T14.1 Chapter Outline

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T14.1 Chapter Outline

• Chapter 14
• Cost of Capital
• Chapter Organization
• 14.1 The Cost of Capital Some Preliminaries
• 14.2 The Cost of Equity
• 14.3 The Costs of Debt and Preferred Stock
• 14.4 The Weighted Average Cost of Capital
• 14.5 Divisional and Project Costs of Capital
• 14.7 Calculating WACC for Bombardier
• 14.8 Summary and Conclusions

U of L Finance 3040
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Cost of Capital

• The rate of return that compensates investors for
  the use of the capital needed to finance the
  firm/project
• This expected return on the part of the investor
  in turn represents the firms cost for that
  capital
• Investors expect higher returns to compensate for
  higher levels of risk
• The terms required return, appropriate discount
  rate and cost of capital are all used
  interchangeably - they all essentially mean the
  same thing

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Cost of Capital continued

• A key point is the cost of capital depends
  primarily on the use of the funds ----not the
  source
• so if we were analyzing a risk free investment
  we should use a proxy for a risk free return as
  the cost of capital for the project
• as the risk increases - the discount rate should
  increase because the required return by investors
  is increasing to compensate them for the higher
  risk

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Financial Policy and Cost of Capital

• A firms capital structure ie its mixture of debt
  and equity is a function of the firms financial
  policy - it is up to management to decide the
  capital structure for the firm
• how that structure is decided is for another
  class!
• A firms cost of capital is a mixture of returns
  needed to compensate its creditors and
  shareholders - it reflects both the cost of debt
  and equity capital
• A firms weighted average cost of capital (WACC)
  reflects the respective weighting of the firms
  debt and equity capital in its capital structure

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The Cost of Equity

• The return that equity investors require on
  their investment in the firm
• This expected return must be estimated - there is
  no direct means of observing the return that
  investors are expecting.
• Two Approaches
• The Dividend Growth Model Approach
• the return that shareholders require on the
  stock is seen as the firms cost of equity capital

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Cost of Equity

• The SML or Security Market Line Approach
• The SML essentially tells us the reward (return)
  for bearing risk in financial markets what
  return is expected for a given level of risk
• required return is a function of 3 things
• risk free rate
• market risk premium
• systematic risk of the asset relative to the
  average risk - called the beta coefficient

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T14.3 The Dividend Growth Model Approach

• Estimating the cost of equity the dividend
  growth model approach
• According to the constant growth model,
• D1
• P0
• RE - g
• Rearranging,
• D1
• RE
  g
• P0

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T14.4 Estimating the Dividend Growth Rate
based on historical growth

• 
  PercentageYear Dividend
  Dollar Change Change
• 1990 4.00 - -
• 1991 4.40 0.40 10.00
• 1992 4.75 0.35 7.95
• 1993 5.25 0.50 10.53
• 1994 5.65 0.40 7.62
• Average Growth Rate(10.00 7.95 10.53
  7.62)/4 9.025

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Estimating the Dividend Model Growth Rate -
Earnings Retention Approach

• If we assume the retention ratio remains constant
  
• Then
• growth in earnings growth in dividends
• growth in earnings is a function of both the
  retained earnings and the return on the retained
  earnings
• Earnings next year earnings this year
  retained earnings this year return on retained
  earnings
• Using ROE (an historical return) as a proxy for
  investors expected return
• g Retention Ratio ROE

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The Cost of Equity - SML Approach

• Required return is a function of 3 things
• risk free rate
• market risk premium - reflecting the risk
  associated with the market as a whole e.g the TSE
  risk
• systematic risk of the asset relative to the
  average risk - called the beta coefficient -
  reflecting how the individual stock in question
  varies with the market as a whole- so if the
  stock historically is much more volatile (risky)
  than the market then the return should reflect
  that incremental risk

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T14.5 Example The SML Approach

• From the SML comes the Capital Asset Pricing
  Model (CAPM)
• According to the CAPM RE Rf bE ? (RM
  - Rf)
• Rf risk free rate of return
• Rm market risk
• Rm-RF market risk premium
• BE estimate of systematic risk, the risk for an
  individual security relative to the market risk
  as a whole

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SML Approach

• Get the risk-free rate (Rf ) from financial
  pressmany use the 1-year Treasury bill rate,
  say 2.5
• . Get estimates of market risk premium and
  security beta.
• a. Historical risk premium RM - Rf e.g.
  3.4 on Canadian equities b. Beta
  historical (1) Investment information services -
  e.g., SP, Value Line (2) Estimate from
  historical data
• 3. Suppose the beta is 1.40, then, using the
  approach
• RE Rf bE ? (RM - Rf)
• 2.5 1.40 ? 3.4
• 7.26

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Cost of Equity - Summary

• The return that equity investors require on their
  investment in the firm
• Investors expected returns companys cost of
  equity capital (investors return on the security
  the cost to the company issuing the security)
• Investors expected returns are based on their
  risk assessment of the firm (higher risk leads to
  higher expected returns)
• 2 approaches in estimating this expected return/
  cost
• Dividend Growth Model
• SML approach
• SML approach as two advantages takes into
  account risk and can be used for companies which
  do not pay dividends

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The Cost of Debt

• 1. The cost of debt, RD, is the return the
  firms long term creditors demand on new
  borrowing.
• The interest rate on the new borrowing reflects
  that expected return and is the cost of that
  capital to the firm
• 2. The cost of debt is observable
• a. Yield on currently outstanding debt.
• b. Yields on newly-issued similarly-rated
  bonds.
• 3. The historic debt cost is irrelevant -- why?
• Example We sold a 20-year, 12 bond 10 years
  ago at par. It is currently priced at 120. What
  is our cost of debt?
• The yield to maturity is 8.90, so this is
  what we use as the cost of debt, not 12.

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Costs of Preferred Stock

• 1. Preferred stock is a perpetuity, so the cost
  is
• RP D/P0
• 2. Notice that cost is simply the dividend
  yield.
• Example We sold an 8 preferred issue 10
  years ago. It sells for 120/share today.
• The dividend yield today is 8.00/120 6.67,
  so this is what we use as the cost of
  preferred.

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The Weighted Average Cost of Capital

• Capital structure weights
• 1. Let E the market value of the equity.
• P the market value of the preferred equity
• D the market value of the debt.
• Then V E P D, so E/ V P/V D/ V
  100
• 2. So the firms capital structure weights
  are E/ V, P/V and D/ V.
• (we are using market values for the firms debt
  and equity in determining the weights- if these
  are fluctuating widely, then book values would be
  the alternative.)
• 3. Interest payments on debt are tax-deductible,
  so the after tax cost of debt is the pretax cost
  multiplied by (1 - corporate tax rate).
• After tax cost of debt RD ? (1 - Tc)
• 4. Thus the weighted average cost of capital is
• WACC (E/V) ? RE (P/v) x Rp (D/V) ?
  RD ? (1 - Tc)

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Example Eastman Chemicals WACC

• Eastman Chemical has 78.26 million shares of
  common stock outstanding. The book value per
  share is 22.40 but the stock sells for 58. The
  market value of equity is 4.54 billion.
  Eastmans stock beta is .90. T-bills yield 4.5,
  and the market risk premium is assumed to be
  9.2.
• The firm has four debt issues outstanding.
• Coupon Book Value Market Value Yield-to-Maturity
• 6.375 499m 501m 6.32
• 7.250 495m 463m
  7.83
• 7.635 200m 221m
  6.76
• 7.600 296m 289m
  7.82
• Total 1,490m 1,474m

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Example Eastman Chemicals WACC (concluded)

• Cost of equity (SML approach)
• RE .045 .90 ? (.092) .045 .0828 .1278
  ? 12.8
• Cost of debt
• Multiply the proportion of total debt
  represented by each issue by its yield to
  maturity the weighted average cost of debt
  7.15
• Capital structure weights
• Market value of equity 78.26 million ? 58
  4.539 billionMarket value of debt 501m
  463m 221m 289m 1.474 billion
• V 4.539 billion 1.474 billion 6.013
  billion
• D/V 1.474b/6.013b .2451 ? 25 E/V
  4.539b/6.013b .7549 ? 75
• WACC .75 (12.8) .25 ? 7.15(1 - .35) 10.76

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Summary of Capital Cost Calculations (Table
14.1)

• I. The Cost of Equity, RE
• A. Dividend growth model approach
• RE D1 / P0 g
• B. SML approach
• RE Rf ? E ? (RM - Rf)
• II The Cost of Preferred Equity
• RP D/P0
• III. The Cost of Debt, RD
• A. For a firm with publicly held debt, the cost
  of debt can be measured as the yield to
  maturity on the outstanding debt.
• B. If the firm has no publicly traded debt, then
  the cost of debt can be measured as the yield
  to maturity on similarly rated bonds.

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Summary of Capital Cost Calculations (concluded)

• IV The Weighted Average Cost of Capital (WACC)
• A. The WACC is the required return on the firm
  as a whole. It is the appropriate discount rate
  for cash flows similar in risk to the firm.
• B. The WACC is calculated as
• WACC (E/V) ? RE (P/V) x RP (D/V) ? RD ?
  (1 - Tc)
• where Tc is the corporate tax rate, E is the
  market value of the firms common equity, P is
  the market value of the firms preferred equity
  and D is the market value of the firms debt, and
  
• V E P D

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Divisional and Project Costs of Capital

• When is the WACC the appropriate discount rate?
• When the project is about the same risk as the
  firm.
• The WACC is not appropriate when a company has
  more than one line of business e.g. Two
  divisions, and each has a distinctive risk
  profile. Todays telecommunications companies
  with regulated telephone business alongside
  higher risk e-business ventures

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Divisional and Project Costs of Capital

• Other approaches to estimating a discount rate
• Divisional cost of capital - each divisions cost
  of capital is calculated separately
• Pure play approach - look externally and find
  companies that focus on as exclusively as
  possible the type of project in which we are
  considering investing. (could be used in
  estimating the cost of capital for the division
• Subjective approach - subjective adjustments to
  the overall WACC

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Comments on Bombardier WACC

• Short-term versus long-term financing in
  estimating WACC
• Market versus Book Value
• WACC (E/V) ? RE (D/V) ? RD ? (1 - Tc)
• YTM on bonds, and the cost of debt RD
• The cost of preferred stock in the WACC
  calculation
• V EPD
• WACC (E/V) ? RE (P/V) ? RP(D/V) ? RD ? (1
  - Tc)
• ..many factors have now changed for
  Bombardier!!!!
• .what would we expect the WACC for Bombardier to
  be today higher or lower than a few years ago??

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WACC Example problem

• Elway Mining Corporation has 8 million shares of
  common stock outstanding, 1 million shares of 6
  percent preferred outstanding, and 100,000 9
  percent semiannual coupon bonds outstanding, par
  value 1,000 each. The common stock currently
  sells for 35 per share and has a beta of 1.0,
  the preferred stock currently sells for 60 per
  share, and the bonds have 15 years to maturity
  and sell for 89 percent of par. The market risk
  premium is 8 percent, T-bills are yielding 5
  percent, and the firms tax rate is 34 percent.
• a. What is the firms market value capital
  structure?
• b. If the firm is evaluating a new investment
  project that has the same risk as the firms
  typical project, what rate should the firm use to
  discount the projects cash flows?

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WACC Example Continued

• a. MVD 100,000 (1,000) (.89) 89M
• MVE 8M(35) 280M
• MVp 1M(60) 60M
• V 89M 280M 60M 429M
• D/V 89M/429M .207,
• E/V 280M/429M .653, and
• P/V 60M/429M .140.

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WACC Example Continued

• b. For projects as risky as the firm itself, the
  WACC is the appropriate discount rate. So
• RE .05 1.0(.08) .13 13
• P0 890 45(PVIFARD,30)
  1,000(PVIFRD,30)
• RD 10.474, and RD (1 - Tc) (.10474)(1 -
  .34) .0691 6.91
• RP 6/60 .10 10
• WACC .653 (13) .207 (6.91) .14 (10)
• 11.32

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NPV/WACC Example 2

• True North, Inc. is considering a project that
  will result in initial after tax cash savings of
  6 million at the end of the first year, and
  these savings will grow at a rate of 5 percent
  per year indefinitely. The firm has a target
  debt/equity ratio of .5, a cost of equity of 18
  percent, and an after tax cost of debt of 6
  percent. The cost-saving proposal is somewhat
  riskier than the usual project the firm
  undertakes management uses the subjective
  approach and applies an adjustment factor of 2
  percent to the cost of capital for such risky
  projects. Under what circumstances should True
  North take on the project?

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NPV/WACC Example 2 Continued

• WACC (.3333)(.06) (.6666)(.18) .14
• Project discount rate .14 .02 .16
• NPV - cost PV cash flows
• PV cash flows 6M/(.16 - .05) 54.55M
• So the project should only be undertaken if its
  cost is less than 54.55M.