Chapter 12
CAPM Advantages/ Disadvantages
-Advantages ~Explicitly adjusts for risk (through measure of systematic risk or Beta) ~Can be used for all companies whether they pay dividends or not(as long as we can compute beta) -Disadvantages ~Have to estimate the expected market risk premium (which may change over time) ~Have to estimate Beta (Which may also change) ~We are relying on the past to predict the future
Which of the following are components used in the construction of the WACC?
-Cost of preferred stock -Cost of common stock -Cost of debt
Weighted Average Cost of Capital
-Our company can be thought of as a portfolio of its common stock, preferred stock and debt (and any other sources of capital) -The overall cost of capital is just a weighted average of the various components -The weights are determined by how much of each type of financing we use
Preferred stock ___.
-Pays a constant dividend -Pays dividends in perpetuity
To estimate a firm's equity cost of capital using the CAPM, we need to know the ___.
-Stock's beta -Market risk premium -Risk-Free Rate
Cost of Equity
-The cost of equity is the return required by stockholders given the risk of the cash flows from the firm -Two main methods 1) Dividend growth model 2) CAPM (or SML)
Divisional Costs of Capital
-Using the WACC as the discount rate is only appropriate for projects with the same level of risk as the entire firm -If a project is of a different level of risk, we need to determine an appropriate discount rate for the project -Different divisions often require separate discount rates because the risk characteristics are different in the divisions
Cost of Debt
-Usually focus on long-term debt -Best estimate for the cost of debt is the bond's yield-to-maturity ~Coupon rate isn't the cost of debt (fixed when bonds are issued --> does not change with risk) -We may want to use estimates based on the new bond rating we expect when we issue new debt
Some risk adjustment to firm's WACC for projects of differing risk, even if it is subjective, is probably:
Better than no risk adjustment
The WACC is the minimum required return for ___.
The Overall Firm
According to the CAPM, what is the expected return on a stock if its beta is equal to zero?
The risk-free rate
The cost of capital depends primarily on the ___ of funds, not the ___.
Use ; Source
CAPM Example Suppose our company has a beta of 1.5. The market risk premium is expected to be 6% and the current risk-free rate is 4%. We have used analysts' estimates to determine that the market believes our dividends will grow at 5% per year and our last dividend was $0.75. Our stock is currently selling for $10. What is our cost of equity?
Using SML: RE=0.04+1.5(0.06) = 0.13 Cost of Equity: 13% Using DGM: RE=(0.75(1.05))/10 +0.05=.12875 Cost of Equity: 12.875% Average them both= 12.937%
Dividend Growth Model Advantages/Disadvantages
-Advantages : Easy to understand and use -Disadvantages ~ Only works for companies paying dividends ~Not applicable if dividends are not growing at a reasonably constant rate ~Extremely sensitive to estimated growth rate ~Does not explicitly consider risk
The rate used to discount project cash flows is known as the ___.
-Discount Rate -Required Return -Cost of Capital
To estimate the dividend yield of a particular stock, we need:
-Forecasts of the dividend growth rate, g -The current stock price -The last dividend paid, D0
Dividend Growth Model
-We can rewrite the basic dividend growth model to show the components of the required return (R=(D1/P0)+g) -The dividend and the current price are easily observable. How do you get a growth rate though? ~Historical average =how fast dividends have grown during the past few years ~Analysts' Estimates =find online =How long can this growth rate be sustained?
If a firm has multiple projects, each project should be discounted using ___.
A discount rate commensurate with the project's risk
Dividends paid to common stockholders ___ be deducted from the payer's taxable income for tax purposes.
Cannot
Extended Example Equity Info: 50 million shares $80 per share Beta = 1.15 Market Risk Premium: 6% Risk-Free Rate: 3% Debt Info: $1 billion in outstanding debt (face value) Current Quote: 110 Coupon Rate: 9%, semiannual coupons 15 years to maturity Tax Rate: 40%
Cost of Equity? RE=0.03+1.15(0.06)=0.099 or 9.9% Cost of Debt? Ro=0.0785 or 7.85% After-Tax Cost of Debt? 0.0785(1-0.40) = .0471 or 4.71% Capital Structure Weights? E=50 mill shares x$80 per share= $4 Billion D=$1 Billion in FV x 110% =$1.1 billion market value V= 4 billion + 1.1 Billion = $5.1 Billion total market value We= 4 bill/ 5.1 bill = 0.784 Wd= 1.1 bill/ 5.1 bill = 0.216 What is the WACC? WACC= 0.784 (0.099) + 0.216(0.0785)(1-0.40) = 0.0878 or 8.78%
Which of the following are tax-deductible to the firm?
Coupon interest paid on bonds
Cost of Preferred Stock
-Generally ~Preferred stock pays a constant dividend every period ~Dividends are to be paid forever (does not change) -We can just rearrange the perpetuity formula ~ Rp = D / Po
To apply the dividend discount model to a particular stock, you need to estimate the ___.
-Growth rate -Dividend yield
The growth rate of dividends can be found using:
-Historical dividend growth rates -Security analysts' forecasts
Which of the following are true?
-Ideally we should use market values in the WACC -Book values are often similar to market values for debt
Which of the following are true about a firm's cost of debt?
-It is easier to estimate than the cost of equity -Yields can be calculated from observable data
Which of the following is true about a firm's cost of debt?
-It is easier to estimate than the cost of equity -Yields can be calculated from observable data
What will happen over time if a firm uses its overall WACC to evaluate all projects, regardless of each project's risk level?
-It will accept projects that it should have rejected -The firm overall will become riskier -It will reject projects that it should have accepted
Cost of Capital cont.
-The cost of capital is the same as the required return (in time value money) or the appropriate discount rate -We use this to calculate NPV and decide on investment projects -We need to earn at least the cost of capital to compensate our investors for the funds that they have provided
Cost of Capital
-The return on assets/investments depends on the risk of the assets/investments -The return to an investor is the same as the cost to the company -The cost of capital provides information about how the market views the risks of our assets -Because most companies are not financed completely with equity, the cost of capital helps us determine the required return for capital budgeting projects ~Most companies are financed by both debt and equity
CAPM Approach
-Use the Security Market Line (SML) to calculate required return on equity -Need Rf (current risk-free rate), Market risk premium (Rm-Rf) and Systematic risk (Beta)
Weighted Average Cost of Capital Cont.
-When we did capital budgeting, we were concerned w/ after-tax cash flows so we need to consider taxes as well -Tax-Deductibility of interest expense reduces our after-tax cost of debt -Dividends (common and preferred) are not deductible so there is no tax impact on these costs
If an all-equity firm discounts a project's cash flows with the firm's overall weighted average cost of capital even though the project's beta is less than the firm's overall beta, it is possible that the project might be:
Rejected, when it should be accepted
Finding a firm's overall cost of equity is difficult because:
It cannot be observed directly
If a firm issues no debt, its average cost of capital will equal ___.
Its cost of equity
Weighted Average Cost of Capital Example: Suppose you have a market value of equity equal to $500 million and a market value of debt of $350 million. Assume no preferred stock is used. What is the capital Structure weights?
V= 500 + 350 = $850 mill We = E/V= 500mill/850mill= 0.5882 or 58.82% Wd=D/V= 350mill/850mill = 0.4118 or 41.18% 0.5882 + 0.4118 = 1.00 or 100%
What does WACC stand for?
Weighted Average Cost of Capital
Dividend Growth Model Example : Suppose your company is expected to pay a dividend of $1.50 next year. The dividend has been growing steadily at 5.1% per year and that is expected to continue. The current price is $25. What is the cost of equity?
(1.50/25) =0.06 or 6% 0.06+0.051 = 0.111 Price of Common Stock= 11.1%
Subjective Approach
-Consider the project's risk relative to the rest of the company -If the project is more risky, use a discount rate higher than the WACC (higher required rate of return) -If less risky, use a lower discount rate (lower required rate of return) -You still may take projects that you should not and pass up ones that you should take, but the errors should be smaller than if you don't consider the different levels of risk
Cost of Debt Example : 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. What is the cost of debt?
0.09 x 1000= 90 --> each payment is $45 25 years --> 50 payments total 908.71 = -PV 50 = N 45 = PMT 1000 = FV Compute Interest per year --> gives semi annual rate =5% x 2 = 10% cost of debt for firm
Divisional Costs of Capital Example What would happen if we use the WACC for all projects regardless of risk? Assume WACC=15%
Assume WACC=15% Project / Require Return / IRR A (risky) / 20% / 17% B (moderate) / 15% / 18% C (stable) / 10% / 12% Accept if IRR exceeds 15% =Accept A and B =Reject C But we should have rejected A because they was a higher risk But we should have accepted C because there was a higher return since it was lower
The return an investor in a security receives is ___ the cost of the security to the company that issued it.
Equal to
(T/F) Projects should always be discounted at the firm's overall cost of capital.
False
Components of the WACC include funds that come from ___.
Investors
Weighted Average Cost of Capital Notation and Weights
Notation: E=Market Value of Equity = # outstanding shares times price per share D=Market Value of Debt=# outstanding bonds times bond price P=Market Price of Preferred Stock = # outstanding shares of preferred stock times price per share (ONLY if its issued; can be 0 or positive) V=Market Value of the Firm = D+E+P Weights: We=E/V=% financed w/ equity Wd=D/V=% financed w/ debt Wp=P/V=% financed w/ preferred stock
Other companies that specialize only in projects similar to the project your firm is considering are called ___.
Pure Plays
What can we say about the dividends paid to common and preferred stockholders?
-Dividends to preferred stockholders are fixed -Dividends to common stockholders are not fixed
Pure Play Approach
-Find one or more firms that specialize in the area we are considering -Find betas and average -One problem: Leverage ~A pure play firm could have a higher beta not because of more business risk, but because of more financial leverage ~More leverage = more debt = higher Beta
For a firm with outstanding debt, the cost of debt will be the ___ on that debt.
-Yield to maturity
Subjective Approach Example
Risk Level / Discount Rate Very Low = WACC - 6% Low = WACC - 3% Same Risk as Firm = WACC High = WACC + 5% Very High = WACC + 10% -Lower amount of risk= subtract from WACC = lower risk premium -Higher amount of risk = add to WACC = higher risk premium