Finance 350 Business Finance Cost of Capital Slide 15

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Finance 350 Business FinanceCost of Capital
(Slide 15)

• Instructor Yen-cheng Chang

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Quiz 3 Problem 3

• Big 5 Sporting Goods announced their earnings n
  Nov. 3, 2008. It was worse then what the market
  had expected. You did some analysis and found
  their stock price behavior is like the following.
  You also found that there has not been any major
  news that would significantly affect Big 5s
  stock price since Nov. 3.

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Quiz 3 Problem 3

• What can you say about the level of efficiency in
  the stock market? Explain.
• Since the stock price is very slow in reflecting
  the earnings announcement (17 days), we can
  conclude that the market is not semi-strong
  efficient.
• Can we say the market is therefore weakly
  efficient? Not necessarily.
• On the graph, illustrate the stock price reaction
  if the market is of strong form efficiency.

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Quiz 3 Problem 3
Stock Price
Time
Nov.3
Nov.20
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Quiz 3 Problem 3
Stock Price
Time
Nov.3
Nov.20
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Did the Monkey Beat the Market?
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Did the Monkey Beat the Market?
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WACC

• To evaluate any project (or firm), the discount
  rate is determined by the riskiness of the cash
  flows.
• It is the rate of return in the market with the
  same amount of systematic risk, i.e., the
  opportunity cost of the capital devoted to this
  project (or firm).
• Firm capital debt equity
• When evaluating the whole firm, or a project with
  similar risk as the whole firm, we need a
  discount rate that represents the opportunity
  cost of the firms capital.

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WACC

• Is there a catch-all cost of capital that
  represents the riskiness of the firms assets?

Investors expected rate of return (RHS) is the
cost of capital on assets (LHS).
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WACC

• From the last slide, we see intuitively the
  firms cost of capital is a mix of the required
  rate of return on the firms debt, preferred
  stock, and common stock.
• Weighted Average Cost of Capital

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Cost of Debt

• Question What is the cost of debt if the firm
  issues debt today? What is the required rate of
  return for the firms existing debt?
• Yield to Maturity represents the return if
  investors purchase the firms bond today (new or
  existing) and hold it to maturity.
• Interest paid on debt is considered a
  tax-deductible expense! That means that the true
  after-tax cost of the debt to the firm is lower
  than the YTM.

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Cost of Debt

• Example Your firm is issuing 100,000 in 10
  coupon debt at par and has a 35 tax rate. What
  is your after-tax cost of debt for this debt?
• Effective after-tax interest expense
• 10 X (1-Tax Rate) X 100,000 6,500
• So, the net cost of debt after tax is not 10,
  its

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Cost of Preferred Stock Capital

• Recall that preferred stock typically pays a
  perpetual dividend. Thus, its price equals
• Rearranging, we have

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Cost of Common Stock Capital

• Theres more than one method, but the most common
  approach is using the CAPM
• 1. Estimate the firms beta of equity, typically
  by regressing 60 months of the companys returns
  against 60 months of returns for a market proxy
  such as the SP 500.
• 2. Determine the risk-free rate, typically by
  using the yield on Treasury bills or bonds.
• 3. Estimate the market risk premium, typically by
  comparing historical returns on a market proxy to
  contemporaneous risk-free rates.
• 4. Apply the CAPM
• Cost of Equity rE Risk-Free Rate Equity Beta
  Market Risk Premium

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Cost of Common Stock Capital

• Alternatively, we can use the Constant Dividend
  Growth Model. Recall the stock price under this
  model
• Rearranging
• This model assumes that you can forecast the
  dividend next period and it is continue to grow
  at rate g forever.

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Cost of Common Stock Capital Example

• Weyerhaeuser Beta 1.2.
• 10-year treasury yield 4.5
• Market risk premium 5
• Next expected dividend 2/share
• Expected dividend growth rate 4
• Current stock price 71
• Use the two previous models to estimate the cost
  of equity of Weyerhaeuser.

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Cost of Common Stock Capital Example

• Approach 1 (CAPM)
• rE rf betamarket risk premium
• 4.5 1.25 10.5
• Approach 2 (CDGM)
• rE Div1 / P g 2 / 71 4 6.8
• Which one to believe?
• What is the dividend growth rate that will equate
  the two models?

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Cost of Common Stock Capital Example

• CAPM Cost of equity 10.5
• CDGM Cost of equity
• Div1 / P g 2 / 71 g
• Let 10.5 2 / 71 g
• ? g 7.7.

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WACC

• Putting everything together
• E, P, and D are the percentage of the market
  value of common equity, preferred stock, and debt
  relative to total firm market value.
• For a firm without preferred stock, P 0.
• For an unlevered firm, D0.

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WACC Example

• The expected return on Targets equity is 11.5.
  The firms YTM on its debt is 6. Debt accounts
  for 18 and equity for 82 of Targets total
  market value. If the corporate tax rate is 35,
  what is this firms WACC?

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WACC Example

• Use the WACC formula
• This number represents the average cost of
  capital (opportunity cost, expected return) of
  Targets assets.

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WACC
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WACC The Recipe

• When you need a discount rate for the total FCF
  from the firm
• Determine the FCF using techniques in Chapter 8
  9.
• Compute the WACC
• Compute firm value by discounting the FCF using
  the WACC.
• Can we use WACC to discount incremental CFs from
  individual projects?

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WACC for Individual Projects

• Recall To evaluate any project (or firm), the
  discount rate is determined by the riskiness of
  the cash flows. This risk that we care about is
  systematic risk.
• IF an investment has similar systematic risk as
  the whole firm, then we could use WACC to
  discount its discount rate.

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WACC for Individual Projects

• Alcoa, worlds leading producer of aluminum, is
  considering extending the life of one of its
  aluminum mines for 4 years.
• Upfront cost 6.67M
• Upfront capital expenditure 24M (straight-line,
  4 year depreciation)
• Annual sales 60M/year
• COGS 25M/year
• Operating Expense 9M/year
• No NWC requirements
• Tax rate 35
• WACC 12.69.

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WACC for Individual Projects

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WACC for Individual Projects

• Suppose you are the financial planning director
  for U.S. Copper mining. You learn through
  watching your children that marshmallow covered
  Cheerios are the next big thing in breakfast
  cereals. You decide that your company should
  produce this product. How do you come up with a
  required rate of return? Again, a projects
  discount rate is determined by the projects CF
  systematic risk, NOT the risk of the company
  making this decision.
• Questions If a projects CF has high standard
  deviation, but is not correlated with the market
  (Corr0), what is the discount rate?

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WACC for Individual Projects

• Must estimate the ? of the project. How do we do
  this?
• Look at companies that operate primarily in the
  business of the project. What ? do those
  companies have. These firms total systematic
  risk will be similar to the systematic risk of
  our project.
• Historical returns on various assets. Compute ?
  directly.

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WACC for Individual Projects

• Cisco is evaluating the possibility of selling
  digital video recorders (DVRs). Ciscos WACC is
  13.3. DVRs would be a new line of business for
  Cisco, so the systematic risk of this business
  would likely differ from the systematic risk of
  Ciscos current business. You need to find the
  cost of capital for the DVR business. Assuming
  that rf 4.5, and the market risk premium 5.

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WACC for Individual Projects

• Look for a firm that operates primarily in the
  DVR business ? TiVo.

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WACC for Individual Projects

• TiVo has no debt, so the WACC of TiVo is simply
  its cost of equity using CAPM
• WACCTiVo 4.5 0.935
• 9.15
• Therefore, the correct discount rate to use is
  9.15 for this investment, which is less risky
  than Ciscos existing business (WACC13.3).

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WACC for Individual Projects

• What happens if a firm uses WACC to discount all
  project CFs? Assume a firms overall asset has
  the same systematic risk as the market.
  Risk-free rate is 7. Market risk premium is 8.