteen

Cost of Capital


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


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.


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.


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.


18-6

The Dividend Growth Model Approach

• According to the constant growth model:

Rearranging:

gR

gDP

E

) (1 0

0

gP

DRE

0

1


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.

7.8%or 0.078

0.03 $3.20

1.03 $0.15

ER


18-8

Estimating g

9.025%

/47.62 10.53 7.95 10.00 rategrowth Average

One method for estimating the growth rate is to use the historical average.


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.


18-10

The SML Approach

Required return on a risky investment is dependent on three factors:

– the risk-free rate, Rf

– the market risk premium, E(RM) – Rf

– the systematic risk of the asset relative to the average,

fMEfE RRRR


18-11

Example—Cost of Equity Capital: SML Approach

• Obtain the risk-free rate (Rf) 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.


18-12

Example—Cost of Equity Capital: SML Approach (continued)

%.

%. . %

RRRR fMEfE

1217

9474016


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.


18-14

The Cost of Debt

• The cost of debt, RD, is the interest rate on new borrowing.

• RD is observable:

– yields on currently outstanding debt– yields on newly-issued similarly-rated bonds.

• The historic cost of debt is irrelevant—why?


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?

14.4%

/2$86 $100

/10$86 $100 $12

/2NP PV

/NP PV

nI

RD

The yield to maturity is 14.4 per cent, so this is used as the cost of debt, not 12 per cent.


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.

0

P

DRp


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.


18-18

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.


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:

CD TR 1 debt ofcost tax -After

CDE TRVDRV

E 1 WACC


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.


18-21

Example—Weighted Average Cost of Capital (continued)

The firm has four debt issues outstanding:


18-22

Example—Cost of Equity(SML Approach)

%.

%. . %.

RRRR fMEfE

6511

94790054


18-23

Example—Cost of Debt

The weighted average cost of debt is 7.15 per cent.


18-24

Example—Capital Structure Weights

• Market value of equity = 78.26 million × $58 = $4.539 billion.• Market value of debt = $1.474 billion.

9.32%or 0.0932

0.30 1 0.0715 0.245 0.1165 0.755 WACC

75.5%or 0.755 $6.013b$4.539b

24.5%or 0.245 $6.013b$1.474b

billion $6.013 billion $1.474 billion $4.539

VE

VD

V


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.


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.


18-27

The SML and the WACC

Expectedreturn (%)

Beta

SML

WACC = 15%

= 8%

Incorrectacceptance

Incorrectrejection

B

A

161514

Rf =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.


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 Return IRR Decision

A 15% 14% Reject

B 15% 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).


18-29

The SML and the Subjective Approach

Expectedreturn (%)

Beta

SML

20

WACC = 14

10

Rf = 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%


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.

DEA fVDfV

Ef


18-31

Example—Project Cost including Flotation CostsSaddle 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?

12.6%

0.07 0.30 0.15 0.70

Af

The weighted average flotation cost is 12.6 per cent.


18-32

Example—Project Cost including Flotation Costs (continued)

million $34.32

0.126 1

$30m project ofcost True

million $30 costsflotation ignoringcost Project


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.


18-34

Example—NPV (No Flotation Costs)

322 $159

000 500 $1 0.118

800 $195 NPV

11.8%or 0.118

0.30 1 0.1 0.4 15% 0.6 WACC


18-35

Example—NPV (With Flotation Costs)

$7340

982 651 $1 - 0.118

800 $195 NPV

982 651 $1 0.092 1

000 500 $1 cost True

9.2%or 0.092

0.05 0.4 0.12 0.6

Af

Flotation costs decrease a project’s NPV and could alter an investment decision.

fundamentals of corporate finance/3e,ch18

Economy & Finance

mcgrawhill australiapty

cost of equity18

cost of debtand

growth rate

examplecost of equity

dividend growth model

dividend growth model

growth estimate