Cost of Capital

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Cost of Capital

• Business 2039

1
K. Hartviksen
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Key Terms and Concepts

• specific marginal cost
• cost of equity, debt and preferred stock
• cost net of taxes and floatation costs
• retention ratio
• weighted average cost of capital (WACC)

• target capital structure weights
• market value weights (MV)
• book value weights (BV)
• marginal cost of capital (MCC)
• investment opportunity schedule (IOS)
• pure play approach

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K. Hartviksen
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Purpose of the WACC

• The weighted average cost of capital tells the
  financial manager the minimum rate of return that
  investors in the firm require as compensation for
  their investment.
• It is the relevant discount rate that should be
  used when evaluating capital budget proposals (as
  long as those proposals have the same basis risk
  as the firm as a whole.)
• It can be used to evaluate the performance of
  management through measures such as economic
  value added (EVA)
• It can provide an appropriate foundation for
  compensation incentives for managers and
  employees that take the interests of shareholders
  into account.

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Calculating WACC(The issue of current
liabilities.)

• General Guidelines
• we generally measure the cost of the major
  long-term sources of financing that represent the
  CORE financing sources for the firm.
• this means that we generally exclude from this
  the cost of any current liabilities (accruals and
  notes payable), because while large firms may
  utilize these sources, they are usually a
  temporary (or impermanent) source of financing
  and in relative terms, the dollar amount of
  current liabilities is often immaterial given the
  amount of long-term debt and equity financing
  used.
• another problem with current liabilities is that
  they often dont have an explicit cost that can
  be objectively measured. (ie. employees dont
  charge interest on wages they have earned, but
  that not yet been paid.)

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Calculating WACC(The formula)
Once you have the specific marginal costs of
capital (after accounting for taxes and
floatation costs) and you have found the
appropriate weights to use, the actual
calculation of a WACC is a simple matter.
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Calculating WACC(Modeling the solution on a
spreadsheet)
Use of a spreadsheet model to calculate the WACC
can be helpful
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Weighting Systems(Three systems to choose from.)

• There are three different weighting systems
• book value weights least desirable
• market value weights
• target (optimal) capital structure weights. best
• If you have optimal weightsuse themthey are
  superior to the other systems.
• If you dont have optimal weights, but can
  calculate market value weightsuse them.
• If nothing else is available, use book value
  weights.

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Book Value Weights

• These weights come from the firms most recent
  balance sheet.
• Since the balance sheet is based on historical
  costs, it may not be reflective of current market
  values, nor is it likely to reflect the firms
  target capital structure objective.
• This weighting system should only be used in
  situations where optimal and market value weights
  either are not available or cannot be determined
  from the information given.

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Book Value Weights

• XYZ Company Limited
• Balance Sheet
• as at January 30, 2xxx
• ASSETS LIABILITIES
• Current Assets 147,000 Current
  Liabilities 75,250
• Net Fixed Assets 15,000,250 8.5 2020 Mortgage
  Bonds 4,000,000
• Common stock (1,000,000 outstanding) 7,155,00
  0
• Retained earnings 3,917,000
• TOTAL ASSETS 15,147,250 TOTAL LIABILITIES AND
  O. EQUITY 15,147,250

Total Capital 15,072,000 BV weight of Equity
11,072/15,072 73.46 BV weight of Debt
4,000/15,072 26.5
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Market Value Weights

• In order to calculate market value (MV) weights,
  you will need to know the total market value of
  debt, and common stock (and preferred stock if
  the company uses it.)
• To calculate total MV you need to know the
  current price of the security in each class, as
  well as the total number of securities
  outstanding
• Total Market Capitalization Price times
  Quantity
• The following balance sheet date, when combined
  with market price data, will allow you to
  calculate MV weights.

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Market Value Weights

• XYZ Company Limited
• Balance Sheet
• as at January 30, 2xxx
• ASSETS LIABILITIES
• Current Assets 147,000 Current
  Liabilities 75,250
• Net Fixed Assets 15,000,250 8.5 2020 Mortgage
  Bonds 4,000,000
• Common stock (1,000,000 outstanding) 7,155,00
  0
• Retained earnings 3,917,000
• TOTAL ASSETS 15,147,250 TOTAL LIABILITIES AND
  O. EQUITY 15,147,250

Total MV of Equity Price per share times number
of shares 1M 21.50 21.5M Total MV of
Bonds Price per bond times number of bonds
950 4,000 3,800,000
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Market Value Weights
Total MV of Equity Price per share times number
of shares 1M 21.50 21.5M Total MV of
Bonds Price per bond times number of bonds
950 4,000 3,800,000
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Market Value Weights

• As you can see, MV weights can differ
  substantially from book value weights this is
  because MV weights reflect current prices (hence
  they reflect current interest rates and other
  economic factors including the going concern
  value of the stock).
• BV weights reflect history.

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Optimal Capital Structure Weights

• Optimal or target capital structure weights are
  the relative weights of debt, preferred and
  equity that will result in maximization for the
  firms value and concurrently, minimization of
  the firms WACC.
• At this stage in the course they will often be
  given to you.
• As you will learn in the capital structure
  portion of the course, the optimal capital
  structure occurs because of the tax-deductibility
  of interest expense the firm incurs on debt
  financing.
• As the firm uses more and more debt, however, the
  benefits of the lower cost of debt is eventually
  offset by the present value of bankruptcy costs.
• At some intermediate use of debt, these forces
  offset one another producing a point where the
  value of the firm is maximized.

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Current View of Capital Structure
Optimal Capital Structure 40 debt, 60 common)
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Specific Marginal Cost of Equity

• There are a number of different approaches that
  can be used to estimate the cost of equity.
  Certainly the two most common (since they are
  based on current market conditions) are
• Dividend Capitalization Model Approach, and
• the Capital Asset Pricing Model Approach.
• You will want to determine the investors
  required return (ie. calculate the cost of
  retained earnings) and then, calculate the cost
  of new equity (taking floatation costs into
  account).

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Specific Marginal Cost of Equity

• Dividend Capitalization Model Approach
• the current stock price and most recent dividend
  of a publicly traded firm should be readily
  available. The only thing you will need to
  estimate is the growth rate.

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Specific Marginal Cost of Equity

• Estimating the growth rate for dividends
• one way to do that is to calculate the percentage
  change in dividends per share, each year for the
  past few years, and then to average those
  percentage returns.
• Or, you can determine the compound growth in
  dividends by taking the last DPS and equating it
  with an earlier DPS and solving for the compound
  rate in the following equation
• Or, you can estimate next years growth rate
  based on current earnings plus the rate of return
  earned on earnings that were retained by the firm
  this year.

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Specific Marginal Cost of Equity

• Estimating the growth rate for dividends
• CAUTION
• Dont forget that the constant growth dividend
  capitalization model uses one growth rateand it
  is assumed by the model, that that growth will
  start now and will continue on forever!
• If this assumption is not suitable given what
  you know about the company and its stock, then,
  use of a different model or approach will be
  required.

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Specific Marginal Cost of Equity

• Capital Asset Pricing Model Approach
• the risk-free rate (yield on 91-day T-bills) is
  readily observable. The expected return on the
  market portfolio and the beta risk of the company
  will have to be estimated by you based on your
  research in the marketplace.

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Specific Marginal Cost of Preferred Stock

• Preference shares usually take the form of
  another Class of shares. This class usually has
  a priority of claims that is superior to that of
  the common share class, and usually has a fixed
  or stated dollar dividend per share. For
  example, Class B 2.50 shares.
• The dividend, despite being stated, is NOT a
  legal obligation of the firmhowever, management
  will do everything it can to pay those dividends
  annually, since most preferred shares also
  carry a cumulative feature.
• Because of this, we can use the no-growth
  dividend capitalization model to value the
  preference shares. If we have the current
  market price of those shares (23.32) and the
  DPS, we can estimate the preferred shareholders
  required rate of return from this market data

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Specific Marginal Cost of Preferred Stock

• Floatation costs associated with preferred stock
  may be 6. If this is the case we can determine
  the cost of new preferred stock by incorporating
  this into the required rate of return formula

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Specific Marginal Cost of Debt

• The cost of debt to a taxable corporation is a
  function of
• the debt investors required return,
• the floatation cost percentage that will be borne
  by the firm to raise new debt capital externally,
  and
• the income tax rate facing the firm (because
  interest expense is tax deductible).
• To determine the cost of debt follow these steps
• 1. Calculate the investors required return on
  debt (ie. calculate the YTM on the companys
  current bonds)
• 2. Multiply the investors required return by (1
  - t) where tcorporate tax rate
• 3. Divide the after-tax required return by (1- f)
  where f floatation cost percentage.

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Specific Marginal Cost of Debt

• There are two different approaches used to
  calculate the investors required return
• The approximation approach
• The exact approach to determining the Yield to
  Maturity
• - solve for the discount rate that equates the
  current market price of the bonds with the sum of
  the present value of all cash flows expected from
  this investment.

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Specific Marginal Cost of Debt

• The exact approach to determining the Yield to
  Maturity
• - solve for the discount rate that equates the
  current market price of the bonds with the sum of
  the present value of all cash flows expected from
  this investment.

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Specific Marginal Cost of Debt

• Calculating the Specific Marginal Cost of Debt
  Capital

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Specific Marginal Cost of Debt

• NOTE
• It is very important for you to realize that even
  though investors in a companys bonds currently
  require, lets say a 12 return, a new issue of
  bonds by the same firm COULD require a different
  rate of return.
• This is because each bond issue will have
  different assets pledged as collateral for the
  loanand the default risk to which the investor
  is exposed, is a function of the likely
  liquidation value of those specific assets (some
  equipment might be sold at 0.40 on the dollar,
  while a functioning plant and equipment might get
  0.80 on the dollar).
• Further, it is unlikely that the new bond issue
  will have a superior claim to the current
  bondholders because of other restrictive
  covenants.
• BOTTOM LINE the actual required rate of return
  on a new issue will no doubt be higher than the
  current required rate of return investors demand
  on the outstanding bonds of the firm.

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Investment Opportunity Schedule (IOS)

• In any one year, a firm may consider a number of
  capital projects.
• The greater the number of projects undertaken,
  the more money that the firm will have to raise
  in order to finance them.
• There is a limit to the amount of money that can
  be raised in any one year (ie. the capital
  markets are finite ie. there is a limit to the
  number of investors and their investment dollars
  that will consider investing in any prospect in
  any given year.) hence it is important that the
  capital budgeting analysis be extended to take
  this fact into account.

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Investment Opportunity Schedule (IOS)

• This Investment opportunity schedule is the
  prioritized list of capital projects, listed by
  IRR (internal rate of return) from highest to
  lowest.
• At the same time, the cumulative investment
  required is listed.
• Example
• Consider a firm that has six different capital
  investment proposals this year. Each project has
  its own IRR and capital cost.
• (see the next slide)

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Investment Opportunity Schedule (IOS)

• Example
• Consider a firm that has six different capital
  investment proposals this year. Each project has
  its own IRR and capital cost. Each project has
  the same risk as the firm as a whole.

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Investment Opportunity Schedule (IOS) ...

• Example
• The first step in developing an IOS is to order
  the projects from highest IRR to lowest, and then
  to calculate the cumulative capital cost of the
  projects.

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Investment Opportunity Schedule (IOS) ...

• Example
• First, it is clear that project A is
  unacceptableit offers a rate of return (IRR)
  that is less than the firms cost of capital.
• The remaining projects certainly meet the first
  investment screen (they have positive NPVs
  that is, they offer rates of return in excess of
  the firms WACC).
• Now we can prepare a graphical representation of
  the IOS by plotting the projects IRR against the
  cumulative dollars of capital to be raised.

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Investment Opportunity Schedule (IOS) ...
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Investment Opportunity Schedule (IOS) ...
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Investment Opportunity Schedule (IOS) ...
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Integrating the IOS and the MCC
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Integrating the IOS and the MCC
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Calculating the break in the MCC

• The preceding diagram illustrates how marginal
  projects can be rejected because of the
  increasing marginal cost of capital.
• The most common reason for the MCC to rise, is
  because the firm will often use retained
  earnings, before it will go outside the firm to
  raise external equity. (This makes a lot of
  sense since new equity means incurring floatation
  costs.)
• Breaks can also occur because the firm has to
  issue a different bond issue or preferred issue
  at a higher required return.
• If a firms optimal capital structure is 46
  equity, 11 preferred stock and 43 debt, and it
  has 2,576,000 of retained earnings to use for
  capital investment the break in the MCC (the
  point where R/E will be exhausted will occur at
  (2,576,000 / .46 5,600,000) of capital to be
  raised.

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WACC before and after the break in the
MCC(Modeling the solution on a spreadsheet)
The cost of capital before the break assumes use
of retained earnings (ie. the cost of equity
without (5) floatation costs (and the WACC after
the break assumes the cost of external equity)
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Understanding Breaks in the MCC
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NPV Profiles(Varying the discount rate and
finding the range of possible NPVs.)

• The WACC is an estimateand as an estimate it can
  be wrong (perhaps as much as 1 to 2)
• Consequently, once we have our estimate, it is
  sometimes useful to test the NPV of our capital
  project against varying discount rates to see
  over what range of discount rates the NPV will
  remain positive.
• This can be done on a spreadsheet, and then
  graphed for greater visual clarity. (Shown in
  the following two slides.)

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NPV Profiles(Varying the discount rate and
finding the range of possible NPVs.)
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NPV Profiles(Varying the discount rate and
finding the range of possible NPVs.)
IRR 16
If the firms cost of capital is 16 or less,
then adoption of the project will increase the
value of the firm. If there is any uncertainty
that the WACC could be higher than 16, further
attention would be required.
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Divisional Costs of Capital

• An overall cost of capital developed for a highly
  diversified conglomerate may not be appropriate
  for decisions made within specific divisions of
  the company.
• High-risk divisions (with high return
  possibilities) would have a disproportionate
  share of their investment proposals accepted if
  they use an overall WACC.
• The solution to this is to develop risk-adjusted
  discount rates that reflect the unique risk
  characteristics of each division.
• Developing these estimates can sometimes be
  accomplished by looking at other firms in that
  industry that are not highly diversified in their
  operations this is called the pure play approach.