Practical financial managment 7e LASHER chapter 13

1. Foundations. 2. Financial Background: A Review of Accounting, Financial Statements, and Taxes. 3. Cash Flows and Financial Analysis. 4. Financial Planning. 5. The Financial System, Corporate Governance, and Interest. Part II: DISCOUNTED CASH FLOW AND THE VALUE OF SECURITIES. 6. Time Value of Money. 7. The Valuation and Characteristics of Bonds. 8. The Valuation and Characteristics of Stock. 9. Risk and Return. Part III: BUSINESS INVESTMENT DECISIONS--CAPITAL BUDGETING. 10. Capital Budgeting. 11. Cash Flow Estimation. 12. Risk Topics and Real Options in Capital Budgeting. 13. Cost of Capital. Part IV: LONG-TERM FINANCING ISSUES. 14. Capital Structure and Leverage. 15. Dividends. Part V: OPERATIONS ISSUES--WORKING CAPITAL MANAGEMENT AND PLANNING. 16. The Management of Working Capital. 17. Corporate Restructuring. 18. International Finance.

Chapter 13 Cost of Capital

Target Capital Structure

Raising Money in the Proportions of the Capital Structure

The Purpose of the Cost of Capital

The cost of capital is the average rate paid for the use of the firm’s capital funds

Capital is money acquired for use over long periods

The cost of capital provides a benchmark against which to evaluate investments

– Projects should not be undertaken unless they return more than the cost of the funds invested in them => the cost of capital

Rule is equivalent to

– Project IRR exceeds the cost of capital

– Project NPV > 0 when calculated at the cost of capital

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Capital Components and Structure

A firm’s Capital Components are

– Debt

– Preferred stock

– Common equity

Capital structure is the mix of the three capital

components - generally expressed in percentages

Capital Structure Concepts

Target Capital Structure

– A mix of components that management

considers optimal and strives to maintain

Raising Money in the Proportions of the Capital Structure

– In cost of capital calculations, we assume

money is raised in a constant proportion of debt, preferred and common equity

Returns on Investments and the

Costs of Capital Components

Investors provide capital by purchasing the

firm’s securities

– Returns paid to investors adjusted for taxes and administrative expenses are the firm’s costs

The risk of securities to investors differ

– Equity: riskiest investment, highest investor return, highest cost to company

– Debt: safest investment, earns lowest return, costs firm least

The Weighted Average Calculation (WACC)

A firm’s cost of capital is a weighted average of the costs of the three capital components where the weights reflect the $ amounts of each component

in use

Referred to in two ways

– k, the cost of capital

– WACC, for weighted average cost of capital

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Concept Connection Example 13-1

information about its capital structure.

Concept Connection Example 13-1

Capital Structure and Cost Book Versus Market Value

WACC can be calculated using either book or market values of capital components

WACC used to evaluate next year’s projects

– Supported by capital raised next year

– Book values - capital raised and spent years ago– Current market values are best estimate of next

year’s capital market conditions

Market values are the appropriate basis for

WACC calculations

Capital Structure Customary ApproachStructure: Assume the firm will either

– Maintain present capital structure based

on the current market prices of its

securities

– Or strive to achieve some target structure

also based on current market prices

Costs: Always use market-based

component costs to develop the WACC.

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Calculating the WACC

Step 1: Develop a market-value-based

capital structure

Step 2: Adjust market returns on the

underlying securities to reflect the costs of the underlying capital components

Step 3: Combine in calculating the WACC

Concept Connection Example 13-2 Market-Value-Based Capital Structure

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The Wachusett Corporation has the following capital situation.

Debt: 2,000 30-year, $1,000 face value, 12% coupon

bonds issued 5 years ago Now selling to yield 10%.

Preferred stock: 4,000 shares of preferred are

outstanding, each share pays an annual dividend of $7.50 Originally sold to yield 15% of $50 face value Now yielding 13%.

Equity: 200,000 shares of common stock are selling at

$15.

Develop Wachusett's market-value-based capital

structure

Concept Connection Example 13-2 Market-Value-Based Capital Structure

The market value of each capital component is the current price of each security multiplied by the number outstanding.

Concept Connection Example 13-2 Market Value-Based Capital Structure

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Preferred stock

PP = $7.50 / 13 = $57.69 Multiply by 4,000 for market value of preferred

$57.69 x 4,000 = $230,760

Equity

At $15 the market value of equity is $15 x 200,000 shares = $3,000,000 Summarize and calculate the component weights:

Calculating Component

Costs of Capital

Tax adjustment applies only to debt (Tax rate is T)

– Interest is tax deductible to the paying firm

– Cost of debt = kd (1 – T)

– Debt made even cheaper by tax adjustment

Flotation costs: percentage of security’s price (f)

– Apply to preferred and new sales of common – Increases effective cost

– Cost of component = kp / (1 – f) or ke / (1 – f)

Concept Connection Example 13-3

Cost of Debt

Blackstone has 12% coupon bonds yielding 8% to

investors buying them now Blackstone’s marginal tax rate is 37% What is Blackstone’s cost of debt?

Cost of debt = kd(1 - T)

= 8%(1 - 37)

= 5.04%

Concept Connection Example 13-4

Cost of Preferred Stock

Francis issued preferred paying 6% of its $100 par value Flotation costs are 11%.

– a What is Francis’s cost of preferred if

similar issues yield 9%

– b Calculate the cost of preferred if the

shares are selling for $75.

Concept Connection Example 13-4

Cost of Preferred Stock

The Cost of Common Equity

The cost of common equity is not precise due to the uncertainty of future equity cash flows

– The market return on common equity is estimated

The Cost of Retained Earnings

Retained earnings (RE) are not free

– Reinvested earnings that belong to stockholders – Stockholders could have spent if paid as dividends

No adjustments to return on RE necessary

– Payments to stockholders not tax deductible

– No new securities so no flotation costs

Investor return = Component cost of RE

– Three ways to estimate

CAPM, Gordon Model, and Risk Premium

The CAPM Approach

Estimate using using the CAPM’s SML:

kx = kRF + (kM - kRF) bX

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Concept Connection Example 13-5 Cost of

The Dividend Growth (Gordon Model) Approach

The Gordon model is usually used to estimate intrinsic

value However, it can also be solved for return by substituting the stock’s current price.

Use actual price

Solve for ke, which represents expected

return.

g k

) g 1

(

D P

e

0 0

− +

=

The Dividend Growth (Gordon Model)

Approach Example 13-6

Periwinkle stock sells for $33.60, paid a dividend of $1.65 and will grow at 7.5% Estimate its cost of retained earnings.

Solution:

The Risk Premium Approach

Difference between debt and equity risks is fairly constant

– Estimate return on equity by adding 3% to 5% to the return on its debt:

The Cost of New Common Stock

Firms often need to raise more equity than that

generated by retained earnings

Equity from new stock is just like equity from RE, except it involves flotation costs

Market return estimates for RE must be adjusted for flotation costs to determine the cost of issuing new common stock

– Use the Gordon model

– Insert (1 ─ f) to recognize flotation costg

P ) f 1 (

) g 1

=

The Cost of New Common Stock

Example 13-8

Periwinkle of Example 13-6 needs to raise money beyond RE Estimate its cost of new equity from stock if floatation costs are 12%

Solution:

The Marginal Cost of Capital (MCC )

WACC not independent of amount of capital raised

WACC typically rises as more capital is raised

The Marginal Cost of Capital (MCC) is a graph of the WACC showing increases as larger amounts are raised during a planning period

The Break in MCC When Retained

Earnings Run Out

Breaks (jumps) in the MCC occur when

cheap sources of financing are used up

First increase in MCC usually occurs when the firm runs out of RE and starts raising external equity by selling stock

Locating the Break is important

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Concept Connection Example 13-9

The MCC

Concept Connection Example 13-9

Example 13-9 Locating the Break In

Brighton’s MCC Schedule

Business plan projects RE of $3M

Capital structure is 60% equity

Capital is raised in the proportions of the capital structure we ask

– $3M is 60% of what number?

$3M / 6 = $5M (WACC Break)

Brighton’s MCC Schedule

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Other Breaks in the MCC Schedule

Other Breaks in the MCC Schedule occur when the cost of borrowing increases

– As debt increases firm becomes riskier

so lenders require higher interest rates

Causes further upward breaks in the MCC

Combining the MCC and IOS

The investment opportunity schedule (IOS)

is a plot of the IRRs of available projects

arranged in descending order

The MCC and IOS plotted together show

which projects should be undertaken

Interpreting the MCC

– The firm's WACC for the planning period

is at intersection of the MCC and the IOS

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Figure 13-2 MCC Schedule and IOS

Projects A, B and C should be undertaken because their expected returns exceed the

expected costs.

A Potential Mistake—Handling

Separately Funded Projects

If a project is funded entirely by a single capital source

Should the cost of capital used to evaluate that project be the cost of the single source, or the firm's WACC?

– It should be the WACC because firms cannot

continue to raise capital at the single source rate indefinitely

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