CostofCapital: Review

Valuation XIMB ProfessorBanikantaMishra

(WeightedAverage)CostofCapital
AcompanysaysthatitscurrentWACCis20%. Whatdoesthis20%CostofCapital looselymean? Forevery$1raisedbythecompanynow, ithastop pay yout (informofdividendsandinterest) $0.20 or20cents peryearforever
[Sincewearetalkingaboutperpetualdebt, weareignoringthefacevalueofthebond.]

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Prof.BanikantaMishra

WhyisWACCImportant?
Whyisthis20%WACCrelevant? Becausethisalsomeansthat, the h companyhas h toearn atleast20centsper$1(or,20%). Thisisthereforecalledthehurdlerate. Regulatorscallthisthefairreturn.

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Prof.BanikantaMishra

HowisWACCComputed?
WACC = WE RE + WD RD + WP RP

whereRE,RD,andRP denote respectiveRRRsonEquity, Equity Debt, Debt andPreferredStock andWE,WD,andWP denote respective ti weights i ht onth theseth threesourcesof ffi financing i
Twoquestionsarise:
1) WhyarewetakingR,theReturnorRRR,astheCostoffinancing? 2) Whataretheweights Ws mentionedabove?

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ReturnastheCost
1)WhyarewetakingR,theReturn,astheCostoffinancing? WhatisRETURNfromtheinvestorsperspective istheCOSTfromthefirmsperspective (ignoringflotationorissuancecosts) Note:WeshouldalwaystaketheCURRENTorMARGINALCost(RRR) (RRR), NOTtheHISTORICALCost(orRRR) Forinstance, ifourexisting debtwasissuedtwoyearsbackatacostof10%, 10% ourCostofDebtisnot10%now Wehavetofindoutwhatitwouldcostus ifweissuedebtTODAY Caveat:Moreover,RRRdependsNOTonthesourceoffunds,butitsuse
(forinstance,RRRofequityraisedforinvestmentinariskfreeprojectisRf.)

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UseOnlyTargetWeights
2)Whataretheweights?
Id ll th Ideally, theseweights i ht should h ldbe b firms fi TARGETWEIGHTSbased b donmarket k tvalues l (e.g.afirmmaytargettohave60%Equity,30%Debt,and10%PreferredORtarget2:1DebtEquityRatio) ButiftheTargetWeightsarenotavailable,wecanassumethefollowing
WE = E D P (Equity Ratio), WD = (Debt Ratio), and WP = (Pr eferred Ratio) V V V

whereE, E D D,andPdenote denote,respectively respectively,MARKETVALUESofDebt Debt,Equity Equity,andPreferred Preferred, and,V,asusual,denotesthesumofthesemarketvalues(=>V=E+D+P)]

Note:IfMarketvalueofDebtandPreferredarenotavailable, wecantakethebookvaluesassurrogates Caveat:Evenwhenaprojectisfinancedwithonlydebtoronlyequity, therelevantRRRisstilltheWACCbasedonTargetWeights, NOTonebasedon100%debtor100%equityoronweightsdifferentfromTarget

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WhichWACCtoUse?
WACC = WE RE + WD RD + WP RP
shouldbeusedtodiscountactual(orLevered)OperatingCF

BUT,ifwewanttodiscounttheUNLEVERED OCF =OCF InterestTaxShield=OCF (Interestxtc), weshoulduse

E D P (Tax adjusted) WACC = R E + R D (1 t c ) + R P V V V
whereE/VistheMarketValuebasedTargetEquityRatio Ratio, andD/VandP/Varedefinedaccordingly

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Prof.BanikantaMishra

WACCVariations
IfCurrentLiabilities(CL)isanimportantfinancingsource, thefirmshouldusethefollowingWACCtodiscountunleveredCFs

WACC =

E D P CL RE + RD (1 t c ) + RP + R CL V V V V

IfafirmisisfinancedwithonlyDebtandEquity, Equity itshouldusethefollowingWACCtodiscountunleveredCFs

D E WACC = RD (1 t c ) + RE V V
(thisisoften ( f takenasthedefault f WACCf forUNLEVEREDOCFs) )
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WACCInputs
CostofEquity CostofDebt CostofPreferredStock TargetWeights
OR CurrentDebtRatio,EquityRatio,PreferredRatio

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Prof.BanikantaMishra

COE(CostofEquity):TwoApproaches
1.DGM (DividendGrowthModel) Easytounderstandanduse,BUT Doesnotexplicitlytakeriskintoaccount ANDQuitesensitivetoestimateofg, whichisespeciallydifficulttoestimateif Companyisnotpayingdividends Dividendisnotgrowingatasteadyrate 2.CAPM(orSML) Ittakesriskexplicitlyintoaccount,BUT MeasureofRisk(Beta)mayvaryovertime

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COE:DGMApproach
D (1 + g) D D t +1 Pt = t +1 = t R => E = +g RE g RE g Pt
Looksfamiliar?R=DY+CGY So COE(CostofEquity)=RE =RRR=DY+g So, g,thegrowthrate,is Estimatedfromhistoricaldata O taken OR k f fromanalysts l forecasts f
Supposeacompany,whosedividendshavebeengrowingsteadily@5%, hasjustpaidadividendof$4.00,anditspricenowis$20.00 WhatisthefirmsCOE?

COE = RE =
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D t (1 + g) 4.00 (1 + 5%) +g= + 5% = 26% Pt 20.00

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COE:CAPMorSMLApproach
Ri =Rf +i (RM Rf)
NeedThreeVariables: Rf CurrentTreasuryRate(easilyavailable) i Obtainedbyregressinghistoricalstockreturnonmarketreturn (RM Rf) Usuallytakenasequaltothehistoricalspread

Acompanyhasa of1.25; CurrentRf (TreasuryRate)is6.00%, HistoricalRM Rf Spreadhasbeen8.00% COE=Ri =Rf +i (RM Rf)=6%+(1 (1.25 25x8%)=16.00% 16 00%
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COD(CostofDebt)
TypicallytheCostofLongtermDebt WeknowCOD=RRR=Rf +RiskPremium But,howdowecomputeit? ItistheEffectiveYieldor,forannualcoupon,YTM. Suppose$1,000,000FaceValuedebtoutstanding CurrentQuote:115(=>Priceis$115per$100Par) TimetoMaturity:7years CouponRate:10%,annual payments ,COD=EffectiveYield=YTM=7.20% Then,
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COD:ACaveat
CODistheEffectiveYieldonDebt, whichequalsYTMforannualcouponpayments

RecallthatYTMis NOTthesameasCurrentYieldORCouponRate

Inthepreviousexample, COD=EffectiveYield=YTM=7.20% whereasCouponRate=10%andCurrentYield=8.70%

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COD:NonTradedDebt
Whatifthecompanysdebtdoesnottradepublicly? Then,wedonthaveitspriceorvalue, wecannotexplicitlycomputeeffectiveyield Insuchcases, lookatEffectiveYieldofdebtofothersimilarfirms Similar Similarinrisk,rating,debtratio
(possiblysameorsimilarlineofbusiness)

Howtocomputevalueofdebthere? Discountinterestpaymentsandparvaluesby theCostofDebtobtainedabovetogetdebtvalue

(orelse,takeBookValueassubstituteforMarketValue)
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COP(CostofPreferredStock)
Typicallyaperpetuity, sometimesmaybeagrowingperpetuity GenericFormula:
D t +1 D => RP = t +1 + g RP g Pt whereg,thegrowthrate,istypicallyzero Pt =

Afirmspreferredshares, thathavebeenpaying$2.50dividendannually, areselling lli nowfor f $20.00 $20 00

So, R P = D t +1 2.50 g + = + 0 = 12.50% Pt 20.00
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TaxAdjustedWACC
Wheninterestpaymentsaretaxdeductible, deductible theeffectiveCostandValueofDebtislower; therefore,thetaxadjusted(oraftertax)WACCislower
WACC = WD R D (1 t c ) + WE RE

Recallthatthisisthedefault WACC. ThisrateisusedtodiscountUNLEVEREDcashflow. flow LetusnowanalyzewhatUNLEVEREDcashflowis.

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ComputingOperatingCashflow
= = = + + = NetSales COGS NoncashCharges(Depreciationetc.) EBIT Interest EBTorTaxableIncome T Taxes @34% EATorNetIncome NonCashCharges Interest Cashflow(ActualorLevered)
Prof.BanikantaMishra

1,509 750 65 =694 70 =624 212 =412 65 70 =547

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ComputingUnlevered (Operating)CF
= = = + + = NetSales COGS NoncashCharges(Depreciationetc.) EBIT Interest EBTorTaxableIncome T Taxes @34% EATorNetIncome NonCashCharges Interest Cashflow(Unlevered)
Prof.BanikantaMishra

1,509 750 65 =694 0 =694 236 =458 65 0 =523

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ActualandUnlevered OperatingCF
Whatistherelationshipbetween ActualOperatingCFof$547 andUNLEVERED(Operating)CFof$523? Unlevered l dCF =OperatingCF (InterestTaxShield) =OperatingCF (InterestxTaxRate) =$547 ($70x34%)=$547 $24=$523 So,ifweknowtheActualOperatingCF, wecanderivetheUnleveredCFfromit, merelybysubtractingITS(InterestTaxShield)
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FactorsAffectingE andRE
Aswesee, , followingfourvariablesaffectE (which,inturn,affectsRE) 9 u =etaoftheUnleveredFirm 9DER=DebtEquityRatio, p Taxrate 9tc =Corporate
(orthedifferencebetweenu andD )
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D E

9D =etaofDebt

What Determines u?
Unlevered Cash Flow = Revenue Fixed Cost Variable Cost
(where these items are on an after-tax basis)

PV of FC u = Re v 1 + = Re v (1 + O OLF ) PV of CFu
whereREV isthebetaoffirmsRevenue,FCisFixedCost,CFu istheUnleveredcashflow, PVdenotesPresentValue,andOLFstandsforOperatingLeverageFactor

Intherealworld,howdowefindRev foranewfirm? Unlever E ofsimilarfirmstogettheiraverageRev. UsethisaverageRev asthenewfirmsRev. Firm

DER 0.60 0.65 0.50

D 0.05 0.05 0.04

u* 2.00 1.05 1.40

OLF 0.60 0.40 0.40

Rev 1.25 0.75 1.00 A Average 1.00 1 00

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1 2.702 2 1.440 3 1.808

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Using1.00asthenewfirmsRev ,andusingitsownOLFandDER,wegetitsE
Prof.BanikantaMishra

WhatAffectsREV?
REV foracompany p ywouldberelatively ylowerif: itsproductsareessentialgoods, itsproductsdonothavegoodsubstitutes, itsclientelebelongstohighincomegroups, itsellshighpriceluxuryitems, itsellsinreasonably ylarge, g ,urbanmarkets REV foracompanywouldberelativelyhigherif itssalesaresensitivetobusinesscycle, itsellstomiddleclassclientele, itsellsinsmall,rural/nonurbanmarkets
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ComputingaFirms Firm sWACC:Practice

RequiredData(NoticeOverlaps):
DDM

GrowthRateinDividends,Earnings,Prices MostRecentDividendandSharePrice HistoricalReturnonfirm firms sStockandMarketIndex (oretaofFirmsStock)

COE CAPM

CurrentRateonTreasury(90day/1year/) HistoricalIndexTreasurySpread (thatis.Rm Rf forchosenIndexandTreasury) Coupon p Rate, ,Amount, ,CurrentPrice, ,Maturity yofeachissue TargetDebtEquityRatio:MarketValuebased (orNumberofSharesOutstandingandSharePrice, AmountorFaceValueofDebtforeachpastissue, issue andcurrentBondMarketPriceQuoteforeachissue)
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COD

WEIGHTS

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ComputingWeightedCOD
Thoughmostfirmstypicallyhave oneclass l of fcommonshares, h Theywouldhaveseveralissuesofdebt, issuedatdifferentpointsoftimeinpast, withdifferenttimestomaturity,couponrates Insuchcases,weshouldcompute averageEffectiveYield(orYTM), which hi his i the th weighted i ht daverageof f EffectiveYieldsofdifferentbondsoutstanding

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CODandMarketValueofDebt
GIVENDATA Coupon Maturity Amount* CurrentPrice 9.00% 7 00% 7.00% Coupon 9.00% 7.00% Total
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2010 2015

$25mil $75mil

101.28%(ofpar) 89 45% 89.45% YTM 8.50% 8.90%

DERIVEDBYUS MarketValue Value* %ofTotal

weight

$ $25.32 mil $67.08 mil $92.40mill

27.40 72.60

WeightedAverage 8.79%

*MultiplyingAmount(orTotalFaceValue)byPricegivestheMarketValue
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MarketValueofEquityandWeights
SupposethesameCompanyhas onemillion illi shares h outstanding, di eachwithacurrentpriceof$200 ThenitsMarketValueofEquity= $200million So theMarketValueDebtEquityRatio So, =92.40/200.00=46.20% Moreover, ,
D 92.40 = = 31.60% V 92.40 + 200.00 E => = 100% 31.60% = 68.40% V
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ComputingCOE
Supposewefindthatthiscompanys dividendhasbeengrowingatarateof5%, andthemostrecentdividendwas$20 So,itsDGMCOE=

$20 (1 + 5%) + 5% = 15.50% $200

Wealsofindthatits is0.95, current90dayTreasuryBillyieldis3.45%,and historicalmarkettreasuryspreadhasbeen8.50%, itsCAPMCOEis

3.45%+(0.95x8.50%) 11.50%
Weuseaverageof fDGMand dCAPMCOE=13.50%
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TheFinalAct
(Tax Adjusted) WACC = WD RD (1 t C ) + WE RE WACC CC = [31 3 .60% x 8.79 9% x (1 34 3 %)] + [(68.40 0% x 13 3.50 0% )] = 11.07 0 %
Supposethiscompanyisevaluatingaproject thatrequires$40.00millionininvestment, generatesannualEBITsof$5.50million overits10yearlife, andcompanystaxrate=34%. Ignoringinterest,EBT=EBIT=$5.50million NetIncome=$5.50million(1 34%)=$3.63million UnleveredCF=NI+NonCashCharge=$3.63 $3 63+$4.00 $4 00=$7.63 $7 63
(assumingthat$40millionisdepreciatedstraightlineover10years)

PV=7.63xPVIFA11.07%,10 =$44.80 So,accepttheprojectasPV>I.

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FirmasaPortfolioofDebt&Equity
Ifwethinkofthefirmasaportfolioofdebtandequity,
then WACC = WD RD + WE RE D E OR WACC = RD + RE V V

But,ifF istheetaoftheFirm But Firm, thenfromtheCAPMperspective, TaxunadjustedWACC=Rf +F (Rm Rf) ,Taxunadjusted j WACCcanbethought g ofastheRF. So,
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F asaPortfolioeta
WeknowfromCAPManalysisthat portfolio f li beta b is i aweighted i h daverageof f etasofindividualsecuritiesintheportfolio
p = w i i
i =1 n

So,takingCompanyasaportfolioofDebtandEquity, wecanwriteFirmsbeta,F ,asfollows

F = wD D + wE E

So,ifacompanys D is0.25andE is1.50whilewD =0.20andwE =0.80,

F = (0.20 x 0.25) + (0.80 x 1.50) = 1.25
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FirmasaPortfolioofTwoDivisions
Forafirmwithtwodivisions:XandY,
F = w X X + w Y Y

whereadivisionsweightrepresents thefractionoffirmvalueaccountedforbythedivision, division But,gettingadivisionsvalueisdifficult, and, ,therefore, ,soisitsweight g Weightshouldbebasedonastock concept(likeNFA), andNOTonaflow concept(likerevenueorexpense) Correspondingly,theWACCofthecompanyis
WACC = WX R X + WY R Y where h RX isthe h RRRfor f DivisionXand dRY for f DivisionY
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DivisionalCOC(CostofCapital)
WACCistheappropriatediscountratetovalue aprojectasriskyastheoverallfirm BUT,whenvaluingaprojectforDivisionX, weshoulduseRX asthediscountrate, andsimilarlyRY forDivisionYprojects, assumingthataprojectforadivision isasriskyasthedivisionitself
(thatis,thetypicalprojectinthedivision)

But, B t how h d dowefind fi dout tRX and dRY? PurePlayApproach:Lookatsimilarfirms SubjectiveApproach:Fudgefactor? Similarmeanssamebusiness,sameleverage(?)
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DivisionalCOC:AnExample
FirmsDivisions
AutomotiveRetailer

Value
$600million

eta
2.00 1 25 1.25

RRR*
24.00% 16 50% 16.50%

HardDriveManufacturing 375million

ElectricUtility 525million 0.60 10.00%

TOTAL WeightedAverage
*4%+( x10%)

$1,500million 1 3225 17.225% 1.3225 17 225%

CorporateCOC

If fweuseCorporate p (Company) ( p y)RRRof f17.225%for f alldivisions,wewouldtendtobe biasedagainst electricutilityandharddrivedivisionprojectsandfor retailerdivision

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ErrorsofUsingCorporateCOC
Twotypesoferrorarecommitted whenweusethecorporateorcompanyCOCfor evaluatingdivisionspecificprojects Type 1Error: Rejectingaprojectwhenitshouldbeaccepted
E g AnElectricUtilityprojectwithERR=12%(>RRR=10%)shouldbeaccepted, E.g. accepted butifweusethecorporateCOCof17.225%,wewouldwronglyrejectit

Type2Error: Acceptingaprojectwhenitshouldberejected
E.g.RetailerdivisionprojectwithERR=20%(<RRR=24%)shouldberejected, butifweusethecorporateCOCof17.225%,wewouldwronglyacceptit

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