Chapter 14 Cost of Capital 14-1 McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc All rights reserved Chapter Outline • The Cost of Capital – Overview • The Cost of Equity • The Cost of Debt • The Cost of Preferred Stock • The Weighted Average Cost of Capital (WACC) • Divisional and Project Costs of Capital • Floatation Costs relative to WACC 14-2 Chapter Outline • The Cost of Capital – Overview • The Cost of Equity • The Cost of Debt • The Cost of Preferred Stock • The Weighted Average Cost of Capital (WACC) • Divisional and Project Costs of Capital • Floatation Costs relative to WACC 14-3 Why the Cost of Capital Is Important We know that the return earned on assets depends on the risk of those assets The return to an investor is the same as the cost to the company 14-4 Why the Cost of Capital Is Important Our cost of capital provides us with an indication of how the market views the risk of our assets Knowing our cost of capital can also help us determine our required return for capital budgeting projects 14-5 Chapter Outline • The Cost of Capital – Overview • The Cost of Equity • The Cost of Debt • The Cost of Preferred Stock • The Weighted Average Cost of Capital (WACC) • Divisional and Project Costs of Capital • Floatation Costs relative to WACC 14-6 The Cost of Equity The cost of equity is the return required by equity investors given the risk of the cash flows from the firm: •Business risk •Financial risk 14-7 The Cost of Equity There are two major methods for determining the cost of equity: Dividend growth model (aka: the Gordon Model) 14-8 SML, or the CAPM The Dividend Growth Model (The Gordon Model) Start with the dividend growth model formula and rearrange to solve for RE D1 P0 = RE − g D1 RE = +g P0 14-9 Dividend Growth Model Example Suppose that your company is expected to pay a dividend of $1.50 per share next year There has been a steady growth in dividends of 5.1% per year and the market expects that to continue The current price is $25 What is the cost of equity? 14-10 1.50 RE = + 051 = 111 = 11.1% 25 Flotation Costs: An NPV Example • Your company is considering a project that will cost $1 million • The project will generate after-tax cash flows of $250,000 per year for years • The WACC is 15%, and the firm’s target D/E ratio is 14-65 • The flotation cost for equity is 5%, and the flotation cost for debt is 3% Flotation Costs: An NPV Example What is the NPV for the project before adjusting for flotation costs? WACC = 15% PV of future cash flows = $1,040,105 NPV = 1,040,105 - 1,000,000 = $ 40,105 14-66 Flotation Costs: An NPV Example What is the NPV for the project after adjusting for flotation costs? fA = (.375)(3%) + (.625)(5%) = 4.25% PV of future cash flows = 1,040,105 NPV = 1,040,105 - 1,000,000/(1-.0425) = $ -4,281 14-67 Flotation Costs: An NPV Example •The project would have a positive NPV of $40,105 without considering flotation costs •Once we consider the cost of issuing new securities, the NPV becomes a negative $4,281! 14-68 Comprehensive Problem •A corporation has 10,000 bonds outstanding with a 6% annual coupon rate, years to maturity, a $1,000 face value, and a $1,100 market price •The company’s 100,000 shares of preferred stock pay a $3 annual dividend, and sell for $30 per share •The company’s 500,000 shares of common stock sell for $25 per share and have a beta of 1.5 The risk free rate is 4%, and the market return is 12% •Assuming a 40% tax rate, what is the company’s WACC? 14-69 Ethics Issues  How could a project manager adjust the cost of capital (i.e., appropriate discount rate) to increase the likelihood of having his/her project accepted?  Is this ethical or financially sound? 14-70 Terminology • Security Market Line (SML) • Capital Asset Pricing Model (CAPM) • Yield or Yield to Maturity (YTM) • Cost of Capital • Weighted Average Cost of Capital (WACC) • Pure Play risk • Subjective Risk 14-71 Terminology (ctd) • Capital Structure • Cost of Equity • Cost of Debt • Cost of Capital • Capital Budgeting (NPV, IRR) • Floatation Costs 14-72 Formulas D1 P0 = RE − g D1 RE = +g P0 Cost of Equity (Dividend Growth Model) RE = R f + β E ( E ( RM ) − R f ) 14-73 Cost of Equity (CAPM) Formulas (continued) Rps = D_ Cost of Preferred Stock P0 After-tax cost of debt = RD(1-TC) WACC = WDRD(1-TC) + WE RE 14-74 Key Concepts and Skills • Be able to compute a firm’s cost of equity using the CAPM and the Dividend Growth model • Be able to compute a firm’s after-tax cost of debt 14-75 Key Concepts and Skills • Know how to compute the WACC of a firm • Identify the consequences to the WACC of considering floatation costs 14-76 What are the most important topics of this chapter? There are two ways to compute the cost of equity: DGM and CAPM The relevant cost of debt to a firm is the after-tax cost Capital structure determines the weights of debt, preferred stock and equity used by the firm 14-77 What are the most important topics of this chapter? The WACC determines the discount rate to be used for capital budgeting purposes for NPV, IRR and MIRR All projects may not have the identical risk classification and we may need to adjust the WACC accordingly 14-78 Questions? 14-79 [...]... 19.55% 14-21 Chapter Outline • The Cost of Capital – Overview • The Cost of Equity • The Cost of Debt • The Cost of Preferred Stock • The Weighted Average Cost of Capital (WACC) • Divisional and Project Costs of Capital • Floatation Costs relative to WACC 14-22 Cost of Debt The cost of debt is the required return on our company’s debt We usually focus on the cost of longterm debt or bonds (as opposed... is the cost of preferred stock? RP = 3 / 25 = 12% 14-30 Chapter Outline • The Cost of Capital – Overview • The Cost of Equity • The Cost of Debt • The Cost of Preferred Stock • The Weighted Average Cost of Capital (WACC) • Divisional and Project Costs of Capital • Floatation Costs relative to WACC 14-31 Capital Structure Weights To compute the WACC, we first need the weights of each source of funds:... example of just debt and equity We often use the market value of both debt and equity 14-33 Capital Structure Valuation Debt’s Market Value = (# of outstanding bonds ) x (the market price of one bond) Equity’s Market Value = (# shares of outstanding common stock) x (the market price of one share of common stock) 14-34 Capital Structure Valuation A firm’s market value is simply the added value of both... Weighted Average Cost of Capital (WACC) • Divisional and Project Costs of Capital • Floatation Costs relative to WACC 14-28 Cost of Preferred Stock Preferred stock is a perpetuity, so we take the perpetuity formula: and then rearrange the terms to solve for RP P0 = D_ Rps 14-29 Rps = D_ P0 Example: Cost of Preferred Stock Your company has preferred stock that has an annual dividend of $3.00 The current... estimated growth rate – an increase in g of 1% increases the cost of equity by 1% • Does not explicitly consider risk 14-14 The SML Approach Use the following information to compute our cost of equity: Risk-free rate, Rf Market risk premium, E(RM) – Rf Systematic risk of asset, β RE = R f + β E ( E ( RM ) − R f ) 14-15 Example - SML Suppose your company has: • an equity beta of 58 • the current risk-free rate... What is the cost of debt? 14-25 25 years/2 = 50 periods = N HP 12$-908.72 = PV C $90/2 = $45 = Payment (PMT) YTM = i = ? $1,000 = FV 5.00 14-26 (x2 = 10%) TI BA II Plus 25 yrs/2 = 50 payments = N 5%(5 x 2 = 10% $ -908.72 = PV $90/2 = $45 (PMT) $1,000 = FV YTM = I/Y = ? 1st 2nd 14-27 Chapter Outline • The Cost of Capital – Overview • The Cost of Equity • The Cost of Debt • The Cost of Preferred Stock... cost of equity using the SML? RE = 6% + 1.5(9%) = 19.5% 14-20 Example – Cost of Equity Our company has a beta of 1.5 The market risk premium is expected to be 9%, and the current risk-free rate is 6% We have used analysts’ estimates to determine that the market believes our dividends will grow at 6% per year and our last dividend was $2 Our stock is currently selling for $15.65 What is our cost of equity... or bonds (as opposed to short-term debt like notes payable) 14-23 Cost of Debt The required return is best estimated by computing the yield-to-maturity on the existing long-term debt (the YTM) The computation of the YTM was presented in the chapter on Bond Valuation 14-24 Example: Cost of Debt: computing the YTM Suppose we have a corporate bond issue currently outstanding that has 25 years left to maturity... as we can estimate beta 14-18 Advantages and Disadvantages of SML Disadvantages: • Have to estimate the expected market risk premium, which does vary over time • Have to estimate beta, which also varies over time • We are using the past to predict the future, which is not always reliable 14-19 Example – Cost of Equity Our company has a beta of 1.5 The market risk premium is expected to be 9%, and the... = 5.1% 14-11 Advantages and Disadvantages of the Dividend Growth Model Advantage: Easy to understand and use 14-12 Advantages and Disadvantages of the Dividend Growth Model • Disadvantages: • Only applicable to companies currently paying dividends • Not applicable if dividends aren’t growing at a reasonably constant rate 14-13 Advantages and Disadvantages of the Dividend Growth Model • Disadvantages ... • The Cost of Capital – Overview • The Cost of Equity • The Cost of Debt • The Cost of Preferred Stock • The Weighted Average Cost of Capital (WACC) • Divisional and Project Costs of Capital... • The Cost of Capital – Overview • The Cost of Equity • The Cost of Debt • The Cost of Preferred Stock • The Weighted Average Cost of Capital (WACC) • Divisional and Project Costs of Capital... • The Cost of Capital – Overview • The Cost of Equity • The Cost of Debt • The Cost of Preferred Stock • The Weighted Average Cost of Capital (WACC) • Divisional and Project Costs of Capital