Ch. 14: Cost of Capital

Cost of Capital

• The return earned on assets depend on the riskiness of those assets.
• The return to an investor is the same as the cost to the company.
• As a manager, cost of capital provides us with an indication of how the market views the riskiness of our assets.
• This estimate provides a natural starting point for calculating the required rate of return for capital budgeting projects.
• Why is cost of capital important?
  • Allows us to implement good capital budgeting decisions.
  • Informs us how to structure our capital structure.

Cost of Equity

• Cost of equity is the return that shareholders require for their investment in the firm.
• Shareholders bear two types of risk:
  • Business (economic) risk
  • Financial risk
• We have already discussed two methods for determining the cost of equity:
  • Dividend Growth Model
    • $R_E = \frac{D_1}{P_0} + g$
    • Cost of equity is a function of dividend yield and capital gains yield
    • How do we implement?
    • Disadvantages:
      • Only applicable to companies currently paying dividends
      • Requires a reasonably constant growth of dividends
      • Sensitive to estimated growth rate (1 for 1)
      • Avoids taking an explicit stand on risk
  • CAPM
    • $R_E = R_f + \beta_E (E(R_m)-R_f)$
    • Cost of equity is a function of:
      • Pure TVM
      • The Reward for Bearing Systematic Risk (Market Risk Premium)
      • The Amount of Systematic Risk
    • How do we implement?
    • Disadvantage: reliance on past returns to predict the future
• Example
  • 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 using the SML?
  • What is our cost of equity using the DGM?

Cost of Debt

• Cost of debt is the return that bondholders require for their investment in the firm.
• Required return is best estimated by computing the yield-to-maturity (YTM) on the existing long-term debt.
• Note: We could also use the CAPM.
• Example
  • Suppose we have a corporate 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 $\$$1,000 bond.
  • What is the cost of debt?

Cost of Preferred Stock

• Preferred stock is a claim on a fixed dividend paid forever.
• $R_{ps} = \frac{D}{P_0}$
• Example
  • Your company has preferred stock that has an annual dividend of $\$$3.00. The current price is $\$$25.
  • What is the cost of preferred stock?

Weighted-average Cost of Capital (WACC)

• Know we know the cost of capital for each source of funds raised by the firm. What is the riskiness of the firm as a whole?
• We need only take the average cost of capital across the sources of funds weighted by their contribution to the assets of the firm.
• Recall $V = D + E$.
  • Market Value of Debt: $D = $ # of outstanding bonds $ \times $ market price of one bond
  • Market Value of Equity: $E = $ # of outstanding shares $ \times $ market price of one share
  • Thus, $R_{WACC} = \frac{D}{D+E} R_D + \frac{E}{D+E} R_E$.
• What about taxes?
  • With taxes, we get to deduct the interest expense of debt ($T_c R_D D$).
  • This tax shield of debt is like having the government pay for a portion of our interest expense ($T_c R_D$).
  • Example
    • Suppose a firm borrows $\$$1 million at 9 percent interest. The corporate tax rate is 34%.
    • What is the total interest bill for the firm?
    • What is the aftertax interest bill for the firm?
    • What is the aftertax interest rate on this loan (cost of debt)?
  • Thus with taxes, $R_{WACC} = \frac{D}{D+E} (1-T_c) R_D + \frac{E}{D+E} R_E$
• Example
  • Equity Information: 50 million shares; $\$$80 per share; $\beta$ = 1.15; Market risk premium = 9%; Risk-free rate = 5%
  • Debt Information: $1 billion in outstanding debt (face value); Current quote = 110; Coupon rate = 9%; semiannual coupons; 15 years to maturity
  • Tax rate: 40 percent
  • What is the cost of debt?
  • What is the cost of equity?
  • What is the weighted-average cost of capital?

Divisional and Project-level Costs of Capital

• The firm-level WACC is only valid for projects of the same riskiness as the entire firm.
• If we are looking at a project that does NOT have the same risk as the firm, then we need to determine the appropriate discount rate for that project.
• If the firm’s WACC was used for every division, then the riskier divisions would get more investment capital and the less risky divisions would lose the opportunity to invest in positive NPV projects.
• Two tools:
  • Pure-Play Approach
    • Find one or more companies that specialize in the product or service that we are considering.
    • Compute (or research) the beta for each company.
    • Take an average of the betas.
    • Use that beta along with the CAPM to find the appropriate return for a project of that identical risk.
    • Use this computed cost of capital for capital budgeting computations.
  • Subjective Approach
    • If the project has more risk than the firm, use a discount rate greater than the WACC.
    • If the project has less risk than the firm, use a discount rate less than the WACC.
    • You may still accept projects that you shouldn’t and reject projects you should accept, but your error rate should be lower than not considering differential risk at all.

Flotation Costs

• Flotation costs are the fees paid to issue stocks or bonds.
• While the required return for a project depends on the risk, it should not depend upon how the money is raised.
• However, the cost of issuing new securities should not just be ignored either.
• Basic Approach:
  • Compute the weighted-average flotation cost.
  • Use the target weights because the firm will issue securities in these percentages over the long term.
• Example
  • 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 firm’s target D/E ratio is .6. The flotation cost for equity is 5%, and the flotation cost for debt is 3%.
  • What is the NPV for the project before adjusting for flotation costs?
  • What is the NPV for the project after adjusting for flotation costs?

Example

• A corporation has 10,000 bonds outstanding with a 6% annual coupon rate, 8 years to maturity, a $\$$1,000 face value, and a $\$$1,100 market price.
• The company’s 100,000 shares of preferred stock pay a $\$$3 annual dividend, and sell for $\$$30 per share.
• The company’s 500,000 shares of common stock sell for $\$$25 per share and have a beta of 1.5. The risk free rate is 4%, and the market return is 12%.
• Assuming a 40% tax rate, what is the company’s WACC?