cost of capital with examples -weighted average

cost of capital with examples

1. THE COST OF CAPITAL

2. Copyright © 2017 by Nelson Education Ltd. 9- 2

3. Cost of Capital: A Critical Element in Business Decisions Used to decide whether to make an investment in capital projects: Most important business decisions require capital, including decisions to develop new products, build factories and distribution centres, install information technology, expand internationally, and acquire other companies. For each of these decisions, a company must estimate the total investment required and decide whether the expected rate of return exceeds the cost of the capital. Used in compensation plans: The cost of capital is also used in many compensation plans, with bonuses dependent on whether the company’s return on invested capital exceeds the cost of capital Used in choosing the mixture of debt and equity to finance the firm: The cost of capital is also a key factor in choosing the mixture of debt and equity used to finance the firm and in decisions to lease rather than buy assets. As these examples illustrate, the cost of capital is a critical element in business decisions Copyright © 2017 by Nelson Education Ltd. 9- 3

4. 9-1 The Weighted Average Cost of Capital Long-term sources of financing Firms use three major long-term capital to support growth: Long-term debt Preferred stock Common equity These are capital components coming from investors. 9- 4

5. Long-Term Sources of Financing Copyright © 2017 by Nelson Education Ltd. 9- 5

6. Capital Components The returns on these capital components required by investors are costs to a firm – (capital) component costs. Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the cost of capital. We do adjust for these items when calculating the cash flows of a project but not when calculating the cost of capital. Copyright © 2017 by Nelson Education Ltd. 9- 6

7. Defining WACC The cost of capital used to analyze capital budgeting decisions should be a weighted average of the various components’ costs, called the weighted average cost of capital (WACC). WACC is also used to discount a firm’s expected free cash flows to arrive at its value. Copyright © 2017 by Nelson Education Ltd. 9- 7

8. 9-2 After-Tax Cost of Debt, r d (1 – T) Before-tax vs. after-tax capital costs Historical (embedded) costs vs. new (marginal) costs Estimating cost of debt Component cost of debt, r d (1 – T) Copyright © 2017 by Nelson Education Ltd. 9- 8

9. Before-Tax vs. After-Tax Capital Costs Tax effects associated with financing can be incorporated either in capital budgeting cash flows or in cost of capital. Most firms incorporate tax effects in the cost of capital. Therefore, focus on after-tax costs. Only cost of debt is affected. Copyright © 2017 by Nelson Education Ltd. 9- 9

10. Historical (Embedded) Costs vs. New (Marginal) Costs The cost of capital is used primarily to make decisions that involve raising and investing new capital. So we should focus on new, or marginal, costs. The cost of previously issued capital, the historical or embedded cost, is important for decisions such as setting rates for profit regulation, not for investment. Copyright © 2017 by Nelson Education Ltd. 9- 10

11. Estimating Cost of Debt Method 1: Ask an investment banker what the coupon rate would be on new debt. Method 2: Find the bond rating for the company and use the yield on other bonds with a similar rating. Method 3: Find the yield (to maturity or to call) on the company’s debt, if it has any. Copyright © 2017 by Nelson Education Ltd. 9- 11

12. A 22-Year, 7% Semiannual Bond Sells f or $897.26. What’s the Pre-Tax Cost of Debt r d ? 35 35 + 1,000 35 1 2 44 i = ? – 897.26 ... 44 – 897.26 35 1,000 4.0% × 2 = r d = 8% N I/YR PV FV PMT INPUTS OUTPUT Copyright © 2017 by Nelson Education Ltd. 9- 12 Cost of Debt

13. Component Cost of Debt Interest is tax-deductible, so the after-tax (AT) cost of debt is: r d AT = r d (1 – T) r d AT = 8%(1 – 0.30) = 5.6% Use nominal rates. flotation costs . Copyright © 2017 by Nelson Education Ltd. 9- 13 (9-1)

14. Flotation Costs and the Cost of Debt Alternative 1: Find the pre-tax yield based on pre-tax cash flows and then adjust it to reflect taxes and flotation costs Alternative 2: Find the after-tax cost of debt incorporating flotation costs based on after-tax cash flows using this formula: Copyright © 2017 by Nelson Education Ltd. 9- 14 (9-2)

15. Example1 cost of debt Suppose a company will issue new 10-year debt with a par value of $1,000 and a coupon rate of 7.5%, paid annually. The tax rate is 30%. If the flotation cost is 2% of the issue proceeds, what is the after-tax cost of debt? Copyright © 2017 by Nelson Education Ltd. 9- 15

16. Example2,3 cost of debt 2 Duchess Corporation, a major hardware manufacturer, is contemplating selling $10 million worth of 20-year, 9% coupon (stated annual interest rate) bonds, each with a par value of $1,000. Because bonds with similar risk earn returns greater than 9%, the firm must sell the bonds for a 2% discount to compensate for the lower coupon interest rate. The flotation costs are 2%. ( rd 9.45%) 3 Currently, Warren Industries can sell 15-year, $1,000-par-value bonds paying annual interest at a 12% coupon rate. As a result of current interest rates, the bonds can be sold for $1,010 each; flotation costs of $30 per bond will be incurred in this process. The firm is in the 40% tax bracket Copyright © 2017 by Nelson Education Ltd. 9- 16

17. Cost of Preferred Stock r ps = Div /p Or r ps = Div /p(1-F) F=floatation cost Copyright © 2017 by Nelson Education Ltd. 9- 17

18. 9-3 Cost of Preferred Stock , r ps =div/P0 P PS = $25, D PS = $1.75, Par = $25, F = 2.5% No maturity dates. D PS is the annual preferred dividend. r ps = P ps (1 – F) D ps = $1.75 $25(1 – 0.025) = $1.75 $24.37 = 0.072 = 7.2% Copyright © 2017 by Nelson Education Ltd. 9- 18 (9.3)

19. Component Cost of Preferred Stock Flotation costs for preferred are significant, so are reflected. Use net price, i.e., P PS (1 – F). Preferred dividends are not deductible, so no tax adjustment, just r ps . Nominal r ps is used. Copyright © 2017 by Nelson Education Ltd. 9- 19

20. Is Preferred Stock More o r Less Risky to Investors Than Debt? More risky; the company is not required to pay the preferred dividend. However, firms want to pay the preferred dividend. Otherwise, (1) they cannot pay the common dividend, (2) it is difficult to raise additional funds, and (3) preferred stockholders may gain control of firm. Copyright © 2017 by Nelson Education Ltd. 9- 20

21. Cost of pref.stock ex: Long Haul Trucking can issue perpetual preferred stock at a price of $25 a share. The issue is expected to pay a constant annual dividend of $1.75 a share. Ignoring flotation costs, what is the company’s cost of preferred stock, rps ? Burnwood Tech plans to issue some $25 par preferred stock with a 6% dividend. The stock is selling on the market for $27.00, and Burnwood must pay flotation costs of 4% of the market price. What is the cost of the preferred stock? Copyright © 2017 by Nelson Education Ltd. 9- 21

22. 9-4 Cost of Common Stock, r s Two ways of raising common equity Rationale behind assigning a cost to retained earnings Three methods of estimating cost of equity Copyright © 2017 by Nelson Education Ltd. 9- 22

23. Two Ways o f Raising Common Equity Directly, by issuing new shares of common stock Indirectly, by reinvesting earnings that are not paid out as cash dividends — retaining earnings Copyright © 2017 by Nelson Education Ltd. 9- 23

24. Rationale behind Assigning a Cost to Retained Earnings Earnings can be either retained and reinvested or paid out as dividends. Investors could use the cash paid out by the firm to buy other securities and earn a return. Thus, an opportunity cost is incurred if earnings are retained and reinvested. Retained earnings are not free sources of capital. Copyright © 2017 by Nelson Education Ltd. 9- 24

25. Cost for Reinvested Earnings Opportunity cost: The return stockholders could earn on alternative investments of equal risk. They could buy similar stocks and earn r s , or the company could repurchase its own stock and earn r s . So, r s is the cost of reinvested earnings and it is the cost of equity. Copyright © 2017 by Nelson Education Ltd. 9- 25

26. Three Methods of Estimating the Cost of Equity, r S 1. CAPM: r s = r RF + ( r M – r RF )b = r RF + (RP M )b 2. DCF: r s = (D 1 /P )+ g 3. Bond-Yield-Plus-Risk Premium: r s = r d + Bond RP Copyright © 2017 by Nelson Education Ltd. 9- 26 (9-4) (9-6) (9-8)

27. 9-5 The CAPM Approach Four-step process: 1. Estimate the risk-free rate, r RF . 2. Estimate the current expected market risk premium, RP M . 3. Estimate the stock’s beta coefficient, b. 4. Apply the CAPM equation E(r)= rfr + beta*(Rm- Rfr ) Copyright © 2017 by Nelson Education Ltd. 9- 27

28. Estimating t he Risk-Free Rate, r RF Many analysts use the yield on a long-term (10 to 20 years) government bond as a proxy for r RF , because: 1. Most shareholders invest on a long-term basis. 2. Yields on T-bills are more volatile than those on long-term ones and r s . 3. Many projects have long lives. Copyright © 2017 by Nelson Education Ltd. 9- 28

29. Estimating RP M = r M – r RF 1. Historical data: Difference between the historical realized return on stocks and the return for long-term federal government bonds 2. Forward-looking data: The expected market return being the sum of the current dividend yield (on some market index) and the expected growth rate in dividends r M = D 1 /P + g = D (1 + g)/P + g Copyright © 2017 by Nelson Education Ltd. 9- 29

30. Expected Dividend Growth Rate, g The historical dividend growth rate Analysts’ forecasts for earnings growth rates There are problems with both methods; e.g., there is no reason to expect future growth to be exactly like past growth, and growth rates in earnings and in dividends are not always identical. Copyright © 2017 by Nelson Education Ltd. 9- 30

31. Estimating Beta Beta is estimated as the slope efficient in a regression of a company’s stock returns against market return. The historical beta is subject to problems such as: 1. No theoretical guidance as to the correct holding period and 2. Statistical imprecision Choosing beta involves judgment. Copyright © 2017 by Nelson Education Ltd. 9- 31

32. An Illustration of CAPM Given: r RF = 5%, RP M = 5.5%, b i = 1.3 = 5.0% + (5.5%)1.3 = 12.2% r S = r RF + RP M × b i Copyright © 2017 by Nelson Education Ltd. 9- 32

33. Issues in Using CAPM It is difficult to estimate the market risk premium. Most analysts use a rate of 3% to 6% for the market risk premium (RP M ). Estimates of beta vary, and estimates are “noisy” (they have a wide confidence interval). Copyright © 2017 by Nelson Education Ltd. 9- 33

34. 9-6 Dividend-Yield-Plus-Growth-Rate, or Discounted Cash Flow (DCF), Approach Assuming that dividends are expected to grow at a constant rate and That markets are at equilibrium Copyright © 2017 by Nelson Education Ltd. 9- 34 (9-6)

35. Estimating the Growth Rate Use the historical growth rate if you believe the future will be like the past. Apply the retention growth model. Obtain analysts’ estimates from sources such as the Bank of Canada website or the National Post . Uncertainty in the growth estimate induces uncertainty in the DCF cost estimate. Copyright © 2017 by Nelson Education Ltd. 9- 35

36. Retention Growth Model Assumptions: 1. The payout rate and the retention rate are expected to be constant. 2. ROE is expected to remain constant. 3. No new common stock is to be issued or new stock is to be sold at book value. 4. Future projects are to be of the same degree of risk as existing assets. Copyright © 2017 by Nelson Education Ltd. 9- 36

37. Retention Growth Model (cont ’d) NCC has had an average ROE = 14.5% over the past 15 years. The ROE has been relatively steady. NCC’s dividend payout rate has averaged 52% over the same time period. The expected future growth rate: g = (Retention rate)(ROE) g = (1 – payout rate)(ROE) g = (1 – 0.52)(14.5%) = 7% Copyright © 2017 by Nelson Education Ltd. 9- 37 (9-7)

38. Illustration of DCF Approach r s = D 1 P + g = $2.40 $32 + 0.05 = 0.075 + 0.05 = 12.5% Given: D 1 = $2.40; P = $32; g = 5% Copyright © 2017 by Nelson Education Ltd. 9- 38

39. Could DCF Methodology Be Applied 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. Copyright © 2017 by Nelson Education Ltd. 9- 39

40. 9-7 Bond-Yield-Plus-Risk-Premium Approach r s = r d + RP Given r d = 8%, RP = 3.7%, r s = 8% + 3.7% = 11.7% This RP  RP M (CAPM). It is a subjective value between 3% to 5%. Produces ballpark estimate of r s , giving a useful check. Copyright © 2017 by Nelson Education Ltd. 9- 40 (9-8)

41. 9-8 Comparison of t he CAPM, DCF, a nd Bond-Yield-Plus-Risk-Premium Methods Method Estimate CAPM 12.2% DCF 12.5% r d + RP 11.7% Average 12.1% Copyright © 2017 by Nelson Education Ltd. 9- 41

42. Costs of Issuing New Common Stock (External Equity) When a company issues new common stock it also has to pay flotation costs to the underwriter. Issuing new common stock may send a negative signal to the capital markets, which may depress stock price; this is another type of issuing cost. Copyright © 2017 by Nelson Education Ltd. 9- 42

43. 9-9 Adjusting the Cost of Stock for Flotation Costs The cost of new common equity (r e ) is higher than the cost of internal equity ( r S ) due to the flotation costs. Flotation costs depend on the risk of the firm and the amount being raised. Flotation costs are highest for common equity. While firms issue equity infrequently, the per-project cost is fairly small. We usually ignore flotation costs when calculating the WACC. Copyright © 2017 by Nelson Education Ltd. 9- 43

44. Cost of New Common Equity: P = $32, D 1 = $2.40, g = 5%, a nd F = 12.5% r e = D 1 P (1 – F) + g = $2.40 $32(1 – 0.125) + 5.0% = $2.40 $28.00 + 5.0% = 13.6% Copyright © 2017 by Nelson Education Ltd. 9- 44 (9-9)

45. Cost of Equity Including Flotation Costs Ignoring flotation costs, NCC’s shareholders require a return of 12.5% according to DCF model. NCC has to earn a return of 13.6% on newly issued equity capital. Flotation costs add 13.6% – 12.5% = 1.1% to its cost of equity. 1.1% may be added to the cost of equity numbers by using other models. Copyright © 2017 by Nelson Education Ltd. 9- 45

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47. 9-10 Weighted Average Cost of Capital, WACC WACC = w d r d (1 – T) + w ps r ps + w ce r s (or r e ) WACC is the cost incurred to raise each new, or marginal, dollar of capital — not the average cost of dollars raised in the past. The weights, w d , w ps , and w ce , should be based on target capital structure, not on the particular sources of financing in any single year. The target weights should be on market values. Copyright © 2017 by Nelson Education Ltd. 9- 47 (9-10)

48. WACC Calculation WACC = w d r d (1 – T) + w ps r ps + w ce r s Recall: r d = 8%, r PS = 7.2%, r S = 12.1% WACC = 0.3(8%)(0.7) + 0.1(7.2%) + 0.6(12.1%) = 1.68% + 0.72% + 7.26% = 9.7% Copyright © 2017 by Nelson Education Ltd. 9- 48

49. 9-11 Factors That Affect the Weighted Average Cost of Capital Market conditions, especially interest rates, market risk premium, and tax rates, are beyond the firm’s control. The firm’s capital structure, dividend policy, and investment policy can be controlled by a firm. Firms with riskier projects generally have a higher WACC. Copyright © 2017 by Nelson Education Ltd. 9- 49

50. 9-12 Adjusting the Cost of Capital for Risk The divisional cost of capital Techniques for measuring divisional betas Estimating the cost of capital for individual projects Copyright © 2017 by Nelson Education Ltd. 9- 50

51. The Divisional Cost of Capital The cost of capital reflects the average risk and overall capital structure of the entire firm. For a firm with multiple divisions with different degrees of risk, it does not make sense for the firm to use its overall cost of capital (WACC) to evaluate all projects regardless of risk involved. Copyright © 2017 by Nelson Education Ltd. 9- 51

52. Is the Firm’s WACC Correct for Each of Its Divisions? NO! The composite WACC reflects the risk of an average project undertaken by the firm. Different divisions may have different risks. The division’s WACC should be adjusted to reflect the division’s risk and capital structure. Copyright © 2017 by Nelson Education Ltd. 9- 52

53. The Risk-adjusted Divisional Cost of Capital Estimate the cost of capital that the division would have if it were a stand-alone firm. This requires estimating the division’s beta, cost of debt, and capital structure. Copyright © 2017 by Nelson Education Ltd. 9- 53

54. Pure Play Method for Estimating Beta f or a Division or a Project Find several publicly traded companies exclusively in the project’s business. Use the average of their betas as proxy for the project’s beta. It is hard to find such companies. Copyright © 2017 by Nelson Education Ltd. 9- 54

55. Estimating the Cost of Capital for Individual Projects Riskier projects have a higher cost of capital. It is difficult to estimate project risk. Three separate and distinct types of risk: Stand-alone risk Corporate, or within-firm, risk Market, or beta, risk Copyright © 2017 by Nelson Education Ltd. 9- 55

56. How Is Each Type o f Risk Used? Stand-alone risk is easiest to calculate. 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. Copyright © 2017 by Nelson Education Ltd. 9- 56

57. A Project-specific, Risk-adjusted Cost of Capital Start by calculating a divisional cost of capital. Use judgment to scale up or down the cost of capital for an individual project relative to the divisional cost of capital. Copyright © 2017 by Nelson Education Ltd. 9- 57

58. 9-13 Four Mistakes to Avoid Current vs. historical cost of debt Mixing current and historical measures to estimate the market risk premium Book weights vs. market weights Incorrect cost of capital components Copyright © 2017 by Nelson Education Ltd. 9- 58

59. Current vs. Historical Cost o f Debt When estimating the cost of debt, don’t use the coupon rate on existing debt (historical cost of debt). Use the current interest rate on new debt. Copyright © 2017 by Nelson Education Ltd. 9- 59

60. Estimating the Market Risk Premium When estimating the risk premium for the CAPM approach, don’t subtract the current long-term T-bond rate from the historical average return on common stocks. For example, if the historical r M has been about 12.2% and inflation drives the current r RF up to 10%, the current market risk premium is not 12.2% – 10% = 2.2% Copyright © 2017 by Nelson Education Ltd. 9- 60

61. Estimating Weights Use the target capital structure to determine the weights. If you don’t know the target weights, then use the current market value of equity, and never the book value of equity. If you don’t know the market value of debt, then the book value of debt often is a reasonable approximation, especially for short-term debt. Copyright © 2017 by Nelson Education Ltd. 9- 61

62. Capital Components Are Sources of Funding That Come f rom Investors Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the WACC. We adjust for these items when calculating the cash flows of the project but not when calculating the WACC. Copyright © 2017 by Nelson Education Ltd. 9- 62