Ch. 14: WACC

WACC =

(We)(Re) + (Wd)(Rd)(1-Tc) To calculate WACC, we multiply the capital structure weights by the associated costs and add them up

There are two major methods for determining the cost of equity

-Dividend growth model -SML, or CAPM

Advantages of SML

-Explicitly adjusts for systematic risk -Applicable to all companies, as long as we can estimate beta -May be useful is a wider variety of circumstances

Disadvantages of SML

-Have to estimate the expected market risk premium, which does vary over time -Have to estimate beta, which also varies over time -We are using the past to predict the future, which is not always reliable

wD =

D/V = percent financed with debt

•What are the two approaches for computing the cost of equity?

Dividend Growth Model and CAPM

wE =

E/V = percent financed with equity

•How should we factor flotation costs into our analysis?

Multiply the weight times the cost of that particular item

•Suppose we have a bond issue currently outstanding that has 25 years left to maturity. The coupon rate is 9%, and coupons are paid semiannually. The bond is currently selling for $908.72 per $1,000 bond. What is the cost of debt?

N = 50; PMT = 45; FV = 1000; PV = -908.72 I/Y = 5%; YTM = 5(2) = 10%

•How do you compute the capital structure weights required for the WACC?

Take D/V where V is D+E

•How do you compute the cost of debt and the after-tax cost of debt?

You compute the yield to maturity for the bonds and then multiply it by (1-corporate tax rate)

Advantages of Dividend Growth Model

easy to understand and use

Subjective Approach

•Consider the project's risk relative to the firm overall •If the project has more risk than the firm, use a discount rate greater than the WACC •If the project has less risk than the firm, use a discount rate less than the WACC •You may still accept projects that you shouldn't and reject projects you should accept, but your error rate should be lower than not considering differential risk at all Focus on the cash flows from the business (more cyclical than S&P 500 or less cyclical?) Take WACC and adjust it for risk A very low risk project would be energy savings

Cost of preferred stock

•Preferred stock is a perpetuity, so we take the perpetuity formula, rearrange and solve for RP •RP = D / P0

•Your company has preferred stock that has an annual dividend of $3. If the current price is $25, what is the cost of preferred stock?

•RP = 3 / 25 = 12%

Cost of Debt

•The cost of debt is the required return on our company's debt •We usually focus on the cost of long-term debt or bonds •The required return is best estimated by computing the yield-to-maturity on the existing debt •We may also use estimates of current rates based on the bond rating we expect when we issue new debt •The cost of debt is NOT the coupon rate the return the firm's creditors demand on new borrowing; the return that lenders require on the firm's debt Can normally be observed either directly or indirectly The interest rate the firm must pay on new borrowing, and we can observe interest rates in the financial markets Coupon rate is irrelevant--look at yield on debt in today's marketplace for calculation

Taxes

•We are concerned with after-tax cash flows, so we also need to consider the effect of taxes on the various costs of capital •Interest expense reduces our tax liability -This reduction in taxes reduces our cost of debt -After-tax cost of debt = RD(1-TC) •Dividends are not tax deductible, so there is no tax impact on the cost of equity Discount rate needs to be expressed on an after-tax basis Interest paid by a corporation is deducible for tax purposes, dividends are not In determining an aftertax discount rate, we need to distinguish between the pretax and the after-tax cost of debt After tax interest rate = pretax rate x (1 - tax rate)

The 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 the risk of those assets •The weights are determined by how much of each type of financing is used

Disadvantages of Dividend Growth Model

-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

Preferred Stock reminders

-Preferred stock generally pays a constant dividend each period -Dividends are expected to be paid every period forever

•Your company is considering a project that will cost $1 million. The project will generate after-tax cash flows of $250,000 per year for 7 years. The WACC is 15%, and the firm's target D/E ratio is .6 The flotation cost for equity is 5%, and the flotation cost for debt is 3%. What is the NPV for the project after adjusting for flotation costs?

1.0/1.6 = 0.625 .6/1.6 = 0.375 Flotation costs = (.375*3)+(.625*5) = 4.25% > cost to issue capital N=7, I/Y=15, PMT=250,000 --> compute PV = 1040105 NPV = 1040105 - (1000000/(1-.0425)) = -4281.423 •The project would have a positive NPV of 40,105 without considering flotation costs •Once we consider the cost of issuing new securities, the NPV becomes negative

Use historical average

Calculate the percent change between each year then add all of these percent changes and divide by the number of percent changes (will be the total amount of years - 1)

•A corporation has 10,000 bonds outstanding with a 6% annual coupon rate, 8 years to maturity, a $1,000 face value, and a $1,100 market price. •The company's 100,000 shares of preferred stock pay a $3 annual dividend, and sell for $30 per share. •The company's 500,000 shares of common stock sell for $25 per share and have a beta of 1.5. The risk free rate is 4%, and the market return is 12%. •Assuming a 40% tax rate, what is the company's WACC?

Debt: 10000 x 1100 = 11000000 market value Yield to maturity: N=8, PB=-110, PMT=60, FV=1000, compute I/Y = 4.48% Equity: CS: 500000 x 25 = 12500000 market value Return = 4 + 1.5(12-4) = 16% Preferred: 100000 x $30 = $3000000.00 Return = D/P = 3/30 = 10% 11,000,000 + 3,000,000 + 12,500,000 = 26,500,000 Debt = 11/26.5 = 0.4151 CS = 12.5/26.5 = 0.4717 Preferred = 3/26.5 = 0.1132 WACC: .1132 * .1 + .4717 * .16 + .4151 * .0448 *(1-.4)= 0.0979

Capital Structure Weights Notation

E = market value of equity = # of outstanding shares times price per share D = market value of debt = # of outstanding bonds times bond price V = market value of the firm = D + E

Capital Structure weights

If there are multiple bond issues, repeat the calculation of D for each and then add up the results If there is debt that is not publicly traded 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 V = E + D

•What are two methods that can be used to compute the appropriate discount rate when WACC isn't appropriate?

Pure play approach (finding a company in that industry) and subjective approach

•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? Use SML

RE = 6% + 1.5(9%) = 19.5%

•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 + .58(8.6) = 11.1%

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? Use DGM

RE = [2(1.06) / 15.65] + .06 = 19.55%

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) + .051 = .111 = 11.1%

The SML Approach

Re = Rf + B(E(Rm)-Rf) Rf = risk free rate market risk premium = E(Rm)-Rf B = systematic risk 1 factor model T-bill average: 4% Large cap stocks 100-year average return: 12% Use long term average instead of current rates when calculating cost of capital for a long term project

If we came up with similar numbers using both the dividend growth model and the SML approach....

we should feel good about our estimate

The Pure Play Approach

•Find one or more companies that specialize in the product or service that we are considering •Compute the beta for each company •Take an average •Use that beta along with the CAPM to find the appropriate return for a project of that risk •Often difficult to find pure play companies We must examine other investments outside the firm that are in the same risk class as the one we are considering, and use the market-required return on these investments as the discount rate We will try to determine what the cost of capital is for such investments by trying to locate some similar investments in the marketplace Take beta of each company, add them up, and average them Ex. Google--Cloud computing, self-driving car, healthcare

The Dividend Growth Model Approach

•Start with the dividend growth model formula and rearrange to solve for RE P = D1/ (Re-g) Re = (D1/P) + g Re = required return

Cost of Equity

•The cost of equity is the return required by equity investors given the risk of the cash flows from the firm -Business risk -Financial risk A firm's cost of capital will reflect both its cost of debt capital and its cost of equity capital There is no way of directly observing the return that the firm's equity investors require on their investment Cost of equity: the return that equity investors require on their investment in the firm

Flotation costs

•The required return depends on the risk, not how the money is raised •However, the cost of issuing new securities should not just be ignored either •Basic Approach: -Compute the weighted average flotation cost -Use the target weights because the firm will issue securities in these percentages over the long term Issue costs If a company accepts a new project, it may be required to issue/float new bonds and stocks If you need to issue a new cost you pay something to do so

Required Return

•The required return is the same as the appropriate discount rate and is based on the risk of the cash flows •We need to know the required return for an investment before we can compute the NPV and make a decision about whether or not to take the investment •We need to earn at least the required return to compensate our investors for the financing they have provided Required return, appropriate discount rate, and cost of capital all mean essentially the same thing The cost of capital depends primarily on the use of the funds, not the source A firm's overall cost of capital will reflect the required return on the firm's assets a whole Same as appropriate discount rate

Divisional and Project Costs of Capital

•Using the WACC as our discount rate is only appropriate for projects that have the same risk as the firm's current operations •If we are looking at a project that does NOT have the same risk as the firm, then we need to determine the appropriate discount rate for that project •Divisions also often require separate discount rates because they might have different riskiness or require the same resources A firm that uses its WACC to evaluate all projects will have a tendency to both accept unprofitable investments and become increasingly risky Ex: If McDonalds buys another restaurant, they should use the same cost of capital If McDonalds buys $5M of energy efficient bulbs, they use the cost of capital of an energy co. (utilities are less volatile than burgers, so we use a different cost of capital)

•Suppose you have a market value of equity equal to $500 million and a market value of debt equal to $475 million. -What are the capital structure weights?

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

Why Cost of Capital Is Important

•We know that the return earned on assets depends on the risk of those assets •The return to an investor is the same as the cost to the company •Our cost of capital provides us with an indication of how the market views the risk of our assets •Knowing our cost of capital can also help us determine our required return for capital budgeting projects The return an investor in a security receives is the cost of that security to the company that issued it We want to know the required return that an investor would want on a similar investment What investors are thinking about our company based on its beta

•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? What is the cost of debt? What is the after-tax cost of debt? What are the capital structure weights? What is the WACC?

•What is the cost of equity? -RE = 5 + 1.15(9) = 15.35% •What is the cost of debt? -N = 30; PV = -1,100; PMT = 45; FV = 1,000; CPT I/Y = 3.9268 -RD = 3.927(2) = 7.854% •What is the after-tax cost of debt? -RD(1-TC) = 7.854(1-.4) = 4.712% •What are the capital structure weights? -E = 50 million (80) = 4 billion -D = 1 billion (1.10) = 1.1 billion -V = 4 + 1.1 = 5.1 billion -wE = E/V = 4 / 5.1 = .7843 -wD = D/V = 1.1 / 5.1 = .2157 •What is the WACC? -WACC = .7843(15.35%) + .2157(4.712%) = 13.06%' IRR needs to be above WACC to accept project so NPV is over 0