Finance Chapter 14
what really is the cost of debt?
the interest rates the firm must pay on the new borrowing interest rates can be found in the financial markets.
Formula for finding after tax rate?
Rd * (1-coporate tax) 9% * (1-.34) = 5.94%
What is the cost of debt?
the return that lenders require on the firms debt can usually be observed directly or indirectly
What is total capitalization?
the sum of its long term debt and equity
If the firm already has bond outstanding, what is the market require rate?
the yield outstanding
How do we avoid this problem?
we look for the market require return on projects with similar risk as the discount rate
what must we do in order to determine the aftertax discount rate?
we must distinguish between the pretax and aftertax cost of debt
In the SML approach, what three things does the required rate of return depend on?
1. The risk-free rate Rf 2.The market risk premium E(Rm) - Rf 3. the systematic risk of the asset relative to average, which is called its Beta coefficient, Beta
What are the two ways used to estimate the cost of equity?
1. the Dividend growth model 2. Security Market Line (SML)
What is the Dividend Growth Model?
P0 = [D0 * (1+g)] / (Re - g) or P0 = D1 / (Re-g) D0 --> dividend just paid D1--> next periods dividend g --> growth rate Re --> required return on equity
Which variables of the dividend growth model can be easily obtain and which variables must be estimated?
Po and Do are observed directly the growth rate must be estimated
Suppose we paid a dividend of $4 per share last year. The stock currently sells for $60 per share. I estimate the dividend will grow steadily at a 6% growth rate. What is the cost of equity?
Re = $4*1.06 / 60) +.06 Re = $4.24/60 + .06 Re =0.131 Re = 13.1%
Imagine the US t-bills are paying about .1%. the market risk premium estimate is 7% and the Beta for publicly traded are companies are widely available. Ex. is Abercrombie and Fitch with beta=1.68
Re = 0.1% + 1.68* (0.07) Re= 11.86%
Suppose a firm borrows 1 million at a 9% interest rate. the corporate tax is 34% What is the aftertax cost of the debt?
The total interest bill is $90,000 this amount is tax deductible 90,000*.34 = 30,600 The after tax interest bill is thus 90,000 - 30,600 which is $59,400 59,000 / 1 million = 5.94%
The subjective approach?
all projects fall into one of three classes or else are mandatory the firms WACC may change through time as economic conditions change the discount rates for the projects also change also for some risk adjustment
What is the firms cost of debt based on historical borrowing sometimes called?
embedded debt cost
Drawbacks to SML approach
must do two calculations for estimations for the market risk premium and the beta coefficient using different time periods or different stocks could result in very different estimates
How does risk effect stock price?
the higher the risk the lower the stock price
How does stock price effect cost of equity?
the lower the stock price, the higher the cost of equity
what is WACC?
the overall return the firm must earn on its existing assets to maintain the value of its stock. it is also the required return on any investments by the firm that have essentially the same risks as existing operations
What are capital structure weights?
the percentage of debt and equity that make up total capitalization of the company Value = Equity + Debt or (V= E+D) 100% = E/V + D/V Remember to use MARKET value
Using the WACC as the discount rate is only appropriate when?
the proposed investment is similar to the firm's existing activites
What is the cost of equity?
the return that equity investors require on their investment in the firm must be estimated
What is the pure play approach?
the use of a WACC that is unique to a particular project, based on companies in similar lines of business
what does the cost of capital depend primarily on?`
the use of the funds, not the source the cost of capital associated with an investment depends on risk of that investment
How to estimate the growth rate?
1. use historical growth rates 2. use analysts forecasting for future growth rates (obtain multiple growth rates and average them)
Using SML, how can we write the expected return on the company's equity?
E(Re) = Rf + Be * (E(Rm) - Rf) Be is the estimated beta to make it look more similar to the dividend growth model approach... Re = Rf + Be * (Rm - Rf)
What is MVA?
Market Value added
whats are the weighted average cost of capital (WACC)?
The weighted average cost of equity and the aftertax cost of debt WACC = [(E/V) *Re] + [(D/V)*Rd *(1-Tc)]
pure play?
a company that focuses on a single line of business
Advantages to SML approach
adjusts for risk applicable to more then just dividend paying companies
Disadvantages of the dividend growth rate approach?
applicable only to companies who pay dividends assumes dividends grow at constant rate estimate cost of equity is very sensitive to estimated growth rate does not explicitly consider risk. no direct adjustment for the riskiness of the investment
What will a firms cost of capital reflect?
both the cost of debt capital and the cost of equity capital
What is EVA?
economic value added
calculating average flotation cost
fa = (E/V)*fE + (D/v) *fd
how do we determine the cost of preferred stock?
fixed dividend (perpetuity) Rp = D/Po D is the fixed dividend Po is the current price per share of preferred stock
projects that have similar risk are said to be
in the same risk class
What can occur if a firm sole uses WACC as its cut off?
it will tend to accept projects that are below the SML line and reject those that are above the SML line this mean the company will accept unprofitable investments and become increasingly risky tends to accept riskier investments
What else is WACC used for?
performance evaluation
How can we use Dividend Growth Model to determine cost of equity?
rearrange equation so Re = (D1/ P0) +g
What is SVA?
shareholder value added
Advantages of the dividend growth rate approach?
simple (easy to understand and use)
flotation costs?
the cost of issuing new bonds or stock that comes with a new project arise as a consequence of the division to undertake a project, they are relevant cash flows
what is a firms target capital structure?
the desired debt-to-equity ratio it wants to maintain
