financialandTHE COST OF CAPITAL ppt.pptx

cost of capital

1. CHAPTER 9 THE COST OF CAPITAL

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

3. 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. Copyright © 2017 by Nelson Education Ltd. 9- 3

4. 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- 4

5. 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- 5

6. 9-2 After-Tax Cost of Debt, r d (1 – T) Before-tax vs. after-tax capital costs Estimating cost of debt Component cost of debt, r d (1 – T) Copyright © 2017 by Nelson Education Ltd. 9- 6

7. Estimating Cost of Debt 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% 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. Ignore flotation costs if they are small. N I/YR PV FV PMT INPUTS OUTPUT 9- 7

8. Flotation Costs and the Cost of Debt Copyright © 2017 by Nelson Education Ltd. 9- 8 (9-2) Suppose NCC can issue 30-year debt with an annual coupon rate of 8%, with coupons paid semi-annually. The flotation costs, F, are equal to 5% of the value of the issue. Find after tax cost of debt

9. Suppose NCC can issue 30-year debt with an annual coupon rate of 8%, with coupons paid semi-annually. The flotation costs, F, are equal to 3% in addition to 2% discount of the value of the issue. Copyright © 2017 by Nelson Education Ltd. 9- 9

10. 9-3 Cost of Preferred Stock , r ps P PS = $25, D PS = 7%, Par = $25, F = 2.5% No maturity dates. D PS is the annual preferred dividend. r ps = P ps (1 – F) D ps = 0.07($25) $25(1 – 0.025) = $1.75 $24.37 = 0.072 = 7.2% Copyright © 2017 by Nelson Education Ltd. 9- 10 (9.3)

11. A company’s preferred stock currently trades at $27 per share and pays a $1.50 annual dividend per share. Flotation costs are equal to 3% of the proceeds. If the company issues preferred stock, what is the cost of the newly issued preferred stock? Copyright © 2017 by Nelson Education Ltd. 9- 11

12. 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- 12

13. 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- 13

14. 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- 14

15. 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- 15

16. 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- 16

17. 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- 17 (9-4) (9-6) (9-8)

18. 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 (9-4). Copyright © 2017 by Nelson Education Ltd. 9- 18

19. 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- 19

20. A company’s beta is 1.4. The yield on a long-term government bond is 5%. If the market risk premium is 5.5%, what is rs ? Copyright © 2017 by Nelson Education Ltd. 9- 20

21. 9-6Dividend-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 Ex1:To illustrate the DCF approach, suppose NCC’s stock sells for $32; its next expected dividend is $2.40; and its expected growth rate is 5%. NCC’s expected and required rate of return, Ex2: A company’s estimated growth rate in dividends is 6%. Its current stock price is $40 and its expected annual dividend is $2. Using the DCF approach, what is rs ? Copyright © 2017 by Nelson Education Ltd. 9- 21

22. 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- 22 (9-7)

23. 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- 23

24. 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%. Ex: A company’s bond yield is 7%. If the appropriate bond risk premium is 3.5%, what is rs , based on the bond-yield-plus-risk-premium approach? Copyright © 2017 by Nelson Education Ltd. 9- 24 (9-8)

25. Costs of Issuing New Common Stock (External 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- 25 (9-9)

26. 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- 26 (9-10)

27. WACC Calculation WACC = w d r d (1 – T) + w ps r ps + w ce r s A firm has the following data: Target capital structure of 25% debt, 10% preferred stock, and 65% common equity; Tax rate = 30%; rd = 7%; r ps = 7.5%; and r s = 11.5%. Assume the firm will not issue new stock. What is this firm’s WACC? Copyright © 2017 by Nelson Education Ltd. 9- 27

28. WACC Brightview Utilities Inc. (BVU) has the following capital structure, which it considers to be WACC optimal: debt = 35%, preferred stock = 15%, and common stock = 50%. BVU’s tax rate is 30%, and investors expect earnings and dividends to grow at a constant rate of 3% in the future. BVU paid a dividend of $3.75 per share last year, and its stock currently sells at a price of $60 per share. Government bonds yield 4%, the market risk premium is 5%, and BVU’s beta is 1.1. These terms would apply to new security offerings: Preferred: New preferred shares could be sold to the public at a price of $25 per share, with a dividend of $1.75. Flotation costs of $2 per share would be incurred. Debt: Debt could be sold at an interest rate of 6%. a. Find the component costs of debt, preferred stock, and common stock. Assume BVU does not have to issue any additional common shares. b. What is the WACC? Copyright © 2017 by Nelson Education Ltd. 9- 28