Topic 9: Weighted-Average Cost of Capital (WACC)
What are the three parts individual asset returns can be decomposed into from CAPM's expected returns equation?
(i) a baseline risk-free return (ii) a systematic component of return driven by overall market returns (iii) an asset-specific idiosyncratic component of return. In this equation we explicitly denote random variables with a tilde
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 the cost of debt - Dividends are not tax-deductible: no tax impact on R(E) and R(P)
What is the Required Return on Equity/Cost of Equity Capital
- The risk-adjusted required return that equity investors demand as compensation for the risk of investing in the firm's equity
What is weighted average cost of capital?
- We can use the individual costs of capital that we have computed to get our "average" cost of capital for the firm - This "average" is the required return on the firm's assets, based on the market's perception of risk of those assets - The weights are determined by how much of each type of financing is used
Three questions to ask when solving discount factors
1. How risky is the asset? 2. What else could you do with the money of equivalent risk- what is the opportunity cost of the funds? 3. At a minimum the firm must earn enough to compensate investors for the use of capital to finance the warehouse- the firm's cost of capital - How much the firm earn to compensate investors for the use of capital to finance the warehouse (in the example)- the firm's cost of capital - In order to invest in the warehouse, the rate of return on that investment must at least compensate the firm for its cost of capital ----If not, the firm could simply give the money back to the equity investors or it could pay off the higher-cost debt
How to compute NPV of a project?
1. Identify the relevant cash flows 2. Determine the appropriate discount rate given the project's risk
Dividend Growth Model Approach Ex: 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. A) What is the cost of equity? B) If the stock price were below $25 (e.g., $22), would the implied cost of equity be above or below 11.1%?
A) (picture) B) Above- A lower price generates a higher expected/required return on equity This is why "underpriced" stocks have expected returns that lay above the SML: too low of prices correspond with too high of expected returns
M&M Propositions How would you answer in the following debate? Q: Isn't it true that the riskiness of a firm's equity will rise if the firm increases its use of debt financing? A: Yes, that's the essence of M&M Proposition II. Q: And isn't it true that, as a firm increases its use of borrowing, the likelihood of default increases, thereby increasing the risk of the firm's debt? A: Yes. Q: In other words, increased borrowing increases the risk of the equity and the debt? A: That's right. Q: Well, given that the firm uses only debt and equity financing, and given that the risks of both are increased by increased borrowing, does it not follow that increasing debt increases the overall risk of the firm and therefore decreases the value of the firm?
A: No, you cannot make this conclusion. While it is true that the equity and debt costs are rising, the key thing to remember is that the cost of debt is still less than the cost of equity. Since we are using more and more debt, the WACC does not necessarily rise.
What is after-tax cost of debt? what happens to 1-t(c) when tax rates go up?
After-tax cost of debt = R(D)(1-T(c)) - 1-tax rate - As tax rates goes up, 1-T(c) gets smaller due to firms being able to deduct the cost of debt from their tax bill
What is cost of debt and how is it best estimated?
Analysis will usually focus on long-term debt or bonds - Required return is best estimated by computing the yield-to-maturity on the existing debt - Cost of debt is NOT the coupon rate - We may also use estimates of current rates based on the bond rating we expect when we issue new debt
If Stock x declines by 2 percent when the general index declines by 1 percent, then the owner cannot really hedge. And her wealth drops much more when the general index declines. This stock is risky (heavily exposed to systematic risk)
Because the stock does not systematically move with the market, its not exposed to systematic risks- therefor a lot safer and provides a way to hedge against systematic risks. *Willingness to pay more- Demand goes up, Price goes up = lower rate of return*
What does beta measure in systematic risk?
Beta measures correlation between: - The stock return - The cost of equity for a stock - The systematic risk the investor faces
Book Values versus Market Values In calculating the WACC if you had to use book values for either debt or equity which would you choose? Why?
Book values for debt are likely to be much closer to market values than are equity book values.
What is a "bottom up beta"?
Bottom up beta is a diversified business that should have a lower beta - High operating flexibility: low fixed cost firms ---Flexible labor contracts ---Outsource. Manufacturing to reduce need for expensive plant and equipment ---Join venture agreements, where fixed costs are borne by someone else - High flexibility= ---Percent (%) change in operating profit ---(%) change in sales
Where does risk come from?
Business risk comes from: 1. Competition 2. Regulation 3. Macroeconomics
Business Risk versus Financial Risk Explain what is meant by business risk and financial risk. Suppose Firm A has greater business risk than Firm B. Is it true that Firm A also has a higher cost of equity capital? Explain.
Business risk is the equity risk arising from the nature of the firm's operating activity and is directly related to the systematic risk of the firm's assets. Financial risk is the equity risk that is due entirely to the firm's chosen capital structure. As financial leverage, or the use of debt financing, increases, so does financial risk and, hence, the overall risk of the equity. Thus, Firm B could have a higher cost of equity if it uses greater leverage.
What is the cost of capital?
Cost of capital = mix or weighted average of cost of equity and cost of debt issued by the firm
What are some of the disadvantages of finding dividend growth?
Disadvantages: - 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%
Are dividends tax deductible? How does it then impact cost of equity?
Dividends are not tax deductible, so there is no tax impact on the cost of equity
Capital structure weights notation: E= D= V=
E= Market value of equity = # of outstanding shares * price per share D= market value of debt= # of outstanding bonds * bond price V= Market value of the firm = D + E
How do firms fund investments?
Firms use different sources to fund investments Two broadest categories of sources of capital are 1. Equity: riskier for the investors R(E) (and preferred equity R(P)) 2. Debt: less risky for the investors R(D)
What is divisional cost of capital?
For a project of NOT the same risk as the firm, then we need the appropriate discount rate - How should Microsoft calculate the cost of capital for the XBox? Divisions also often require separate discount rates
How to find dividend growth
How to find the g- dividend growth: take the average of the dividend growth to get a number for your 'g' factor
If a beta is 2, what will it react to?
If beta is 2, it will be incredibly sensitive to movements in the market premium B= 2, R(i) increases
Divisional Cost of Capital Under what circumstances would it be appropriate for a firm to use different costs of capital for its different operating divisions? If the overall firm WACC were used as the hurdle rate for all divisions, would the riskier divisions or the more conservative divisions tend to get most of the investment projects? Why? If you were to try to estimate the appropriate cost of capital for different divisions, what problems might you encounter? What are two techniques you could use to develop a rough estimate for each divisions cost of capital?
If the different operating divisions were in much different risk classes, then separate cost of capital figures should be used for the different divisions; the use of a single, overall cost of capital would be inappropriate. If the single hurdle rate were used, riskier divisions would tend to receive more funds for investment projects, since their return would exceed the hurdle rate despite the fact that they may actually plot below the SML and, hence, be unprofitable projects on a risk-adjusted basis. The typical problem encountered in estimating the cost of capital for a division is that it rarely has its own securities traded on the market, so it is difficult to observe the market's valuation of the risk of the division. Two typical ways around this are to use a pure play proxy for the division, or to use subjective adjustments of the overall firm hurdle rate based on the perceived risk of the division.
WACC and Taxes Why do we use an after-tax figure for cost of debt but not for cost of equity?
Interest expense is tax-deductible. There is no difference between pretax and aftertax equity costs.
What does interest expense do to tax liability?
Interest expense reduces our tax liability (subject to limitations) - This reduction in taxes reduces our cost of debt
WACC weights. What is investment grade debt?
It is common for analysts to assume that MV(debt)=BV(debt), especially for firms with investment grade debtInvestment Grade Debt= a debt rating of BBB or higher
WACC On the most basic level, if a firm's WACC is 12 percent, what does this mean?
It is the minimum rate of return the firm must earn overall on its existing assets. If it earns more than this, value is created
What does more leverage do?
More leverage increases the variance of net income in good times and lower income in bad times
Project Risk If you can borrow all the money you need for a project at 6 percent, doesn't it follow that 6 percent is your cost of capital for the project?
No. The cost of capital depends on the risk of the project, not the source of the money.
What does preferred equity do?
Pay fixed dividend -Has priority before common shareholders
How to find cost of preferred equity?
Perpetuity!
What is the cost of equity proportional to?
Proportional to the riskiness of the cash flows=cost of equity
Compute the WACC of Parker Industries given the following inputs (ignoring taxes): Β=1.5; Rf=0.8%; MRP=7% RD= 5.09% E=$150bn; D=$50bn
R(E) = R(F) + (beta)[E(R(M)) - R(E)] R(D) = R(1)
Company Risk versus Project Risk Both Dow Chemical Company, a large natural gas user, and Superior Oil, a major natural gas producer, are thinking of investing in natural gas wells near Houston. Both companies are all equity financed. Dow and Superior are looking at identical projects. They've analyzed their respective investments, which would involve a negative cash flow now and positive expected cash flows in the future. These cash flows would be same for both firms. No debt would be used to finance the projects. Both companies estimate that their projects would have a net present value of $1 million at 18 % discount rate and a -$1.1 million NVP at 22 percent discount rate. Dow has a beta of 1.25 whereas Superior has a beta of .75. The expected risk premium on the market is 8%, and risk-free bonds are yielding 12 percent. Should either company proceed? Should both? Explain.
R(Sup) = .12 + .75(.08) = .1800, or 18.00% Both should proceed. The appropriate discount rate does not depend on which company is investing; it depends on the risk of the project. Since Superior is in the business, it is closer to a pure play. Therefore, its cost of capital should be used. With an 18 percent cost of capital, the project has an NPV of $1 million regardless of who takes it.
What is the return on equity in regards to risk?
Return on equity is talking about the systematic component of the risk
What is the cost of equity?
Return required by equity investors given the riskiness of the firm's cash flows - The riskier the cash flow = higher firm's cost of equity
What does risk premium come from? Can it be diversified away?
Risk premium comes from exposure to systematic risk - This risk cannot be diversified away - Therefor the rate of return is going to reflect risk premium that comes from systematic risk
Ex: Stark Industries has a 7% cost of debt, a 14% cost of equity, and a 21% tax rate. What debt-equity ratio is needed for the firm to achieve a 7.5% weighted average cost of capital?
Step 1: WACC --> WE Step 2: W(E) --> D/E
Cost of Debt Estimation How do you determine the appropriate cost of debt for a company? Does it make a difference if the company's debt is privately placed as opposed to being publicly traded? How would you estimate the cost of debt for a firm whose only debt issues are privately held by institutional investors?
The appropriate aftertax cost of debt to the company is the interest rate it would have to pay if it were to issue new debt today. Hence, if the YTM on outstanding bonds of the company is observed, the company has an accurate estimate of its cost of debt. If the debt is privately placed, the firm could still estimate its cost of debt by (a) looking at the cost of debt for similar firms in similar risk classes, (b) looking at the average debt cost for firms with the same credit rating (assuming the firm's private debt is rated), or (c) consulting analysts and investment bankers. Even if the debt is publicly traded, an additional complication occurs when the firm has more than one issue outstanding; these issues rarely have the same yield because no two issues are ever completely homogeneous.
What is the cost of debt?
The cost of debt RD 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 RD is best estimated by the YTM on existing debt RD ≠ coupon rate = promised interest on existing debt
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
DCF Cost of Equity Estimation What are the advantages of using DCF model for determining the cost of equity capital? What are disadvantages? What specific piece of information do you need to find the cost of equity using this model? What are some of the ways in which you could get this estimate?
The primary advantage of the DCF model is its simplicity. The method is disadvantaged in that (a) the model is applicable only to firms that actually pay dividends; many do not; (b) even if a firm does pay dividends, the DCF model requires a constant dividend growth rate forever; (c) the estimated cost of equity from this method is very sensitive to changes in the growth rate, which is a very uncertain parameter; and (d) the model does not explicitly consider risk, although risk is implicitly considered to the extent that the market has impounded the relevant risk of the stock into its market price. While the share price and most recent dividend can be observed in the market, the dividend growth rate must be estimated. Two common methods of estimating the growth rate are to use analysts' earnings and payout forecasts or to determine some appropriate average historical growth rate from the firm's available data.
What is the required return on an asset based on? Riskless vs Risky Project
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 The project needs to earn at least the required return to compensate investors for the financing they provided The cost of capital depends on the use (not source!) of the funds
What is the Security Market Line (SML) or CAPM approach?
The return on any asset: Return = Riskless Rate + Risk Premium
What is the difference between DGM and CAPM/SML
The two approaches typically result in different estimates - DGM --- Easy to understand and use --- Only applicable to companies currently paying dividends, growing at a constant rate; very sensitive to g - CAPM --- Explicitly adjusts for systematic risk --- Applicable to all publicly traded stocks (can compute betas) --- Requires an estimate of [E(RM)-RF] and beta, which vary over time assumes world wit no frictions or transaction costs where investors to care only about mean and standard deviation
How can one determine if something is a good investment? Why is this an important perspective?
To find if something is a good investment, the firm must identify its cost of capital -This is an important perspective: Managers should always consider that they are using investor capital to fund firm operations and projects. Therefore, when managers consider the "opportunity cost of capital", managers shouldn't be thinking so much about what else they (as firm managers) could do with the money, but rather what else the firm's investors could do with the money.
What makes up cost of capital?
To maximize shareholders' value, managers choose projects with NPV>0 - Appropriate Discount Rate = Required Return = Cost of Capital --- Required Return: from an investor's point of view --- Cost of Capital: the same return from the firm's point of view, minimum expected return an investment must offer to be attractive Same concept: opportunity cost of using capital in one way as opposed to alternative financial market investments of the same systematic risk
SML Cost of Equity Estimation What are the advantages of using SML approach to finding the cost of equity capital? What are the disadvantages? What specific pieces of information are needed to use this method? Are all of these variables observable or do they need to be estimated? What are some of the ways in which you could get these estimates?
Two primary advantages of the SML approach are that the model explicitly incorporates the relevant risk of the stock and the method is more widely applicable than is the dividend discount model, since the SML doesn't make any assumptions about the firm's dividends. The primary disadvantages of the SML method are (a) three parameters (the risk-free rate, the expected return on the market, and beta) must be estimated, and (b) the method essentially uses historical information to estimate these parameters. The risk-free rate is usually estimated to be the yield on very short maturity T-bills and is, hence, observable; the market risk premium is usually estimated from historical risk premiums and, hence, is not observable. The stock beta, which is unobservable, is usually estimated either by determining some average historical beta from the firm and the market's return data, or by using beta estimates provided by analysts and investment firms.
What are the two ways to calculate Cost of Equity?
Two ways of calculating RE: 1. DGM 2. CAPM
What are the weights associated with WACC?
WE = E/V = part financed with equity WD =D/V = part financed with debt WP = P/V = part financed with preferred V = market value of the firm = D + E + P - E = market value of equity = # outstanding shares * price per share - D = market value of debt = # of outstanding bonds * bond price (or issue face value*bind % price) - P=market value of preferred= # outstanding preferred shares * price per preferred share T(C) is the corporate tax rate
When elasticity is low firm has __________.
When elasticity is low firm has high operating flexibility
What do companies like to do when tax rates are high?
Whenever tax rates are high, companies like issuing a lot of debt.... Companies like financing themselves - Tax deductibility of interest: They do this to reduce taxable income by the amount of interest
What is Yield-to-maturity (YTM)?
YTM= 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 and maturity
Cost of Capital Suppose Tom O'Bedlam, president of Bedlam Products Inc., has hired you to determine the firm's cost of debt and cost of equity capital. a) The stock currently sells for $50 per share, and the dividend per share will probably be about $5 per share to use the stockholders' money this year, so the cost of equity is equal to 10 percent (=$5/50). What's wrong with this conclusion? b) Based on the most recent financial statements, Bedlam Product's total liabilities are $8 million. Total interest expense for the coming year will be about $1 million. Tom therefore reasons, "We owe 8 million, and we will pay $1 million interest. Therefore, our cost of debt is obviously $1 million/8 million=.125 or 12.5%. Wha's wrong with this conclusion? c) Based on his own analysis, Tom is recommending that the company increase its use of equity financing because "Debt costs 12.5 percent, but equity costs only 10 percent; thus equity is cheaper." Ignoring all the other issues, what do you think about the conclusion that the cost of equity is less than the cost of debt?
a. This only considers the dividend yield component of the required return on equity. b. This is the current yield only, not the promised yield to maturity. In addition, it is based on the This only considers the dividend yield component of the required return on equity. book value of the liability, and it ignores taxes. c. Equity is inherently more risky than debt (except, perhaps, in the unusual case where a firm's assets have a negative beta). For this reason, the cost of equity exceeds the cost of debt. If taxes are considered in this case, it can be seen that at reasonable tax rates, the cost of equity does exceed the cost of debt.