Chapter 14 The Cost of Capital

Topics Covered Chapter 14 The Cost of Capital Konan Chan Financial Management, Fall 2018 Cost of capital Weighted average cost of capital (WACC) Capital structure Required rates of return Divisional costs of capital Flotation costs Financial Management Konan Chan 2 Key Concepts and Skills Know how to determine a firm s cost of equity capital Know how to determine a firm s cost of debt Know how to determine a firm s overall cost of capital Know how to handle flotation costs Understand pitfalls of overall cost of capital and how to manage them Cost of Capital Think about a company is a portfolio composed by all its debt and equity securities Return on company = return on portfolio The return to an investor is the cost to the company Investors required return on company = company cost of capital = investors required return on portfolio Financial Management Konan Chan 3 Financial Management Konan Chan 4

Cost of Capital The return the firm s investors could expect to earn if they invest in securities with comparable degrees of risk. Required return for capital budgeting based on target capital structure A measure how the market views the risk of assets Depends on the use of funds, not the source Cost of Capital - Example Data Inc. has the following structure Market value of debt $194 30% Market value of equity $453 70% Market value of assets $647 100% Given that return on debt is 8% and 14% for return on equity, what is the cost of capital? Portfolio return = 0.3*8% + 0.7*14% = 12.2% Financial Management Konan Chan 5 Financial Management Konan Chan 6 After-Tax Cost of Debt Consider two firms with 35% tax rate:a has no debt, B has $1000 debt with 10% interest rate Company A B EBIT 1000 1000 Interest Expense 0 100 Pre-tax income 1000 900 Taxes (35%) 350 315 Net Income 650 585 B saves 35 of taxes due to debt, making the after-tax interest rate 65/1000 or 6.5% = 10%(1-0.35) Cost of Capital Back to Data case Interest is tax deductible. Given a 35% tax rate, debt only costs 5.2% (=8%*(1-0.35)) WACC = 0.3*5.2% + 0.7*14% = 11.4% If the return on invested project is > 11.4%, it is a good deal! Financial Management Konan Chan 7 Financial Management Konan Chan 8

WACC Weighted Average Cost of Capital (WACC) Expected return on a portfolio of all the firm s securities Company cost of capital Three steps to calculate cost of capital Calculate the value of each security as a proportion of the firm s market value (get the capital structure weights) Determine the required rate of return on each security Calculate a weighted average of these required returns Required Rates of Return Required return on debt (cost of debt) r d = YTM Required return on equity (cost of equity) CAPM/SML,r e = r f + b (r m r f ) Constant growth DDM, Required return on preferred stock Financial Management Konan Chan 9 Financial Management Konan Chan 10 Measure Capital Structure In estimating WACC, use the market value of the securities unless they are not traded Cost of capital must be based on what investors are actually willing to pay for the company s securities Book values are often not equal to true market value of securities Market value of Bonds Market price per bond times number of bonds Market value of Equity Market price per share times number of shares Pros and Cons of DDM Advantage easy to understand and use Disadvantages Only applicable to companies currently paying dividends Not applicable if dividends aren t growing at a reasonably constant rate Extremely sensitive to the estimated growth rate an increase in g of 1% increases the cost of equity by 1% Does not explicitly consider risk Financial Management Konan Chan 11 Financial Management Konan Chan 12

Pros and Cons of SML Advantages Explicitly adjusts for systematic risk Applicable to all companies, as long as we can compute beta Disadvantages Have to estimate the expected market risk premium and beta, which vary over time Rely on the past to predict the future, which is not always reliable Cost of Equity - Example Suppose the company has a beta of 1.5. The market risk premium is expected to be 9% and the current risk-free rate is 6%. Assume that analysts estimate that dividends will grow at 6% per year and the last dividend was $2. The stock is currently selling for $15.65. What is the cost of equity? Using SML: r e = 6% + 1.5(9%) = 19.5% Using DDM: r e = [2(1.06) / 15.65] +.06 = 19.55% Financial Management Konan Chan 13 Financial Management Konan Chan 14 Cost of Equity In Practice CAPM r f : 3 month T-bill rate b : get estimate from data company: Yahoo, Value-Line, Bloomberg (r m r f ) : historical market risk premium Constant growth DDM Get estimate of growth from analysts forecasts: Yahoo, Bloomberg Use historical average g = ROE * RR Cost of Debt We usually focus on the cost of long-term bonds Use after-tax cost of debt to get WACC The required return is best estimated by computing the yield-to-maturity on the existing debt When the bond is not traded, use rates based on the expected bond rating The cost of debt is NOT the coupon rate, which represents the cost of debt at the time of issuance but not the current or expected cost of debt Financial Management Konan Chan 15 Financial Management Konan Chan 16

WACC WACC Example We can use the individual costs of capital that we have computed to get our average cost of capital for the firm. This average is the required return on our assets, based on the market s perception of the risk of those assets The weights are determined by how much of each type of financing that we use Generally we use target capital structure weights Equity information 50 million shares $80 per share Beta = 1.15 Market risk premium = 9% Risk-free rate = 5% Debt information $1 billion in outstanding debt (face value) Current price = 110 Coupon rate = 9%, (semiannual coupons) 15 years to maturity Tax rate = 40% Financial Management Konan Chan 17 Financial Management Konan Chan 18 WACC Example What is the cost of equity? r e = 5% + 1.15(9%) = 15.35% What is the cost of debt? N = 30; PV = -1100; PMT = 45; FV = 1000; CPT I/Y = 3.9268 r d = 3.927%(2) = 7.854% What is the after-tax cost of debt? r d (1-T C ) = 7.854%(1-.4) = 4.712% WACC Example What are the capital structure weights? E = 50 million (80) = 4 billion D = 1 billion (1.10) = 1.1 billion V = 4 + 1.1 = 5.1 billion w e = E/V = 4 / 5.1 =.7843 w d = D/V = 1.1 / 5.1 =.2157 What is the WACC? WACC =.7843(15.35%) +.2157(4.712%) = 13.06% Financial Management Konan Chan 19 Financial Management Konan Chan 20

Divisional Costs of Capital Using WACC as the discount rate is appropriate only for projects that have the same risk as the firm s current operations A company s WACC is for average risk projects, i.e., for projects that are in the firms existing business If we are looking at a project that is NOT the same risk as the firm, then we need to determine the appropriate discount rate for that project Divisions also often require separate discount rates The Pure Play Approach Find one or more companies that specialize in the product or service that we are considering Compute the beta for each company Take an average Use that beta along with the CAPM to find the appropriate return for a project of that risk Often difficult to find pure play companies Financial Management Konan Chan 21 Financial Management Konan Chan 22 Subjective Approach Consider the project s risk relative to the firm overall If the project is more risky than the firm, use a discount rate greater than the WACC If the project is less risky than the firm, use a discount rate less than the WACC You may still accept projects that you shouldn t and reject projects you should accept, but your error rate should be lower than not considering differential risk at all Financial Management Konan Chan 23 Flotation Costs Flotation costs are costs of issuing securities to public Flotation costs can be high, for example, issue 10 million worth of stocks but get only 9 million cash In practice, flotation costs will be treated as incremental negative cash flows Compute the (weighted) average flotation cost Use the target weights because the firm will issue securities in these percentages over the long term Financial Management Konan Chan 24

NPV and Flotation Costs Consider a project that will cost $1 million and generate after-tax cash flows of $250,000 per year for 7 years. Assume WACC is 15% and target D/E ratio is 0.6. The flotation cost for equity is 5% and the flotation cost for debt is 3%. What is the NPV for the project after adjusting for flotation costs? Average flotation cost = (.375)(3%) + (.625)(5%) = 4.25% PMT = 250,000, N = 7, I/Y = 15, CPT PV = 1,040,105 NPV = 1,040,105-1,000,000/(1-.0425) = -4,281 The project would have a positive NPV of 40,105 without considering flotation costs Once we consider the cost of issuing new securities, the NPV becomes negative Comprehensive Problem A corporation has 10,000 bonds outstanding with a 6% annual coupon rate, 8 years to maturity, a $1,000 face value, and a $1,100 market price. The company s 100,000 shares of preferred stock pay a $3 annual dividend, and sell for $30 per share. The company s 500,000 shares of common stock sell for $25 per share and have a beta of 1.5. The risk free rate is 4%, and the market return is 12%. Assuming a 40% tax rate, what is the company s WACC? Financial Management Konan Chan 25 Financial Management Konan Chan 26 Comprehensive Problem MV of debt = 10,000 x $1,100 = $11,000,000 Cost of debt = YTM: N=8; PV=-1,100 ; PMT=60; FV=1000; CPT I/Y = 4.48% MV of preferred = 100,000 x $30 = $3,000,000 Cost of preferred = 3/30 = 10% MV of common = 500,000 x $25 = $12,500,000 Cost of common =.04 + 1.5 x (.12 -.04) = 16% Comprehensive Problem Total MV = $11M + $3M + $12.5M = 26.5M Weight of debt = 11M/26.5M =.4151 Weight of preferred = 3M/26.5M =.1132 Weight of common = 12.5M/26.5M =.4717 WACC =.4151 x.0448 x (1 -.4) +.1132 x.10 +.4717 x.16 =.0979 = 9.8% Financial Management Konan Chan 27 Financial Management Konan Chan 28

Ethics Issues How could a project manager adjust the cost of capital (i.e., appropriate discount rate) to increase the likelihood of having his/her project accepted? Is this ethical or financially sound? Financial Management Konan Chan 29 Quick Quiz What are the two approaches for computing the cost of equity? How do you compute the cost of debt and the after-tax cost of debt? How do you compute the capital structure weights required for the WACC? What is the WACC? What happens if we use the WACC for the discount rate for all projects? What are two methods that can be used to compute the appropriate discount rate when WACC isn t appropriate? How should we factor flotation costs into our analysis? Financial Management Konan Chan 30