Chapter 14
Disadvantages for the CAPM method? (2)
RE is extremely sensitive to changes in beta and the market risk premium, which are both estimated We are using past data to predict the future
What does WACC represent?
The WACC represents an average cost to a company It is 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. So, if we were evaluating the cash flows from a proposed expansion of our existing operations, this is the discount rate we would use.
What is one important thing to remember when estimating the cost of debt?
The coupon rate is not the cost of debt!
pre-tax vs after-tax for debt
The interest expense a company pays on its debt is tax-deductible Interest expense (like all expenses) serves to shield income from taxation, so paying interest expense reduces income tax expense
What does the dividend discount model require us to do that could be potentially harmful?
The model requires us to estimate g, the rate of growth if the company, by either.. using historical data and calculating g, or using online analysts' estimates
Tripleday Printing Company is currently at its target debt-equity ratio of 100 percent. It is considering building a new $500,000 printing plant in Kansas. This new plant is expected to generate aftertax cash flows of $73,150 per year forever. The tax rate is 21 percent. There are two financing options: A $500,000 new issue of common stock: The issuance costs of the new common stock would be about 10 percent of the amount raised. The required return on the company's new equity is 20 percent. A $500,000 issue of 30-year bonds: The issuance costs of the new debt would be 2 percent of the proceeds. The company can raise new debt at 10 percent. What is the NPV of the new printing plant?
To begin, because printing is the company's main line of business, we will use the company's weighted average cost of capital to value the new printing plant: WACC= (E/V) × RE + (D/V) × RD × (1−TC) = .50 × .20 + .50 × .10 × (1 − .21) = .1395, or 13.95% Because the cash flows are $73,150 per year forever, the PV of the cash flows at 13.95 percent per year is: PV = $73,150/.1395 = $524,373
If the firm chooses to finance a project with weights other than it's target D/E ratio (for example, it chooses to finance a project with all debt), should it calculate flotation costs using the target weights or the weights actually used?
To take this into account, the firm should always use the target weights in calculating the flotation cost. The firm should use the target weights, even if it can finance the entire cost of the project with either debt or equity. The fact that a firm can finance a specific project with debt or equity is not directly relevant. If a firm has a target debt-equity ratio of 1, for example, but chooses to finance a particular project with all debt, it will have to raise additional equity later on to maintain its target debt-equity ratio.
Valuing the firm finds which variable from the WACC equation?
V, the market value of the total capital structure.
Market value of equity (common and preferred) Market value of debt
We will use the symbol E (for equity) to stand for the market value of the firm's equity. We calculate this by taking the number of shares outstanding and multiplying it by the price per share. Similarly, we will use the symbol D (for debt) to stand for the market value of the firm's debt. For long-term debt, we calculate this by multiplying the market price of a single bond by the number of bonds outstanding. If there are multiple bond issues (as there normally would be), we repeat this calculation of D for each and then add up the results. If there is debt that is not publicly traded (because it is held by a life insurance company, for example), we must observe the yield on similar publicly traded debt and then estimate the market value of the privately held debt using this yield as the discount rate. For short-term debt, the book (accounting) values and market values should be somewhat similar, so we might use the book values as estimates of the market values. w Finally, we will use the symbol V (for value) to stand for the combined market value of the debt and equity: V = E + D
When will the WACC potentially lead to problems? How can we fix this?
When we are evaluating investments with risks that are substantially different from those of the overall firm, use of the WACC will potentially lead to poor decisions. Try to determine what the cost of capital is for such investments by trying to locate some similar investments in the marketplace, or adopt an approach that involves making subjective adjustments to the overall WACC.
When asked to find the present value of a firm, use the...
adjusted CFA (adjusted to eliminate the impact of the tax-shield from debt financing).
The cost of capital depends primarily on...
how funds are employed, rather than how funds are raised
The after-tax cost of debt is ______ its pre-tax cost
lower than
The WACC is the...
return required on the total assets of the firm Each source of capital has a required return, R The weighted average cost of capital, WACC, reflects the average market return required on all sources of long-term capital. In other words, a firm's cost of capital will reflect both its cost of debt capital and its cost of equity capital.
Estimating the cost of debt: For firms with publicly held debt, Rd is... For firms without publicly held debt, Rd is... But in the WACC formula we find...
the pre-tax Yield to Maturity, YTM (The coupon rate is not the cost of debt!) the pre-tax YTM on bonds of similar risk (issued by other firms) the after-tax YTM
The after-tax cost of equity is ______ the pre-tax cost of equity
the same as
As the Balance Sheet makes evident, funding for new assets is obtained from:
Debt: loans and bonds Equity: preferred stock and common stock
pre-tax vs after-tax for equity
Dividend payments to preferred and common stockholders are not expenses Dividend payments do not appear on the income statement (except, perhaps, as footnotes). Therefore, dividend payments are not tax-deductible
Suppose Spatt's target capital structure is 60 percent equity, 40 percent debt. The flotation costs associated with equity are still 10 percent, but the flotation costs for debt are less—say 5 percent. Calculate the weighted average flotation cost What does this cost mean? ON FORM SHEET
Earlier, when we had different capital costs for debt and equity, we calculated a weighted average cost of capital using the target capital structure weights. Here we will do much the same thing. We can calculate a weighted average flotation cost, fA, by multiplying the equity flotation cost, fE, by the percentage of equity (E/V) and the debt flotation cost, fD, by the percentage of debt (D/V) and then adding the two together The weighted average flotation cost is 8 percent. What this tells us is that for every dollar in outside financing needed for new projects, the firm must actually raise $1/(1 − .08) = $1.087. In our example, the project cost is $100 million when we ignore flotation costs. If we include them, then the true cost is $100 million/(1 − fA) = $100 million/.92 = $108.7 million.
What is true of interest expense?
Interest expense reduces income tax This is why we take the pre-tax cost of debt (the YTM) and multiply it by (1 - Tc). This gives us the pre-tax cost appropriately reduced due to the tax shield.
What is one issue with calculating a firm's cash flows in order to evaluate the firm's value?
Interest paid is a financing cost, not an operating cost. However, the firm's actual cash flows reflect the reduction of taxes because of debt financing We must adjust the cash flows to remove the impact of the interest tax shield
If companies do not provide the demanded return to investors: (3)
Investors flee Stock price drops The corporate fails to achieve its purpose
How can we evaluate the value of a firm?
Just as we can evaluate the future cash flows of a project to estimate the project's value, we can evaluate the future cash flows from the total assets of a firm to estimate the total firm's value
Disadvantages of the dividend discount model (4)
Not useful if the firm does not pay dividends We are using past data to predict the future RE is extremely sensitive to changes in g The approach does not explicitly consider risk
flotation 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 flotation costs. Flotation costs are incurred by a publicly traded company when it issues new securities, and includes expenses such as underwriting fees, legal fees and registration fees.
How do we find Rm and Rf for the CAPM method of estimating the required return on equity? What about beta?
Once we know Rf, the market risk premium, (RM - Rf), can be estimated by finding the historical market (e.g. using S&P 500 data) We could employ analysts' estimates of beta
If a project earns more than the WACC... (3)
Value (the NPV) is added to the firm The stock price will rise The goal of the firm is achieved
For projects of above-average risk, the discount rate is often... This implies.... And results in a ______ required rate of return
adjusted upward greater than average volatility of the project's future cash flows higher
The WACC is the firm's ________________ It is the discount rate for It is the required rate of return for an
average cost of capital an NPV analysis IRR analysis
A capital project's discount rate is also called the ______ or ______________ It is the....
cost of capital; required rate of return rate required by investors on a financial asset of comparable risk
When should the WACC be employed?
it should be employed when valuing projects of average risk
What does removing the impact of debt financing do to cash flows?
Removing the impact of debt financing reduces cash flows from assets
What will we use as a risk-free instrument?
US Treasury bills
The returns demanded by investors are...
the costs incurred by companies
