key concepts & skills calculate & explain a firm’s cost of common equity capital a...
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Cost of capital
Key Concepts & SkillsCalculate & explain
A firm’s cost of common equity capitalA firm’s cost of preferred stockA firm’s cost of debt
A firm’s overall cost of capitalAnalyze & discuss pitfalls of overall cost of
capital & how to manage themPrint out the associated PDF for this PowerPoint
slideshow to use during the show if you want to!You will find that file where you found this video &
slides
Cost of Capital BasicsThe cost to a firm for capital funding
The return to the providers of those fundsThe return earned on assets should depend on the
risk of those assetsIn equilibrium WACC = ROA
A firm’s cost of capital indicates how the market views the risk of the firm’s assets
A firm must earn at least the required return to compensate investors for the financing they have provided
The required return is the same as the appropriate discount rate
IBMSources of data
S&P NetAdvantage Database in the SEU library online
Finance.yahoo.comDate: 11/17/2011
Cost of Common EquityReturn required by equity investors given the
risk of the cash flows from the firmTwo major methods for determining the cost
of equityDividend growth modelCAPM
Dividend Growth Model ApproachStart with the
dividend growth model formula & rearrange to solve for RE
Assumption is that the stock is priced fairly
Does this look familiar?
gP
DR
P
DgR
gR
DP
0
1E
0
1E
E
10
Dividend Growth ModelThe current stock price is $185.27Your company is expected to pay a dividend
of $3.00 per share next yearD1 or D0?
Dividends have grown at a steady rate of 10.00% per year & the market expects that to continueHow long can that really continue?
What is the cost of equity?
%62.110.10000162.00.1000$185.27
$3.00R E
gP
DR
0
1E
Advantages & Disadvantages of Dividend Growth ModelAdvantage
Easy to understand & useDisadvantages
Only applicable to companies currently paying dividends
Not applicable if dividends, earnings, stock price are not growing at a reasonably constant rate
Sensitive to the estimated growth rateDoes not explicitly consider riskRelies on the past to predict the future
The CAPM (SML) ApproachUse the following information to compute the
cost of equityRisk-free rate
Rf
Market risk premium E(RM) – Rf
Systematic risk of asset
fMEfE R)E(RβRR
The CAPM (SML) Approach
Company’s equity beta = 0.49Current risk-free rate = 3.00% Expected market risk premium = 17.00% What is the cost of equity capital?
%33.11.00%1749.03.00%R E
Advantages & Disadvantages of SMLAdvantages
Explicitly adjusts for systematic riskApplicable to all companies, as long as beta is
availableDisadvantages
Must estimate the expected market risk premium
Must estimate betaRelies on the past to predict the future
Cost of preferred stockIf IBM had preferred
stockUse the current price
of the preferred stockAlong with its annual
dividendAnd the constant
growth modelTo estimate its cost of
preferred stockThe growth in
dividends is zero
0P
0
1E
P
DR
stock preferredfor 0g
reflect oequation t Alter the
gP
DR
Cost of DebtThe cost of debt
Required return on a company’s debtWhat is the name for that kind of yield?
Yield to maturity on existing debt
The cost of debt is NOT the coupon rate on OLD or OUTSTANDING DEBT
Cost of DebtOutstanding
bond issue34 years to
maturity Coupon rate
= 7.00%Coupons paid
semiannuallyCurrently
bond price = $1,339.71
What is the YTM?
CLR TVMSet P/Y = 2
N = 34 years x 2 payments per year = 68
PV = -1339.71PMT= (0.0700 x 1000.00)/2 = 35FV = 1000.00CPT I/Y = 4.93%
Cost of DebtUse the YTM on the firm’s debtInterest is tax deductible, so the after-tax
(AT) cost of debt is
If the corporate tax rate = 25.66%
)T(1RR CBTD,ATD,
%66.3)2566.0(1%93.4R ATD,
Weighted Average Cost of CapitalWACCUse the individual (component) costs of
capital to compute a weighted average cost of capital for the firm
This averageThe required return on the firm’s assets, based
on the market’s perception of the risk of those assets
The weights are determined by how much of each type of financing is used
Determining theWeights for the WACCWeights
Proportions of the firm that will be financed by each component
Always use the target weights, if possibleIf not available, use market valuesIf not available, use book values
Capital Structure Weights: MarketFrom observed prices in the marketNotation
E = market value of common equity = # outstanding shares of common shares times price per share
P = market value of preferred stock = # outstanding shares of preferred shares times price per
shareD = market value of debt
= # outstanding bonds times bond price
V = market value of the firm = E + P + DWeights
E/V = proportion financed with common equity P/V = proportion financed with preferred stock D/V = proportion financed with debt
Capital Structure Weights: BookFrom observed balances on the balance sheetNotation
E = book value of common equity = common stock + capital in excess of par + retained
earnings – treasury stockP = book value of preferred stockD = book value of typically only long-term debt
V = book value of the firm = E + P + DCapital structure weights
E/V = proportion financed with common equity P/V = proportion financed with preferred stock D/V = proportion financed with debt
WACC
Capital structure
weights
Component costs before
tax
CDPE T -1RVD RV
P RVE WACC
Where
(E/V) = proportion of common equity in capital structure (P/V) = proportion of preferred stock in capital structure (D/V) = proportion of debt in capital structure
RE = firm’s cost of equity RP = firm’s cost of preferred stock RD = firm’s cost of debt
TC = firm’s corporate tax rate
Estimating WeightsMarket value of common equity Market price of the common stock = $185.27
per share 1,178,766,125 shares common stock
Market value of equity (E) = $185.27 per share x 1,178,766,125 shares= $218,390,000,000 (a little more than $218 B)
Estimating WeightsPreferred stock?
There is none…so P/V = 0
Estimating WeightsBook value of long-term debtAlthough we know the market price per bond of
the long-term debt, we do not have the number of bonds outstanding
So, I will use the book value of long-term debt insteadOk to do if interest rates have not changed or If we do not have all the data from the market
Book value of long-term debt from the balance sheet=$21,932,000,000 (almost $22 B)
Estimating WeightsUsing market value of equity & book value of debt to calculate the weights
AmountsE = $218,390,000,000P = $0D = $21,932,000,000
V = $240,322,000,000Weights
E/V = $218,390,000,000/$240,322,000,000 = 0.9087 or 90.87%
P/V = $0/$240,322,000,000 = 0.0000 or 0.00%
D/V = $21,932,000,000/$240,322,000,000 = 0.0913 or 9.13%
WACCUsing market value of equity & book value of debt to calculate the weights
%10.63
0.33%0.00%10.30%
)2566.01(%93.40.0913
R0.0000
11.33%0.9087
T -1 x RVD RV
P RVE WACC
debt ofcost
tax-after weighted
stock preferred ofcost
tax-after weighted
equitycommon ofcost
tax-after weighted
debt ofcost tax -after%66.3
P
debt ofcost
tax-after weighted
debt ofcost tax -after
CD
stock preferred ofcost
tax-after weighted
P
equitycommon ofcost
tax-after weighted
E
Estimating WeightsUsing book value of equity & book value of debt to calculate the weights
AmountsE = $22,291,000,000P = $0D = $21,932,000,000
V = $44,223,000,000Weights
E/V = $22,291,000,000/$44,223,000,000 = 0.5041 or 50.41%
P/V = $0/$44,223,000,000 = 0.0000 or 0.00%
D/V = $21,932,000,000/$44,223,000,000 = 0.4959 or 49.59%
WACCUsing book value of equity & book value of debt to calculate the weights
%7.53
1.81%0.00%5.71%
)2566.01(%93.40.4959
R0.0000
11.33%0.5041
T -1 x RVD RV
P RVE WACC
debt ofcost
tax-after weighted
stock preferred ofcost
tax-after weighted
equitycommon ofcost
tax-after weighted
debt ofcost tax -after%66.3
P
debt ofcost
tax-after weighted
debt ofcost tax -after
CD
stock preferred ofcost
tax-after weighted
P
equitycommon ofcost
tax-after weighted
E
Weight CostAfter-tax
cost
Weighted after-tax
costWeight Cost
After-tax cost
Weighted after-tax
cost
Debt 9.13% 4.93% 3.66% 0.33% Debt 49.59% 4.93% 3.66% 1.81%
Equity 90.87% 11.33% 11.33% 10.30% Equity 50.41% 11.33% 11.33% 5.71%
Tax rate 25.66% Tax rate 25.66%
WACC 10.63% WACC 7.53%
Using market value of equity & book value of debt to calculate the weights
Using book value of equity & book value of debt to calculate the weights
WACC Table for Calculations
Big difference!
Factors that influence a company’s WACCMarket conditions, especially interest rates,
tax rates & the market risk premiumThe firm’s capital structure & dividend policyThe firm’s investment policy
Firms with riskier projects generally have a higher required return
Risk-adjusted required returnA firm’s WACC reflects the risk of an average
project undertaken by the firmDifferent divisions/projects may have
different risks The division’s or project’s required return
should be adjusted to reflect the appropriate risk & capital structure
WACC may not be appropriate
Using WACC for All Projects
What would happen if we use the WACC for all projects regardless of risk?
Using WACC for All ProjectsDifferent decisions using
WACC = 15% Incorrect decision
A risk-adjusted return accounting for the project cash flow risk Correct decision
Tend to accept projects that are too risky…like project ATend to reject projects that are less risky…like project CThe risk of the firm will increase over time using RR = WACC
Project
Expected return =
IRR
Fixed WACC required
return
Risk-adjusted required
returnDecision using required
return = fixed WACCDecision using required return =
risk-adjusted returnA 17% 15% 20% Accept because ER > RR Reject because ER < RRB 18% 15% 15% Accept because ER > RR Accept because ER > RRC 12% 15% 10% Reject because ER < RR Accept because ER > RR
Correct decision
Incorrect decision
Key Concepts & SkillsCalculate & explain
A firm’s cost of common equity capitalA firm’s cost of preferred stockA firm’s cost of debt
A firm’s overall cost of capitalAnalyze & discuss pitfalls of overall cost of
capital & how to manage them
End of cost of capital
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