LECTURE 7 : CHAPTER 10 The Cost of Capital

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Gertrude Long
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1 LECTURE 7 : CHAPTER 10 The Cost of Capital Sources of capital Component costs WACC (Weighted Average Cost of Capital) Adjusting for flotation costs Adjusting for risk

2 What sources of long-term capital do firms use? Long-Term Capital Long-Term Debt Preferred Stock Common Stock Retained Earnings New Common Stock 7-2

3 Calculating the weighted average cost of capital WACC = w d r d (1-T) + w p r p + w c r s = (% of Debt)(After-Tax Cost of Debt) + (% of Preferred Stock)(Cost of Preferred Stock) + (% of Common Equity)(Cost of Common Equity) The w s refer to the firm s capital structure weights. The r s refer to the cost of each component. 7-3

4 Should our analysis focus on before-tax or after-tax capital costs? Stock price depends on After-Tax Cash Flows (A-T CFs). Therefore, we should focus on A-T capital costs, i.e. use A-T costs of capital in WACC. Only r d needs adjustment, because interest is tax deductible. 7-4

5 Should our analysis focus on historical (embedded) costs or new (marginal) costs? The cost of capital is used primarily to make decisions that involve raising NEW capital for NEW projects. So, focus on today s MARGINAL costs (for WACC). 7-5

6 How are the weights determined? WACC = w d r d (1-T) + w p r p + w c r s Use accounting numbers or market value (book vs. market weights)? Use actual numbers or target capital structure? 7-6

7 Component cost of DEBT WACC = w d r d (1-T) + w p r p + w c r s r d is the marginal cost of debt capital. Cost of debt is interest rate on new debt, not that on already outstanding debts. The yield to maturity on outstanding L-T debt is often used as a measure of r d. Why tax-adjust, i.e. why r d (1-T)? 7-7

8 Component cost of debt Interest is tax deductible, so A-T r d = B-T r d (1-T) Use nominal rate. = 10% (1-0.40) = 6% Flotation costs are small, so ignore them. 7-8

9 Component cost of PREFERRED STOCK WACC = w d r d (1-T) + w p r p + w c r s r p is the marginal cost of preferred stock, which is the return investors require on a firm s preferred stock. Preferred dividends are not tax-deductible, so no tax adjustments necessary. Just use nominal r p. Our calculation ignores possible flotation costs. 7-9

10 What is the cost of preferred stock? The cost of preferred stock can be solved by using this formula: r p = D p / P p = $10 / $ = 9% 7-10

11 Component cost of EQUITY WACC = w d r d (1-T) + w p r p + w c r s r s is the marginal cost of common equity using retained earnings or internal equity. Most firms, once established, obtain almost all their new equity from retained earnings, hence r s is their cost of equity. r e is the rate of return investors require on the firm s common equity using NEW equity. r e = r s + a factor that reflects cost of issuing new stock. Established firms rarely issue new stock, r e is rarely relevant except for very young firms. 7-11

12 Three ways to determine the cost of common equity, r s CAPM: r s = r RF + (r M r RF ) b DCF: r s = (D 1 / P 0 ) + g Own-Bond-Yield-Plus- Risk-Premium : r s = r d + RP 7-12

13 If the r RF = 7%, RP M = 6%, and the firm s beta is 1.2, what s the cost of common equity based upon the CAPM? r s = r RF + (r M r RF ) b = 7.0% + (6.0%)1.2 = 14.2% 7-13

14 If D 0 = $4.19, P 0 = $50, and g = 5%, what s the cost of common equity based upon the DCF approach? D 1 = D 0 (1 + g) D 1 = $4.19 (1 +.05) D 1 = $ r s = (D 1 / P 0 ) + g = ($ / $50) = 13.8% 7-14

15 What is the expected future growth rate? The firm has been earning 15% on equity (ROE = 15%) and retaining 35% of its Net Income or earnings (dividend payout = 65%). This situation is expected to continue. g = ( 1 Payout ) (ROE) = Retention Ratio x ROE = (0.35) (15%) = 5.25% Very close to the g that was given before. 7-15

16 CAPM vs DCF Method for r s In some cases, average of the r s from the 2 approaches is used. If firm does not pay dividend or dividend is unpredictable, use CAPM approach. If firm pay steady dividends but has a beta that appears out of line with other firms in its industry, use mainly DCF approach. 7-16

17 If r d = 10% and RP = 4%, what is r s using the own-bond-yield-plus- risk-premium method? r s = r d + RP r s = 10.0% + 4.0% = 14.0% RP is the risk premium of a firm s stock over its own bonds, generally ranging from 3% to 5%. Actual value used is a judgment. This method produces a ballpark estimate of r s, and can serve as a useful check. This RP is not the same as the CAPM RP M nor CAPM RP i. 7-17

18 What is a reasonable final estimate of r s? Method Estimate CAPM 14.2% DCF 13.8% r d + RP 14.0% Average 14.0% 7-18

19 Why is the cost of retained earnings (r s ) cheaper than the cost of issuing new common stock (r e )? When a company issues new common stock they also have to pay flotation costs to the underwriter. Issuing new common stock may send a negative signal to the capital markets, which may depress the stock price. 7-19

20 If issuing new common stock incurs a flotation cost of 15% of the proceeds, what is r e? r e D P 0 0 (1 g) (1 -F) $4.19(1.05) $50(1-0.15) $ $ % g 5.0% 5.0% 7-20

21 If issuing new common stock incurs a flotation cost of 15% of the proceeds, what is r e? F is the percentage flotation cost required to sell the new stock. P 0 (1-F) is the net price per share received by the company. This higher rate of return is the floatation-adjusted cost of equity. 7-21

22 Flotation costs Flotation costs depend on the firm s risk and the type of capital being raised. Flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small. Most debt is raised from banks and in private placements and hence involves no flotation. Further preferred stock is rarely used. We will frequently ignore flotation costs when calculating the WACC. 7-22

23 Ignoring flotation costs, what is the firm s WACC? WACC = w d r d (1-T) + w p r p + w c r s = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1% 7-23

24 What factors influence a company s composite WACC? Market conditions Interest rates affect directly cost of debt, equity and preferred stock Prevailing tax rates Recent lowering of tax rates on dividends and capital gains, relative to rates on interest income, makes stocks more attractive, lowering the relative cost of equity (thus WACC). Lower dividend and capital gains taxes lead to change in optimal capital structure: less debt and more equity. The firm s capital structure and dividend policy. If a firm changes its capital structure such that it increases its target debt ratio, this may lower its WACC as the after-tax cost of debt is lower than the cost of equity. However, increase use of debt increase riskiness of both debt and equity and may increase their costs. This might offset the effect of the change in weights, leaving WACC unchanged or higher. 7-24

25 What factors influence a company s composite WACC? Dividend policy affects retained earnings and hence the need to issue new shares which incur floatation costs. This suggests that higher dividend payout ratio, the smaller the retained earnings, leading to greater need to issue shares (with its associated cost), resulting in higher cost of equity/wacc. On the other hand, investors may want more dividends and an increase in payout ratio may lead to higher price/decrease in required return on equity. Optimal dividend policy is a complicated issue. The firm s investment policy. Firms with riskier projects generally have a higher WACC. 7-25

26 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. 7-26

27 Adjusting WACC for Risk: 2 Firms with different Avg Risk Rate of Return (%) A Acceptance Region WACC H Rejection Region 8.0 L 0 Risk L Risk Average Risk H Risk 7-27

28 Adjusting WACC for Risk: 2 Firms with different Avg Risk Low Risk Firm L: overall WACC L = 8% High Risk Firm H: overall WACC H = 12% Both considering Project A: expected return = 10.5% with hurdle/project WACC = 10% If blindly follow WACC criteria (which should apply only to typical projects of firm), and ignoring risk: Firm L will accept Pjt A as its expected return of 10.5% > WACC L of 8%. Firm H will reject Pjt A as its expected return of 10.5% < WACC H of 12%. Factoring Risk, Pjt A s hurdle rate (its WACC) is 10%. Both firms (L and H) will accept Project A as its expected return of 10.5% > its hurdle rate of 10% 7-28

29 Adjusting WACC for Risk: 1 Firm with 2 divisions Rate of Return (%) 13 Division H s WACC WACC Project L Composite WACC for Firm A Project H 7 Division L s WACC 0 Risk L Risk Average Risk H Risk 7-29

30 Adjusting WACC for Risk: 1 Firm with 2 divisions Division L: involved in low-risk projects and has WACC L = 7% Division H: involved in high-risk projects and has WACC H = 13% Firm s composite WACC F = ½(7%) + ½(13%) = 10% Mistake to use WACC F of 10% for either division. Division L is looking at low-risk project L with 9% expected return while Division H is looking at high-risk project H with 11% return. Using the firm or composite WACC of 10%, we would reject Project L (9%) and accept Project H (11%) Factoring risk, we should accept Project L (9%) > WACC L (7%), reject Project H (11%) < WACC H (13%) 7-30

Lecture 6 Cost of Capital

Lecture 6 Cost of Capital What Types of Long-term Capital do Firms Use? 2 Long-term debt Preferred stock Common equity What Types of Long-term Capital do Firms Use? Capital components are sources of funding