Chapter 10 Fina311
Market Value of Equity
# of shares outstanding x current stock price
Factors that Affect the WACC a Firm can Control (3)
1. By Changing its Capital Structure = Ex. if they change to increase target debt, WACC tends to decrease (all things held constant) but an increase in debt is likely to cause the riskiness of debt + equity to increase + these increases may offset the effects of the changes in the weights + the WACC will increase 2. Changing its Dividend Payout Ratio = the higher the dividend payout ratio, the less Retained Earnings so the need to sell stock + incur flotation costs increases. So the greater the dividend payout ratio, smaller the addition to Retained Earnings, which leads to an increase in the cost of equity and WACC 3. Altering Capital Budgeting Decisions Rules to accept projects with higher or lower risk than before. Ex. investing in new capital assets with the same levels of risk as the existing ones (which firms tend to do) will keep the WACC the same, but if they go and invest in new and risky lines of business its cost of debt and equity (WACC) will increase
Problems with Cost of Capital Estimates (5)
1. Depreciation-Generated Funds = funds from depreciation is an opportunity cost + is equal to WACC from Retained Earnings, Preferred Stock, and Debt 2. Privately Owned Firms = its hard to measure the cost of equity for a fund that is not publicly traded. The same techniques apply but its just extremely hard to get the data 3. Measurement Problems = it is hard to obtain accurate data for the CAPM, like for "g" or "rs" so we can't be 100% sure 4. Costs of Capital for Projects of Differing Risks = its hard to measure a projects risk 5. Capital Structure Weights = establishing a target capital structure is a major task
What are the basic steps to budgeting? (3)
1. Estimate the required rate of return on securities 2. Calculate a weighted average of the costs of their different types of capital 3. Use this average cost of capital for budgeting purposes
Problems with the CAPM Method (2)
1. If a firms stockholders are not well diversified, they may be concerned w/ stand alone risk rather than just market risk, if this is the case, CAPM would underestimate rs 2. Even if the CAPM method is valid, its still hard to obtain accurate estimates of the required inputs
Factors that Affect the WACC a Firm Cannot Control (3)
1. Interest Rates in the Economy = if they increase, the cost of debt will increase because the firm must pay bondholders more when it borrows 2. General Level of Stock Prices = if they decrease, they pull the stocks price down and so its cost of equity increases 3. Tax Rates = b/c tax rates have an affect on the component cost of debt, they have an important effect on the firms cost of capital, also when tax rates on dividends and capital gains decrease relative to rates on interest income, stocks become relatively more attractive than debt
What are the Ways New Common Equity is Raised? (2)
1. Retaining some of the current years earnings 2. Issuing new common stock
Notation: rd( 1 - T )
After Tax Component Cost of Debt it is the relevent cost of new debt taking into account the tax deductibility of interest T is the firms marginal tax rate, and this is the debt cost used to calculate the weighted average cost of capital. this is *ALWAYS* lower than rd because interest is tax deductible *the after tax component is the one which is used to calculate the WACC*
Notation: rs + How to is it found
Component Cost of Common Equity Raised by Retained Earnings ( i.e Internal Equity ) the rate of return required by stockholders on a firms common stock most firms once they've become well established, obtain all of their new equity as retained earnings so rs is their cost of new equity its hard to measure but remember rs = r^s Required Rate of Return = Expected Rate of Return rs = rRF + RP = D0 / P0 + g = r^s the left side is the CAPM + the right side is the Discount Dividend we can estimate rs by filling things in
Notation: re
Component Cost of External Equity ( i.e Common Equity Raised by Issuing New Stock) re is equal to rs plus a factor that reflects the (flotation) cost of issuing new stock established firms rarely issue new stock, so re is only for young growing firms
Notation: rp + How is it found (Formula)
Component Cost of Preferred Stock it is the rate of return investors require on the firms preferred stock it is found as the yield investors expect to earn on the preferred stock Dp / P0 Dp= preferred dividend
How to Calculate the next Dividend Payment
D0 ( 1 + g )
Notation: rd How is it found?
Interest Rate on Firms New Debt this is the before tax component cost of debt, it is the interest rate a firm pays on its new debt it is found by calculating the yield to maturity on the firms current outstanding bonds
Notation: wd, wp, wc + What does the Common Equity portion contain?
Target Weights of Debt, Preferred Stock, Common Equity the common equity portion includes retained earnings, internal equity, new common stock and external equity
How to find the Present Value of Future Cash Flows?
a discount rate is needed, and the discount rate is the firms cost of capital
Capital Components
a type of capital used to raise funds, specifically investor supplied items- debt, preferred stock, common equity
Weighted Average Cost of Capital (WACC)
a weighted average of the component cost of debt, preferred stock and common equity
What are the only types of Capital the WACC is concerned about?
capital provided by investors, interest bearing debt, preferred stock, common equity. nothing else.
Where does Debt usually come from? What is Preferred Stock? Who does Retained Earnings belong to?
debt usually comes from banks or through bonds preferred stock is a hybrid with mashups of debt and common equity. Its like debt because of its predictable fixed dividends but also like common equity because if a company skips a dividend it won't go bankrupt common shareholders
Which Component Cost is tax deductible and why?
debt, because debt is tax deductible
What are increases in assets funded by?
increases in capital components
A firms primary objective is to Increase Shareholder value, what is the principal way to do this?
invest in projects that earn more than their cost of capital
Averaging the Alternatives Approach
means that you average the 3 different approaches
Are Retained Earnings free?
no, they still have an opportunity cost a firm needs to earn atlas as much on retained earnings that if the stockholders were to go somewhere else and invest in investments of comparable risk
Bond-Yield-Plus-Risk-Premium Approach to Estimate Cost of Common Equity
studies show that the risk premium on a stock ranges from 3% to 5%. So if you have the bond yield you can find a generally accurate measure of equity cost rs = Bond Yield + Risk Premium
Optimal Capital Structure
the best target capital structure that maximizes the firms value
Component Cost
the cost of borrowing each component, which gets combined for the WACC Ex. borrowing money @ 10% means the component cost is at 10%
What is the Key element in the Capital Budgeting Process? This is the "hurdle rate"
the cost of capital
What do the rates of return investors require on bonds and stocks represent?
the costs of those securities to the firm
What would happen if you didn't adjust the WACC when there were riskier projects?
the firm would accept too many risky projects + reject too many safe ones, and over time the firm would become too risky
Why is the After Tax Cost of Debt used instead of the other one?
the goal of a firm is to increase the value of stock, and the stock price depends on the after-tax cash flows
What is the Cost of Debt? + What s the Best Measure of the Cost of Debt?
the interest rate on NEW debt, not old outstanding debt yield to maturity over the coupon rate
Target Capital Structure
the mix of debt, preferred stock, and common equity the firm plans to raise to fund its future projects
Discounted Cash Flow (DCF) Approach to Estimate Cost of Common Equity
this is if dividends are expected to grow at a constant rate. The answer to this equation is the minimum rate of return that should be earned on Retained Earnings to justify not paying P0 = ( D1 / rs ) - g if you don't know rs.... rs = r^s = ( D1 / P0 ) + Expected g
CAPM Approach to Estimate Cost of Common Equity (4)
this it the most commonly used method to estimate cost of Common Equity 1. Estimate the Risk Free Rate (rRF), generally by 10 year bonds 2. Estimate the stocks beta coefficient (bi) and use it as an index of the stocks risk 3. Estimate the Market Risk Premium , remember its the difference between the return investors require on the average stock and the risk free rate 4. Substitute the preceding values into the CAPM equation to estimate the required rate of return (rs). rs = rRF + (RPM) bi
What must you do with the WACC for riskier projects?
you must take the weight and the WACC of each project and add them up