Ch 14 - Cost of Capital & WACC

What's the Discount Rate?

% Interest rate (I/Y or r) used to determine PV of cash flows

Pure Play Approach involves:

- A company with a SINGLE line of business - Unlikely to find a public company like that

2 Internal Factors of WACC (the firm can control)

1. Capital Structure Policy 2. Dividend Policy

2 External Factors of WACC

1. Interest Rates 2. Tax Rates

How to determine bond price when figuring Weight of Debt?

% of par the bonds are selling at (1040, 1000)

Subjective Approach

- Assign investments to "risk" categories based on risk premiums - Find all public companies and scale them out (what they do & their beta on a scale) - Base decision on risk level off of other companies depending on your own risk level

Cost of Equity is a function of the firm's _________ and _____________ risk

- Business and Financial - Common shareholders return - Found using Dividend Growth model or SML/CAPM

Financial Risk

- Capital structure decision to increase debt increases the ________ , which can lead to additional reward! - Results in additional variability in EPS & ROE

Weighted Average Cost of Capital (WACC)

- Cost of capital for the firm as a whole, and it can be interpreted as the required return on the overall firm. - The weighted average of the cost of equity and the after-tax cost of debt - All variables should be current market values (costs and dollars)

Cost of Capital

- FIRM's POV in terms of what cost they will pay an investor if they were to entice an investor to buy an asset - Debt and Equity from company's perspective - Average riskiness of all securities it has issued, may be less risky (bonds) or more risky (common stock)

Floatation Costs

- If a company accepts a new project, it may be required to issue, or "float" new bonds and stocks. This means that the firm will incur some costs, which we call ________________ - "fees associated with raising new capital(debt/equity)" - Retained Earnings are not subject to _________

"Homemade Leverage" (Case I ideal scenario)

- If all market participants have equal access to the capital markets, there's nothing special about corporate borrowing - A shareholder can alter effective leverage from holding the firm's shares in their brokerage account and therefore the risk & return to match shareholder preference

When is it appropriate to use WACC as a discount rate & what to do to adjust WACC if it is NOT appropriate?

- If capital project exists with same/similar risk use the WACC (constantly using this will lead to incorrect lower WACC which could give you the impression that you owe debtors less than you actually owe) - You adjust WACC with (Pure play approach & Subjective approach)

CAPM

- Provides the expected required return (in the future) someone needs to make from investing in an asset - Uses Beta (measure of systematic risk) - Appropriate when valuing common equity (dividend discount model) - Appropriate if valuing capital project if firm is financed 100% with EQUITY & the project has similar risk as the company! (NO DEBT)

Business Risk

- Risk inherent in a firm's operations - Not affected by how a firm finances its assets - Return for the risk is the ROA

Two adjustments made for floatation costs:

1. Increase capital raised for project to include floatation costs ("gross capital" per book) 2. Adjust up the cost of debt and new equity to include floatation costs

What is the most commonly used asset in determining the risk free rate for Cost of Equity calculations?

10-yr Treasury Bond

According to figure 14.1 When Beta = 1, E(R) should =

15%

Increasing beta leads to incorrect _____________ Decreasing beta leads to incorrect _____________

ACCEPTANCE REJECTION

CAPM/SML is more used by _________

Analysts

Why is there no optimal CS in Case I the ideal scenario?

Because it depends on the preferences of the shareholder and the risk/return he or she requires (all subjective)

After-tax cost of debt

Before tax cost of debt (YTM) * (1-T)

How did Modigliani & Miller decide the "optimal capital structure"

By comparing 2 companies that are thee EXACT SAME (theoretical) same, other than their financing - Full equity financed vs. partially debt financed - Assumed "Perfect economic world" with no TAXES / BANKRUPTCY costs - Found a higher ROE with some debt than no debt

Dividend Policy

Changes in the amount of dividends paid out reflects a change in the firm's retained earnings

Capital Structure Policy

Changes in the proportions of debt and equity affect WACC (internal factor of WACC)

YTM is the...

Current market interest rate for a firm's bonds

Interest Expense =

Debt level * Interest rate

Debt is more beneficial/less-risky than Equity because

Debt-holders have a 1st claim, contractual right to receive interest/principal payments back Equity holders have a contingent right & longer-term claim

What are some advantages / disadvantages of using the Dividend Growth Model in evaluating Cost of Equity vs. CAPM/SML

Dividend growth model relies on the most recent dividend payment and not all companies pay dividends , otherwise it's pretty simple. CAPM/SML relies on Beta (widely available) and a risk free rate (usually 10-yr treasury bond) BUT the risk premium is a difficult number to estimate

Combined market value (V) =

E + D + P

Give a type of company in which using the Subjective approach is probably more suitable than the pure play approach:

EX. A large technology company - Chance of finding appropriate company is not that great

If Firm A has a risk level above the average riskiness of other firms, Firm A should _____________ WACC. Otherwise Firm A will become riskier, accept too many high-risk projects and reject too many low risk.

INCREASE (Adjust up)

Required Return

Looks at what the interest rate is from the INVESTOR's POV based on risk

Capital Structure

Mix of financing used by the firm (debt & equity)

Does preferred stock increase in value when the "firm's value" increases?

NO

Earnings per Share (EPS) =

Net Income (includes taxes) / Shares outstanding

Weight of Debt

Portion of a firm's assets that were purchased using "Debt financing"

Weight of Preferred Stock

Portion of a firms assets that are purchased by issuing new preferred stock

How does an increase in interest rates affect cost of debt and cost of equity?

RD and RE would increase as well (rates increase proportional with interest rates)

Capital Components

Right side of the balance sheet (L+E)

Firms ________ ADJUST the WACC to reflect the riskiness of each individual project

SHOULD

What does a Debt/Equity ratio = 1 suggest?

That you have the same amount of debt & equity outstanding, 1/2 of assets financed with debt and the other 1/2 financed with equity

What 2 things do Tax Rates affect?

The after-tax cost of debt used in WACC and changes in the capital gains rate

Pure Play Approach

The use of a WACC that is unique to a particular project, based on companies in similar lines of business

Leverage

Using debt as part of the capital structure is also called using ____________

The_______ represents how much a company needs to return on avg. to investors, given the risk level of the company (how its financed and its projects)

WACC

Optimal Capital Structure will also minimize the ________ because the value of the firm is the sum of all future cash flows discounted at _______

WACC, WACC

Wtf is (D/V)RD(1-TC) ?

Weight of Debt * Cost of debt

What is a likely outcome when using the Subjective Approach to determine WACC?

With the Subjective Approach, you will likely accept some projects you should reject, and accept some projects you should reject, but ... you will STILL make fewer errors than if you simply used the WACC to evaluate everything!

Cost of Debt

YTM of a bond (helps to determine which interest rate the firm pay out) YTM*(1-T)

Preferred Stock is like a cross of ______ and _______. Payment on preferred stock is constant (like debt) but it is called a dividend (like equity). Also NO maturity

stock and debt