The Hurdle Rate The minimum rate of return that must be met for a company to undertake a particular project

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Audra Pope
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1 Risk, Return and Capital Budgeting The Hurdle Rate The minimum rate of return that must be met for a company to undertake a particular project The Weighted Average Cost of Capital (WACC) -The hurdle rate for capital budgeting decisions -Return on the project must EXCEED return required by provides of capital r b = before tax cost of debt r i = r b (1 T c) = after tax cost of debt r ps = after tax cost of preferred shares r s return required by shareholders w j = proportion of debt, equity and preferred shares in the firm, based on market values of capital structure after financing has been raised Capital k = r WACC = r iw debt + r psw ps + r W Structure Weights W equity = _S_ V S = W debt = _B_ V P = market value of preferred shares B = market value of debt V = value of the firm W ps = _P_ V market value of equity (Market price x number of shares) Value of the firm (V) = S + B+ + P WACC = r b Assumptions -Need efficient markets (1 Tc)( B V ) + r ps ( -If project risk = firm overall risk, use firm WACC to evaluate the project -If project risk firm overall risk, DO NOT use the firm WACC. We should use a discount rate that matches the risk of the project -WACC is a discount rate that matches firm overall risk Ex. A firm issued bonds 10 years ago at a cost of debt = 12%. The firm currently can issue bonds at a cost of debt = 10%. Which cost of debt should be used to calculate WACC? a. 10% *Should be looking forward, NOT back b. 12% Ex. A project costs $10M. The firm borrows $10M to fund this project at a before tax cost of debt, rb = 10%. Assume no tax. Assume project risk = firm risk. Firm WACC = 14%. Which discount rate do we use to evaluate this project? a. 10% b. 14% *How a project is funded does not matter in discount rate What are Efficient Markets? -A market is efficient if prices quickly reflect all available information about the firm

2 Ex. a) Reactive industries has the following capital structure. Its corporate tax rate is 35%. What is its WACC? Security Market Value Return required by investors Debt $20 M 8% Preferred stock $10 M 10% Equity $50 M 15% b) Passive footwear has a WACC of 12%. Its debt sells at a yield to maturity of 9%, and its tax rate is 40%. Its cost of equity is 15%. If the firm is financed by debt and common equity only, what fraction of the firm r s = Div i + g is financed by equity? P o P = F x C 1 (1+rb) n rb + The Cost of Equity -The return that investors require on a stock, r s Capital Asset Pricing Model (CAPM) Valuation R s R f + β (r m Determinants of Beta R ) -Firms whose revenues are highly cyclical have higher β -Firms that have a high degree of operating leverage have higher β -Firms with a higher degree of financial leverage have higher β s β = Covariance Ex. The Market retention, firm retention Bedrock Corporation s common stock has a beta of 1.4. If the risk free rate is 5% and the market risk premium is 9%, what is Bedrock s cost of equity capital? Dividend YTM = coupon + of coupon payments (face value price) maturity Valuation

3 -To solve for r s, the firm s cost of equity: -Growth rate is usually unknown; estimate it from past growth or use analysts forecasts of future growth rates Ex. The Chilton Oil Co. just issued a dividend of $3 per share on its common stock. The company is expected to maintain a constant 5% growth rate in its dividends If the stock sells for $60 a share, what is Chilton s cost of equity? Ex. Stock in Eddy Industries has a beta of 1.2. The market risk premium is 7.5% and T-bills are currently yielding 6%. Eddy s most recent dividend was $3.15 per share and dividends are expected to grow at a 3% annual rate indefinitely. If the stock sells for $27.50 per share, what is your best estimate of Eddy s cost of equity? Cost of Debt -The interest is tax deductible we call it the interest tax shield -Tax shield = tax savings -The interest tax shield reduces the cost of debt -r i = r b (1 T c) is the after tax cost of new debt Ex. Consider a firm that borrows $1 million at 9%. The corporate tax rate is 40%. What is the cost of debt to this firm? Bonds F = face value of the bond (typically $1,000) n = number of years until the bond matures

4 C = annual coupon rates r b = the NOMINAL return required by investors. Also the YTM P = the market price of the bond *To get the semi-annual, divide r b by 2 and multiple n by 2 Bonds & Yield to Maturity -The yield to maturity is the market interest rate that equates a bond s present value of interest payments and principal repayment with its price YTM = C P = F Trade at par YTM > C P < F Trade at discount YTM < C P > F Trade at premium Ex. An investor is considering an investment in one of two bonds which have the same yield to maturity of 9%. Both bonds pay semi-annual coupons. Bond 1 has a coupon rate of 10% and 15 years to maturity. [premium] Bond 2 has a coupon rate of 8% and 25 years to maturity. [discount] Without undertaking any calculation, which bond will trade at premium? Which bond will trade at a discount? Price both bonds. Suppose there exists a 3 rd bond, bond 3. If bond 3 trades at par, what is its coupon rate? Yield to Maturity Approximation Ex. In the mid 1990 s Union Gas had an annual bond outstanding with 27 years to maturity and a coupon rate of 8.65%. The bond was currently selling for % of its face value. Union Gas tax rate is 35%. What is Union Gas (approximation) cost of debt? Ex. Armstrong Inc. is planning to issue new debt. Armstrong can currently issue debt that has an annual coupon rate of 10%, pays interest semi-annually, has 20 years to maturity to net $1,198 per bond. If the firm s tax rate is 35%, what is the firm s approximate after tax cost of debt? firm 1 + (1-T r ps $I PP) 1 + (1-T WACC = D ps f WACC = f PP) x division = B division r i + S division bwr P debt ps + f psw ps f sw equity division = R f + β division (r M rf division WACC β pure play '

5 After Tax Cost of Preferred Shares -Dividends are paid from after tax income; no tax adjustment is required P ps = price of preferred stock Ex. Black Inc. has an issue of preferred stock with a $7 stated dividend that just sold for $95 per share. What is Black s cost of preferred stock? Ex. ON FINAL EXAM SPLIT INTO 3 MC. Waters Beginning has 1 million shares of common stock outstanding with a market price of $12 per share. The firm s outstanding bonds, which have a total face value of $5 million, have 10 years to maturity, a coupon rate of 10%, and sells for $985. The risk-free rate is 7%, and the analysts expected return for the market is 14%. WB stock has a beta of 1.2 and WB is in the 40% tax bracket. Find Waters Beginning s WACC. Ex. Fernando s has a 7.2 million shares of common stock o/s. The current share price is $32 and the book value per share is $23. Fernando s also has 2 bond issues o/s, both make semi-annual payments. The firm issue has a face value of $70 million, a 7% coupon and sells for 86% of par. The second issue has a face of $50 million, a 6.5% coupon and sells for 82% of par. The first issue matures in 10 years, the second in 6 years. The firm s most recent dividend was $3, and the dividend growth rate is 6%. The overall cost of debt is simply the average of the costs of the 2 debt issues. The tax rate is 35%. What is Fernando s WACC?

Incorporating Floatation Costs f s = floatation cost of equity f ps = floatation cost of preferred shares f b = floatation cost of debt -If $I is needed to invest in a project, then the floatation

6 Incorporating Floatation Costs f s = floatation cost of equity f ps = floatation cost of preferred shares f b = floatation cost of debt -If $I is needed to invest in a project, then the floatation cost is: -The floatation cost is a time 0 cash flow that must be incurred so that the firm can undertake the project Firm vs. Project Risks -What if risk of the project/division is different from firm risk? -If project risk < WACC, risk rejecting profitable projects (like A) -If project risk > WACC, risk accepting unprofitable projects (like B) -Solution: base project acceptance/rejection on divisional or project cost of capital. Calculating Project WACC Pure Play Approach 1. Calculate r i (cost of debt) for the firm, and assume it applies across all divisions 2. Find a publicly traded firm whose projects match the risk of the divisional project 3. Estimate the weights for the division and use these to calculate the division s β

7 4. Divisional cost of equity is: 5. Divisional WACC: Ex. In order to estimate the equity cost of capital for their electronics division, Li Industries has identified a pure-play firm. Date for the electronics division and the pure play firm are: Electronics Division Pure Play Firm Marginal Tax Rate, T Debt/equity ratio If the pure play firm s levered β is 1.20, the risk free rate is 11% and the market risk premium is 9%, what is the electronics division s cost of equity capital? Ex. Marriott Corp. needs an equity (levered) Beta for its restaurant division for capital budgeting. The restaurant division has debt and equity of B=$0.5 billion and S = $1 billion. The corporate tax rate is 34% for all firms. The risk free rate is 4% and the market risk premium is 8.4%. Data for Pure Play Firms ($B) β PP B S V Burger King McDonald s Wendy s Can we use a weighted average of the equity betas of the pure play firms? If so, what is the equity beta and cost of equity for Marriott s restaurant division? Ex. Independence Mining Corp has 7 million shares of common stock o/s, 1 million shares of 6% preferred stock o/s with a face value of $100 and 100,000 9% semi-annual bonds o/s, par value $1,000 each. The common stock currently sells for $35 a share and has a beta of 1. The preferred stock currently sells for $60 a share and the bonds have 15 years to maturity and sell for 89% of par. The market risk premium is 8%, T-bills are yielding 7% and Independence Mining s tax rate is 34%. What is the firm s

8 market value capital structure? If the firm is evaluating a new investment project that has the same risk as the firm, what rate should the firm use to discount the project s cash flows? Ex. RAM Corp is considering a project that will result in an initial after tax cash savings of $6 million at the end of the first year, and these savings will grow at a rate of 3% indefinitely. The firm has a target debtequity ratio of 1.5, a cost of equity of 17%, and an after tax cost of debt of 6%. The cost-savings proposal is somewhat riskier than the usual project that the firm undertakes; management uses a subjective approach and applies an adjustment factor of +2% to the cost of capital for projects of this risk. Under what circumstances should the firm take this project? Reducing the Cost of Capital -Cost of capital is: -Positively related to risk of firm/project -Negatively related to liquidity -Because the expected return to the investor is the cost of capital to the firm, the cost of capital is positively related to beta -Liquidity is the cost of buying and selling stock: -Brokerage fees, bid-ask spread, and market impact costs -Bid-ask spread the amount by which the ask price exceeds the bid. This is the difference in price between the highest price that a buyer is willing to pay for an asset and the lowest price for which a seller is willing to sell it -Market impact costs the cost faced by a trader of an index or security. -Investors demand a higher return when trading stocks with higher costs increases r s and therefore increases WACC Adverse Selection -Adverse selection: -The specialist will lose money on a trade if the trader has information that the specialist

9 does not have -What firms can do: -Firm has incentive to lower trading costs to lower WACC -Firms can increase number of uninformed traders: -Use of split stocks -Facilitate online trading -Reduce information asymmetries: -Release of information by firm -Role of analysts

Chapter 12 Cost of Capital

Chapter 12 Cost of Capital 1. The return that shareholders require on their investment in the firm is called the: A) Dividend yield. B) Cost of equity. C) Capital gains yield. D) Cost of capital. E) Income