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## Cost of capital

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**Key Concepts & Skills**• Calculate & explain • A firm’s cost of common equity capital • A firm’s cost of preferred stock • A firm’s cost of debt • A firm’s overall cost of capital • Analyze & discuss pitfalls of overall cost of capital & how to manage them • Print out the associated PDF for this PowerPoint slideshow to use during the show if you want to! • You will find that file where you found this video & slides**Cost of Capital Basics**• The cost to a firm for capital funding • The return to the providers of those funds • The return earned on assets should depend on the risk of those assets • In equilibrium WACC = ROA • A firm’s cost of capital indicates how the market views the risk of the firm’s assets • A firm must earn at least the required return to compensate investors for the financing they have provided • The required return is the same as the appropriate discount rate**IBM**• Sources of data • S&P NetAdvantage Database in the SEU library online • Finance.yahoo.com • Date: 11/17/2011**Cost of Common Equity**• Return required by equity investors given the risk of the cash flows from the firm • Two major methods for determining the cost of equity • Dividend growth model • CAPM**Dividend Growth Model Approach**• Start with the dividend growth model formula & rearrange to solve for RE • Assumption is that the stock is priced fairly • Does this look familiar?**Dividend Growth Model**• The current stock price is $185.27 • Your company is expected to pay a dividend of $3.00per share next year • D1 or D0? • Dividends have grown at a steady rate of 10.00% per year & the market expects that to continue • How long can that really continue? • What is the cost of equity?**Advantages & Disadvantages of Dividend Growth Model**• Advantage • Easy to understand & use • Disadvantages • Only applicable to companies currently paying dividends • Not applicable if dividends, earnings, stock price are not growing at a reasonably constant rate • Sensitive to the estimated growth rate • Does not explicitly consider risk • Relies on the past to predict the future**The CAPM (SML) Approach**• Use the following information to compute the cost of equity • Risk-free rate • Rf • Market risk premium • E(RM) – Rf • Systematic risk of asset • **The CAPM (SML) Approach**• Company’s equity beta = 0.49 • Current risk-free rate = 3.00% • Expected market risk premium = 17.00% • What is the cost of equity capital?**Advantages & Disadvantages of SML**• Advantages • Explicitly adjusts for systematic risk • Applicable to all companies, as long as beta is available • Disadvantages • Must estimate the expected market risk premium • Must estimate beta • Relies on the past to predict the future**Cost of preferred stock**• If IBM had preferred stock • Use the current price of the preferred stock • Along with its annual dividend • And the constant growth model • To estimate its cost of preferred stock • The growth in dividends is zero**Cost of Debt**• The cost of debt • Required return on a company’s debt • What is the name for that kind of yield? • Yield to maturity on existing debt • The cost of debt is NOT the coupon rate on OLD or OUTSTANDING DEBT**Cost of Debt**• Outstanding bond issue • 34 years to maturity • Coupon rate = 7.00% • Coupons paid semiannually • Currently bond price = $1,339.71 • What is the YTM? • CLR TVM • Set P/Y = 2 • N = 34 years x 2 payments per year = 68 • PV = -1339.71 • PMT= (0.0700 x 1000.00)/2 = 35 • FV = 1000.00 • CPT I/Y = 4.93%**Cost of Debt**• Use the YTM on the firm’s debt • Interest is tax deductible, so the after-tax (AT) cost of debt is • If the corporate tax rate = 25.66%**Weighted Average Cost of CapitalWACC**• Use the individual (component) costs of capital to compute a weighted average cost of capital for the firm • This average • The required return on the firm’s assets, based on the market’s perception of the risk of those assets • The weights are determined by how much of each type of financing is used**Determining theWeights for the WACC**• Weights • Proportions of the firm that will be financed by each component • Always use the target weights, if possible • If not available, use market values • If not available, use book values**Capital Structure Weights: MarketFrom observed prices in the**market • Notation • E = market value of common equity • = # outstanding shares of common shares times price per share • P = market value of preferred stock • = # outstanding shares of preferred shares times price per share • D = market value of debt • = # outstanding bonds times bond price • V = market value of the firm = E + P + D • Weights • E/V = proportion financed with common equity • P/V = proportion financed with preferred stock • D/V = proportion financed with debt**Capital Structure Weights: BookFrom observed balances on the**balance sheet • Notation • E = book value of common equity • = common stock + capital in excess of par + retained earnings – treasury stock • P = book value of preferred stock • D = book value of typically only long-term debt • V = book value of the firm = E + P + D • Capital structure weights • E/V = proportion financed with common equity • P/V =proportion financed with preferred stock • D/V = proportion financed with debt**WACC**• Where • (E/V) = proportion of common equity in capital structure • (P/V) = proportion of preferred stock in capital structure • (D/V) = proportion of debt in capital structure • RE = firm’s cost of equity • RP = firm’s cost of preferred stock • RD = firm’s cost of debt • TC = firm’s corporate tax rate Capital structure weights Component costs before tax**Estimating WeightsMarket value of common equity**• Market price of the common stock = $185.27 per share • 1,178,766,125 shares common stock • Market value of equity (E) = $185.27 per share x 1,178,766,125 shares • = $218,390,000,000 (a little more than $218 B)**Estimating WeightsPreferred stock?**There is none…so P/V = 0**Estimating WeightsBook value of long-term debt**• Although we know the market price per bond of the long-term debt, we do not have the number of bonds outstanding • So, I will use the book value of long-term debt instead • Ok to do if interest rates have not changed or • If we do not have all the data from the market • Book value of long-term debt from the balance sheet • =$21,932,000,000 (almost $22 B)**Estimating WeightsUsing market value of equity & book value**of debt to calculate the weights • Amounts • E = $218,390,000,000 • P = $0 • D = $21,932,000,000 • V = $240,322,000,000 • Weights • E/V = $218,390,000,000/$240,322,000,000 • = 0.9087 or 90.87% • P/V = $0/$240,322,000,000 • = 0.0000 or 0.00% • D/V = $21,932,000,000/$240,322,000,000 • = 0.0913 or 9.13%**WACCUsing market value of equity & book value of debt to**calculate the weights**Estimating WeightsUsing book value of equity & book value of**debt to calculate the weights • Amounts • E = $22,291,000,000 • P = $0 • D = $21,932,000,000 • V = $44,223,000,000 • Weights • E/V = $22,291,000,000/$44,223,000,000 • = 0.5041 or 50.41% • P/V = $0/$44,223,000,000 • = 0.0000 or 0.00% • D/V = $21,932,000,000/$44,223,000,000 • = 0.4959 or 49.59%**WACCUsing book value of equity & book value of debt to**calculate the weights**WACCTable for Calculations**Big difference!**Factors that influence a company’s WACC**• Market conditions, especially interest rates, tax rates & the market risk premium • The firm’s capital structure & dividend policy • The firm’s investment policy • Firms with riskier projects generally have a higher required return**Risk-adjusted required return**• A firm’s WACC reflects the risk of an average project undertaken by the firm • Different divisions/projects may have different risks • The division’s or project’s required return should be adjusted to reflect the appropriate risk & capital structure • WACC may not be appropriate**Using WACC for All Projects**What would happen if we use the WACC for all projects regardless of risk?**Using WACC for All Projects**• Different decisions using • WACC = 15% • Incorrect decision • A risk-adjusted return accounting for the project cash flow risk • Correct decision • Tend to accept projects that are too risky…like project A • Tend to reject projects that are less risky…like project C • The risk of the firm will increase over time using RR = WACC Incorrect decision Correct decision**Key Concepts & Skills**• Calculate & explain • A firm’s cost of common equity capital • A firm’s cost of preferred stock • A firm’s cost of debt • A firm’s overall cost of capital • Analyze & discuss pitfalls of overall cost of capital & how to manage them