ࡱ> ~}k ^bjbj ,}}V7l,,,@###8# $@?$$($$$S&r'l1(8@?B?B?B?B?B?B?$w@ Bf?,i(1&"S&i(i(f?-$$={?---i(8$,$@?-i(@?--4V<@,,=$$ p=&f@x#)= ,=?0? = %C*%C,=-@@Chapter 15 COST OF CAPITAL SLIDES CASES The following cases from Cases in Finance by DeMello can be used to illustrate concepts discussed in this chapter: Determining the Cost of Capital (2 cases) EVA Evaluation of Project Risk/Beta CHAPTER WEB SITES SectionWeb Address15.1www.ibbotson.com15.2www.zacks.com/earningswww.bloomberg.com15.4valuation.ibbotson.comfinance.yahoo.commoney.cnn.comwww.msnbc.comwww.bondsonline.comwww.sec.govwww.sternstewart.com  CHAPTER ORGANIZATION 15.1 The Cost of Capital: Some Preliminaries Required Return versus Cost of Capital Financial Policy and Cost of Capital Cost of Equity The Dividend Growth Model Approach The SML Approach The Costs of Debt and Preferred Stock The Cost of Debt The Cost of Preferred Stock The Weighted Average Cost of Capital The Capital Structure Weights Taxes and the Weighted Average Cost of Capital Calculating the WACC for Eastman Chemical Solving the Warehouse Problem and Similar Capital Budgeting Problems Performance Evaluation: Another Use of the WACC Divisional And Project Costs of Capital The SML and the WACC Divisional Cost of Capital The Pure Play Approach The Subjective Approach Flotation Costs and the Weighted Average Cost of Capital The Basic Approach Flotation Costs and NPV Summary and Conclusions ANNOTATED CHAPTER OUTLINE Slide 15.1 Key Concepts and Skills Slide 15.2 Chapter Outline The Cost of Capital: Some Preliminaries Slide 15.3 Why Cost of Capital Is Important Required Return versus Cost of Capital Lecture Tip, page 494: Students often find it easier to grasp the intricacies of cost of capital estimation when they understand why it is important. A good estimate is required for: -good capital budgeting decisions neither the NPV rule nor the IRR rule can be implemented without knowledge of the appropriate discount rate -financing decisions the optimal/target capital structure minimizes the cost of capital -operating decisions cost of capital is used by regulatory agencies in order to determine the fair return in some regulated industries (e.g. electric utilities) Lecture Tip, page 494: EVA (Economic Value Added) is discussed more later in the chapter. It is a metric of firm and managerial performance that has become widely accepted in modern business. It may be useful to mention it here as a motivation for understanding WACC. The students bonuses may very well depend on whether or not they can outperform this number. You can take the students to the Stern Stewart web site (www.sternstewart.com) to show them how it is described by the inventors. Slide 15.4 Required Return Cost of capital, required return and appropriate discount rate are different phrases that all refer to the opportunity cost of using capital in one way as opposed to alternative financial market investments of the same systematic risk. -required return is from an investors point of view -cost of capital is the same return from the firms point of view -appropriate discount rate is the same return as used in a PV calculation Financial Policy and Cost of Capital Capital structure the firms combination of debt and equity. The capital structure decision is discussed later; here, a firms cost of capital reflects the average riskiness of all of the securities it has issued, which may be less risky (bonds) or more risky (common stock). The Cost of Equity The Dividend Growth Model Approach According to the constant growth model, P0 = D1 / (RE g) Rearranging terms and solving for the cost of equity gives: RE = (D1 / P0) + g which equals the dividend yield plus the growth rate (capital gains yield). Slide 15.5 Cost of Equity Slide 15.6 The Dividend Growth Model Approach Slide 15.7 Dividend Growth Model Example Implementing the Approach Price and latest dividend are directly observed; g must be estimated. Estimating g typically use historical growth rates or analysts forecasts. Lecture Tip, page 496: It is noted in the text that there are other ways to compute g. Rather than use the arithmetic mean, as in the example, the geometric mean (which implies a compound growth rate) can be used. OLS regression with the log of the dividends as the dependent variable and time as the independent variable is also an option. Example: YearDividend$ Change% Change1994$4.00--19954.40$.4010.00%19964.75.357.9519975.25.5010.5319985.65.407.62 Average growth rate = (10 + 7.95 + 10.53 + 7.62) / 4 = 9.025% Slide 15.8 Example: Estimating the Dividend Growth Rate Advantages and Disadvantages of the Approach -Approach only works for dividend paying firms -RE is very sensitive to the estimate of g -Historical growth rates may not reliably predict future growth rates -Risk is only indirectly accounted for by the use of the price Slide 15.9 Advantages and Disadvantages of Dividend Growth Model Lecture Tip, page 497: Some students may question how one would value a non-dividend paying firm. Point out that, in the case of growth-oriented, non-dividend-paying firms, analysts often look at the trend in earnings or use similar firms to project the future date of the first expected dividend and its future growth rate. However, such processes are subject to greater estimation error, and when companies fail to meet (or even exceed) estimates, the stock price can experience a high degree of variability. It should also be pointed out that no firm pays zero dividends forever at some point, every going concern will pay dividends. Lecture Tip, page 497: Heres a good real-world exercise to illustrate real-world growth rates. You can assign this as homework, or do it in class if your classroom has Internet access. Go to www.stockscreener.com, find the Growth Rates boxes, and use 40% and 1,000% as the minimum and maximum values for 5-year compounded annual growth rates for revenues and earnings. In December of 2001, the search of NYSE firms turns up nine companies that meet these criteria. Interestingly, a search of the NASDAQ National Market companies turns up the same number. No NASDAQ Small-cap firms meet these criteria. Search engines such as Stockscreener can be useful in illustrating both the magnitude of real-world growth rates and the differences across market or industry segments. The SML Approach RE depends on: -The risk-free rate, Rf -The expected market risk premium, E(RM) - Rf -The amount of systematic risk, measured by (E By CAPM, RE = Rf + (E(E(RM) Rf) Slide 15.10 The SML Approach Click on the web surfer icon to go to the Bloomberg web site and show students how to find the beta and T-bill rate. Slide 15.11 Example SML Slide 15.12 Advantages and Disadvantages of SML Slide 15.13 Example Cost of Equity Implementing the Approach Betas are widely available, and T-bill rates are often used for Rf. The expected market risk premium is the more difficult number to come up with. One of the problems is that we really do need an expectation, but we only have past information and market risk premiums do vary through time. Early in 2000, Federal Reserve Chairman, Alan Greenspan, indicated that part of his concern with the current state of the U.S. stock markets is the reduction in the market risk premium. He felt that investors were either becoming less risk averse, or they did not truly understand the risk they were taking by investing in the stock. Nonetheless, the historical average is often used as an estimate for the expected market risk premium. Advantages and Disadvantages of the Approach -This approach explicitly adjusts for risk in a fashion that is consistent with capital market history -It is applicable to virtually all publicly traded stocks -The main disadvantage is that the past is not a perfect predictor of the future and both beta and the market risk premium vary through time Lecture Tip, page 499: Students are often surprised when they find that the two approaches typically result in different estimates. Suggest that it would be more surprising if the results were identical. Why? The underlying assumptions of the two approaches are very different. The constant growth model is a variant of a growing perpetuity model and requires that dividends are expected to grow at a constant rate forever and the discount rate is greater than the growth rate. The SML approach requires assumptions of normality of returns and/or quadratic utility functions. It also requires the absence of taxes, transaction costs and other market imperfections. The Costs of Debt and Preferred Stock The Cost of Debt Cost of debt (RD) the interest rate on new debt can easily be estimated using the yield-to-maturity on outstanding debt or by knowing the bond rating and looking up rates on new issues with the same rating. Slide 15.14 Cost of Debt Lecture Tip, page 499: An easy way to illustrate this point is to look at what happens to corporate bond rates and mortgage rates as the federal reserve board changes the fed funds rate. The biggest impact in 2001 has been on shorter-term Treasuries with a lesser impact on mortgage rates and corporate debt. Lecture Tip, page 499: It is beneficial to reemphasize the distinction between the coupon rate, the current yield and the yield-to-maturity. The cost of debt is equal to the yield-to-maturity because it is the market rate of interest that would be required on new debt issues. The coupon rate, on the other hand, is the firms promised interest payments on existing debt and the current yield is the income portion of total return. If you dont emphasize this point, some students want to just use the coupon rate on current debt. Slide 15.15 Example: Cost of Debt Real-World Tip, page 500: Corporate Treasurers Rush to Sell Bonds so read the headline of a Wall Street Journal article describing the reactions of corporate treasurers facing the welcome combination of a strong economy and low interest rates in 1996. Firms that had issued bonds to take advantage of low market rates were described as opportunistic issuers. More than $30 billion of debt was issued between September and November 1996. Good anecdotal evidence comes from Alice Peterson, treasurer of Sears, Roebuck, and Co. According to the article, Sears Roebuck Acceptance Corp. issued $300 million of debt. Ms. Peterson indicated that they looked at 10-year Treasury yields, which were at historically low levels. For more information, see the November 25, 1996 issue of The Wall Street Journal. The Cost of Preferred Stock Preferred stock is generally considered to be a perpetuity, so you rearrange the perpetuity equation to get the cost of preferred, RP RP = D / P0 Slide 15.16 Cost of Preferred Stock Slide 15.17 Example: Cost of Preferred Stock The Weighted Average Cost of Capital The Capital Structure Weights E = market value of the firms equity = # outstanding shares times price per share D = market value of the firms debt = # bonds times price per bond V = combined market value of the firms equity and debt = E + D (Assuming that there is no preferred stock and current liabilities are negligible. If this is not the case, then you need to include these components as well. This is really just the market value version of the balance sheet identity. The market value of the firms assets = market value of liabilities + market value of equity.) Lecture Tip, page 501: It may be helpful to mention and differentiate between the three types of weightings in the capital structure equation: book, market and target. It is also helpful to mention that the total market value of equity incorporates the market value of all three common equity accounts on the balance sheet (common stock, additional paid in capital and retained earnings). Slide 15.18 Weighted Average Cost of Capital Slide 15.19 Capital Structure Weights Slide 15.20 Example Capital Structure Weights Lecture Tip, page 501: The cost of short-term debt is usually very different from that of long-term debt. Some types of current liabilities are interest free, such as accruals. However, accounts payable has a cost associated with it if the company foregoes discounts. The cost of notes payable and other current liabilities depends on market rates of interest for short-term loans. Since these loans are often negotiated with banks, you can get estimates of the short-term cost of capital from the companys bank. The market value and book value of current liabilities are usually very similar, so you can use the book value as an estimate of market value. Taxes and the Weighted Average Cost of Capital After-tax cash flows require an after-tax discount rate. Let TC denote the firms marginal tax rate. Then, the weighted average cost of capital is: WACC = (E/V)RE + (D/V)RD(1-TC) WACC overall return the firm must earn on its assets to maintain the value of its stock. It is a market rate that is based on the markets perception of the risk of the firms assets. Slide 15.21 Taxes and the WACC Slide 15.22 Extended Example WACC I Slide 15.23 Extended Example WACC II Slide 15.24 Extended Example WACC III Lecture Tip, page 502: If the firm utilizes substantial amounts of current liabilities, equation 15.7 from the text should be modified as follows: WACC = (E/V)RE + (D/V)RD(1-TC) + (P/V)RP + (CL/V)RCL where CL/V represents the market value of current liabilities in the firms capital structure and V = E + D + P + CL. Calculating the WACC for Eastman Chemical Slides 15.25 Eastman Chemical I Slide 15.26 Eastman Chemical II Slide 15.27 Eastman Chemical III Several web sites are utilized to find the information required to compute the WACC. 1. Go to a site such as finance.yahoo.com; type in EMN and choose profile. Get the market value of equity(price*shares outstanding) and beta 2. Go to the bonds section to get the risk-free rate and decide on an estimate of the market risk premium, such as 9.1% calculated in an earlier chapter. Estimate RE using the CAPM. 3. Use the dividend growth model and estimates of EPS growth to estimate RE. 4. Decide which model provides the most realistic estimate or average them. 5. Go to www.bondsonline.com to find the weighted average of the yield-to-maturity for bond issues. Book value and market value of debt is often similar, so you may want to use the book value for simplicity. 6. Use market value weights to compute the WACC. Solving the Warehouse Problem and Similar Capital Budgeting Problems Lecture Tip, page 507: The warehouse problem employs the WACC as the discount rate in a NPV calculation. This is only appropriate if the warehouse has approximately the same risk characteristics as the overall firm. A second assumption that is often discussed in financial literature is that the project should be financed in the same proportion of debt versus equity as used in the WACC. However, as discussed earlier, the appropriate discount rate for a project depends on the risk of the project, not on how it is paid for. The WACC is the best estimate we have of the markets perception about the risk of the firm and the required return given that risk. Consequently, the key assumption is that the project is the same risk as the firms current assets. Slide 15.28 Table 15.1 Cost of Equity Slide 15.29 Table 15.1 Cost of Debt Slide 15.30 Table 15.1 WACC Performance Evaluation: Another Use of the WACC Video Note: Economic Value Added (EVA) can be used to reinforce the concepts discussed in the Reality Bytes box. Divisional and Project Costs of Capital Slide 15.31 Divisional and Project Costs of Capital Click on the web surfer icon to go to an index of businesses owned by General Electric. You can use this to generate discussion about why it is not appropriate to use the overall firm WACC for every division. The SML and the WACC The WACC is the appropriate discount rate only if the proposed investment is of similar risk as the firms existing assets. Slide 15.32 Using WACC for All Projects Example Lecture Tip, page 510: Ask the class to consider a situation in which a company maintains a large portfolio of marketable securities. Now ask them to consider the impact this large security balance would have on a companys current and quick ratios and how this might impact the companys ability to meet short-term obligations. The students should easily remember that a larger liquidity ratio implies less risk (and less potential profit). Although, the revenue realized from the marketable securities would be less than the interest expense on the companys comparable debt issues, these holdings would result in lowering the firms beta and WACC. This example allows students to recognize that the expected return and beta of an investment in marketable securities would be below the companys WACC, and justification for such investments must be considered relative to a benchmark other than the companys overall WACC. Divisional Cost of Capital When a firm has different operating divisions with different risks, its WACC is an average of the divisional required returns. In such cases, the cost of capital for projects of average risk in each division needs to be established. If you do use the firms WACC across divisions, then riskier divisions will receive the bulk of the funding and less risky divisions will have to forego what would be good projects if the appropriate discount rate were used. This will lead to an increase in risk for the overall firm. Lecture Tip, page 511: It may help students to distinguish between the average cost of capital to the firm and the required return on a given investment if the idea is turned around from the firms point of view to the investors point of view. Consider an investor who is holding a portfolio of T-bills, corporate bonds and common stocks. Suppose there is an equal amount invested in each. The T-bills have paid 5% on average, the corporate bonds 10%, and the common stocks 15%. Thus, the average portfolio return is 10%. Now suppose that the investor has some additional money to invest and they can choose between T-bills that are currently paying 7% and common stock that is expected to pay 13%. What choice will the investor make if he uses the 10% average portfolio return as his cut-off rate? (Invest in common stock 13%>10%, but not in T-bills 7%<10%.) What if he uses the average return for each security as the cut-off rate? (Invest in T-bills 7% > 5%, but not common stock 13%<15%.) Lecture Tip, page 511: You may wish to point out here that the divisional concept is no more than a firm-level application of the portfolio concept introduced in the section on risk and return. And, not surprisingly, the overall firm beta is therefore the weighted average of the betas of the firms divisions. The Pure Play Approach Pure play a company that has a single line of business. The idea is to find the required return on a near substitute investment. Slide 15.33 The Pure Play Approach The Subjective Approach Assigns investment to risk categories that have higher or lower risk premiums than the firm as a whole. International Note, page 512: The difficulty in arriving at an appropriate estimate of the cost of capital for project analysis is magnified for firms engaged in multinational investing. In Financial Management for the Multinational Firm, Abdullah suggests that adjustments to foreign project hurdle rates should reflect the effects of the following: -foreign exchange risk -political risk -capital market segmentation -international diversification effects Making these adjustments requires a great deal of judgment and expertise, as well as an understanding of the underlying financial theory. Most multinational firms find it expeditious to adjust the hurdle rates subjectively, rather than attempting to quantify precisely the effects of these factors for each foreign project. Slide 15.34 Subjective Approach Lecture Tip, page 512: What an individual firm considers a risky investment and what the financial market considers a risky investment may not be the same. Recall that the market is concerned with systematic risk, or non-diversifiable risk. If a firm is considering an investments total risk in assigning it to a risk category, the risk categories may not line up with the SML. Slide 15.35 Subjective Approach Example Flotation Costs and the Weighted Average Cost of Capital The Basic Approach Weighted average flotation cost (fA) sum of all flotation costs as a percent of the amount of the security issued, multiplied by the target structure weights. The multiplier 1 / (1 fA) is used to determine the gross amount of capital to be raised so after-flotation cost amount is sufficient to fund the investment. Slide 15.36 The Basic Approach Flotation Costs and NPV If a project requires an investment of $I before flotation costs, then compute the gross capital requirement as I/(1 fA) and use this figure as the investment cost in calculating NPV. Example: Suppose ABC Company is considering opening another office. The expansion will cost $50,000 and is expected to generate after-tax cash flows of $10,000 per year in perpetuity. The firm has a target debt/equity ratio of .5. New equity has a flotation cost of 10% and a required return of 15%, while new debt has a flotation cost of 5% and a required return of 10%. The tax rate is 34%. Cost of capital = (1/1.5)(15) + (.5/1.5)(10)(1-.34) = 12.2% Flotation cost = (1/1.5)(10) + (.5/1.5)(5) = 8.33% Initial investment = 50,000/(1-.0833) = 54,526 NPV = 10,000/.122 54,526 = 27,441 Slide 15.37 NPV and Flotation Costs Example Lecture Tip, page 516: Some students will recognize that while new debt and equity issues would be subject to flotation costs, the retained earnings component of equity would not. The retention of these earnings does have a cost, but it would be lower than the cost of issuing new equity. The key point to make is that whenever external financing is used, there is an additional cost associated with that financing, and that cost is a relevant cash flow for capital budgeting purposes. Summary and Conclusions Slide 15.38 Quick Quiz A- PAGE 206 CHAPTER 15 CHAPTER 15 A- PAGE 205 Key Concepts and Skills Chapter Outline Why Cost of Capital Is Important Required Return Cost of Equity The Dividend Growth Model Approach Dividend Growth Model Example Example: Estimating the Dividend Growth Rate Advantages and Disadvantages of Dividend Growth Model The SML Approach Example SML Advantages and Disadvantages of SML Example Cost of Equity Cost of Debt Example: Cost of Debt Cost of Preferred Stock Example: Cost of Preferred Stock The Weighted Average Cost of Capital Capital Structure Weights Example: Capital Structure Weights Taxes and the WACC Extended Example WACC I Extended Example WACC II Extended Example WACC III Eastman Chemical I Eastman Chemical II Eastman Chemical III Table 15.1 Cost of Equity Table 15.1 Cost of Debt Table 15.1 WACC Divisional and Project Costs of Capital Using WACC for All Projects Example The Pure Play Approach Subjective Approach Subjective Approach Example Flotation Costs NPV and Flotation Costs - Example Quick Quiz $.GW/0LM`a}~  $ U V W U V l FGH  DE5K#$QR jbH* 6>*] 56\]6]5\j5CJU\mHnHuT $%&-. $If $d N ZZ^/\$If $$Ifa$n$$Ifl  0,"LL t0  64 la/05Lt$If $$Ifa$n$$Ifl  0,"LL t0  64 laLMN`P$If $$Ifa$n$$Ifl  0,"LL t0  64 la`af}t$If $$Ifa$n$$Ifl  0,"LL t0  64 la}~P$If $$Ifa$n$$Ifl  0,"LL t0  64 la@$If $$Ifa$n$$Ifl  0,"LL t0  64 la@X8`$If $$Ifa$n$$Ifl  0,"LL t0  64 la3\A_-.Wl^ & F   4 5 O P s  V V GHdeR & F & F & F & F^:Qede89$If & F & F & F & F "'.n@h___n\h___ $$Ifa$$If$$Ifl\ |6064 lap ./49=BCHMQWnPh___nTh___ $$Ifa$$If$$Ifl\ |6064 lap WX]bfklmnPh___n]X] & F $$Ifa$$If$$Ifl\ |6064 lap Bm45%TUwx $Tyz & F & F & FRS_`dehijnotu ""h%%%&&&&'''))*^*q* -"-$-------002222(5555566 6 6e7{777888888 8!8+8-8.8/88::;;<<???AABBLF 6H*] 6>*]6] 56\]5\ jbH*Xzm!!"<""j%%%t&u&&&''))))%-B-----'. & F & F & F & F'.(.N.m../02A2g222)5*5Z5566667:7d7e77/8 & F & F `^ `` & F & F/88888939499::;j;;<m<<h>????@@E@F@@@@ & F & F & F@@AAA{B|BBBMFiFRGTGrHVLMM)N*NMNNNgNNNO3PJPZP & F & F & FLFrHHULVLmLMNNOO2P3PIPJPYPZPvPwPPPQQQRRS#S~STTTTUUXXZZZZZZZZZZZZZZ^0JmHnHu0J j0JUH* 6>*]6] 56\]3ZPwPPQQRRSSSSSS9U:UYUZUsU.V7V9WWW*X}X~XX & F & F & F & FXXZZZZZZZZZ[#[D[T[c[[[[\\&\J\c\p\\\ & F$a$ & F & F\\\\!]4]P]m]]]]]]] ^1^W^n^^^^^^^^^ & F* 001hP/ =!"#$% i8@8 NormalCJ_HaJmH sH tH 2@2 Heading 1$@&5\D@D Heading 2$$d @&N 5\NN Heading 3$<@&5CJOJQJ\^JaJ8@8 Heading 4$$@&a$6]<A@< Default Paragraph FontBOB RWJ Chapter Heading6CJ .O. 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