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1、,CHAPTER 10The Cost of Capital,Cost of capital componentsAccounting for flotation costsWACCAdjusting cost of capital for riskEstimating project risk,What types of capital do firms use?,DebtPreferred stockCommon equity:Retained earnings New common stock,Should we focus on before-tax or after-tax capi
2、tal costs?,Should we focus on historical(embedded)costs or new(marginal)costs?,A 15-year,12%semiannual bond sells for$1,153.72.Whats kd?,60,60+1,000,60,0,1,2,30,i=?,30-1153.72 60 1000 5.0%x 2=kd=10%,-1,153.72,.,INPUTS,OUTPUT,Component Cost of Debt,Interest is tax deductible,sokd AT=kd BT(1 T)=10%(1
3、0.40)=6%.Use nominal rate.Flotation costs small.Ignore.,Whats the cost of preferred stock?Pp=$111.10;10%Q;Par=$100.,Use this formula:,Picture of Preferred Stock,2.50,2.50,0,1,2,kp=?,-111.1,.,2.50,$111.10=.kPer=2.25%;kp(Nom)=2.25%(4)=9%.,DQkPer,$2.50kPer,$2.50$111.10,Note:,Preferred dividends are not
4、 tax deductible,so no tax adjustment.Just kp.Nominal kp is used.Our calculation ignores flotation costs.,Is preferred stock more or less risky to investors than debt?,More risky;company not required to pay preferred dividend.However,firms try to pay preferred dividend.Otherwise,(1)cannot pay common
5、dividend,(2)difficult to raise additional funds,(3)preferred stockholders may gain control of firm.,Why is yield on preferred lower than kd?,Corporations own most preferred stock,because 70%of preferred dividends are nontaxable to corporations.Therefore,preferred often has a lower B-T yield than the
6、 B-T yield on debt.The A-T yield to an investor,and the A-T cost to the issuer,are higher on preferred than on debt.Consistent with higher risk of preferred.,Example:,kp=9%kd=10%T=40%,kp,AT=kp kp(1 0.7)(T),=9%9%(0.3)(0.4)=7.92%.,kd,AT=10%10%(0.4)=6.00%.,A-T Risk Premium on Preferred=1.92%.,Why is th
7、ere a cost for retained earnings?,Earnings can be reinvested or paid out as dividends.Investors could buy other securities,earn a return.Thus,there is an opportunity cost if earnings are retained.,Opportunity cost:The return stockholders could earn on alternative investments of equal risk.They could
8、 buy similar stocks and earn ks,or company could repurchase its own stock and earn ks.So,ks is the cost of retained earnings.,Three ways to determine cost of common equity,ks:,1.CAPM:ks=kRF+(kM kRF)b.2.DCF:ks=D1/P0+g.3.Own-Bond-Yield-Plus-Risk Premium:ks=kd+RP.,Whats the cost of common equity based
9、on the CAPM?kRF=7%,RPM=6%,b=1.2.,ks=kRF+(kM kRF)b.,=7.0%+(6.0%)1.2=14.2%.,Whats the DCF cost of commonequity,ks?Given:D0=$4.19;P0=$50;g=5%.,D1P0,D0(1+g)P0,$4.19(1.05)$50,ks=+g=+g=+0.05=0.088+0.05=13.8%.,Suppose the company has been earning 15%on equity(ROE=15%)and retaining 35%(dividend payout=65%),
10、and this situation is expected to continue.Whats the expected future g?,Retention growth rate:g=(1 Payout)(ROE)=0.35(15%)=5.25%.Here(1 Payout)=Fraction retained.Close to g=5%given earlier.Think of bank account paying 10%with payout=100%,payout=0%,and payout=50%.Whats g?,Could DCF methodology be appl
11、ied if g is not constant?,YES,nonconstant g stocks are expected to have constant g at some point,generally in 5 to 10 years.But calculations get complicated.,Find ks using the own-bond-yield-plus-risk-premium method.(kd=10%,RP=4%.),This RP CAPM RP.Produces ballpark estimate of ks.Useful check.,ks=kd
12、+RP=10.0%+4.0%=14.0%,Whats a reasonable final estimate of ks?,MethodEstimateCAPM 14.2%DCF 13.8%kd+RP 14.0%Average 14.0%,1.When a company issues new common stock they also have to pay flotation costs to the underwriter.2.Issuing new common stock may send a negative signal to the capital markets,which
13、 may depress stock price.,Why is the cost of retained earnings cheaper than the cost of issuing new common stock?,Two approaches that can be used to account for flotation costs:,Include the flotation costs as part of the projects up-front cost.This reduces the projects estimated return.Adjust the co
14、st of capital to include flotation costs.This is most commonly done by incorporating flotation costs in the DCF model.,New common,F=15%:,Comments about flotation costs:,Flotation costs depend on the risk of the firm and the type of capital being raised.The flotation costs are highest for common equi
15、ty.However,since most firms issue equity infrequently,the per-project cost is fairly small.We will frequently ignore flotation costs when calculating the WACC.,Whats the firms WACC(ignoring flotation costs)?,WACC=wdkd(1 T)+wpkp+wcks=0.3(10%)(0.6)+0.1(9%)+0.6(14%)=1.8%+0.9%+8.4%=11.1%.,What factors i
16、nfluence a companys composite WACC?,Market conditions.The firms capital structure and dividend policy.The firms investment policy.Firms with riskier projects generally have a higher WACC.,WACC Estimates for Some Large U.S.Corporations,Nov.1999,CompanyWACCIntel12.9%General Electric11.9Motorola11.3Coc
17、a-Cola11.2Walt Disney10.0 AT&T 9.8Wal-Mart 9.8Exxon 8.8H.J.Heinz 8.5BellSouth 8.2,Should the company use the composite WACC as the hurdle rate for each of its projects?,NO!The composite WACC reflects the risk of an average project undertaken by the firm.Therefore,the WACC only represents the“hurdle
18、rate”for a typical project with average risk.Different projects have different risks.The projects WACC should be adjusted to reflect the projects risk.,Risk and the Cost of Capital,Divisional Cost of Capital,What are the three types of project risk?,Stand-alone riskCorporate riskMarket risk,How is e
19、ach type of risk used?,Market risk is theoretically best in most situations.However,creditors,customers,suppliers,and employees are more affected by corporate risk.Therefore,corporate risk is also relevant.,Subjective adjustments to the firms composite WACC.Attempt to estimate what the cost of capit
20、al would be if the project/division were a stand-alone firm.This requires estimating the projects beta.,What procedures are used to determine the risk-adjusted cost of capital for a particular project or division?,Methods for Estimating a Projects Beta,1.Pure play.Find several publicly traded compan
21、ies exclusively in projects business.Use average of their betas as proxy for projects beta.Hard to find such companies.,2.Accounting beta.Run regression between projects ROA and S&P index ROA.Accounting betas are correlated(0.5 0.6)with market betas.But normally cant get data on new projects ROAs be
22、fore the capital budgeting decision has been made.,Find the divisions market risk and cost of capital based on the CAPM,given these inputs:,Target debt ratio=40%.kd=12%.kRF=7%.Tax rate=40%.betaDivision=1.7.Market risk premium=6%.,Beta=1.7,so division has more market risk than average.Divisions requi
23、red return on equity:ks=kRF+(kM kRF)bDiv.=7%+(6%)1.7=17.2%.WACCDiv.=wdkd(1 T)+wcks=0.4(12%)(0.6)+0.6(17.2%)=13.2%.,How does the divisions market risk compare with the firms overall market risk?,Division WACC=13.2%versus company WACC=11.1%.Indicates that the divisions market risk is greater than firms average project.“Typical”projects within this division would be accepted if their returns are above 13.2%.,
