Finance lecture 10 - cost of capital

general concept: our cost of capital provides us with an indication of what?

indication of how the market views the risk of our assets

cost of debt - general concept: the cost of debt is not what?

not the coupon rate

weighted average cost of capital - effect of tax: we are concerned with after tax cash flows so we also need to consider the effect of taxes on the various costs of capital. What is the effect of interest expense on tax liability? And, therefore what is the effect on the cost of debt

reduces tax liability - this reduction in taxes reduces our cost of debt

Cost of equity- CAPM approach: what is the CAPM equation?

refer to sheet

cost of debt: example - What is cost of debt for the following bond issue? 25 years left to maturity. coupon rate is 9% and coupons are paid semiannually bond is currently selling for $908.72 per $1,000 bond.

refer to sheet (lecture 10, slide 13)

general concept: we need to earn at least the .................... to compensate our investors for the financing they have provided

required return

general concept: what must we know before we can compute the NPV and make a decision about whether or not to take the investment?

required return

divisional and project cost of capital: if a firm uses its WACC to make accept-reject decisions for all types of projects, it will have a tendency toward incorrectly accepting ............ projects and incorrectly rejecting ............... projects

risky less risky

general concept: the return of an investor is the same as what?

same as the cost to the company

weighted average cost of capital - general concept: What is the average?

the average is the required return on the firm's assets, based on the market's perception of the risk of those assets

cost of debt - general concept: with cost of debt what do we usually focus on?

the cost of long-term debt or bonds

cost of debt - general concept: define cost of debt

the required return on our company's debt

cost of equity: define the cost of equity

the return required by equity investors given the risk of the cash flows from the firm

general concept: the return earned on assets depends on what?

the risk of those assets

weighted average cost of capital - general concept: What can we use to get our average cost of capital for the firm?

use the individual costs of capital that we have computed

cost of debt - general concept: we may also use estimates of current rates based on what?

based on the bond rating we expect when we issue new debt

cost of debt - general concept: The required return is best estimated by doing what?

by computing the yield to maturity on the existing debt

general concept: Knowing our cost of capital can also help us determine what?

determine our required return for capital budgeting projects

weighted average cost of capital - general concept: weights are determined by what?

determined by how much of each type of financing is used

divisional and project cost of capital: if we are looking at a project that is not of the same risk as the firm, then we need to determine the appropriate ............. for that project

discount rate

general concept: the required return is the same as the appropriate ................... and is based on the risk of the cash flows

discount rate

divisional and project cost of capital: divisions also often require separate .............

discount rates

weighted average cost of capital - effect of tax: why is there no tax impact on the cost of equity?

dividends are not tax deductible

Cost of equity- CAPM approach: what information do we use to compute our cost of equity?

- Risk-free rate, Rf - Market risk premium, E(Rm) - Rf - systematic risk of asset,

divisional and project cost of capital: what is the subjective approach?

- consider the project's risk relative to the firm overall - if the project is more/ less risky than the firm use a discount rate greater / less than the WACC (you may still accept projects that you shouldn't and reject projects you should but your error rate should be lower than not considering differential risk at all)

cost of equity: what are the two major methods for determining the cost of equity?

- dividend growth model - CAPM

divisional and project cost of capital: what is the pure play approach?

- find one or more companies that specialize in the product or service that we are considering - compute and average the beta for each company - use that beta along with the CAPM to find the appropriate return for a project of that risk

cost of equity: state the advantage(s) of the dividend growth model

- it is easy to understand and use

cost of equity: state the disadvantages of the dividend growth model (4)

- only applicable to companies currently paying dividends - not applicable if dividends aren't growing at a reasonably constant rate - extremely sensitive to the estimated growth rate - an increase in g of 1% increases the cost of equity by 1% - does not explicitly consider risk

weighted average cost of capital - effect of tax - example - Equity Information: 50 million shares $80 per share Beta = 1.15 Market risk premium = 9% Risk-free rate = 5% Debt Information: $1 billion in outstanding debt (face value) Current quote = 110 Coupon rate = 9%, semiannual coupons 15 years to maturity Tax rate = 40% What is the cost of debt?

1,100 = 45 (1 - 1/(1+r)^30 / r) + 1000/(1+r)^30 r = 3.9268% Rd = 3.9268(2) = 7.854%

what are the main advantages of the CAPM approach?

1. explicitly adjusts for systematic risk 2. applicable to all companies, as long as we can compute beta

what are the main disadvantages of the CAPM approach?

1. have to estimate the expected market risk premium which does vary over time 2. have to estimate beta, which also varies over time 3. we are relying on the past to predict the future which is not always reliable

weighted average cost of capital - general concept: in the formula what is the notation D?

D = market value of debt = # outstanding bonds times bond price

weighted average cost of capital - general concept: in the formula, what is the notation E?

E = market value of equity = # outstanding shares times price per share

divisional and project cost of capital: using the WACC as our discount rate is only appropriate for what projects?

Projects that are the same risk as the firm's current operations

weighted average cost of capital - effect of tax: after tax cost of debt = .........................

RD (1-Tc)

Cost of equity- CAPM approach: example Suppose your company has an equity beta of .58 and the current risk-free rate is 6.1%. If the expected market risk premium is 8.6%, what is your cost of equity capital?

RE = 6.1 + 0.58(8.6) = 11.1%

weighted average cost of capital - effect of tax - example - Equity Information: 50 million shares $80 per share Beta = 1.15 Market risk premium = 9% Risk-free rate = 5% Debt Information: $1 billion in outstanding debt (face value) Current quote = 110 Coupon rate = 9%, semiannual coupons 15 years to maturity Tax rate = 40% What is the after tax cost of debt?

Rd(1-Tc) = 7.864%(1-4) = 4.712%

cost of equity: In the dividend growth model approach, we rearrange the formula to solve for .... what is the formula and the rearrangement? (refer to sheet)

Re

cost of equity: 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. What is the cost of equity?

Re = 1.50 / 25 + 0.051 = 0.111

weighted average cost of capital - effect of tax - example - Equity Information: 50 million shares $80 per share Beta = 1.15 Market risk premium = 9% Risk-free rate = 5% Debt Information: $1 billion in outstanding debt (face value) Current quote = 110 Coupon rate = 9%, semiannual coupons 15 years to maturity Tax rate = 40% What is the cost of equity?

Re = 5 + 1.15 (9) = 15.35%

cost of equity - Example: Suppose our company has a beta of 1.5. The market risk premium is expected to be 9% and the current risk-free rate is 6%. We have used analysts' estimates to determine that the market believes our dividends will grow at 6% per year and our last dividend was $2. Our stock is currently selling for $15.65. what is our cost of equity?

Using SML: RE = 6% + 1.5(9%) = 19.5% using DGM: : RE = [2(1.06) / 15.65] + .06 = 19.55%

weighted average cost of capital - general concept: example - Suppose you have a market value of equity equal to $500 million and a market value of debt = $475 million. What are the capital structure weights?

V = $500 million + $475 million = $975 million wE = E/D = $500 / $975 = .5128 = 51.28% wD = D/V = $475 / $975 = .4872 = 48.72%

weighted average cost of capital - general concept: in the formula what is V?

V = market value of the firm = D + E

weighted average cost of capital - general concept: in the formula what are the weights WE and WD?

WE = E/V = percent financed with equity WD = D/V = Percent financed with debt

weighted average cost of capital - effect of tax: WACC = ..........................

WeRe + WdRd (1-Tc)