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CHAPTER 9 The Cost of Capital

CHAPTER 9 The Cost of Capital. Sources of capital Component costs WACC Adjusting for flotation costs Adjusting for risk. Capital Components- one of the types of capital used by firms to raise money. • There are three major capital structure components; Debt Preferred Stock

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CHAPTER 9 The Cost of Capital

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  1. CHAPTER 9The Cost of Capital Sources of capital Component costs WACC Adjusting for flotation costs Adjusting for risk

  2. Capital Components- one of the types of capital used by firms to raise money • •There are three major capital structure components; • Debt • Preferred Stock • Common Equity – retained earning and issue new shares • • The cost of each component is called the component cost of that particular type of capital. Example if DD can borrow money at 10%, its component cost of debt is 10%

  3. Cost of capital (CoC) • Normally, firm’s source of finance is mix (combination of debt, preferred stock and common equity) • The firm’s overall cost of capital reflects the combined cost of all the sources of financing used by the firm. • The following symbols identify the cost of each : • Kd /Kd(1-T)= component cost of debt • Kp= component of preferred stock • Ks= component of common equity

  4. Cost of capital (CoC) • Kd /Kd(1-T) – the relevant cost of new debt, taking into account tax deductibility of interest • Kp= the rate of return investor requires on the firm preferred stock. (Ks= Dp/Pp) • Ks= the rate of return investor requires on firms common stock • This overall CoC is referred to weighted average of the component costs (WACC).

  5. CoC is the discount rate (or required of return) that is used to determine the Net Present Value (NPV) of investment /project. • Required rate of return (RR) = opportunity cost of capital to the investor for taking an investment. • Opportunity cost (OC) is the basis to determine the CoC. • In addition of OC we also need to consider: - the tax consequences - cost of issuing capital (floatation cost) Cost of capital (CoC)

  6. Calculating the weighted average cost of capital • Each firm have optimal capital structure – the % of debt, preferred stock and common equity that cause its stock price to be maximized. Thus, the WACC can calculate as follows: WACC = wdkd(1-T) + wpkp + wcks • The w’s refer to the firm’s capital structure weights /target proportion. • The k’s refer to the cost of each component.

  7. Determining Individual Cost of Capital • Cost of Debt  Cost of raising long-term funds through borrowing • Interest is tax deductible, so After-tax cost of debt = interest rate – tax saving = kd - kdT = kd (1-T) • Kd(1-T) = 10% (1-0.4) = 6.0% In effect, the government pays part of the cost of debt because interest is deductible. Therefore, the cost reduced to 6%.

  8. Determining Individual Cost of Capital • Example: kd = 9%; tax rate (T) = 34% Tax saving – for every RM1.00 of interest paid, the firm enjoys a tax saving = RM0.34 After-tax cost of Debt = kd = 0.09(1-0.34)=0.0594 = 5.94% • Most corporate long-term debts are incurred through the sale of bonds. Funds are therefore raised through issuance and sale of bonds. • The net proceeds for the sales of a bond, or any security are the funds actually received from the sale, I.e after deducting the floatation costs/issuing capital.

  9. SS Corp, a major electrical good manufacturer, is contemplating selling RM10m worth 20-year, 9% coupon (stated annual interest rate) bonds, each with a face value of RM1,000. Since similar risk bonds earn return greater than 9%, the firm must sell the bonds for RM980 to compensate for the lower coupon interest rate. The floatation costs paid to the investment banker are 2% of the face value of the bond (2% x RM1,000), or RM20. The net proceed to the firm from the sale of each bond are therefore RM960(RM980-RM20). The cash flows are as follow: End of YrCF 0 +RM960 1-20 -90 20 -RM1000

  10. A 15-year, 12% semiannual coupon bond sells for $1,153.72. What is the cost of debt (kd)? • Remember, the bond pays a semiannual coupon, so kd = 5.0% x 2 = 10%. ytm = 60 + (1000-1153.72) 30 1000 + 2(1153.72) 3 =0.0497x2 =9.95% =10%

  11. Component cost of debt • Interest is tax deductible, so A-T kd = B-T kd (1-T) = 10% (1 - 0.40) = 6% • Use nominal rate. • Flotation costs are small, so ignore them.

  12. Cost of Preferred Stock (kp) • The component cost of preferred stock is a function of its stated divided. • Preferred dividends are not tax-deductible, so no tax adjustments necessary. Just use kp. • Our calculation ignores possible flotation costs. • Kp = Preferred stock dividend /net issuing price • Kp = Dp/Pp • Example; A has preferred stock that pays a RM10 dividend per share and sells for RM97.50 after deducting floatation cost of RM2.50. • Kp = RM10/RM97.50 = 10.3%

  13. Cost of Common Equity,ks (Stock) • Unlike debt and preferred stock, CFs from CS are not fixed or known before hand. • 2 sources of CS: - Ks = retained earnings – internally generated fund (no flotation cost) - Ke= new stock issues • Equity raise by issuing stock has higher cost than raised as retained earning due to flotation cost. • Issuing new stock may send a –ve signal to the capital market which may depress the stock price • Explicit cost for new CS: - dividends - floatation costs • Retained earnings – no extra dividends or floatation costs. But their use is not free. Consider the opportunity cost of using money (profits) that could have been distributed to shareholders (SH).

  14. Earning can be reinvested or paid out as dividend. Investor could buy other securities, earn a return • Opportunity cost to SH = the return the SHs could earn by investing the funds (the profit should have been distributed) in assets whose risk is similar to that of the firm. • Three methods estimating ks =cost of retained earning CAPM ks = rf + (rm – rf) Constant dividend growth model (Dividend-Yield-Plus Growth-rate) Bond yield plus premium

  15. 1. CAPM • Estimate the cost of RE using SML. The SML provides an estimate of SH required rate of return based on a stock’s systematic risk • Eg; From information provided by SS corporation investment advisers and its own analyses, it is found that the krf = 7%, firm’s beta, ; 1.5; and the expected market return, km = 11%. Substituting these values into SML equation, the company estimates the cost of retained earning, Ks as follows: • Ks = 7% + [(11% - 7%])1.5] = 13.0%

  16. If the kRF = 7%, RPM = 6%, and the firm’s beta is 1.2, what’s the cost of common equity based upon the CAPM? ks = kRF + (kM – kRF) β = 7.0% + (6.0%)1.2 = 14.2%

  17. In order to estimate the cost of issuing new common stock, the SML estimate of Ke must be adjusted to reflect the size of floatation costs. • Ke = Ks (Pcs-Fcs)/Pcs or Ke = Ks (1s-fcs) Fcs – the CS floatation cost in RM per share fcs - the floatation cost as a percent of the CS price Use in term of amount Use in term of %

  18. Example: assume the government treasury bill is 6.06%, current market risk premium is 9%. The firm’s beta is 1.30. What is firm’s cost of retained earning using SML approach? • Ks = 6.08% + 9% (1.30) = 17.78% • To pursue a large number of attractive capital budgeting project, the firm may need to issue new CS if its addition to retained earning is insufficient to finance current project. If the floatation cost is 7% of the gross proceeds of a stock issue, what is firms’ cost of new CS • Ke = Ks = 17.78% = 19.12% (1-fcs) (1-0.07) Firm’s estimate cost of issuing CS is 19.12%

  19. 2. Constant Dividend Growth Model • The value of a firm’s CS is equal to the present value of all future dividend. When the div are expected to grow at a rate g forever and g is less than investor’s required rate of return, ks, then the value of a share of CS, Ps, can be written as P0 = D1 ks - g

  20. Rearrange the formula to find the investor’s required rate of return ks = D1 + g = kre P0 The SH RRoR represents the firm’s cost of retained earning, kre. The ratio D1/Pcs represents the current income yield to SH from their investment of Pcs. • Cost of new CS kcs = D1 + g or D1 + g (Pcs- Fcs) Pcs(1- fcs)

  21. If D0 = $4.19, P0 = $50, and g = 5%, what’s the cost of common equity based upon the DCF approach for retained earning? D1 = D0 (1+g) D1 = $4.19 (1 + .05) D1 = $4.3995 ks = D1 / P0 + g = $4.3995 / $50 + 0.05 = 13.8%

  22. What is the expected future growth rate? • The firm has been earning 15% on equity (ROE = 15%) and retaining 35% of its earnings (dividend payout = 65%). This situation is expected to continue. g = ( 1 – Payout ) (ROE) = (0.35) (15%) = 5.25% • Very close to the g that was given before.

  23. Cost of new CS kcs = D1 + g or D1 + g (Pcs- Fcs) Pcs(1- fcs) • Flotation costs depend on the risk of the firm and the type of capital being raised. • The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small. • We will frequently ignore flotation costs when calculating the WACC.

  24. If issuing new common stock incurs a flotation cost of 15% of the proceeds, what is ke?

  25. 3. Bond-yield-plus-risk-premium • Here, ks = bond yield + risk premium • = kd + RP • Not same RP as CAPM – just judgment call (usually between 3-5%) • Use when analyst have no confident in CAPM, thus use a subjective to estimate a firm cost of common equity. • Subjective based on logical that firms with risky, low-rated and consequently high-interest rate debt and also have risky as well as high-cost equity.

  26. 3. Bond-yield-plus-risk-premium • Here, ks = bond yield + risk premium • = kd + RP • For example : ks = 8% + 4% =12% The bond of a riskier company might carry a yield of 12%, making its estimates cost of equity 16% ks = 12% + 4% =12%

  27. Should our analysis focus on before-tax or after-tax capital costs? • Stockholders focus on A-T CFs. Therefore, we should focus on A-T capital costs, i.e. use A-T costs of capital in WACC. Only kd needs adjustment, because interest is tax deductible.

  28. Should our analysis focus on historical (embedded) costs or new (marginal) costs? • The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on today’s marginal costs (for WACC).

  29. Why is the cost of retained earnings cheaper than the cost of issuing new common stock? • When a company issues new common stock they also have to pay flotation costs to the underwriter. • Issuing new common stock may send a negative signal to the capital markets, which may depress the stock price.

  30. What factors influence a company’s composite WACC? • Factor classified into 2: • The firm cannot control • The firm can control • The firm cannot control • Level of interest rates (increase) • The cost of debt increase, because firms will have to pay bondholders more to obtain debt capital • CAPM – higher interest rate increase the Kcs and Kp • Tax rates • Tax rates used in calculation of Kd, thus give effect to the cost of capital

  31. What factors influence a company’s composite WACC? • The firm can control • The firm’s capital structure( used in calculating WACC as weighted based) • When the capital structure change, the weighted also change and such a change can effect its cost of capital • dividend policy • Effect the CoC because it effect the level of retained earning • If Less retained earning, the firm need to issues new share that higher cost then retained, thus CoC will increase. • The firm’s investment policy. • Normally, firm invest in assets of the same type and with the same degree of risk in the existing assets. • Firms with riskier projects generally have a higher WACC.

  32. Adjusting the Cost of Capital for Risk • CoC is key element in the capital budgeting • Capital budgeting • A project should be accepted if and only if its estimated return exceeds it CoC (Return > CoC) • Thus, CoC also reffered as ‘Hurdle Rate” • Project return should must “jump the hurdle”

  33. Risk and the Cost of Capital Firm WACC Accept Low 8% R>8% High 12% R>12% • The “hurdle rate” of Firm L and H is 8% and 12% respectively • Project A, is > risky than L, but <risky than H> Project A offer 10.5% return. Thus firm L • should accept the project A (10.5%>8%) and firm H should reject the pro. A (10.5%<12%) • However is wrong if the hurdle rate for the project is 10%, thus both (L&H) should accept A

  34. Should the company use the composite WACC as the hurdle rate for each of its projects? • NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the “hurdle rate” for a typical project with average risk. • Different projects have different risks. The project’s WACC should be adjusted to reflect the project’s risk.

  35. Estimating project risk • Riskier project should assigned a higher CoC, thus important to estimate project risk. • The risk can classified into three :- • Stand-alone risk • Measure by the variability of the project expected return () (disregarding the portfolio) • Corporate risk- within-firm • Project risk to the corporation • Measure by the project impact on uncertainty about the firm future earnings • Market risk-beta • Part of a project risk that cannot be eliminated by diversification • Measured by the project’s beta coefficient

  36. How is each type of risk used? • Market risk is theoretically the most relevant measure because it is the one reflected in stock price. • However, creditors, customers, suppliers, and employees are more affected by corporate risk. • Therefore, corporate risk is also relevant.

  37. Problem areas in cost of capital • Privately owned firms • Discuss most on public firm but not concentrated on firm not traded the stock (private firm) • Measurement problems • Difficult to get the CAPM data, thus most measurement is only estimation not accurate • Adjusting costs of capital for different risk • Difficult to measure project in order to assign the pro. risk • Capital structure weights • It is major task to establish the capital structure

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