Chapter 1 Cost of Capital The required return for an asset is a function of the risk of the asset and the return to the investor is the same as the cost to the company. The firms cost of capital provides an indication of how the market views the risk of the asset. Knowing the cost of capital helps the financial manager determine the required return for capital projects. The required return is the same as the appropriate discount rate and is based on the risk of the cash flows. We need to know the required return for an investment before we can compute the NPV and make a decision about whether or not to take the investment. We need to earn at least the required return to compensate our investors for the financing they have provided. Weighted Average Cost of Capital (WACC) Given the following information, what is the WACC for the following firm? Debt: Preferred Stock: Common Stock: 9,000 bonds with a par value of $1,000 and a quoted price of 11.65. The bonds have coupon rate of 7 percent and 8 years to maturity. 0,000 shares of 3.5 percent preferred selling at a price of $65. 400,000 shares of stock selling at a market price of $48. The beta of the stock is 0.9. The stock just paid a dividend of $.10 per share and the dividends are expected to grow at 6 percent per year indefinitely. Market: The expected return on the market is 14 percent and the risk-free rate is 3.5 percent. The company is in the 38 percent tax bracket. 1. Component Costs Debt 70 1,16.50 PVIFA 1,000 PVIF 8, 8, N Cpt I PV Pmt FV Fin 311 Chapter 1 Handout Page 1
Preferred Stock k p = D 1 = P 0 Equity: The cost of equity is the return required by equity investors given the risk of the cash flows from the firm. R f + [E(R M ) R f ] = Advantages of the CAPM Explicitly adjusts for systematic risk Applicable to all companies, as long as we can compute beta Disadvantages of the CAPM Have to estimate the expected market risk premium, which does vary over time Have to estimate beta, which also varies over time We are relying on the past to predict the future, which is not always reliable D 1 + g = P 0 Advantage of Gordon Growth Model Easy to understand and use Disadvantages of Gordon Growth Model 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 Page Fin 311 Chapter 1 Handout
. Component Weights Debt: (9,000)($1,16.50) = w d = PS: (0,000)($65) = w p = E: (400,000)($48) = w e = 3. WACC WACC = w D R D (1-T C ) + w P R P + w E R E WACC = Fin 311 Chapter 1 Handout Page 3
The Perkins Company has employed you to analyze a capital project. It has given you the following information: Bond Coupon Rate Price Quote Maturity Number of Bonds Outstanding 1 6.75 95.5 35,000 7.5 110 0 45,000 The bonds make semiannual interest payments and the marginal tax rate is 40 percent. Perkins expects the next dividend (D 1 ) to be $0.45 and its common stock is currently selling for $5.65 per share. The expected growth rate in earnings and dividends is a constant 5%. Perkins has a beta of 1.3, the risk-free rate is 3 percent, and the expected market return is 1.5 percent. Perkins has 5,000,000 shares of common stock outstanding. To complete the analysis, the NPV and IRR need to be calculated the project. The initial investment is $1. million. The operating cash flows are $6 million for years one through four and $8 million for year five. Should Perkins accept this project? 1. Component Costs Debt Bond 1 67.5 955.00 PVIFA 1,000 PVIF,, Bond N Cpt I PV Pmt FV 7.5 1,100.00 PVIFA 1,000 PVIF 0, 0, N Cpt I PV Pmt FV Page 4 Fin 311 Chapter 1 Handout
Weighted cost of debt Bond 1: (35,000)($955.00) = w d1 = Bond : (45,000)($1,100.00) = w d = R D = w D1 R D1 + w D R D R D = Equity R f + [E(R M ) R f ] = D 1 + g = P 0. Component Weights Debt: w d = E: (5,000,000)($5.65) = w e = 3. WACC WACC = w D R D (1-T C ) + w P R P + w E R E WACC = CF 0-1. CF 1 6.0 F 1 4 CF 8.0 F 1 I 10.404% Cpt NPV Cpt IRR Fin 311 Chapter 1 Handout Page 5
Adjusting the cost of capital WACC and CAPM Draw graph Divisional Cost of Capital Using the WACC as our discount rate is only appropriate for projects that are the same risk as the firm s current operations 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 Transco Genco Regulated, Low Risk Unregulated, High Risk Page 6 Fin 311 Chapter 1 Handout
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 Example Risk Level Discount Rate Very Low Risk WACC 8% Low Risk WACC 3% Same Risk as Firm WACC High Risk WACC + 5% Very High Risk WACC + 10% 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 Beta: Should you use an industry beta? Fin 311 Chapter 1 Handout Page 7