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r 14
Cost of Capital
14-1
McGraw-Hill/Irwin
Chapter Outline
The Cost of Equity
The Cost of Debt
The Cost of Preferred Stock
The Weighted Average Cost of
Capital (WACC)
Divisional and Project Costs of
Capital
Floatation Costs relative to WACC
14-2
1. Dividend growth
model (aka: the
Gordon Model)
14-3
2.
SML, or the
D1
P0
RE g
D1
RE
g
P0
14-4
Dividend Growth
Model Example
Suppose that your company is
expected to pay a dividend of $1.50
per share next year.
There has been a steady growth in
dividends of 5.1% per year and the
market expects that to continue. The
current price is $25.
RE
14-5
Advantages and
Disadvantages of the
Dividend Growth Model
Advantage:
Easy to
understand and
use
14-6
Advantages and
Disadvantages of the
Dividend Growth Model
Disadvantages:
Only applicable to
companies
currently paying
dividends
14-7
Not applicable if
dividends arent
growing at a
reasonably constant
rate
Advantages and
Disadvantages of the
Dividend Growth Model
Disadvantages :
Extremely
sensitive to the
estimated growth
rate an increase
in g of 1%
increases the cost
of equity by 1%
14-8
Does not
explicitly consider
RSystematic
E (asset,
RM ) R f )
risk
E Rf
E ( of
14-9
Example - SML
Suppose your company has:
an equity beta of .58
the current risk-free rate is
6.1%
What
the expected
market
riskusing
is the cost
of equity
premium
is 8.6% technique?
the
SML valuation
Advantages and
Disadvantages of
SML
Advantages:
Explicitly adjusts for
systematic risk
Applicable to all companies,
as long as we can estimate
beta
14-11
Advantages and
Disadvantages of
SML
Disadvantages:
Have to estimate the expected
market risk premium, which
does vary over time
Have to estimate beta, which
also varies over time
14-12
Cost of Debt
The cost of debt is the
required return on our
companys debt
We usually focus on the cost
of long-term debt or bonds
(as opposed to short-term
debt like notes payable)
14-13
Cost of Debt
The required return is best
estimated by computing the
yield-to-maturity on the
existing long-term debt (the
YTM).
The computation of the YTM
was presented in the
chapter on Bond Valuation
14-14
Example: Cost of
Debt: computing the
YTM
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.
14-15
Cost of Preferred
Stock
Preferred stock is a
perpetuity, so we take
the perpetuity
formula:
and then rearrange the
terms to solve for RP
P0 = D_
Rps
14-16
Rps = D_
P0
Example: Cost of
Preferred Stock
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?
RP = 3 / 25 = 12%
14-17
Capital Structure
Weights
To compute the
WACC, we first
need the weights
of each source of
funds: namely
debt, preferred
stock and equity
14-18
Capital Structure
Weights
Lets simplify with
an example of just
debt and equity.
We often use the
market value of
both debt and
equity
14-19
Capital Structure
Valuation
Debts Market Value = (# of
outstanding bonds ) x (the
market price of one bond)
Equitys Market Value = (#
shares of outstanding common
stock) x (the market price of one
share of common stock)
14-20
Capital Structure
Valuation
A firms market value is
simply the added value of
both the debt and the equity:
V=D + E
14-21
Capital Structure
Weights
WD = D/V
This is the %
financed with debt
WE = E/V
This is the %
financed with
equity
14-22
Student Alert!
The capital
structure weights
must always add up
to 100%
WD + WE = 100%
or
WD + WPS + WE =
100%
14-23
Example: Capital
Structure Weights
Suppose you have a market value
of equity equal to $500 million and
a market value of debt equal to
$475 million.
What are the capital structure
weights?
V = $500 million + $475 million = $975 million
wD = D/V = 475 / 975 = .4872 = 48.72%
wE = E/V = 500 / 975 = .5128 = 51.28%
14-24
14-25
WACC = WDRD(1-TC) + WE RE
14-27
Together WACC
Example
Equity
Information:
50 million shares
$80 per share
Beta = 1.15
Market risk
premium = 9%
Debt Information:
$1 billion in
outstanding debt
(face value)
Current quote = 110
Coupon rate = 9%,
semiannual coupons
15 years to maturity
14-28
Risk-free
rate =tax rate is 40%
The firms
5%
WACC Example
1. What is the cost of
debt?
N = 30; PV = -1,100; PMT = 45;
FV = 1,000; CPT I/Y = 3.9268
RD = 3.927(2)
= 7.854%
2. What is the cost of
equity (using the CAPM)?
RE = 5 + 1.15(9) = 15.35%
14-29
WACC Example
3. What is the AFTER-TAX
cost of debt?
14-30
WACC Example
4. What are the capital structure
weights?
Debt = 1 billion ($1.10) = $1.1
billion
Equity = 50 million ($80) = $4
billion
Value of the Firm = 4 + 1.1 =
$5.1 billion
14-31
WACC = WDRD(1-TC) + WE RE
WACC = .2157 (4.712%) + .7843 (15.35%)
= 13.06%
14-32
14-34
Project Risk An
Example
What would happen if we use the
WACC for all projects regardless of
risk?
Assume the WACC = 15%
Project
14-35
A
B
C
Required Return
20%
15%
10%
17%
18%
12%
IRR
Project Risk
Differentiation
We have two tools in finance to
help us here:
14-37
Subjective Approach
Consider the projects risk relative
to the firm overall:
14-39
Subjective Approach
You may still
accept projects
that you shouldnt
and reject projects
you should accept,
but your error
rate should be
lower than not
considering
differential risk at
all.
14-40
Subjective Approach:
An Example
14-41
Risk Level
Discount Rate
WACC 8%
Low Risk
WACC 3%
WACC
High Risk
WACC + 5%
WACC + 10%
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
14-42
Flotation Costs
However, the cost of
issuing new securities
should not just be ignored
either.
The Basic Approach:
1. Compute the weighted
average flotation cost
2.
14-43
Comprehensive
Problem
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 companys 100,000 shares of preferred
stock pay a $3 annual dividend, and sell for
$30 per share.
The companys 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%.
14-48
Questions?
14-49