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Chap 012

The Cost of Equity is the return required by equity investors. The cost of debt and Preferred stock are the divisional and project costs of capital.

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0% found this document useful (0 votes)
495 views

Chap 012

The Cost of Equity is the return required by equity investors. The cost of debt and Preferred stock are the divisional and project costs of capital.

Uploaded by

sueern
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
You are on page 1/ 30

Chapter 12

Cost of Capital

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McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter Outline
• The Cost of Capital: Some Preliminaries
• The Cost of Equity
• The Costs of Debt and Preferred Stock
• The Weighted Average Cost of Capital
• Divisional and Project Costs of Capital

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Why Cost of Capital Is Important?


• Capital budgeting
• r = interest rate, discount rate, required return,
cost of capital, opportunity cost
• The required return on asset depends on the risk
of the asset
• How much return required by investor = cost to
the company
• How to calculate the cost of capital (r)?
– Where the capital being raised
– Return required by capital suppliers

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Capital Components

3 sources of capital:
1) Common stock (Equity) - RE
2) Debts - RD
3) Preferred stock - RP

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1) Cost of Equity (RE)


• The cost of equity is the return required by
equity investors
• There are two major methods for
determining the cost of equity
– Dividend growth model
– SML or CAPM

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The Dividend Growth Model


Approach
• Start with the dividend growth model
formula and rearrange to solve for RE
D1
P0 =
RE −g
D1
RE = +g
P0
Cost of equity = Dividend Yield + Capital gains Yield

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Dividend Growth Model


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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Example: Estimating the
Dividend Growth Rate
• One method for estimating the growth rate is to use the
historical average
Year Dividend Percent Change
– 2000 1.23
– 2001 1.30
– 2002 1.36
– 2003 1.43
– 2004 1.50

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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 aren’t growing at a
reasonably constant rate
– Extremely sensitive to the estimated growth
rate – an increase in g of 1% increases the
cost of equity by 1%
– Does not explicitly consider risk
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The CAPM Approach (SML)


• Derived from Capital Asset Pricing Model

R E = R f + β E [E(R M ) − R f ]

– Rf = Risk-free rate
– E(RM)= Market return
– E(RM) – Rf = Market risk premium,
β = beta = Systematic risk of asset,

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Example - SML

• 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


SML
• 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, which also varies over time
– We are relying on the past to predict the future, which
is not always reliable

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Example – Cost of Equity


• Suppose our company has a beta of 1.5. The market risk
premium is expected to be 9% and the current risk-free
rate is 6%. We have used analysts’ estimates to
determine that the market believes our dividends will
grow at 6% per year and our last dividend was $2. Our
stock is currently selling for $15.65. What is our cost of
equity?

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2) Cost of Debt (RD)

• The cost of debt is the investors’ required return


on company’s debt
• The cost of long-term debt or bonds
• The cost of debt is NOT the coupon rate
• Best estimated by using the Yield to maturity
(YTM) on the existing debt
• YTM is the rate implied by the current bond price
• The rate that equals the PV of bond’s cash flows
with bond price.

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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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3) Cost of Preferred Stock (Rp)


• Preferred generally pays a constant dividend
every period
• Dividends are expected to be paid every period
forever
• Preferred stock is an perpetuity, so we take the
perpetuity formula, rearrange and solve for RP
• PV = C/r ==> P = D/Rp
• RP = D / P0

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Cost of Preferred Stock -


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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Capital Structure Weights


• We can use the individual costs of capital that we
have computed to get our “average” cost of capital
for the firm.
• Weights according to:
– Target capital structure
– Current market value of capital structure
– Book values of capital structure

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Capital Structure Weights
• Suppose you have a market value of equity equal to
$500mil, market value of debt = $475mil and
preferred market value = 25mil:

• Suppose a company has a target debt equity ratio of


0.6:

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Taxes and WACC


• After-tax cash flows After-tax cost of capital
• Interest expense for debt is tax deductible:
– Reduces cost of debt
– After-tax cost of debt = RD(1-TC)
– TC = corporate tax rate
• Dividends for common equity and preferred
equity are not tax deductible.

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Weighted Average Cost of
Capital (WACC)
E D P
WACC = R E + R D (1 − Tc) + R P
V V V
where: E/V = Weight for Equity
RE = Cost of Equity
D/V = Weight for Debt
RD = Cost of Debt
Tc = Corporate tax rate
P/V = Weight for Preferred
Rp = Cost of Preferred
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Example – WACC
• Equity Capital: • Debt Capital:
– 50,000 shares – $1 million in outstanding
– $80 per share debt (at face value)
– Beta = 1.15 – Current quote = 118.39%
– Market risk premium = 9% – Coupon rate = 9%,
– Risk-free rate = 5% semiannual coupons
– 15 years to maturity
• Preferred Capital: – Tax rate = 40%
– 10,000 shares
– $110 per share
– Dividend rate of 5.5%

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Example – WACC

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Example – WACC

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Divisional and Project Costs of


Capital
• Using the WACC as our discount rate is only
appropriate for projects that are the same risk as
the firm’s current operations
• 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
• Divisions also often require separate
discount rates

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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 project’s risk relative to the firm
overall
• Assume WACC=15% for average risk class
• If the project is more risky than the firm, use a
discount rate greater than the WACC (r>15%)
• If the project is less risky than the firm, use a
discount rate less than the WACC (r<15%)

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Subjective Approach - Example


Risk Level Discount Rate

Very Low Risk WACC – 8% =12%

Low Risk WACC – 3% = 17%

Same Risk as Firm WACC = 20%

High Risk WACC + 5% = 25%

Very High Risk WACC + 10% = 30%


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Quick Quiz
• What are the two approaches for computing the cost
of equity?
• How do you compute the cost of debt and the after-
tax cost of debt?
• How do you compute the capital structure weights
required for the WACC?
• What is the WACC?
• What happens if we use the WACC for the discount
rate for all projects?

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Tutorial
• Problem 4, 10 & 18 from page 397

• Problem 18:
- under Debt:
“…a quoted price of 108.” change to
“…a quoted price of 105.34.”

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