Business Finance 2

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1. Why are some advantages and disadvantages of firms’s use of long-term debt?

2. Define and explain the concept of flotation costs.

3. What are the benefits to investors of owning preferred stock?

The Cost of Capital

CHAPTER 9

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Topics in Chapter
Cost of capital components
Debt
Preferred stock
Common equity
WACC
Factors that affect WACC
Adjusting cost of capital for risk

Determinants of Intrinsic Value:
The Weighted Average Cost of Capital

What types of long-term capital do firms use?
Long-term debt
Some firms also use permanent short-term debt
Other firms have temporary short-term debt for seasonal fluctuations in inventory, but this is usually not part of the capital structure
Preferred stock
Common equity

Capital Components
Capital components are sources of funding that come from investors.
Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the cost of capital.
We do adjust for these items when calculating the cash flows of a project, but not when calculating the cost of capital.

Before-tax vs. After-tax Capital Costs
Tax effects associated with financing can be incorporated either in capital budgeting cash flows or in cost of capital.
Most firms incorporate tax effects in the cost of capital. Therefore, focus on after-tax costs.
Only cost of debt is affected.

Historical (Embedded) Costs vs. New (Marginal) Costs
The cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we should focus on marginal costs.

Cost of Debt
Method 1: Ask an investment banker what the coupon rate would be on new debt.
Method 2: Find the bond rating for the company and use the yield on other bonds with a similar rating.
Method 3: Find the yield on the company’s debt, if it has any.

A 15-year, 12% semiannual bond sells for $1,153.72. What’s rd?

Component Cost of Debt
Interest is tax deductible, so the after tax (AT) cost of debt is:
rd AT = rd BT(1 – T)
rd AT = 10%(1 – 0.25) = 7.5%.
Use nominal rate.
Flotation costs small, so ignore.

Cost of preferred stock: Pps = $116.95; 10%Q; Par = $100; F = 5%
Use this formula:

Time Line of Preferred

Note:
Flotation costs for preferred are significant, so are reflected. Use net price.
Preferred dividends are not deductible, so no tax adjustment. Just rps.
Nominal rps is used.

Is preferred stock more or less risky to investors than debt?
More risky; company not required to pay preferred dividend.
However, firms want to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, and (3) preferred stockholders may gain control of firm.

Why is yield on preferred lower than rd?
Corporations own most preferred stock, because 50% of preferred dividends are nontaxable to corporations.
Therefore, preferred often has a lower
B-T yield than the B-T yield on debt.
The A-T yield to investors and A-T cost to the issuer are higher on preferred than on debt, which is consistent with the higher risk of preferred.

Example: rps = 9%, rd = 10%, T = 25%, Preferred exclusion = 50%
rps, AT = rps – rps(1 – % Exclusion)(T)
= 9% – 9%(1 – 0.50)(0.25) = 7.875%
rd, AT = 10% – 10%(0.25) = 7.50%
A-T Risk Premium on Preferred = 0.375%

What are the two ways that companies can raise common equity?
Directly, by issuing new shares of common stock.
Indirectly, by reinvesting earnings that are not paid out as dividends (i.e., retaining earnings).

Why is there a cost for reinvested earnings?
Earnings can be reinvested or paid out as dividends.
Investors could buy other securities, earning a return.
Thus, there is an opportunity cost if earnings are reinvested.

Cost for Reinvested Earnings
Opportunity cost: The return stockholders could earn on alternative investments of equal risk.
They could buy similar stocks and earn rs, or company could repurchase its own stock and earn rs. So, rs, is the cost of reinvested earnings and it is the cost of common equity.

Three ways to determine the cost of equity, rs:
1. CAPM: rs = rRF + (rM – rRF)b
= rRF + (RPM)b.
2. DCF: rs = D1/P0 + g.
3. Own-Bond-Yield-Plus-Judgmental-Risk Premium: rs = rd + Bond RP.

CAPM Cost of Equity: rRF = 5.6%, RPM = 6%,
b = 1.2
rs = rRF + (RPM )b
= 5.6% + (6.0%)1.2 = 12.8%.

Issues in Using CAPM (1 of 2)
Most analysts use the rate on a long-term
(10 to 20 years) government bond as an estimate
of rRF.

Issues in Using CAPM (2 of 2)
Most analysts use a rate of 3.5% to 6% for the market risk premium (RPM)
Estimates of beta vary, and estimates are “noisy” (they have a wide confidence interval).

Dividend Growth Cost of Equity, rs:
D0 = $3.26; P0 = $50; g = 5.8%

Estimating the Growth Rate
Use the historical growth rate if you believe the future will be like the past.
Obtain analysts’ estimates: Value Line, Zacks, Yahoo!Finance.
Use the earnings retention model, illustrated on next slide.

Earnings Retention Model (1 of 2)
Suppose the company has been earning 15% on equity (ROE = 15%) and has been paying out 62% of its earnings.
If this situation is expected to continue, what’s the expected future g?

Earnings Retention Model (2 of 2)
Growth from earnings retention model:
g = (Retention rate)(ROE)
g = (1 – Payout rate)(ROE)
g = (1 – 0.62)(15%) = 5.7%.
This is close to g = 5.8% given earlier.

Could the dividend growth approach be applied if g is not constant?
YES, nonconstant g stocks are expected to have constant g at some point, generally in 5 to 10 years.
But calculations get complicated. See the Ch09 Mini Case.xlsx or see Web 09B worksheet in the file Ch09 Tool Kit.xlsx.

The Own-Bond-Yield-Plus-Judgmental-Risk-Premium Method: rd = 10%, RP = 3.2%
rs = rd + Judgmental risk premium
rs = 10.0% + 3.2% = 13.2%
This judgmental-risk premium  CAPM equity risk premium, RPM.
Produces ballpark estimate of rs. Useful check.=

What’s a reasonable final estimate of rs?
Method Estimate
CAPM 12.8%
Dividend growth 12.4%
rd + judgment 13.2%
Average 12.8%

Determining the Weights for the WACC
The weights are the percentages of the firm that will be financed by each component.
If possible, always use the target weights for the percentages of the firm that will be financed with the various types of capital.

Target Weights
wd = 30%
wps = 10%
ws = 60%

Estimating Weights for the Capital Structure
(1 of 6)
If you don’t know the targets, it is better to estimate the weights using current market values than current book values.
Calculate the market value of debt if you have the information.
If you don’t know the market value of debt, then it is usually reasonable to use the book values of debt, especially if the debt is short-term.

Estimating Weights for the Capital Structure
(2 of 6)
Debt
Price = $1,153.72
70,000 bonds
Market value of debt:
$1,153.72(70,000) = $80,760,400.
Approximately equal to $80.76 million.

Estimating Weights for the Capital Structure
(3 of 6)
Preferred stock
Price = $116.95
200,000 shares
Market value of preferred stock:
$116.95(200,000) = $23,390,000.
Equal to $23.90 million.

Estimating Weights for the Capital Structure
(4 of 6)
Common stock
Price = $50.00
3 million shares
Market value of preferred stock:
$50.00(3) = $150 million.

Estimating Weights for the Capital Structure
(5 of 6)
Market value:
Debt = $80.76 million
Preferred = $23.30 million
Common = $150 million
Total value = $254.60 million

Estimating Weights for the Capital Structure
(6 of 6)
Market value weights:
Debt = $80.76/$254.60 = 31.79%
Pref. = $23.30/$254.60 = 9.17%
Common = $150/$254.60 = 59.04%
The market value weights are very close to the target weights.

What’s the WACC using the target weights?
WACC = wdrd(1 – T) + wpsrps + wsrs
WACC = 0.3(10%)(1 − 0.25) + 0.1(9%)
+ 0.6(12.8%)
WACC = 10.83%

What factors influence a company’s WACC?
Uncontrollable factors:
Market conditions, especially interest rates.
The market risk premium.
Tax rates.
Controllable factors:
Capital structure policy.
Dividend policy.
Investment policy. Firms with riskier projects generally have a higher cost of equity.

Is the firm’s WACC correct for each of its divisions?
NO! The composite WACC reflects the risk of an average project undertaken by the firm.
Different divisions may have different risks. The division’s WACC should be adjusted to reflect the division’s risk and capital structure.

The Risk-Adjusted Divisional Cost of Capital
Estimate the cost of capital that the division would have if it were a stand-alone firm.
This requires estimating the division’s beta, cost of debt, and capital structure.

Pure Play Method for Estimating Beta for a Division or a Project
Find several publicly traded companies exclusively in project’s business.
Use average of their betas as proxy for project’s beta.
Hard to find such companies.

Accounting Beta Method for Estimating Beta
Run regression between project’s ROA and S&P Index ROA.
Accounting betas are correlated (0.5 – 0.6) with market betas.
But normally can’t get data on new projects’ ROAs before the capital budgeting decision has been made.

Divisional Cost of Capital Using CAPM (1 of 2)
Target debt ratio = 10%.
rd = 12%.
rRF = 5.6%.
Tax rate = 25%.
betaDivision = 1.7.
Market risk premium = 6%.

Divisional Cost of Capital Using CAPM (2 of 2)
Division’s required return on equity:
rs = rRF + (rM – rRF)bDiv.
rs = 5.6% + (6%)1.7 = 15.8%.
WACCDiv. = wd rd(1 – T) + wsrs
= 0.1(12%)(1 – 0.25) + 0.9(15.8%)
= 15.12%

Division’s WACC vs. Firm’s Overall WACC?
Division WACC = 15.12% versus company WACC = 10.83%.
“Typical” projects within this division would be accepted if their returns are above 15.12%.

What are the three types of project risk?
Stand-alone risk
Corporate risk
Market risk

How is each type of risk used?
Stand-alone risk is easiest to calculate.
Market risk is theoretically best in most situations.
However, creditors, customers, suppliers, and employees are more affected by corporate risk.
Therefore, corporate risk is also relevant.

A Project-Specific, Risk-Adjusted Cost of Capital
Start by calculating a divisional cost of capital.
Use judgment to scale up or down the cost of capital for an individual project relative to the divisional cost of capital.

Costs of Issuing New Common Stock
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 stock price.

Four Mistakes to Avoid
Current vs. historical cost of debt
Mixing current and historical measures to estimate the market risk premium
Book weights vs. Market Weights
Incorrect cost of capital components
See next slides for details.

Current vs. Historical Cost of Debt
When estimating the cost of debt, don’t use the coupon rate on existing debt, which represents the cost of past debt.
Use the current interest rate on new debt.

Estimating the Market Risk Premium
When estimating the risk premium for the CAPM approach, don’t subtract the current long-term T-bond rate from the historical average return on common stocks.
For example, if the historical rM has been about 12.2% and inflation drives the current rRF up to 10%, the current market risk premium is not 12.2% – 10% = 2.2%!

Estimating Weights
Use the target capital structure to determine the weights.
If you don’t know the target weights, then use the current market value of equity.
If you don’t know the market value of debt, then the book value of debt often is a reasonable approximation, especially for short-term debt.

Capital components are sources of funding that come from investors.
Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the WACC.
We do adjust for these items when calculating project cash flows, but not when calculating the WACC.

(
)
(
)
(
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ps
ps
ps
D
0.1$100
r
P1F$116.9510.05
$10
0.0909.0%
$111.10
==
—
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(
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(
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0
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s
00
D1g
D
rgg
Pp
$3.121.058
0.058
$50
6.6%5.8%
12.4%
+
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