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1、10-1Copyright 2001 by Harcourt,Inc.All rights reserved.CHAPTER 10The Cost of CapitalnCost of capital componentsnAccounting for flotation costsnWACCnAdjusting cost of capital for risknEstimating project risk10-2Copyright 2001 by Harcourt,Inc.All rights reserved.What types of capital do firms use?Debt
2、Preferred stockCommon equity:Retained earnings New common stock10-3Copyright 2001 by Harcourt,Inc.All rights reserved.Stockholders focus on A-T CFs.Therefore,we should focus on A-T capital costs,i.e.,use A-T costs in WACC.Only kd needs adjustment.Should we focus on before-tax or after-tax capital co
3、sts?10-4Copyright 2001 by Harcourt,Inc.All rights reserved.The cost of capital is used primarily to make decisions that involve raising new capital.So,focus on todays marginal costs(for WACC).Should we focus on historical(embedded)costs or new(marginal)costs?10-5Copyright 2001 by Harcourt,Inc.All ri
4、ghts reserved.A 15-year,12%semiannual bond sells for$1,153.72.Whats kd?6060+1,0006001230i=?30 -1153.72 60 1000 5.0%x 2=kd=10%NI/YRPVFVPMT-1,153.72.INPUTSOUTPUT10-6Copyright 2001 by Harcourt,Inc.All rights reserved.Component Cost of DebtnInterest is tax deductible,sokd AT =kd BT(1 T)=10%(1 0.40)=6%.n
5、Use nominal rate.nFlotation costs small.Ignore.10-7Copyright 2001 by Harcourt,Inc.All rights reserved.Whats the cost of preferred stock?Pp=$111.10;10%Q;Par=$100.Use this formula:10-8Copyright 2001 by Harcourt,Inc.All rights reserved.Picture of Preferred Stock2.502.50012kp=?-111.1.2.50$111.10=.kPer=2
6、.25%;kp(Nom)=2.25%(4)=9%.DQkPer$2.50kPer$2.50$111.1010-9Copyright 2001 by Harcourt,Inc.All rights reserved.Note:nPreferred dividends are not tax deductible,so no tax adjustment.Just kp.nNominal kp is used.nOur calculation ignores flotation costs.10-10Copyright 2001 by Harcourt,Inc.All rights reserve
7、d.Is preferred stock more or less risky to investors than debt?nMore risky;company not required to pay preferred dividend.nHowever,firms try to pay preferred dividend.Otherwise,(1)cannot pay common dividend,(2)difficult to raise additional funds,(3)preferred stockholders may gain control of firm.10-
8、11Copyright 2001 by Harcourt,Inc.All rights reserved.Why is yield on preferred lower than kd?nCorporations own most preferred stock,because 70%of preferred dividends are nontaxable to corporations.nTherefore,preferred often has a lower B-T yield than the B-T yield on debt.nThe A-T yield to an invest
9、or,and the A-T cost to the issuer,are higher on preferred than on debt.Consistent with higher risk of preferred.10-12Copyright 2001 by Harcourt,Inc.All rights reserved.Example:kp=9%kd=10%T=40%kp,AT=kp kp(1 0.7)(T)=9%9%(0.3)(0.4)=7.92%.kd,AT=10%10%(0.4)=6.00%.A-T Risk Premium on Preferred=1.92%.10-13
10、Copyright 2001 by Harcourt,Inc.All rights reserved.Why is there a cost for retained earnings?nEarnings can be reinvested or paid out as dividends.nInvestors could buy other securities,earn a return.nThus,there is an opportunity cost if earnings are retained.10-14Copyright 2001 by Harcourt,Inc.All ri
11、ghts reserved.nOpportunity cost:The return stockholders could earn on alternative investments of equal risk.nThey could buy similar stocks and earn ks,or company could repurchase its own stock and earn ks.So,ks is the cost of retained earnings.10-15Copyright 2001 by Harcourt,Inc.All rights reserved.
12、Three ways to determine cost of common equity,ks:1.CAPM:ks=kRF+(kM kRF)b.2.DCF:ks=D1/P0+g.3.Own-Bond-Yield-Plus-Risk Premium:ks=kd+RP.10-16Copyright 2001 by Harcourt,Inc.All rights reserved.Whats the cost of common equity based on the CAPM?kRF=7%,RPM=6%,b=1.2.ks=kRF+(kM kRF)b.=7.0%+(6.0%)1.2 =14.2%.
13、10-17Copyright 2001 by Harcourt,Inc.All rights reserved.Whats the DCF cost of commonequity,ks?Given:D0=$4.19;P0=$50;g=5%.D1P0D0(1+g)P0$4.19(1.05)$50ks=+g=+g=+0.05=0.088+0.05=13.8%.10-18Copyright 2001 by Harcourt,Inc.All rights reserved.Suppose the company has been earning 15%on equity(ROE=15%)and re
14、taining 35%(dividend payout=65%),and this situation is expected to continue.Whats the expected future g?10-19Copyright 2001 by Harcourt,Inc.All rights reserved.Retention growth rate:g=(1 Payout)(ROE)=0.35(15%)=5.25%.Here(1 Payout)=Fraction retained.Close to g=5%given earlier.Think of bank account pa
15、ying 10%with payout=100%,payout=0%,and payout=50%.Whats g?10-20Copyright 2001 by Harcourt,Inc.All rights reserved.Could DCF methodology be applied if g is not constant?nYES,nonconstant g stocks are expected to have constant g at some point,generally in 5 to 10 years.nBut calculations get complicated
16、.10-21Copyright 2001 by Harcourt,Inc.All rights reserved.Find ks using the own-bond-yield-plus-risk-premium method.(kd=10%,RP=4%.)nThis RP CAPM RP.nProduces ballpark estimate of ks.Useful check.ks=kd+RP =10.0%+4.0%=14.0%10-22Copyright 2001 by Harcourt,Inc.All rights reserved.Whats a reasonable final
17、 estimate of ks?MethodEstimateCAPM 14.2%DCF 13.8%kd+RP 14.0%Average 14.0%10-23Copyright 2001 by Harcourt,Inc.All rights reserved.1.When a company issues new common stock they also have to pay flotation costs to the underwriter.2.Issuing new common stock may send a negative signal to the capital mark
18、ets,which may depress stock price.Why is the cost of retained earnings cheaper than the cost of issuing new common stock?10-24Copyright 2001 by Harcourt,Inc.All rights reserved.Two approaches that can be used to account for flotation costs:nInclude the flotation costs as part of the projects up-fron
19、t cost.This reduces the projects estimated return.nAdjust the cost of capital to include flotation costs.This is most commonly done by incorporating flotation costs in the DCF model.10-25Copyright 2001 by Harcourt,Inc.All rights reserved.New common,F=15%:10-26Copyright 2001 by Harcourt,Inc.All right
20、s reserved.Comments about flotation costs:nFlotation costs depend on the risk of the firm and the type of capital being raised.nThe flotation costs are highest for common equity.However,since most firms issue equity infrequently,the per-project cost is fairly small.nWe will frequently ignore flotati
21、on costs when calculating the WACC.10-27Copyright 2001 by Harcourt,Inc.All rights reserved.Whats the firms WACC(ignoring flotation costs)?WACC=wdkd(1 T)+wpkp+wcks =0.3(10%)(0.6)+0.1(9%)+0.6(14%)=1.8%+0.9%+8.4%=11.1%.10-28Copyright 2001 by Harcourt,Inc.All rights reserved.What factors influence a com
22、panys composite WACC?nMarket conditions.nThe firms capital structure and dividend policy.nThe firms investment policy.Firms with riskier projects generally have a higher WACC.10-29Copyright 2001 by Harcourt,Inc.All rights reserved.WACC Estimates for Some Large U.S.Corporations,Nov.1999CompanyWACCInt
23、el12.9%General Electric11.9Motorola11.3Coca-Cola11.2Walt Disney10.0 AT&T 9.8Wal-Mart 9.8Exxon 8.8H.J.Heinz 8.5BellSouth 8.210-30Copyright 2001 by Harcourt,Inc.All rights reserved.Should the company use the composite WACC as the hurdle rate for each of its projects?nNO!The composite WACC reflects the
24、 risk of an average project undertaken by the firm.Therefore,the WACC only represents the“hurdle rate”for a typical project with average risk.nDifferent projects have different risks.The projects WACC should be adjusted to reflect the projects risk.10-31Copyright 2001 by Harcourt,Inc.All rights rese
25、rved.Risk and the Cost of Capital10-32Copyright 2001 by Harcourt,Inc.All rights reserved.Divisional Cost of Capital10-33Copyright 2001 by Harcourt,Inc.All rights reserved.What are the three types of project risk?nStand-alone risknCorporate risknMarket risk10-34Copyright 2001 by Harcourt,Inc.All righ
26、ts reserved.How is each type of risk used?nMarket risk is theoretically best in most situations.nHowever,creditors,customers,suppliers,and employees are more affected by corporate risk.nTherefore,corporate risk is also relevant.10-35Copyright 2001 by Harcourt,Inc.All rights reserved.nSubjective adju
27、stments to the firms composite WACC.nAttempt to estimate what the cost of capital would be if the project/division were a stand-alone firm.This requires estimating the projects beta.What procedures are used to determine the risk-adjusted cost of capital for a particular project or division?10-36Copy
28、right 2001 by Harcourt,Inc.All rights reserved.Methods for Estimating a Projects Beta1.Pure play.Find several publicly traded companies exclusively in projects business.Use average of their betas as proxy for projects beta.Hard to find such companies.10-37Copyright 2001 by Harcourt,Inc.All rights re
29、served.2.Accounting beta.Run regression between projects ROA and S&P index ROA.Accounting betas are correlated(0.5 0.6)with market betas.But normally cant get data on new projects ROAs before the capital budgeting decision has been made.10-38Copyright 2001 by Harcourt,Inc.All rights reserved.Find th
30、e divisions market risk and cost of capital based on the CAPM,given these inputs:nTarget debt ratio=40%.nkd=12%.nkRF=7%.nTax rate=40%.nbetaDivision=1.7.nMarket risk premium=6%.10-39Copyright 2001 by Harcourt,Inc.All rights reserved.nBeta=1.7,so division has more market risk than average.nDivisions r
31、equired return on equity:ks=kRF+(kM kRF)bDiv.=7%+(6%)1.7=17.2%.WACCDiv.=wdkd(1 T)+wcks =0.4(12%)(0.6)+0.6(17.2%)=13.2%.10-40Copyright 2001 by Harcourt,Inc.All rights reserved.How does the divisions market risk compare with the firms overall market risk?nDivision WACC=13.2%versus company WACC=11.1%.nIndicates that the divisions market risk is greater than firms average project.n“Typical”projects within this division would be accepted if their returns are above 13.2%.