Professional Documents
Culture Documents
Slide Contents
Learning Objectives Principles Used in This Chapter
1. The Cost of Capital: An Overview 2. Determining the Firms Capital Structure Weights 3. Estimating the Costs of Individual Sources of Capital 4. Summing Up Calculating the Firms WACC 5. Estimating Project Cost of Capital 6. Floatation costs and Project NPV
Key Terms
Copyright 2011 Pearson Prentice Hall. All rights reserved.
14-2
Learning Objectives
1. Understand the concepts underlying the firms overall cost of capital and the purpose of its calculation. 2. Evaluate a firms capital structure, and determine the relative importance (weight) of each source of financing. 3. Calculate the after-tax cost of debt, preferred stock, and common equity.
14-3
14-4
14-5
14-6
14-8
14-9
14-10
14-11
WACC equation
14-12
14-13
14-14
14-15
14-16
14-18
14-19
Checkpoint 14.1
Calculating the WACC for Templeton Extended Care Facilities, Inc.
In the spring of 2010, Templeton was considering the acquisition of a chain of extended care facilities and wanted to estimate its own WACC as a guide to the cost of capital for the acquisition. Templetons capital structure consists of the following:
14-20
Checkpoint 14.1
Calculating the WACC for Templeton Extended Care Facilities, Inc. (Cont.)
Templeton contacted the firms investment banker to get estimates of the firms current cost of financing and was told that if the firm were to borrow the same amount of money today, it would have to pay lenders 8%; however, given the firms 25% tax rate, the after-tax cost of borrowing would only be 6% 8%(1.25). Preferred stockholders currently demand a 10% rate of return, and common stockholders demand 15%. Templetons CFO knew that the WACC would be somewhere between 6% and 15% since the firms capital structure is a blend of the three sources of capital whose costs are bounded by this range.
14-21
Checkpoint 14.1
14-22
Checkpoint 14.1
14-23
Checkpoint 14.1
14-24
14-25
12%
10%
8%
6%
4%
2%
14-26
37.5% Debt
14-27
14-28
14-29
Step 3: Solve
The WACC is equal to 11.625% as calculated below.
Weights Debt Common Stock 0.375 0.625 Cost 0.06 0.15 Product 0.0225 0.09375
Preferred Stock
0
1
0.1
WACC
0
0.11625
14-30
Step 4: Analyze
We observe that as Templeton chose to increase the level of debt to 37.5% and retire the preferred stock, the WACC decreased marginally from 12.125% to 11.625%. Thus altering the weights will change the WACC.
14-31
14-34
14-35
14-36
14-37
14-38
14-39
14-40
14-41
14-42
14-43
14-44
14-45
14-46
Checkpoint 14.2
Estimating the Cost of Common Equity for Pearson plc Using the Dividend Growth Model Pearson plc (PSO) is an international media company that operates three business groups: Pearson Education, the Financial Times, and Penguin. In the spring of 2009, Pearsons CFO called for an update of the firms cost of capital. The first phase of the estimation focused on the firms cost of common equity. How would the CFO determine the cost of the companys equity, using the dividend growth model?
14-47
Checkpoint 14.2
14-48
Checkpoint 14.2
14-49
Checkpoint 14.2: Check Yourself Prepare two additional estimates of Pearsons cost of common equity using the dividend growth model where you use growth rates in dividends that are 25% lower than the estimated 6.25% (i.e., for g equal to 5% and 7.81%)
14-50
14-51
14-52
14-53
Step 3: Solve
14-54
14-55
Step 4: Analyze
Pearsons cost of equity is estimated at 9.89% and 12.83% based on the different assumptions for growth rate.
Thus growth rate is an important variable in determining the cost of equity. However, estimating the growth rate is not easy.
14-56
We can also estimate the growth rate using the historical data and computing the arithmetic average or geometric average.
14-57
14-58
14-59
14-60
14-61
14-62
14-63
Checkpoint 14.3
Estimating the Cost of Common Equity for Pearson plc using the CAPM
A review of current market conditions at the end of March 2009 reveals that the 10-year U.S. Treasury Bond yield that we will use to measure the risk-free rate was 2.81%, the estimated market risk premium is 6.5%, and the beta for Pearsons common stock is 1.20.
Determine Pearsons cost of common equity using the CAPM, as of March 2009.
14-64
Checkpoint 14.3
14-65
Checkpoint 14.3
14-66
14-67
14-68
14-69
14-70
14-71
14-72
Step 3: Solve
14-73
Step 4: Analyze
Pearsons cost of equity is shown to be sensitive to the estimates used for riskfree rate of interest, beta and market risk premium. Based on the estimates used, the cost of common equity ranges from 4.03% to 15.73%.
14-74
14-76
14-77
14-79
14-80
14-81
14-82
14-83
The divisions are generally defined by geographical regions (e.g., Asian region versus European region) or industry.
14-84
14-85
The estimate of pure play firms cost of capital can then be used as a proxy for that particular divisions cost of capital.
14-86
14-87
14-88
14-89
For example, these costs may include fees paid to an investment banker, and costs incurred when securities are sold at a discount to the current market price.
14-91
14-92
14-93
= $100 million (1-.055) = $105.82 million Thus the firm will raise $105.82 million, which includes floatation cost of $5.82 million.
14-94
Checkpoint 14.4
Incorporating Flotation Costs into the Calculation of NPV
The Tricon Telecom Company is considering a $100 million investment that would allow it to develop fiber optic high-speed Internet connectivity to its 2 million subscribers. The investment will be financed using the firms desired mix of debt and equity with 40% debt financing and 60% common equity financing. The firms investment banker advised the firms CFO that the issue costs associated with debt would be 2% while the equity issue costs would be 10%. Tricon uses a 10% cost of capital to evaluate its telecom investments and has estimated that the new fiber optic project will yield future cash flows valued at $115 million. However, to this point no consideration has been given to the effect of the costs of raising the financing for the project or flotation costs. Should the firm go forward with the investment in light of the flotation costs?
Copyright 2011 Pearson Prentice Hall. All rights reserved.
14-95
Checkpoint 14.4
14-96
Checkpoint 14.4
14-97
Checkpoint 14.4
14-98
14-99
NPV
= PV(inflows) Initial outlay Floatation costs
14-100
Initial Outlay
NPV
Floatation costs
14-101
14-102
14-103
Step 3: Solve
We can use equation 14-5 to estimate the weighted average floatation cost as follows:
14-104
= $100 million (1- 0.102) = $111.36 million Thus, floatation costs is equal to $11.36 million.
14-105
14-106
Step 4: Analyze
The project is feasible even after consideration of higher floatation costs as the NPV is positive at $3.64 million.
However, the problem illustrates that floatation costs can be significant and cannot be ignored while evaluating projects.
14-107
Key Terms
Cost of capital Cost of debt Cost of preferred equity Cost of common equity Divisional WACC Floatation costs Weighted Average Cost of Capital
14-108