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10 - 1 n Capital components: debt, preferred stock, and common stock. n Any 10 - 1 n Capital components: debt, preferred stock, and common stock. n Any increase in total assets must be financed by an increase in one or more of these capital components n Kd: the interest rate on the firm’s new debt Kps: the cost of preferred stock Ks: the cost of retained earnings Ke: the cost of common equity (equity obtained by issuing new common stock as apposed to retaining eanings Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 2 1. The cost of debt Kd(1 -T) is the after tax 10 - 2 1. The cost of debt Kd(1 -T) is the after tax cost of debt. The relevant cost of new debt, taking into account the tax deductibility of interest. In effect, the government pays part of the cost of debt because interest is deductible. Note that the cost of debt is the interest rate on new debt, not the interest rate paid on existing or old debt. Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 3 A 15 -year, 12% semiannual bond sells for $1, 153. 72. 10 - 3 A 15 -year, 12% semiannual bond sells for $1, 153. 72. What’s kd? 0 1 i=? 60 30 N OUTPUT 30 . . . -1, 153. 72 INPUTS 2 60 -1153. 72 60 I/YR PV PMT 60 + 1, 000 1000 FV 5. 0% x 2 = kd = 10% Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 4 Component Cost of Debt n Interest is tax deductible, so kd 10 - 4 Component Cost of Debt n Interest is tax deductible, so kd AT = kd BT(1 – T) = 10%(1 – 0. 40) = 6%. Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 5 2. The cost of preferred stock (Kp) The rate of return 10 - 5 2. The cost of preferred stock (Kp) The rate of return investors require on the firm’s preferred stock. Preferred stock is a perpetuity that pays a fixed dividend (Dp) forever. Kp = Preferred dividend / the current price of the preferred stock Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 6 What’s the cost of preferred stock? Pp = $111. 10; $10 10 - 6 What’s the cost of preferred stock? Pp = $111. 10; $10 dividend/share Use this formula: Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 7 Note: n Preferred dividends are not tax deductible, so no tax 10 - 7 Note: n Preferred dividends are not tax deductible, so no tax adjustment. Just kp. n Nominal kp is used. n Our calculation ignores flotation costs. Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 8 Why is there a cost for retained earnings? n Earnings can 10 - 8 Why is there a cost for retained earnings? n Earnings can be reinvested or paid out as dividends. n Investors could buy other securities, earn a return. n Thus, there is an opportunity cost if earnings are retained. Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 9 n Opportunity cost: The return stockholders could earn on alternative investments 10 - 9 n Opportunity cost: The return stockholders could earn on alternative investments of equal risk. n They could buy similar stocks and earn ks. So, ks is the cost of retained earnings. The rate of return required by stockholders on a firm’s common stock Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 10 Three ways to determine cost of common equity, ks: 1. CAPM: 10 - 10 Three ways to determine cost of common equity, ks: 1. CAPM: ks = k. RF + (k. M – k. RF)b. 2. The bond-yield plus risk-premium approach: Ks= bond yield + firm’s risk premium firms with risky, low-rated, and consequently high -interest-rate debt will also have risky, high-cost equity. The risk premium over a firm’s own bond yield has generally ranged from 3 to 5 percentage. Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 11 3. Discount Cash Flow model (Constant dividend growth model) Ks = 10 - 11 3. Discount Cash Flow model (Constant dividend growth model) Ks = (D 1/Po) + g How to estimate g? g = (1 - dividend pay out ratio)*ROE Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 12 What’s the cost of common equity based on the CAPM? k. 10 - 12 What’s the cost of common equity based on the CAPM? k. RF = 7%, RPM = 6%, b = 1. 2. ks = k. RF + (k. M – k. RF )b. = 7. 0% + (6. 0%)1. 2 = 14. 2%. Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 13 What’s the DCF cost of common equity, ks? Given: D 0 10 - 13 What’s the DCF cost of common equity, ks? Given: D 0 = $4. 19; P 0 = $50; g = 5%. D 1 D 0(1 + g) ks = P + g = +g P 0 0 $4. 19(1. 05) = + 0. 05 $50 = 0. 088 + 0. 05 = 13. 8%. Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 14 Suppose the company has been earning 15% on equity (ROE = 10 - 14 Suppose the company has been earning 15% on equity (ROE = 15%) and retaining 35% (dividend payout = 65%), and this situation is expected to continue. What’s the expected future g? Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 15 Retention growth rate: g = (1 – Payout)(ROE) = 0. 35(15%) 10 - 15 Retention growth rate: g = (1 – Payout)(ROE) = 0. 35(15%) = 5. 25%. Here (1 – Payout) = Fraction retained. Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 16 Find ks using the own-bond-yield-plusrisk-premium method. (kd = 10%, RP = 10 - 16 Find ks using the own-bond-yield-plusrisk-premium method. (kd = 10%, RP = 4%. ) ks = kd + RP = 10. 0% + 4. 0% = 14. 0% n This RP ¹ CAPM RP. n Produces ballpark estimate of ks. Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 17 What’s a reasonable final estimate of ks? Method Estimate CAPM 14. 10 - 17 What’s a reasonable final estimate of ks? Method Estimate CAPM 14. 2% DCF 13. 8% kd + RP 14. 0% Average Copyright © 2001 by Harcourt, Inc. 14. 0% All rights reserved.

10 - 18 Why is the cost of retained earnings (ks) cheaper than the 10 - 18 Why is the cost of retained earnings (ks) cheaper than the cost of issuing new common stock (ke)? 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. Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 19 Two approaches that can be used to account for flotation costs: 10 - 19 Two approaches that can be used to account for flotation costs: n Include the flotation costs as part of the project’s up-front cost. This reduces the project’s estimated return. n Adjust the cost of capital to include flotation costs. This is most commonly done by incorporating flotation costs in the DCF model. Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 20 n Ke = [D 1/Po(1 -F) ] + g F is 10 - 20 n Ke = [D 1/Po(1 -F) ] + g F is the percentage flotation cost incurred in selling the new stock. So, Po (1 -F) is the net price per share received by the company. Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 21 New common, F = 15%: Copyright © 2001 by Harcourt, Inc. 10 - 21 New common, F = 15%: Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 22 n Because of flotation costs, dollars raised by selling new stock 10 - 22 n Because of flotation costs, dollars raised by selling new stock must “work harder” than dollars raised by retaining earnings. Moreover, since no flotation costs are involved, retained earnings have a lower cost than new stock. n Therefore, the firms should utilize retained earnings to the extent possible to avoid the costs of new common stock. n However, if a firm has more good investment opportunities, issuing new common stock is necessary. Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 23 n The retained earnings breakpoint represents the total amount of financing 10 - 23 n The retained earnings breakpoint represents the total amount of financing that can be raised before the firm is forced to sell new common stock. n Retained earnings breakpoint = addition to retained earnings/equity fraction Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 24 n E. g) Suppose a firm estimates its earnings to be 10 - 24 n E. g) Suppose a firm estimates its earnings to be $100 M next year and has a payout ratio of 40%. Its capital structure consists of 45% debt, 2% preferred, and 53% equity. n The break point will be $60 M/0. 53 = $113. 2 M; After the firm has raised total capital of $113. 2 M, the firm will be forced to issue new common stock. by Harcourt, Inc. Copyright © 2001 All rights reserved.

10 - 25 Comments about flotation costs: n Flotation costs depend on the risk 10 - 25 Comments about flotation costs: n Flotation costs depend on the risk of the firm and the type of capital being raised. n The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small. n We will frequently ignore flotation costs when calculating the WACC. Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 26 5. Weighted Average Cost of Capital (WACC) If all new equity 10 - 26 5. Weighted Average Cost of Capital (WACC) If all new equity will come from retained earnings: WACC = Wd [Kd(1 -t)] + Wp(Kps) + Wc(Ks) Wd, Ws, Wc are the weights used for debt, preferred stock, and common equity. Assume that the firm has established such a target and will finance all new investments so as to maintain a constant target capital structure. Weights should be based on the market value. Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 27 What’s the firm’s WACC (ignoring flotation costs)? WACC = wdkd(1 – 10 - 27 What’s the firm’s 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%. Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 28 n The company has a target capital structure of 40 percent 10 - 28 n The company has a target capital structure of 40 percent debt and 60 percent equity n Bonds pay 10% coupon (semiannual), mature in 20 years and sell for $849. 54 n the company stock beta is 1. 2 n rf = 10%, market risk premium = 5% n the company is a constant growth firm that just paid a dividend of $2, sells for $27 per share, and a growth rate of 8% n marginal tax rate is 40%. Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 29 What factors influence a company’s composite WACC? n Market conditions. (the 10 - 29 What factors influence a company’s composite WACC? n Market conditions. (the level of interest rates, tax rates…) n The firm’s capital structure and dividend policy. n The firm’s investment policy. Firms with riskier projects generally have a higher WACC. Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 30 WACC Estimates for Some Large U. S. Corporations, Nov. 1999 Company 10 - 30 WACC Estimates for Some Large U. S. Corporations, Nov. 1999 Company Intel General Electric Motorola Coca-Cola Walt Disney AT&T Wal-Mart Exxon H. J. Heinz Bell. South Copyright © 2001 by Harcourt, Inc. WACC 12. 9% 11. 9 11. 3 11. 2 10. 0 9. 8 8. 5 8. 2 All rights reserved.

10 - 31 Should the company use the composite WACC as the hurdle rate 10 - 31 Should the company use the composite WACC as the hurdle rate for each of its projects? n NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the “hurdle rate” for a typical project with average risk. n Different projects have different risks. The project’s WACC should be adjusted to reflect the project’s risk. Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 32 What procedures are used to determine the risk-adjusted cost of capital 10 - 32 What procedures are used to determine the risk-adjusted cost of capital for a particular project or division? n Subjective adjustments to the firm’s composite WACC. n Attempt to estimate what the cost of capital would be if the project/division were a stand-alone firm. This requires estimating the project’s beta. Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 33 Find the division’s market risk and cost of capital based on 10 - 33 Find the division’s market risk and cost of capital based on the CAPM, given these inputs: n Target debt ratio = 40%. n kd = 12%. n k. RF = 7%. n Tax rate = 40%. n beta. Division = 1. 7. n Market risk premium = 6%. Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 34 n Beta = 1. 7, so division has more market risk 10 - 34 n Beta = 1. 7, so division has more market risk than average. n Division’s required return on equity: ks = k. RF + (k. M – k. RF)b. Div. = 7% + (6%)1. 7 = 17. 2%. WACCDiv. = wdkd(1 – T) + wcks = 0. 4(12%)(0. 6) + 0. 6(17. 2%) = 13. 2%. Copyright © 2001 by Harcourt, Inc. All rights reserved.

10 - 35 How does the division’s market risk compare with the firm’s overall 10 - 35 How does the division’s market risk compare with the firm’s overall market risk? n Division WACC = 13. 2% versus company WACC = 11. 1%. n Indicates that the division’s market risk is greater than firm’s average project. n “Typical” projects within this division would be accepted if their returns are above 13. 2%. Copyright © 2001 by Harcourt, Inc. All rights reserved.