Chapter 14 (Cost of Capital)
Which one of the following statements is correct?
Overall, a company makes better decisions when it uses the subjective approach than when it uses its WACC as the discount rate for all projects.
Why does the tax amount need to be adjusted when valuing a firm using the cash flow from assets approach?
The tax effect of the interest expense must be removed.
Pure Play Approach
The use of a WACC that is unique to a particular project, based on companies in similar lines of business.
The capital asset pricing model approach to equity valuation:
assumes the reward-to-risk ratio is constant.
The average of a company's cost of equity, cost of preferred, and aftertax cost of debt that is weighted based on the company's capital structure is called the:
weighted average cost of capital.
WACC: Capital structure weights and definitions
E = market value of equity = # outstanding shares times price per share D = market value of debt = # outstanding bonds times bond price P = market value of preferred = # outstanding shares times price per share V = Market value of the firm = D + E + P **if market values are not available, use book values Weights: w_E = E / V = percent financed with equity w_D = D / V = percent financed with debt w_P = P / V = percent financed with preferred
When computing the adjusted cash flow from assets, the tax amount is calculated as:
EBIT(T_C)
Two broad sources of capital are:
Equity (or stocks): which is riskier for investors Bonds: less risky for investors
What is the effect of taxes on the cost of capital?
Interest expense is tax-deductible, reducing the firm's tax liability. This reduction in taxes reduces our cost of debt **After-tax cost of debt = R_D(1 - t_C)
What is the SLM-CAPM approach?
The security market line (SML) is a line drawn on a chart that serves as a graphical representation of the capital asset pricing model (CAPM), which shows different levels of systematic, or market, risk of various marketable securities plotted against the expected return of the entire market at a given point in time.
What is Weighted Average Cost of Capital?
The weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation. -Overall it's the return the firm must earn on its assets to maintain the value of its stock. Hence, it is a market rate based on the market's perception of the risk of the firm's assets -WACC is the required return on the firm as a whole.
Regarding the Dividend Growth Model (DGM), how is g (the growth rate) estimated?
Two methods: 1. use analysts' forecasts of future growth rates. 2. Use the historical average of past growth rates.
Cost of debt is best estimated by the _____ on existing debt.
YTM Yield-to-maturity = Rate at which bond cash flows are discounted in the market -The market interest rate required on new debt issues -When these is no outstanding debt: use current YTMs of new issued similar bonds of with the same expected rating
The capital structure weights used in computing a company's weighted average cost of capital:
are based on the market values of the outstanding securities.
Preston Industries has two separate divisions. Each division is in a separate line of business. Division A is the largest division and represents 65 percent of the company's overall sales. Division A is also the riskier of the two divisions. When management is deciding which of the various divisional projects should be accepted, the managers should:
assign appropriate, but differing, discount rates to each project and then select the projects with the highest net present values.
The cost of capital for a new project:
depends upon how the funds raised for that project are going to be spent.
What is the Dividend Growth Model (DGM)?
determines if a stock is overvalued or undervalued assuming that the firm's expected dividends grow at a value g forever, which is subtracted from the required rate of return (RRR) or k. R_E = required return on equity = cost of equity Cost of equity = dividend yield + growth rate = dividend yield + capital gains yield
The cost of preferred stock is computed the same as the:
rate of return on a perpetuity.
The weighted average cost of capital for a company is least dependent upon the:
standard deviation of the company's common stock.
The discount rate assigned to an individual project should be based on:
the risks associated with the use of the funds required by the project.
The primary advantage of using the dividend growth model to estimate a company's cost of equity is:
the simplicity of the model.
The flotation cost for a company is computed as:
the weighted average of the flotation costs associated with each form of financing.
When should we use the WACC to discount cash flows for projects and investments by the firm?
-The firm's WACC is the appropriate discount rate only for projects of the same risk as its current operations -For a project of NOT the same risk as the firm, then we need the appropriate discount rate -Divisions also often require separate discount rates
A good estimate of the required rate of return is needed for:
-good capital budgeting decisions -financing decisions -operating decisions
Why does the cost of capital depend primarily on the use of the funds and not on their source?
Because it is the use that determines the risk of the project.
Beta of levered vs. unlevered firms:
Borrowing money raises the volatility of earnings Leverage affects a firm's exposure to systematic risk - after bad market shocks, bondholders are first in line. Hence, a firm's beta increases. Hamada devised a formula to account for them: B_L=B_u[1+(1-t_C)(D/E)]
Which one of the following statements related to WACC is correct for a company that uses debt in its capital structure?
The WACC would most likely decrease if the firm replaced its preferred stock with debt.
Black River Tours has a capital structure of 60 percent common stock, 5 percent preferred stock, and 35 percent debt. The dividend payout ratio is 30 percent, the company's beta is 1.21, and the tax rate is 21 percent. Given this, which one of the following statements is correct?
The cost of equity is unaffected by a change in the company's tax rate.
The ________ _________ of a firm is the mix of debt and equity the firm chooses to fund its investments.
capital structure -cost of capital = mix of cost of equity issued and cost of debt issued by the firm
The required return on an asset is based on the risk of the asset's _____ _____.
cash flows ¤A riskless project: its required return is the risk-free rate offered on securities of the same horizon ¤A risky project: its required return is the return on financial assets of the same systematic risk ¤Firms need to earn at least the required return to compensate investors for the financing they provided
To compute the NPV of a project, the firm needs to determine its what?
cost of capital **cost of capital = the required rate of return on the firm's assets.
Textile Mills borrows money at a rate of 8.7 percent. This interest rate is referred to as the:
cost of debt.
The ______ ___ ______ is the return required by equity investor given the risk of the cash flows from the firm.
cost of equity
A company's weighted average cost of capital:
is the return investors require on the total assets of the firm.
Advantage(s) of the Dividend Growth Model (DGM):
it is easy to understand and use.
Which one of these will increase a company's aftertax cost of debt?
A decrease in the company's tax rate
Which one of the following statements is correct?
A project that is unacceptable today might be acceptable tomorrow given a change in market returns.
Required Return = Cost of Capital =
Appropriate discount rate Required Return: from an investor's point of view Cost of Capital: the same return form the firm's point of view Appropriate Discount Rate: the same return as used in a PV calculation
Incorporating flotation costs into the analysis of a project will:
increase the initial cash outflow of the project.
Assigning discount rates to individual projects based on the risk level of each project:
may cause the company's overall weighted average cost of capital to either increase or decrease over time.
Dividends are not tax-deductible, which means there is...
no tax impact on R_E
Jenner's is a multi-division firm that uses its overall WACC as the discount rate for all proposed projects. Each division is in a separate line of business and each presents risks unique to those lines. Given this, a division within the firm will tend to:
prefer higher risk projects over lower risk projects.
The weighted average cost of capital for a firm with debt is the:
rate of return a company must earn on its existing assets to maintain the current value of its stock.
Flotation costs for a levered firm should be:
weighted and included in the initial cash flow.
What causes a firm's WACC to increase?
when the beta and rate of return on equity increase because an increase in WACC denotes a decrease in valuation and an increase in risk.
If a company uses its WACC as the discount rate for all of the projects it undertakes then the company will tend to:
increase the average risk level of the company over time.
When a firm has flotation costs equal to 8.3 percent of the funding need, project analysts should:
increase the initial project cost by dividing that cost by (1 − .083).
The cost of equity for a company with a debt-equity ratio of .41:
is affected by either a change in the company's beta or its projected rate of growth.
A company's pretax cost of debt:
is based on the current yield to maturity of the company's outstanding bonds.
Assume Russo's has a debt-equity ratio of .4 and uses the capital asset pricing model to determine its cost of equity. As a result, the company's cost of equity:
is dependent upon a reliable estimate of the market risk premium.
The cost of preferred stock:
is equal to the dividend yield.
The aftertax cost of debt:
is highly dependent upon a company's tax rate.
The dividend growth model:
is only as reliable as the estimated rate of growth.
What happens when a firm decides to use the same WACC for all divisions in the company, regardless of their risk?
it would lead to the firm choosing risky projects and rejecting safer projects. **See WACC Chart
The Road Stop is a national hotel chain with a cost of capital of 12.4 percent. This chain is considering opening a high-end resort that is expected to have a cost of capital that is at least 13 percent. The estimated net present value of the resort project is $500 when discounted at 12.4 percent. The best representation of this situation is that the resort project should:
probably be put on hold until its cost of capital can be lowered.
When a manager develops a cost of capital for a specific project based on the cost of capital for another firm that has a similar line of business as the project, the manager is utilizing the ________ approach.
pure play
What are attributes of preferred stock?
-Preferred pays a constant dividend every period -Dividends are expected to be paid forever -Preferred stock is a perpetuity, so we take the perpetuity formula, rearrange and solve for R_P
What are the two major methods for determining the cost of equity?
1. Dividend Growth Model (DGM) 2. SML-CAPM approach
Disadvantages of the Dividend Growth Model (DGM):
1. Only applicable to companies currently paying dividends = greater estimation error and variability. 2. Not applicable if dividends are not growing at a reasonably constant rate. 3. Past g may not predict future g. 4. Very sensitive to estimated growth rate: an increase in g by 1% increases RE by 1%. 5. Finally, this approach really does not explicitly consider risk. Unlike the SML approach (which we consider next), there is no direct adjustment for the riskiness of the investment. For example, there is no allowance for the degree of certainty or uncertainty surrounding the estimated growth rate for dividends. As a result, it is difficult to say whether or not the estimated return is commensurate with the level of risk.
Two methods we use to get the Beta for a project?
1. Pure Play Approach: look at firms which focus on the type of projects we are interest. 2. Subjective Approach: what we do if we don't have any data on similar firms.
Change in WACC is determined by two competing effects:
1. WACC ↓when w_d increases, and tax savings increases. 2. WACC ↑when R_E increases. **an increase in debt may increase the risk for shareholders
According to the CAPM, the return on equity (R_E) depends on:
1. the risk-free rate, R_F 2. the expected market risk premium, E(R_M) - r_F 3. The amount of systematic risk, measured by Beta_E R_E = r_F + B_E[E(R+M)-r_F] **T-bill rates are often used for r_F **the historical average is often used as an entire estimate for the expected market risk premium
Subjective approach
1.Consider the project's risk relative to the overall firm 2.If the project is riskier than the firm, use a discount rate greater than its WACC 3.If the project is less risky than the firm, use a discount rate lower than its WACC **You may still accept projects that you shouldn't and reject projects you should accept, but your error rate should be lower than not considering differential risk at all
Cost of Capital is estimated in three steps:
1.Estimate the cost of equity, debt, preferred, current liabilities 2.Compute their relative weights 3.Compute the WACC
Steps in the Pure Play approach?
1.Find one or more companies that specialize in the product or service that we are considering 2.Compute the beta for each company 3.Take an average 4.Use that beta along with the CAPM to find the appropriate return for a project of that risk **often difficult to find pure play companies
Advantages of SML-CAPM approach:
1.It explicitly adjusts for systematic risk 2.It is applicable to all companies, as long as we can compute their betas: publicly traded stocks
Disadvantages of SML-CAPM approach:
1.It requires the estimation of the expected market risk, which varies over time 2.It requires the estimation of β, which also varies over time 3.The past is not a perfect predictor of the future
All else constant, which one of the following will increase a company's cost of equity if the company computes that cost using the security market line approach? Assume the firm currently pays an annual dividend of $1 a share and has a beta of 1.2.
A reduction in the risk-free rate
Use WACC to discount unlevered cash flows:
CFFA = EBIT*(1-t)+D-(change in NWC)-NCS
A group of individuals got together and purchased all of the outstanding shares of common stock of DL Smith Inc. What is the return that these individuals require on this investment called?
Cost of equity
Which one of the following is the primary determinant of a firm's cost of capital?
Use of the funds raised
The subjective approach to project analysis:
assigns discount rates to projects based on the discretion of the senior managers of a firm. **the firm places projects into one of several risk classes. The discount rate used to value the project is then determined by adding (for high risk) or subtracting (for low risk) an adjustment factor to or from the firm's WACC.
Why does the Dividend Growth Model (DGM) versus the Security Market Line (SML) approach typically yield different estimates?
because the underlying assumptions of the two approaches are very different. DGM requires that: -Expected dividends grow at a constant rate forever **R_E > g SML requires: -Investors to care only about mean and standard deviation -Absence of taxes, transaction costs, and other frictions
A company's current cost of capital is based on:
both the returns currently required by its debtholders and stockholders.
How can WACC be used to measure a firm's corporate performance?
by using Economic Value Added (EVA) -- this is the most popular way. EVA = WACC x (Debt + Equity)
The cost of debt (R_D) is the return that lenders require on the firm's ____.
debt **We usually focus on the cost of long-term debt or bonds because investments have long-term horizon
A company's overall cost of equity is:
directly related to the risk level of the firm.