Finance Ch. 14

Cost of Capital and SML

-SML tells us the going rate for bearing risk in the economy. -when a company invests, an investment must have better returns than the market for the same risk. Such an investment will have a positive NPV. -This creates value for our shareholders otherwise they might as well invest in the market themselves. -The appropriate discount rate on a new project is the minimum expected rate of return an investment must offer to be attractive. -called this because the required return is what the firm must earn on its capital investment in a project just to break even.

The Cost of Preferred Stock

-preferred stock has a fixed dividend paid every period forever. R(p)=D/P(0) -D is the fixed dividend and P(0) is the current price per share of preferred stock.

Financial Policy and Cost of Capital

Capital structure is the particular mixture of debt and equity a firm chooses to employ. -we assume a firm has a fixed debt-equity ratio. -Reflects firms target capital structure. -Overall cost of capital will reflect the required return on the firms assets as a whole. -A firms cost of capital will reflect both its cost of debt capital and cost of equity capital.

SML Approach

Depends on 3 things. -Risk free rate. -The market risk premium. -The systematic risk of the asset relative to average, which we called its beta coefficient. Equation -R(E)=R(f) + B(E)x [R(m)-R(f)] Advantage and Disadvantages -Adjusts for risk, applicable to companies other than just those with steady dividend growth. -Requires that two things must be estimated, market risk premium and the beta coefficient. -having to rely on the past to predict the future.

The Subjective Approach

Due to difficulties in establishing discount rates for individual projects, adopting an approach that involves making subjective adjustments to the overall WACC. -Establishing 4 classes High, moderate, low risk and mandatory. -Mandatory, cost of capital is irrelevant because the project must be taken. -partitioning is to assume that all projects either fall into one of three risk classes.

The Weighted Average Cost of Capital

E= The market value of the firms equity. -Calculate by taking the number of shares outstanding and multiplying it by the price per share. D= Market value of the firms 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 bonds, calculations are repeated for each bond and then the results are added up. V=E+D 100%=E/V+D/V (Capital Structure Weights)

Floatation Costs

If a company accepts a new project, it may be required to issue, or float new bonds and stocks. -firms will incur some costs called flotation costs. -costs arise as a consequence of the decision to undertake a project. -These costs are the percentage of new stock issued that is considered a fee.

Required Return vs Cost of Capital

If a required return on an investment is 10%, this usually means that the investment will have a positive NPV if its returns exceed 10%. -10% is also considered the cost of capital because we must earn 10% percent on the investment just to compensate investors. -the cost of capital associated with an investment depends on the risk of that investment. -The cost of capital depends primarily on the use of funds, not the source.

Taxes and the Weighted Average Cost of Capital

Interest paid by a corporation is deductible for tax purposes. -Government pays some of the interest. -T(c) stands for corporate tax rate. -R(d)x[1-T(c)]

The Cost of Debt

The return lenders require on the firms debt. -The cost of debt is the interest rate the firm must pay on new borrowing, we can observe through financial markets. -The rate that tells us roughly what the firms cost of debt was back when the bond was issued, not what the cost is today. (coupon rate) -Cost of Debt R(d) -

Cost of Equity

The return that equity investors require on their investment in the firm. -No way to know true required rate of return but there is two ways of estimating. (Dividend growth model) (SML Approach) -R(E)=D(1)/P(0)+G -G is the growth rate. -P is the price per share of stock. -D is the next periods projected dividend (D1) -D(0) is the dividend just paid. In the case of only have D(0) to calculate D(1) multiply D(0)x(1+g) This will give you the firms cost of equity. Advantages and Disadvantages -Simple, easy to understand and easy to use. -only applicable to companies that issue dividends. -only applicable in cases where there is steady dividend growth which in not usually the case. -Estimated cost of equity is sensitive to the estimated growth rate. -Does not really consider risk, no direct adjustment for the riskiness of the investment.

Pure Play Approach

The use of WACC that is unique to a particular project, based on companies in similar lines of business. -Companies that focus specifically on one line of business.

Divisional and Project Costs of Capital

Using WACC as the discount rate for future cash flows is appropriate only when the proposed investment is similar to the firms existing activities. -Using WACC although can sometimes give bad results causing investments to look good when they aren't and look bad when they are good. -Using WACC to evaluate all projects will have a tendency to both accept unprofitable investments and become increasingly risky. -If a corporation has more than one line of business, one being more risky than the other. -if these two divisions were to compete for resources and WACC was used for the cutoff the riskier line of business would tend to have greater returns ignoring the risk.

WACC

Weighted average cost of capital, the weighted average of the cost of equity and the after tax cost of debt. WACC=[E/V] x R(e) + [P/V] x R(d) x [1-t(c)] -the overall return the firm must earn on its existing assets to maintain the value of its stock. -also the required return on any investments by the firm that have essentially the same risks as existing operations. -discount rate is we were to be evaluating the cash flows from a proposed expansion of existing operations. -If firm used preferred stock in capital structure, then our expression for WACC would change slightly. P/V is added representing the percentage of preferred stock used. WACC=[E/V] x R(e) + [P/V] x R(p) +[D/V] x R(d) x [1-T(c)]