Caroline Sharon

Stephania
Financial Management – Chapter 9
MMUGM Jakarta, Executive 24A
Goal

To do a major expansion program and estimate its cost of capital in

smaller capital costs condition

Current Conditions

1. Firm’s tax rate 40%

2. 12% coupon, semiannual payment, noncallable bonds 15 years
maturity $1,153.72
3. 10%, $100 par value, quarterly dividend, perpetual preffered
stock $113.10
4. Common Stock selling $50 per share. D0 $4.19, 5% growth. Β
1.2, yiel T-bonds 7%, market risk premium 6%
5. Target capital structure 30% long term debt, 10% PS an 60%
common equity
 What sources of long-term
capital do firms use?

Long-Term Capital
Long-Term Capital

Long-Term Debt
Long-Term Debt Preferred Stock
Preferred Stock Common Stock
Common Stock

Retained Earnings
Retained Earnings New Common
New Common Stock
Stock
 Should our analysis focus on before-
tax or after-tax capital costs?

• Stockholders focus on after tax CFs.

Therefore, we should focus on after tax
capital costs, i.e. use after tax costs of
capital in WACC.

• Only cost of debt needs adjustment,

because interest is tax deductible.
 Should our analysis focus on historical
(embedded) costs or new (marginal) costs?

The cost of capital is used primarily to

make decisions that involve raising new
capital. So, focus on today’s marginal
costs (for WACC).
 How are the weights determined?
Component cost of debt?

WACC = wdrd(1-T) + wprp + wcrs

• Use accounting numbers or market value (book vs. market
weights)?
• Use actual numbers or target capital structure?
• rd is the marginal cost of debt capital.
• The yield to maturity on outstanding L-T debt is often used as a
measure of rd.
• Why tax-adjust, i.e. why rd(1-T)
• Interest is tax deductible, so
A-T rd = B-T rd (1-T)
= 10% (1 - 0.40) = 6%
• Use nominal rate.
• Flotation costs are small, so ignore them.
 Component cost of preferred stock?
What is the cost of preferred stock?

WACC = wdrd(1-T) + wprp + wcrs

• rp is the marginal cost of preferred stock, which is the

return investors require on a firm’s preferred stock.
• Preferred dividends are not tax-deductible, so no tax
adjustments necessary. Just use nominal rp.
• Our calculation ignores possible flotation costs.
• The cost of preferred stock can be solved by using this
formula:
rp = Dp / Pp
= $10 / $111.10
= 9%
 Is preferred stock more or less risky to
investors than debt? Why is the yield on
preferred stock lower than debt?

• More risky; company not required to pay preferred dividend.

• However, 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.

• Preferred stock will often have a lower B-T yield than the B-T
yield on debt.
– Corporations own most preferred stock, because 70% of
preferred dividends are excluded from corporate taxation.
• The A-T yield to an investor, and the A-T cost to the issuer,
are higher on preferred stock than on debt. Consistent with
higher risk of preferred stock.
 What are the two ways that companies
can raise common equity?

• Directly, by issuing new shares of

common stock.
• Indirectly, by reinvesting earnings
that are not paid out as dividends
(i.e., retaining earnings).
Why is there a cost for reinvested earnings?

• Earnings can be reinvested or paid out as dividends.

• Investors could buy other securities, earn a return.
• If earnings are retained, there is an opportunity cost (the
return that stockholders could earn on alternative
investments of equal risk).
– Investors could buy similar stocks and earn rs.
– Firm could repurchase its own stock and earn rs.

If the rRF = 7%, RPM = 6%, and the firm’s beta is 1.2,
what’s the cost of common equity based upon the CAPM?

rs = rRF + (rM – rRF) b

= 7.0% + (6.0%)1.2 = 14.2%
 If D0 = $4.19, P0 = $50, and g = 5%, what’s the cost
of common equity based upon the DCF approach?

D1 = D0 (1 + g) rs = (D1 / P0) + g
D1 = $4.19 (1 + .05) = ($4.3995 / $50) + 0.05
D1 = $4.3995 = 13.8%

What is the expected future growth rate?

• The firm has been earning 15% on equity (ROE = 15%)
and retaining 35% of its earnings (dividend payout =
65%). This situation is expected to continue.

g = ( 1 – Payout ) (ROE)
= (0.35) (15%)
= 5.25%

• Very close to the g that was given before.

 Can DCF methodology be applied if
growth is not constant?

• Yes, nonconstant growth stocks are

expected to attain constant growth at
some point, generally in 5 to 10 years.
• May be complicated to compute.
 If rd = 10% and RP = 4%, what is rs
using the own-bond-yield-plus-risk-
premium method?

• This RP is not the same as the CAPM

RPM.
• This method produces a ballpark
estimate of rs, and can serve as a useful
check.

rs = rd + RP
rs = 10.0% + 4.0% = 14.0%
What is a reasonable final estimate of rs?

Method Estimate
CAPM 14.2%
DCF 13.8%
rd + RP 14.0%
Average 14.0%
 Determining the Weights for the WACC

• The weights are the percentages of the firm that

will be financed by each component.

• If possible, always use the target weights for the

percentages of the firm that will be financed
with the various types of capital.
 Estimating Weights for the Capital
Structure

• If you don’t know the targets, it is better to estimate

the weights using current market values than
current book values.

• If you don’t know the market value of debt, then it is

usually reasonable to use the book values of debt,
especially if the debt is short-term.

• Suppose the stock price is $50, there are 3 million

shares of stock, the firm has $25 million of preferred
stock, and $75 million of debt.
 h. What is Harry Davis’s Weighted
Average Cost of Capital (WACC) ?

¾ Vce = $50 (3 million) = $150 million.

¾ Vps = $25 million.
¾ Vd = $75 million.
Total value = $150 + $25 + $75 = $250 million.
™ wce = $150/$250 = 0.6
™ wps = $25/$250 = 0.1
™ wd = $75/$250 = 0.3

WACC = wdrd(1 - T) + wpsrps + wcers

= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4% = 11.1%.
 i. What factors influence a
company’s WACC ?

¾ Market conditions, especially interest rates

and tax rates.
¾ The firm’s capital structure and dividend
policy.
¾ The firm’s investment policy. Firms with
riskier projects generally have a higher
WACC.
 j. Should the company use the composite
WACC as the hurdle rate for each of its
divisions ?

ƒ NO! The composite WACC reflects the risk of

an average project undertaken by the firm.
ƒ Different divisions may have different risks.
The division’s WACC should be adjusted to
reflect the division’s risk and capital structure.
 k. What procedures are used to
determine the risk-adjusted cost of
capital for a particular division?

ƒ Estimate the cost of capital that the

division would have if it were a stand-
alone firm.
ƒ This requires estimating the division’s
beta, cost of debt, and capital structure.
 k. What approaches are used to
measure a division beta ?
1. Pure play. Find several publicly traded companies
exclusively in project’s business.
Use average of their betas as proxy for project’s beta.
Hard to find such companies.
2. Accounting beta. Run regression between project’s ROA
and S&P index ROA.
Accounting betas are correlated (0.5 – 0.6) with market
betas.
But normally can’t get data on new projects’ ROAs before
the capital budgeting decision has been made.
 l. What would your estimate be for
the division’s cost of capital ?
ƒ Target debt ratio = 10%.
ƒ rd = 12% ; rRF = 7%.
ƒ Tax rate = 40% ; betaDivision = 1.7.
ƒ Market risk premium = 6%.
• Beta = 1.7, so division has more market risk than
average.
• Division’s required return on equity:
rs = rRF + (rM – rRF)bDiv.
= 7% + (6%)1.7 = 17.2%.
WACCDiv. = wdrd(1 – T) + wcrs
= 0.1(12%)(0.6) + 0.9(17.2%)
= 16.2%.
 How does the division’s WACC compare
with the firm’s overall WACC ?

• Division WACC = 16.2% versus company WACC = 11.1%.

• “Typical” projects within this division would be accepted if
their returns are above 16.2%.
Rate of Return
(%) Acceptance Region

WACC

WACC H H

A Rejection Region
WACC A
B
WACC L L

Risk
0 Risk L Risk A Risk H
 m. What are three types of project risk ?
How is each type of risk used ?

ƒ Stand-alone risk
Stand-alone risk is easiest to calculate.
ƒ Corporate risk
However, creditors, customers, suppliers,
and employees are more affected by
corporate risk.
ƒ Market risk
Market risk is theoretically best in most
situations.
n. Why is the cost of internal equity from
reinvested earnings cheaper than the
cost of issuing new common stock ?
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 markets, which may depress
stock price.
 o.1. Estimate the cost of new common
equity: P0=$50, D0=$4.19, g=5%,
and F=15%.
$ 4 . 19 (1 . 05 )
D 0 (1 + g ) =
$ 50 (1 − 0 . 15 )
+ 5 .0 %
re = + g
P0 ( 1 − F ) =
$ 4 . 40
+ 5 . 0 % = 15 . 4 %.
$ 42 . 50

o.2. Estimate the cost of new 30-year debt:

Par=$1,000, Coupon=10%paid annually,
and F=2%.
• Using a financial calculator:
– N = 30
– PV = 1000(1-.02) = 980
– PMT = -(.10)(1000)(1-.4) = -60
– FV = -1000
• Solving for I: 6.15%
 Comments about flotation costs:

• Flotation costs depend on the risk of the firm

and the type of capital being raised.
• The flotation costs are highest for common
equity. However, since most firms issue
equity infrequently, the per-project cost is
fairly small.
• We will frequently ignore flotation costs
when calculating the WACC.
 p. What four common mistakes in
estimating the WACC should Harry
Davis avoid ?
1. When estimating the cost of debt, don’t use the
coupon rate on existing debt. Use the current
interest rate on new debt.
2. When estimating the risk premium for the CAPM
approach, don’t subtract the current long-term
T-bond rate from the historical average return
on common stocks.

For example, if the historical rM has

been about 12.2% and inflation drives
the current rRF up to 10%, the current
market risk premium is not 12.2% -
10% = 2.2%!
3. Don’t use book weights to estimate the weights
for the capital structure.
Use the target capital structure to determine the
weights.
If you don’t know the target weights, then use the
current market value of equity, and never the
book value of equity.
If you don’t know the market value of debt, then
the book value of debt often is a reasonable
approximation, especially for short-term debt.
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4. Always remember that capital components
are sources of funding that come from
investors.
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 WACC.
We do adjust for these items when
calculating the cash flows of the project, but
not when calculating the WACC.