CFA Level 1 Corporate Finance E Book - Part 2

CFA - Corporate Finance E-book 2 of 7
Corporate Finance E-Book

Part 2 of 7
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Cost of Capital
1. Cost of Capital
Capital is a necessary factor of production, and has a cost. The providers of capital require a return on their money. A firm must obviously ensure that stockholders or those that have lent the firm money, such as banks, receive the return that they seek. This return is the cost that the firm will incur to maintain those sources of capital. Therefore, the return that the providers of funds seek is equal to the cost to the firm of maintaining those funds. The cost of capital is important for a firm to calculate, as this is the rate of return that must be used when evaluating capital projects. The return from the project must be greater than the cost of the project in order for it to be acceptable.
In general, a firm can finance its operations from three main sources of capital: 1. Equity or common stock. 2. Preferred stock. 3. Debt.
Qualifying Assets and Costs eligible for capitalization

Each of these components of capital has a cost. The cost of capital used in capital budgeting should be calculated as a weighted average, or composite, of the various types of funds a firm generally uses. WACC = wd rd (1 - t) + wp rp + we re The weighted average cost of capital (WACC) is defined as the weighted average cost of the component costs of debt, preferred stock and common stock or equity. It is also referred to as the marginal cost of capital (MCC) which is the cost of obtaining another dollar of new capital. wd = the weight for debt. wp = the weight for preferred stock. we = the weight for common stock. r = required rate for each component. t = the marginal tax rate.
Taxes and the Cost of Capital Interest on debt is tax deductible and therefore to calculate the cost of debt the tax benefit is deducted This means that after-tax cost of debt = interest rate - tax savings (the government pays part of the cost of debt as interest is tax-deductible). There is no tax savings associated with the use of preferred stock or common stock. Weights of the Weighted Average The target capital structure is the percentage of debt, preferred stock, and common equity that a firm is striving to maintain and that will maximize the firm's stock price. Each firm has a target capital structure, and it should raise new capital in a manner that will keep the actual capital structure on target over time. 1. If the target capital structure is known, it should be used. 2. If not, market values of debt and stocks should be used to calculate weights. That is, the company's current capital structure is assumed to represent the company's target capital structure. 3. If #2 is not possible, then trends in the company's capital structure or use averages of comparable companies' capital structures should be used as the target one.
Example Firm A has a capital structure consisting of 40% debt, 5% preferred stock and 55% common equity (made up of retained earnings and common stock). Firm A pays 10% interest on its debt and has a marginal tax rate of 35%. If Firm A's component cost of preferred stock is 12.5% and the component cost of common stock equity from retained earnings is 13.5%, calculate Firm A's WACC. WACC = 0.4 x 10% (1 - 0.35) + 0.05 x 12.5% + 0.55 x 13.5% = 0.026 + 0.00625 + 0.07425 = 10.65%.
Investment Opportunity Schedule In any one year, a firm may consider a number of capital projects. The greater the number of projects undertaken, the more money that the firm will have to raise in order to finance them. There is a limit to the amount of money that can be raised in any one year (i.e. the capital markets are finite, and there is a limit to the number of investors and their investment dollars that will consider investing in any prospect in any given year.) Hence it is important that the capital budgeting analysis be extended to take this fact into account. The Investment Opportunity Schedule (IOS) is the prioritized list of capital projects, listed by IRR (internal rate of return) from highest to lowest. At the same time, the cumulative investment required is listed.
Example Consider a firm that has six different capital investment proposals this year. Each project has its own IRR and capital cost. Each project has the same risk as the firm as a whole.
Firms Cost of Capital = 10.00%
Capital Project A B C
Initial Cost $1,500,000 $2,300,000 $3,750,000
Annual ATCF Benefits $290,000 $529,000 $940,000
Useful Life 7 6 6
NPV -S88,159
IRR 8.19%
$3,933 $343,945
10.06% 13.07
$180,000
$40,000
$14,737
12.45%
$985,000
$318,540
$222,517
18.50%
$2,154,000
$421,500
$94,671
11.20%
The first step in developing an IOS is to order the projects from highest IRR to lowest, and then to calculate the cumulative capital cost of the projects
Firms Cost of Capital = 10.00%
Capital Project A
Initial Cost $985,000
Cumulative Cost of the Projects $985,000
IRR 18.50%
C D
$3,750,000 $180,000
$4,735,000 $4,915,000
13.07% 12.45%
F B A
$2,154,000 $2,300,000 $1,500,000
$7,069,000 $9,369,000 $10,869,000
11.20% 10.06% 8.19%
First, it is clear that project A is unacceptable: it offers a rate of return (IRR) that is less than the firm's cost of capital. The remaining projects certainly meet the first investment screen (they have positive NPVs, i.e. they offer rates of return in excess of the firm's WACC). Now a graphical representation of the IOS can be prepared by plotting the projects' IRR against the cumulative dollars of capital to be raised.
The height of each cylinder is equal to the project's IRR; the width is equal to the initial investment for the project.
Composite Assets
Intangible assets contained in or on a physical substance, e.g. software contained on a CD, motion picture contained on celluloid film Assets incorporating both intangible and tangible elements e.g. computer hardware containing also the operating system as well as applications software
As a firm raises more and more capital in any one year, it will exhaust the most readily available (and lowest cost first). If the firm has to raise more, it will cost the firm more and the MCC will rise. In this case, project B would definitely be rejected. F is very marginal
The optimal capital budget is that amount of capital raised and invested at which the MCC = marginal return from investing.
2. Cost of debt and preferred stock.

Capital components are the types of capital used by firms to raise fund. They include the items on the right side of a firm's balance sheet (debt, preferred stock and common equity). Any increase in the firm's total assets must be financed by one or more of these capital components.
The cost of debt is defined as the cost to the firm in terms of the interest rate that it pays for ordinary debt (rd) less the tax savings that are achieved. Interest on debt is tax deductible and therefore to calculate the cost of debt the tax benefit is deducted.
Two methods are discussed to estimate the before-tax cost of debt (rd).
Yield-to-Maturity Approach This approach uses the familiar bond valuation equation. Assuming semi-annual coupon payments, the equation is
P0 = PMT1/(1 + rd/2) + ... PMTn/(1 + rd/2)n + FV / (1 + rd/2)n

The six-month yield (rd/2) is derived and then annualized to arrive at the before-tax cost of debt, rd.
Debt-Rating Approach This approach can be used if there isn't a reliable market price for a firm's debt. Based on the company's debt rating, the before-tax cost of debt is estimated by using the yield on comparably rated bonds for maturities that closely match that of the firm's existing debt. For example, assume that: A firm's debt has an average maturity of 5 years; Its credit rating is AAA; The yield on debt with the same debt rating and similar maturity is 6% The marginal tax rate is30% (1 - 30%) Then the companys after tax cost of debt is 6% x (1-30%)= 4.2%.
Other factors such as debt seniority and security may complicate the calculation so analysts must take care when determining the comparable debt rating and yield. Issues in Estimating the Cost of Debt Fixed-rate debt versus floating-rate debt. Estimating the cost of a floating-rate debt is difficult because the cost depends not only on the current yield but also on the future yields. Term structure of interest rates may be used to calculate an average rate. Debt with option like features. Be aware that some debt can have call or put options. (Valuating such debts is a topic for Level 2 candidates.) Non-rated debt. The yields of a firm's debt may not be available, or a firm may not have rated bonds. Leases. If a company uses leasing as a source of capital, the cost of these leases should be included in the cost of capital (long-term debt).
Cost of Preferred Stock
The cost of preferred stock is calculated by dividing the dollar amount of the dividend (which is normally paid on an annual basis), by the preferred stock current price. p = Dp/Pp
It is important to note that tax does not effect the calculation of the cost of preferred stock since preferred dividends are not tax deductible.
3. Cost Of Common Equity.

The cost of common equity (re) is the rate of return stockholders require on common equity capital the firm obtains. It has no direct costs but is related to the opportunity cost of capital: if the firm cannot invest newly obtained equity or retained earnings and earn at least re, it should pay these funds to its stockholders and let them invest directly in other assets that do provide this return. So, firms should earn on retained earnings at least the rate of return shareholders expect to earn on alternative investments with equivalent risk. Estimating the cost of common equity is challenging due to the uncertainty nature of the future cash flows in terms of the amount and timing.
The CAPM Approach

re = RF + [E(RM) - RF] i
Where RF is the risk-free rate, E(RM) is the expected rate of return on the market, and i is the stock's Beta coefficient. [E(RM) - RF] is called the equity risk premium (ERP). Both E (RM) and i need to be estimated.
For example, firm A has a i of 0.6 for its stock. The risk free rate, RF, is 5%. The expected rate of return on the market, E(RM), is 10%. The firm's cost of common equity is therefore calculated as 5% + (10% - 5%) x 0.6 = 8%. Copyright www.educorporatebridge.com
There are several ways to estimate the equity risk premium. 1. The historical equity risk premium approach examines the historical data of realized returns of a country's market portfolio and uses the average rate for both the market portfolio and risk free assets. One study, cited in the textbook, found that the annualized U.S. equity risk premium relative to U.S. Treasury bills was 5.3% (geometric mean). However, there are some limitations in this approach. For example, the level of risk of the stock index and risk aversion of investors may change over time. 2. The dividend discount model based approach or implied risk premium approach analyzes how the market prices an index using the Gordon growth model: re= D1/P0 + g Where re is the required rate of return on the market, D1 are the dividends Expected next period on the index P is the current market value of the equity Expected next period on the index, P0 is the current market value of the equity Market index and g is the expected growth rate of dividends. 3. The survey approach is a direct one: Ask a panel of financial experts for their estimates and take the mean response.
Dividend Discount Model Approach
re = D1/P0 + g
Where D1 is the dividend expected to be paid at the end of year 1, P0 is the current price of the stock, and g is the constant growth rate of dividends. P0 is directly known, and D1 can be predicted if the company has a stable dividend policy. However, it is difficult to establish the proper growth rate (g). One method is to forecast the firm's average future dividend payout ratio and its complement, the retention rate: g = (1.0 - Payout rate) (ROE), where ROE is the expected future rate of return on equity. Another method is to use the firm's historical growth rate, if the past growth rates are stable.
Bond Yield plus Risk Premium Approach Because the cost of capital of riskier cash flows is higher than that of less risky cash flows: re = rd + Risk premium This is a subjective, ad hoc procedure: bond yield is the interest rate on the firm's long-term debt, and risk premium is a judgmental estimate (usually 3 - 5%). For example, suppose that ABC, Inc.'s interest rate on long-term debt is 10%. Assume the risk premium is 5%. ABC's cost of retained earnings is 10% + 5% = 15%.
4. Estimating Beta And Determining A Project Beta.

The determination of cost of capital under the CAPM approach involves the estimation of , risk free rate and market return. is generally determined by comparing the return of the firm or the project as the case may be with the market return and ascertaining the relationship. The historical is the first step in the determination of the ex-ante . Either the historical can be accepted as the proxy for the future or modifications can be made to it to conform to the future. If we are thinking of a new company for a single project, we will have no historical records to go by. We would then compute the of companies of the same size and about the same lines of business and after making necessary adjustments to it; take it as the for the firm.
The pure-play method can be used to take a comparable public traded company's beta and adjust it for financial leverage differences. The that we impute to a project is likely to undergo changes with the change in the capital structure of the company. If the company is entirely equity based, its is likely to be lower than if it undertakes a borrowing.
Let us call the of a firm which is levered as Levered and that of a firm on an all-equity structure as Unlevered .
of a Levered Firm:
L=U (1 + (1 - T) D / E)
where L = of a levered firm U = of an unlevered firm T = tax rate D = component of Debt in capital structure E = component of Equity in capital structure If the of a firm is available and that has been estimated on the premise that the firm is unlevered, we can now ascertain the of the firm should it undertake some borrowing by using the following formula.
of a Unlevered Firm:
U = L / (1 + (1 - T) D /E)
In the same way, given the of a firm which is already levered, we can ascertain what its would be if it chooses on all-equity structure. This also means that if the target firm has leverage different from the structure assumed in estimating the levered , this can first be converted into an unlevered and then re-converted into a levered using the leverage parameters relevant to the firm.
As a first step, we have to identify firms that reasonably resemble the project for which the Beta is to be estimated. The stock of these firms is then taken. Their respective leverage position (ratio of debt to equity) is also considered. After duly adjusting the tax factor and applying the above formula, we can determine the proxy of the project assuming that it is unlevered.
The procedure is illustrated below: Suppose there are three firms P, Q and R, which closely resemble project X that is to be embarked upon. The stock Betas of the three firms are taken and found to be 2.73, 2.23 and 1.73 respectively for P, Q and R. The Ratio of Debt to Equity for the three firms averages to 0.67. The marginal tax rate is 36%. The average stock works out to 2.23. Translating these into the formula for unlevered firms we get: U = L / (1 + (1 - T) (D/E)) =2.23/(1+0.64 x 0.67)=1.56 This suggests that on an all-equity basis the of the project would be 1.56. Now, if the project is proposed to be financed by 50% equity and 50% debt, we can modify the above by applying the formula for Levered firms: L = U (1 + (1 - T) D/E) = 1.56 (1 + 0.64 x 0.5/0.5)=2.56 So, on a 1:1 debt equity ratio, the will be 2.56. This can be used now for determining the cost of equity for the project and its weighted average cost of capital, so that a more meaningful appraisal can be had.
5. Country Risk.
seems not be able to capture country risk for companies in developing countries. Analysts often need to add a country spread (country equity premium) to the market risk premium when using CAPM to estimate the cost of equity.
One simple approach is to use the sovereign yield spread, which represents the yield on a developing country's US$ bond vs. a US Treasury-bond of the same maturity, as a proxy for the country spread. The sovereign yield spread reflects primarily default risk. This approach may be too coarse to estimate equity risk premium.
Another approach is to adjust the sovereign yield spread by using the following formula: Country equity premium = Sovereign yield spread x (annualized of equity index / annualized of the sovereign bond market in terms of the developed market currency) The country equity premium is then added to the equity premium estimated for a similar project in a developed country.
Example Yield on 10-year government US$-denominated bond in China: 8.5%. Yield on 10-year US Treasury bond: 6.5%. The annualized of national stock index: 50%. The annualized of national US$-denominated bond index: 20%. The equity risk premium for a project in the US: 10%. Estimate the equity risk premium for a similar project in China. Sovereign yield spread: 8.5% - 6.5% = 2%.
Country risk premium: 2% x (50%/20%) = 5%. Equity risk premium: 5% + 10% = 15%.
6. Marginal Cost Of Capital Structure.

Marginal cost of capital (MCC) is the cost of obtaining another dollar of new capital. The Marginal cost rises as more and more capital is raised during a given period.
The marginal cost of capital schedule is a graph that relates the firm's weighted average cost of each dollar of capital to the total amount of new capital raised.
The cost of capital is level to the point at which one of the costs of capital changes, such as when the company bumps up against a debt covenant, requiring it to use another form of capital. The break point (BP) is the dollar value of new capital that can be raised before an increase in the firm's weighted average cost of capital occurs. Break point = Amount of capital at which the source's cost of capital changes / Proportion of new capital raised from the source
Example Consider the following schedule of the costs of debt and equity for a company. Assuming
Amount of New Debt (in millions) New debt <$5 $5<new debt<$10 New debt >$10
After Tax Cost of Debt 3% 4% 5%
Amount of New Equity (in millions) New equity <$5 $5<new equity <$10 New equity >$10
Cost of Equity
6% 8% 10%
Assuming the company's target capital structure is 50% debt and 50% equity, the corresponding marginal cost of capital schedule looks like this:
The break points are at $10 million and $20 million. The company can invest up to $10 million with WACC = 9%. After $10 million, the company will have to raise new equity and new debt at higher costs, and WACC will rise to be 12% if the company wants to raise an additional $10. MCC is the cost of last dollar raised by the company, while WACC is the weighted average cost of all capital components used by the company. The MCC will increase as a firm raises more and more capital. Large, established firms typically obtain all the equity capital by retained earnings. Due to the floating costs of issuing new stocks, the cost of retained earnings is always less than the cost of newly issued common equity. If a firm requires so much capital that it has to issue new common stock, the WACC will rise because of the increase cost of new equity.
7. Flotation Costs.
The flotation costs are the costs of issuing a new security, including the money investment bankers earn from the spread between their cost and the price offered to the public, and the accounting, legal, printing and other costs associated with the issue.
The amount of flotation costs is generally quite low for debt and preferred stock (often 1% or less of the face value) so we ignore them here. However, flotation costs of issuing common stocks may be substantial so they must be accounted for in the WACC. Generally, we do this by reducing the proceeds from the issue by the amount of the flotation costs, and recalculating the cost of equity.
re = D1/(P0 - F) + g
Example 1
XYZ is contemplating issuing new equity. The current price of their stock is $30 and the company expects to raise its current dividend of $1.25 by 7% indefinitely. If the flotation cost is expected to be 9%, what would be the cost of this new source of capital? Cost of external equity = (1.25 x 1.07) / (30 x (1 - 0.09)) + 0.07 = 11.9%. Without the flotation cost the cost of new equity would be (1.25 x 1.07) / 30 + 0.07 = 11.46%. Note that flotation costs will always be given, but they may be given as a dollar amount, or as a percentage of the selling price. This is a typical example found in most textbooks. One problem with this approach is that the flotation costs are a cash flow at the initiation of the project and affect the value of any project by reducing the initial cash flow. It is not appropriate to adjust the present value of the future cash flows by a fixed percentage. An alternative approach is to make the adjustment to the cash flows in the valuation computation.
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CFA Level 1 Corporate Finance E Book - Part 2

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CFA - Corporate Finance E-book 2 of 7

Corporate Finance E-Book

CFA - Corporate Finance E-book 2 of 7

CFA - Corporate Finance E-book 2 of 7

Qualifying Assets and Costs eligible for capitalization

CFA - Corporate Finance E-book 2 of 7

CFA - Corporate Finance E-book 2 of 7

CFA - Corporate Finance E-book 2 of 7

CFA - Corporate Finance E-book 2 of 7

Initial Cost $1,500,000 $2,300,000 $3,750,000

Annual ATCF Benefits $290,000 $529,000 $940,000

CFA - Corporate Finance E-book 2 of 7

Initial Cost $985,000

Cumulative Cost of the Projects $985,000

$2,154,000 $2,300,000 $1,500,000

$7,069,000 $9,369,000 $10,869,000

11.20% 10.06% 8.19%

CFA - Corporate Finance E-book 2 of 7

CFA - Corporate Finance E-book 2 of 7

CFA - Corporate Finance E-book 2 of 7

CFA - Corporate Finance E-book 2 of 7

2. Cost of debt and preferred stock.

CFA - Corporate Finance E-book 2 of 7

CFA - Corporate Finance E-book 2 of 7

P0 = PMT1/(1 + rd/2) + ... PMTn/(1 + rd/2)n + FV / (1 + rd/2)n

CFA - Corporate Finance E-book 2 of 7

Cost of Preferred Stock

CFA - Corporate Finance E-book 2 of 7

3. Cost Of Common Equity.

CFA - Corporate Finance E-book 2 of 7

The CAPM Approach

CFA - Corporate Finance E-book 2 of 7

Dividend Discount Model Approach

CFA - Corporate Finance E-book 2 of 7

4. Estimating Beta And Determining A Project Beta.

CFA - Corporate Finance E-book 2 of 7

CFA - Corporate Finance E-book 2 of 7

CFA - Corporate Finance E-book 2 of 7

CFA - Corporate Finance E-book 2 of 7

CFA - Corporate Finance E-book 2 of 7

6. Marginal Cost Of Capital Structure.

CFA - Corporate Finance E-book 2 of 7

CFA - Corporate Finance E-book 2 of 7

After Tax Cost of Debt 3% 4% 5%

CFA - Corporate Finance E-book 2 of 7

CFA - Corporate Finance E-book 2 of 7

CFA - Corporate Finance E-book 2 of 7

CFA - Corporate Finance E-book 2 of 7

For FREE Resources

CFA - Corporate Finance E-book 2 of 7

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For any other enquiry / information

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