Q13.

10 from textbook
Return
State Pr A B C
Boom 0.30 0.30 0.45 0.33
Good 0.40 0.12 0.10 0.15
Poor 0.25 0.01 -0.15 -0.05
Bust 0.05 -0.06 -0.30 -0.09
Your portfolio is invested 30% each in A and C and 40% in B.
a) What is the portfolio expected return?
b) What are the portfolio variance and standard deviation?

1
Chapter 14

Cost of Capital

2
Learning Objectives

Calculate a firms cost of debt

Calculate a firms cost of preferred equity
Calculate a firms cost of common equity
Calculate a firms overall cost of capital
Account for issuing costs
Understand pitfalls of overall cost of capital
and how to manage them

3
Valuing Projects

A projects contribution to firm value is the net

present value of expected cash flows
Discount cash flows using the ____________
Required rate of return for firms projects
______________ (from financial side of firm) is
indication of investors view of:
Riskiness of a firms projects (from operations side of
firm)
Rate of return currently available on investments of
similar risk (current market conditions)

4
Assumptions for Use of
WACC
1 The risk of projects under consideration
matches typical risk of firms projects

2 The mixture of debt and equity to fund the

projects matches the current capital structure
of the firm

5
Measuring Cost of Capital

Use after-tax costs to the firm

Weight by the proportions in the capital
structure

1.97%
1.09
7.20
10.26%

6
Cost of Debt:
Required vs Market
Yield
Investors lend money to the firm when they buy

the firms bonds

Investors in new debt will judge the ability of the
firm to pay the coupons and the principal
The required yield to maturity will reflect the markets
judgement of risk
Outstanding bonds will differ by:
coupon rate
years to maturity
bond rating

7
Measuring Cost of Debt

Firm can deduct interest payments on debt

YieldonFirmsDebt

After-tax Cost of Debt = Rd ( 1 - T )

FirmsMarginalTaxRate

8
Example: Measuring Cost of
Debt - 1
Pogo Petroleum Company can issue debt
yielding 9%. The company is paying a 42%
tax rate. What is the after-tax cost of debt?

9
Example: Cost of Debt
Suppose we have a bond issue 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. The corporate tax rate
is 35%. What is the after-tax cost of debt?

10
Cost of Preferred Stock:
Market Yield
Determining yield is simpler than for debt
No maturity issue (for vanilla preferred)
Dividends not tax deductible, so no tax adjustment

Use the market yield on the firms

outstanding preferred stock

11
Measuring Cost of Preferred
Stock
CurrentSharePrice

R p = Dp / P

Preferred
Dividend

12
Example: Cost of Preferred
Stock
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?

13
Cost of Common Equity:
Discounted Cash Flows
Determining yield is complicated:
CFs (dividends) are not guaranteed
Growth rate hard to forecast
Current price can be volatile

D1 D1
P0 Re g
Re g P0

14
Example: Dividend Growth
Model
Suppose that your company is expected to pay a
dividend of $1.50 per share next year. Dividends
have had a steady growth of 5.1% per year and the
market expects that to continue. The current price is
$25. What is the cost of equity?

15
Example: Estimating the
Dividend Growth Rate
Arithmetic Average
One method for estimating the growth rate is
to use the historical average
Year Dividend Percent Change
1995 1.23
1996 1.30
(1.30 1.23) / 1.23 = %
1997 1.36 (1.36 1.30) / 1.30 = %
1998 1.43 (1.43 1.36) / 1.36 = %
1999 1.50 (1.50 1.43) / 1.43 = %

16
Example: Estimating the
Dividend Growth Rate
Geometric Average
One method for estimating the growth rate is
to use the historical average
Year Dividend
1995 1.23
1996 1.30
1997 1.36
1998 1.43
1999 1.50

17
Cost of Common Equity -
CAPM
Using the CAPM to determine the required
yield on equity
Expected return required Expected return on the
by investors in stock j (well-diversified)
market portfolio

kj = Rf + j [E(Rm) Rf]

Return on a risk- Riskiness of stock j

free investment relative to the riskiness
of the market portfolio

18
CAPM: What is the required
yield on a security?
How risky is stock j relative to the well-
diversified market portfolio?

19
Advantages and Disadvantages of
Dividend Growth Model
Advantage
Dividends and current price usually are easy to observe

Disadvantages
Only applicable to companies currently paying dividends
Not applicable if dividends arent growing at a reasonably
constant rate
Extremely sensitive to the estimated growth rate
Does not explicitly account for risk

20
Advantages and
Disadvantages of CAPM
Advantages
Explicitly adjusts for systematic risk
Applicable to all companies, as long as we can compute
beta

Disadvantages
Have to estimate the expected market risk premium, which
does vary over time
Have to estimate beta

21
Weighted Average Cost of
Capital - WACC
Use the individual costs of capital to get our
average cost of capital for the firm.
This average is the required return on our
assets, using the markets perception of the
risk of those assets
The weights are determined by how much of
each type of financing that we use

22
Capital Structure Weights
E = market value of common equity
= # outstanding shares price per share
P = market value of preferred equity
= # outstanding shares price per share
D = market value of debt
= # outstanding bonds bond price
V = market value of the firm = D + E + P
Weights
wE = E / V = percent financed with common equity
wP = P / V = percent financed with preferred equity
wD = D / V = percent financed with debt

23
Example: Capital Structure
Weights 1
Suppose you have a market value of equity
equal to $500 million and a market value of
debt equal to $475 million.
What are the capital structure weights?

24
Example: Capital Structure
Weights 2
Suppose you have a market value of the firm
equal to $975 M and a target D/E ratio of 1/2.
What are the capital structure weights?

25
WACC

WACC = wE RE + wP RP + wD RD (1-TC)

Interest is tax deductible, but dividends are

not

26
Example: WACC
Equity Information Debt Information
50 million shares $1 billion in outstanding
$80 per share debt (face value)
Beta = 1.15 Current quote = 110
Market risk premium = Coupon rate = 9%, semi-
9% annual coupons
Risk-free rate = 5% 15 years to maturity
Tax rate = 40%

27
Managing Business &
Financial Risks
Debt / equity tends to be higher when cash
flow uncertainty is lower
Utility high D/E Mining low D/E

Debt / equity tends to be higher when firms

assets are tangible
Real estate high R&D firm low

28
Flotation Costs

Compute the weighted average flotation cost

Add this to the project cost
Use the target weights because the firm will
f

issue securities in these percentages over

the long term

Weighted Average Flotation Cost:

E P D
f A f E f P fd
V V V

29
Example: NPV and Flotation
Costs
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 0.6. 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?

30
Chapter 15

Raising Capital

31
Learning Objectives

Describe the financing for early-stage

businesses
Describe how securities are sold to the public
and the role of investment bankers
Describe initial public offerings and the costs
of going public
Perform calculations associated with rights
offerings

32
Start-Up Financing
Personal investment

Love money

Angel investors

Venture capital

33
Venture Capital
Private financing for relatively new businesses in
exchange for stock

Usually entails some hands-on guidance

Usual goal is to take the company public

VC benefits from the capital raised in the IPO

Many VC firms are formed from a group of investors

that pool capital and then have partners in the firm
decide which companies will receive financing

34
Small Business Financing

Venture capital

Business incubators

Government grants

Bank loans

35
Issuing Securities to the
Public
Public issue the creation and sale of
securities that are intended to be traded on
the public markets

All companies listed on the Toronto Stock

Exchange come under the Ontario Securities
Commissions jurisdiction
Securities regulation is provincial

36
Advantages of Going Public

Current stockholders can diversify

Liquidity is increased
Easier to raise capital in the future
Larger pool of capital may decrease cost of
capital
Going public establishes firm value
Facilitate merger negotiations
Increases customer recognition

37
Disadvantages of Going
Public
Must file numerous reports, with costs involved
Operating data must be disclosed
Officers must disclose holdings
Special deals to insiders will be more difficult
A small new issue may not be actively traded, so
market-determined price may not reflect true
value
Managing investor relations is time-consuming

38
Selling Securities to the Public
Management must obtain permission from the
Board of Directors
Prepare and distribute copies of a preliminary
prospectus (red herring) to the OSC and to potential
investors
OSC studies the preliminary prospectus and notifies
the company of required changes (usually 2 weeks)
Once the prospectus is approved, the price is
determined and security dealers can begin selling
the new issue

39
First and Later Public Issues
IPO
Initial Public Offering (or unseasoned new issue).
A companys first equity issue made available to the public.

SEO
Seasoned Equity Offering.
A new issue for a company that has previously issued
securities to the public.

40
Alternative Issue Methods
Cash Offer
New securities offered for sale to the general
public on a cash basis through an investment
bank

Firm Commitment

Best Efforts

Bought Deal

41
IPO Under Pricing

May be difficult to price an IPO because there

isnt a current market price available
Additional asymmetric information associated
with companies going public
Underwriters want to ensure that their clients
earn a good return on IPOs on average
Underpricing causes the issuer to leave
money on the table

42
The Cost of Issuing Securities
Direct expenses:
Spread
Legal fees, filing fees

Indirect expenses
Management time spent working on issue
Must share control with outsiders
Abnormal returns
Price of existing stock tends to decline when new equity is
issued
IPO Underpricing
Over allotment (Green Shoe) option
Additional shares that the syndicate can purchase after the
issue has gone to market

43
Alternative Issue Methods
Rights Offering
New securities offered first to existing shareholders.
More common outside North America.
Allows current shareholders to avoid the dilution that
can occur with a new stock issue
Rights given to the shareholders specify:
Number of shares that can be purchased
Purchase price
Time frame
Rights usually trade on the same exchange as the
companys stock

44
Valuing Rights

The price specified in a rights offering is

generally less than the current market price
The share price will adjust based on the number
of new shares issued and the subscription price

Pcumrights S
Value of right , R
N 1
Pexrights S
Value of right , R
N

45
Example: Rights Offering by
Walton Corporation
Walton Corporation
Share price $40
Shares outstanding 9 million
Equity market value $360 million
Required capital funds $30 million
Subscription price $30
New shares required 1 million

How many rights should be needed to

purchase one new share?
What is the monetary value of these rights?
46
Quick Quiz: Rights Offering

Suppose a company wants to raise $10 M.

The subscription price is $20 and the current
stock price is $25. The firm currently has
5,000,000 shares outstanding.
How many shares have to be issued?
How many rights will it take to purchase one
share?
What is the value of a right?

47
Timing of Rights Issue

Shares go ex-rights 2 business days before

record date.
Price decreases by value of right on ex-rights day

48
Example: Valuing Rights - 1

Madonna Fashions, Inc. has issued rights to its

shareholders. Five rights are needed along with
the $45 subscription price to buy one new
share. The stock is selling for $54 rights-on.
a) What would be the value of one right?
b) What would be the new share price once the
stock goes ex-rights?

49
Example: Valuing Rights - 2

Brandi Wines is planning a rights offering to

raise funds for a $3.8 million project. The price
of the 600,000 shares currently outstanding is
$47. Brandis underwriter is charging a 5%
spread. The subscription price is $40. You have
decided not to purchase any of the new shares.
If you own 4,000 shares, for how much can you
sell your rights?

50
Advantages of Rights
Offerings
Shareholders maintain proportionate
ownership

Taps firms built-in market for new issues

Issue costs are lower than straight public

issue

Trading of shares plus rights can increase

interest in firm

51
Types of Long-term Debt
Bonds public issue of long-term debt
Private issues
Term loans
Direct business loans from commercial banks, insurance
companies, etc.
Maturities 1 5 years
Repayable during life of the loan

Private placements
Similar to term loans with longer maturity
Easier to renegotiate than public issues
Lower costs than public issues

52
Q14.21 from textbook

Knight, Inc. recently issued new securities to

finance a new TV show. The project cost $2.1
million and the company paid $128,000 in
flotation costs. In addition, the equity issued
had a flotation cost of 8% of the amount
raised, whereas the debt issued had a
flotation cost of 3% of the amount raised. If
Knight issued new securities in the same
proportion as its target capital structure, what
is the companys target debt-equity ratio?

53