cf 473.32 11 winter 2014. questions 1. what cash flows should i consider? 2. how does the market set...
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CF
473.32
11
Winter 2014
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Questions
1. What cash flows should I consider?
2. How does the market set “r”?
3. How should I set “r”?
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Setting “r”
basic idea if
• project return > cost of money
then• value of firm should
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Cost of Money
finalinterim• Debt
value if soldpayments
principal
face value
dividends
dividends
interest
coupon
Common shares
Preferred shares
• Equity
• Loans
• Bonds
firm gets money from 2 sources
sources expect benefits back
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Cost of Money
3 ideas to measure this:1. dividend growth
2. earnings retention
3. WACC
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Cost of Money
1. dividend growth
• remember this formula?
• change the labels slightly
• rearrange it
p0 share price now
d1 dividend a year from now
g rate of growth
re return on equity
gr
dp
1
s
gr
dp
e 1
0
gp
dre
0
1
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Cost of Money
1. dividend growth• need to know g
» dividend history
gp
dre
0
1
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dividend history
dividend
2007 $1.10 change growth
2008 $1.20 $0.10 9.09%2009 $1.35 $0.15 12.50%2010 $1.50 $0.15 11.11%2011 $1.55 $0.05 3.33%
average 9.01%
g = .0901
gp
dre
0
1
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Cost of Money
1. dividend growth
2. earnings retention
3. WACC
gp
dre
0
1
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Cost of Money
1. dividend growth
2. earnings retention same formula
different method of finding g
gp
dre
0
1
ROEratioretention g
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Cost of Money
1. dividend growth
2. earnings retention
3. WACC“weighted average cost of capital”
• uses ideas from CAPM
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3. WACC
of $ we get from outside world• what do we pay for debt?
• what do we pay for equity?
• what proportion of each do we have?
cddee trwrwWACC 1
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3. WACC
weight of equity
rate on equity
rate on debtweight of debt
corporate tax rate
% market value of equity
% market value of debtYTM
cddee trwrwWACC 1
crucial: market prices
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3. WACC
cddpepe
femfce tYTM
v
v
p
d
v
vrrr
v
vWACC 1
0
cddee trwrwWACC 1
fmfe rrrr
v
ve
v
vd
dYTM
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Cost of Debt
long-term debt bonds
• YTM not coupon rate
• expected bond ratings
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Cost of Debt
example current bond issue
• $1,000 face value
• 2 years to maturity
• 10% coupon rate (“embedded cost”) paid semiannually
• currently selling for 107% of face value
what is cost of debt?
ignoring taxes for now
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Cost of Equity
example for our firm
• $25.00 current stock price
• $1.80 last dividend
• 7% annual dividend growth
• 0.9 β analysts’ estimates
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Cost of Equity
example current in our market
• 8% risk-free rate
• 7% market risk premium
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2 More Things on ch 14
1. applying WACC’s r2. flotation costs
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1. Applying WACC’s r
WACC’s r used to decide yes or no? which is best?
appropriate for project same risk overall firm core business
otherwise adaptation needed
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1. Adapting WACC’s r
when a specific division’s project outside core business
then find firms that do these projects
• use their average βs
or adjust subjectively
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1. Adapting WACC’s r adjusting subjectively
• example
risk level r
very low WACC - .08
low WACC - .03
same as firm WACC
high WACC + .05
very high WACC + .10
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2. Flotation Costs
r depends on risk not how $ raised
however cost of issuing must be included
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2. Flotation Costs
basic approach: weighted average flotation cost
Use target weights because firm will issue securities in these percentages over the long term.
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2. Flotation Costs
project cost
• $1 million
after-tax cash flows• $250,000/year
• 7 years
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2. Flotation Costs
project WACC
• 15%
firm’s target D/E ratio is .6 flotation costs
• 5% equity
• 3% debt
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2. Flotation Costs
nn
nnn r)(
CF
r)(
CF
r)(
CFNPV
1...
11 2
2
1
1
00.000,50272 CF
421,044,386.1 CF
15.0r
710 015.1
00.000,250...
015.1
00.000,250
015.1
42.386,044,1NPV
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Questions
1. What cash flows should I consider?
2. How does the market set r?
3. How should I set r?
nn
nnn r)(
CF
r)(
CF
r)(
CFNPV
1...
11 2
2
1
1
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1. What cash flows?
ch 10
Has it flowed already?
Would it flow without the project?
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1. What cash flows?
Has it flowed “already”? sunk costs research costs decision-making costs sales to date
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1. What cash flows?
Would it flow without the project?• if so, don’t count it
Incremental only lost gained
“The stand-alone principal”
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1. What cash flows?
Incremental only lost
• capital
• operating
gained• revenues
• CCA tax shield benefits
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CCA tax shield
c cost of asset
tCCA CCA tax rate
tc corporate tax rate
r discount rate
s salvage value
n number of periods in the project
nCCA
cCCA
CCA
cCCAoninstallatiequipment
r)(rt
tst
r
r.
rt
ttccPV
1
1
1
501 shieldCCA tax
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Equipment cost c $100,000
Installation & delivery cost c $10,000
Salvage s $17,000
when? n 6
Marginal tax rate tc40%
CCA tax rate d 20%
discount rate r 10%
6shieldCCA tax )10.01(
1
10.020.0
40.020.0000,17
10.01
10.05.01
10.00.20
40.00.20110,000 PV
“hurdle rate”
0544125shieldCCA tax .,$PV
nCCA
cCCA
CCA
cCCAoninstallatiequipment
r)(rt
tst
r
r.
rt
ttccPV
1
1
1
501 shieldCCA tax