Chapter 14: Cost of Capital
Dividend Growth Model Advantages and Disadvantages
-Easy to understand and use -Disadvantages: only applicable to companies currently paying dividends, not applicable if dividends arent growing, extremely sensitive to the estimated growth rate, does not explicity consider risk
Cost of a Preferred Stock
-Essentially a purpetuity, Rp = D/Po -where D is the fixed dividend and P0 is the current price per share of the preferred stock
Issues with Dividend Growth Model
-First and foremost, the dividend growth model is obviously applicable only to companies that pay dividends. This means that the approach is useless in many cases. Furthermore, even for companies that pay dividends, the key underlying assumption is that the dividend grows at a constant rate. As our previous example illustrates, this will never be exactly the case. More generally, the model is really applicable only to cases in which reasonably steady growth is likely to occur. -A second problem is that the estimated cost of equity is very sensitive to the estimated growth rate.
WACC (weighted average cost of capital)
A weighted average of the component costs of debt, preferred stock, and common equity.
SML Advantages and Disadvantages
Advantages -Explicity adjusts for systematic risk -Applicable to all companies, as long as we can estimate beta Disadvantages -Have to estimate the market risk premium, which varies over time -Have to estimate Beta, also varies over time -Using past to predict the future, not always reliable
SML for Project Selection
An all equity firm should accept projects whose IRRs exceed the cost of equity capital and reject projects whose IRRs fall short of the cost of capital
Book Values versus Market Values [LO3] In calculating the WACC, if you had to use book values for either debt or equity, which would you choose? Why? Book values for debt are likely to be much closer to market values than are equity book values.
Book values for debt are likely to be much closer to market values than are equity book values.
CAPM (cost of equity)
Cash flows of dividends - Equity Re = Rf + BE(E(Rm)- Rf) Re = D1/Po + g Solves for Beta
SML Approach
Compute cost of equity through the -risk free rate (Rf) -market risk premium E(Rm) - Rf -Systematic risk of asset Beta RE = Rf +B(E(Rm) -Rf) = risk free rate + Systematic Risk (B) x Market Risk Premium Pay attention to "market risk premium" or "Return on a market"
The subjective approach to project analysis:
Consider project risks relative to the firm overall -If project has more risk than the firm, use a discount greater than the WACC -If a project has less risk than the firm use a discount rate less than the WACC
Expected Divided next year
D1 = Do×(1+g)
What are flotation costs?
Flotation costs are the costs incurred when a firm issues new stocks or bonds to finance projects.
Market Value of securities
Market price per share multiplied by the number of outstanding shares
Project Risk [LO5] If you can borrow all the money you need for a project at 6 percent, doesn't it follow that 6 percent is your cost of capital for the project?
No. The cost of capital depends on the risk of the project, not the source of the money.
Firm Valuation
PV of FCF discounted at WACC
Market Value of Bonds (Debt)
PV of all the coupons and par value discovered @ current interest rateD
Market Value of Bonds
Present Value of all coupons and par value discounted at current interest rate
Dividend Growth Model Formula to solve for equity cost of capital
RE = D1/P0 + g
Dividend Growth Model formula
Re = (D1/P0) + g
Dividend Growth Model
Return required by equity investors given the risk of the cash flows by the firm
DCF Cost of Equity Estimation [LO1] What are the advantages of using the DCF model for determining the cost of equity capital?
The primary advantage of the DCF model is its simplicity.
What is the primary determinant of the cost of capital for an investment?
The use of the funds.
What specific piece of information do you need to find the cost of equity using DCF model?
While the share price and most recent dividend can be observed in the market, the dividend growth rate must be estimated. Two common methods of estimating g are to use analysts' earnings and payout forecasts or to determine some appropriate average historical g from the firm's available data.
Business Risk
cyclicality of revenue & operating leverage
Financial Risk
financial leverage
Cost of Equity
the return required by equity investors given the risk of the cash flows from the firm Two methods: dividend growth model (DGM) and SML or CAPM
Flotation Costs
the transaction cost incurred when a firm raises funds by issuing a particular type of security
pure play approach
Find one or more companies that specialize in the product or servie that your company specializes in -Compute Beta for each company -Take and average
Cost of Debt
Interest rate required on new debt - YTM -Adjust for tax deductability on interest expense
On the most basic level, if a firm's WACC is 12 percent, what does this mean?
It is the minimum rate of return the firm must earn overall on its existing assets. If it earns more than this, value is created.
Market Value of Stock (Equity)
Market price per share multiplied by the number of outstanding shares
Beta
Sensitivity of stocks return to market return Determined by Business Risk & Financial Risk
Tax
Taxes* = EBIT × TC
SML Advantage over DGM
The SML approach has two primary advantages. First, it explicitly adjusts for risk. Second, it is applicable to companies other than just those with steady dividend growth. It may be useful in a wider variety of circumstances. There are drawbacks, of course. The SML approach requires that two things be estimated: The market risk premium and the beta coefficient.
How can the cost of preferred stock be calculated?
The cost of debt can be calculated by observing the current interest rate the firm must pay on new borrowing or the interest rate on similarly rated bonds.
How can the cost of debt be calculated?
The cost of preferred stock is the dividend yield on the preferred stock. It can also be determined by observing the required returns on similarly rated preferred stock.
Why is the coupon rate a bad estimate of a firm's cost of debt?
The coupon rate measures what the firm's initial cost of debt. It does not estimate the current cost or yield.
What are two approaches to estimating the cost of equity capital?
The dividend growth model approach and the SML approach.
What are the likely consequences if a firm uses its WACC to evaluate all proposed investments?
The likely consequences include accepting projects with more risk than the overall firm and rejected projects with less risk than the firm.
What are the disadvantage of DCF?
The method is disadvantaged in that (a) the model is applicable only to firms that actually pay dividends; many do not; (b) even if a firm does pay dividends, the DCF model requires a constant dividend growth rate forever; (c) the estimated cost of equity from this method is very sensitive to changes in g, which is a very uncertain parameter; and (d) the model does not explicitly consider risk, although risk is implicitly considered to the extent that the market has impounded the relevant risk of the stock into its market price.
What is the pure play approach to determining the appropriate discount rate? When might it be used?
The pure play approach uses a WACC that is unique to a project based on other companies in similar lines of business. It might be used when a company is looking into a project outside of its current operations (a new line of business) and is estimating the required return of the new investment.
Cost of Debt Capital
The required rate of return on companies debt -Focus on LTD and Bonds -Required return is best estimated by omputing the yield to maturity on the existing debt -Adjust for tax deductability & Interest
What is the relationship between the required return on an investment and the cost of capital associated with that investment?
The required return and the cost of capital are essentially the same. The required return is what the firm must earn to compensate the investors for their use of capital required to finance the project.
How are flotation costs included in an NPV analysis?
The true cost of funding the new plant [x/(1-fa)] is deducted from the project's PV of cash flows giving the true NPV of the project.
What do we mean when we say that a corporation's cost of equity capital is 16 percent?
This means that the required return for investors in the firm is 16 percent.
Security Market Line (SML)
Using the SML, we can write the expected return on the company's equity RE = Rf + βE × (RM − Rf)
WACC (weighted average cost of capital)
WACC = (% Equity x Cost Equity) + (%Debt x Cost of Debt)
WACC formula
WACC = WeRe + WdRd (1-Tc) WACC = (Weight of equity x Cost of equity) + (Weight of Debt x Cost of debt) x (1- After Tax Cost)
Why do we adjust a firm's taxes when we do a firm valuation?
We adjust the taxes to removed the effects of debt financing. Debt financing causes a reduction in taxes due to interest paid which is tax deductible.
