Finance (FNCE 101)

Cost of Capital Chapters 14,15

Professor WANG Rong

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Weighted Average Cost of Capital

Company cost of capital Defined as the expected rate of return demanded by investors in a company, determined by the average risk the companys securities.

Calculated as the weighted average of the expected returns on debt and equity, i.e., weighted average cost of capital or WACC
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Note: With taxes, WACC Portfolio Return

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WACC - Example
Example - Geothermal Inc. has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company Cost of Capital? Market value of debt (mil) $194 30% Market value of equity (mil) $453 70% Total value $647 100%

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WACC Example Cont.

1. What is the expected return on a portfolio of all the firms securities?

2. What is companys cost of capital?

Interest is tax deductible. Given a 35% tax rate, debt only costs us 5.2% (i.e. 8 % x .65).

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WACC
Weighted -average cost of capital=

D E WACC = (1 TC ) rD rE V V

Where D and E are the market values of debt and equity, V is the market value of the firm. V=D+E. Capital Structure - The firms mix of debt financing and equity financing. What if there are three sources of financing?
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Measuring Capital Structure

Market Value of Bonds - PV of all coupons and par value discounted at the current interest rate.
Market Value of Equity - Market price per share multiplied by the number of outstanding shares.
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Measuring Capital Structure

Calculate the market value of bonds
If the long term bonds pay an 8% coupon annually and mature in 12 years, what is their market value assuming a 9% YTM? The bonds have a face value of $200 million.

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Cost of Equity

The cost of equity is the return required by equity investors given the risk of the cash flows from the firm. There are two major methods for determining the cost of equity.

Dividend growth model CAPM

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The Dividend Growth Model Approach

From the constant dividend growth model we know that D 1 rE g P 0 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?
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How to Estimate the Dividend Growth Rate

Financial analysts forecast Use the historical average

Year Dividend Percent Change 1995 1.23 (1.30 1.23) / 1.23 = 5.7% 1996 1.30 (1.36 1.30) / 1.30 = 4.6% 1997 1.36 (1.43 1.36) / 1.36 = 5.1% 1998 1.43 (1.50 1.43) / 1.43 = 4.9% 1999 1.50 Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%

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Advantages and Disadvantages of Dividend Growth Model

Advantage easy to understand and use Disadvantages

Only applicable to companies currently paying dividends. Not applicable if dividends arent growing at a reasonably constant rate.

Overestimate the expected return if the current rate of growth is very high but can not be sustained.
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Does not explicitly consider risk.

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The CAPM Approach

rE r f E [ rM r f ]

Example: Suppose your company has an equity beta of .58 and the current risk-free rate is 6.1%. If the expected market risk premium is 8.6%, what is your cost of equity capital?
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Advantages and Disadvantages of CAPM

Advantages

Explicitly adjusts for systematic risk. Applicable to all companies, as long as we can compute beta. Have to estimate the expected market risk premium, which does vary over time Have to estimate beta, which also varies over time
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Disadvantages

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Cost of Debt

The cost of debt is the required return on our companys debt, which is estimated by computing the yield-to-maturity on the existing debt. The cost of debt is NOT the coupon rate. We may also use estimates of current rates based on the bond rating we expect when we issue new debt We usually focus on the cost of long-term debt or bonds.
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Exercise - Cost of Debt Example

Suppose we have a bond issue currently outstanding that has 25 years left to maturity. The coupon rate is 9% and coupons are paid semiannually. The bond is currently selling for $908.72 per $1000 bond. What is the cost of debt?

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Cost of Preferred Stock

Reminders Preferred stock is a perpetuity Dividend is constant and paid every period and lasts forever rP = D / P 0 Example: Your company has preferred stock that has an annual dividend of $3. If the current price is $25, what is the cost of preferred stock?
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WACC for Selected Companies

Company requity rdebt E/V D/V WACC

Amazon Dell Boeing Pfizer GE Ford Heizn

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20.4 14.5 8.3 6.2 9.8 12.4 5.1

8.12 5.04 5.04 4.72 4.72 9.68 5.04

0.90 0.99 0.79 0.96 0.79 0.13 0.74

0.10 0.01 0.21 0.04 0.21 0.87 0.26

18.9 14.4 7.2 6.1 7.6 7.1 4.6

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WACC
Three Steps to Calculating Cost of Capital 1. Calculate the value of each security as a proportion of the firms market value. 2. Determine the required rate of return on each security. 3. Calculate the weighted average of these required returns.
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WACC Example I
Example - Executive Fruit has issued debt, preferred stock and common stock. The market value of these securities are $4mil, $2mil, and $6mil, respectively. The required returns are 6%, 12%, and 18%, respectively. The company has a tax rate at 35%. Q: Determine the WACC for Executive Fruit, Inc.
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Exercise - WACC

Equity Information

Debt Information

50 million shares $80 per share Beta = 1.15 Market risk premium = 9% Risk-free rate = 5%

$1000 million in outstanding debt (face value) Current value = 1100 million Coupon rate = 9%, semiannual coupons 15 years to maturity

Tax rate = 40%

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Company Risk vs. Project Risk

Company cost of capital: expected rate of return demanded by investors in a company, determined by the average risk the companys securities. Project cost of capital: minimum acceptable expected rate of return on a project given its risk. If we are looking at a project that is NOT the same risk as the firm, then we need to determine the appropriate discount rate for that project
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Company Risk vs. Project Risk

Example - Based on the CAPM, ABC Company has a cost of capital of 17%. [4 + 1.3(10)]. A breakdown of the companys investment projects is listed below. When evaluating a new dog food production investment, which cost of capital should be used?
1/3 Nuclear Parts Mfr. B=2.0 1/3 Computer Hard Drive Mfr. B=1.3 1/3 Dog Food Production B=0.6 AVG. B of assets = 1.3
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Using WACC for All Projects Example

What would happen if we use the WACC for all projects regardless of risk? Assume the WACC = 15% (suppose we can use standard IRR rule to evaluate the following projects)
Project A B C Required Return 20% 15% 10% IRR 17% 18% 12%

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Pure Play Approach

Find one or more companies that specialize in the product or service that we are considering Compute the beta for each company Take an average Use that beta along with the CAPM to find the appropriate return for a project of that risk Often difficult to find pure play companies

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Subjective Approach

Consider the projects risk relative to the firm overall and adjust Risk Level Very Low Risk Low Risk Discount Rate WACC 8% WACC 3%

Same Risk as Firm

High Risk Very High Risk
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WACC
WACC + 5% WACC + 10%

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Flotation Costs

Flotation costs the cost of issuing new securities. These costs should be taken into account when evaluating a new project. Basic Approach

Compute the weighted average flotation cost Use the target weights because the firm will issue securities in these percentages over the long term
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NPV and Flotation Costs - 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 7 years. The WACC is 15% and the firms target D/E ratio is .6 The flotation cost for equity is 5% and the flotation cost for debt is 3%. What is the NPV for the project after adjusting for flotation costs?

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Raising capital (Chapter 15)

How do firms raise capital to finance investment projects? Venture Capital (VC) Initial Public Offering (IPO) Seasoned Equity Offering (SEO) Long-term debt

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Venture Capital

Financing for new, often high-risk start-up ventures. Money provided by investors to startup firms and small businesses when the startups do not have access to capital markets (before IPO) VC typically entails high risk for the investor, but it has the potential for above-average returns.

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RISK/RETURN OF DIFFERENT ASSET CLASSES (1926 PRESENT)

Mean Returns
Stocks Bonds T-Bills Real Estate Venture Cap 11.2% 5.3% 3.8% 10% 19%

Std Dev
20.3% 8.6% 3.2% 14% 45%

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Initial Public Offering

A companys first equity issue made available to the public (The first sale of stock by a private company to the public). In an IPO, underwriting firms (underwriters, usually investment banks) are usually involved, which helps the issuing firm determine what type of security to issue (common or preferred), the best offering price and the time to bring it to market.
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IPO Underpricing

IPOs are often underpriced.

The offering price is lower than the closing price on the first day.

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IPO Underpricing

Possible reasons: difficult to price an IPO no current market price available. Underpricing is a compensation for bearing risk of investing in a small and young company. Underpricing serves as an insurance for the underwriter Underwriters want to ensure that their clients earn a good return on IPOs so as to maintain a good relationship with them.

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Seasoned Equity Offering

A new equity issue of securities by a company that has previously issued security to the public. Stock prices tend to decline when companies announce that new equity will be issued (SEO). Possible explanations for this phenomenon

Managerial information Stocks are overvalued. Why issue equity rather than debt? Issue costs Part of the firms value goes to underwriters. Managers time is spent working on the new issue.
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Types of Long-term Debt

Term loans

Direct business loans from commercial banks, insurance companies, etc. Bonds sold to a limited number of investors Bonds sold to the public, available to all investors. In the event of a default, its harder for firms to renegotiate with investors of a public issue since hundreds of holders are involved. The interest rates on public issues of bonds are lower than those on private issues or term loans.

Private placements of bond issues

Public issue of Bonds

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Homework Assignments

Problems are posted at eLearn. Read chapter 15.

Next week: Capital Structure Option Valuation (chapters 24,25)

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