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Cost of Capital
The cost of companys funds The expected return on a portfolio of all the companys existing securities May include cost of debt, cost of preferred stock, cost of RE, or cost of common stock
Determination of Weights
Book Value (Accounting Numbers) or Market Value?
MV reflects expectations of investors and closely reflects how a company has to raise new capital.
Illustration:
At present, Malady Companys balance sheet shows P1 million in short term debt, P1.4 million in long term debt, P0.6 million in preferred stock, and P2 million in common equity. Market values as determined should have been P1.8 million in short term debt, P1.5 million in long term debt, P0.4 million in preferred stock, and 1.3 million in common equity. Assume that before-tax cost of debt is 5%, cost of preferred stock is 8%, and cost of common equity is 10%. Further assume that tax rate is 40%. How much is the WACC?
Flotation Costs
Costs associated with the issuance of new securities, such as the fees paid for the services of an investment banker. Setting the price of the issue Selling the issue to the public They must be accounted for in the computation of WACC, though they are (unfortunately) frequently ignored. There may be flotation costs for debt, preferred stock, and new common stock, but not for retained earnings. Flotation costs are highest for the issuance of new common equity though per project cost is fairly small as firms issue equity infrequently. Flotation costs are often small and insignificant for the issuance of debt and preferred stock, hence they are often ignored in computation for the cost of debt and cost of preferred stock.
rd is the marginal cost of debt capital. The yield to maturity on outstanding L-T debt is often used as a measure of rd. Flotation costs are usually small and are usually ignored.
Cost of Retained Earnings is exactly the same as the Cost of New Common Equity, except that there are no flotation costs.
If rd = 10% and RP = 4%, what is rs using the own-bond-yield-plus-risk-premium method? ks = kd + RP ks = 10.0% + 4.0% = 14.0%
Using CAPM
If the rRF = 7%, MRP = 6%, and the firms beta is 1.2, whats the cost of common equity based upon the CAPM?
Using DCF (DDM & Constant Growth) Method (Cost of Retained Earnings)
If the most current dividend is $4.19, P0 = $50, and constant g = 5%, whats the cost of common equity based upon the DCF approach?
Using DCF (DDM & Constant Growth) Method (Cost of New Common Equity)
If the most current dividend is $4.19, P0 = $50, and constant g = 5%, and flotation costs is 15%, whats the cost of common equity based upon the DCF approach?
Illustration 1 RE Breakpoint
Maleficent Industries has determined that its optimal capital structure is 20% debt, 30% preferred equity, and 50% common equity. It wants to raise $50 million to fund a new project. Currently, it has $20 million in net income and the dividend payout ratio is 50%. How much is the REBP? Should Maleficent use retained earnings or should it issue new common equity?
Illustration 2 RE Breakpoint
SSS has a capital structure that consists of 20% equity and 80% debt. The company expects to report $3 million in net income this year, and 60% of the net income will be paid out as dividends. How large must the firms capital budget be this year without it having to issue any new common stock?
WACC Illustration 2
Anderson Company has four investment opportunities with the following costs (paid at t = 0) and expected returns: Project Cost Expected Return A 2,000 16.0% B 3,000 14.5 C 5,000 11.5 D 3,000 9.5 The company has a target capital structure that consists of 40 percent common equity, 40 percent debt, and 20 percent preferred stock. The company has $1,000 in retained earnings. The company expects its year-end dividend to be $3.00 per share. The dividend is expected to grow at a constant rate of 5 percent a year. The companys stock price is currently $42.75. If the company issues new common stock, the company will pay its investment bankers a 10 percent flotation cost. The company can issue corporate bonds with a yield to maturity of 10 percent. The company is in the 35% tax bracket. How large can the cost of preferred stock be (including flotation costs) and it still be profitable for the company to invest in all four projects?
WACC Illustration 3
Valerie Constructions CFO wants to estimate the companys WACC. She has collected the following information:
The company currently has 20-year bonds outstanding. The bonds have an 8.5 percent annual coupon, a face value of $1,000, and they currently sell for $945. The companys stock has a beta = 1.20. The market risk premium equals 5%. The risk-free rate is 6%. The company has outstanding preferred stock that pays a $2.00 annual dividend. The preferred stock sells for $25 a share. The companys tax rate is 40 percent. The companys capital structure consists of 40 percent long-term debt, 40 percent common equity, and 20 percent preferred stock.
REQUIRED: Compute for the after-tax cost of debt, after-tax cost of preferred stock, after-tax cost of common equity, and WACC
WACC Illustration 4
Gavan Corp. is a steel manufacturer that finances its operations with 40 percent debt, 10 percent preferred stock, and 50 percent equity. The interest rate on the companys debt is 11 percent. The preferred stock pays an annual dividend of $2 and sells for $20 a share. The companys common stock trades at $30 a share, and its current dividend of $2 a share is expected to grow at a constant rate of 8 percent per year. The flotation cost of external equity is 15 percent of the dollar amount issued, while the flotation cost on preferred stock is 10 percent. The company estimates that its WACC is 12.30 percent. Assume that the firm will not have enough retained earnings to fund the equity portion of its capital budget. What is the companys tax rate?
Firms Capital Structure Firms Dividend Policy (RE level) Firms Capital Budgeting Decision Rules Controllable Firms Investment Policy Firms with riskier projects generally have a higher WACC
$3 million
11.5%
Low
Required:
Which projects should Ziege accept if it faces no capital constraints? If Ziege only has the ability to invest a total of $13 million, which projects should it accept, and what will the firms capital budget be for the next year? Suppose that Ziege can raise additional funds in order to increase its capital budget from the level determined in the previous question. However, for every $5 million of new capital raised by Ziege, the firms WACC is expected to increase by 1%. If Ziege proceeds to use the same method of risk adjustment, which projects will it accept, and how much in additional funds must be raised to complete its capital budget?
Required:
Ziege Systems is considering the following independent projects for the next year. The company estimates that its WACC is currently 10%. The company adjusts for risk by adding 2 percentage points to the WACC for high-risk projects and subtracting 2 percentage points from the WACC for low-risk projects. Which projects should Ziege accept if it faces no capital constraints? PROJECT A REQUIRED INVESTMENT $4 million RATE OF RETURN 14.0% RISK High
B
C D E F
$5 million
$3 million $2 million $6 million $5 million
11.5%
9.5% 9.0% 12.5% 12.5%
High
Low Average High Average
G
H
$6 million
$3 million
7.0%
11.5%
Low
Low
Required:
Ziege Systems is considering the following independent projects for the next year. The company estimates that its WACC is currently 10%. The company adjusts for risk by adding 2 percentage points to the WACC for high-risk projects and subtracting 2 percentage points from the WACC for low-risk projects. If Ziege only has the ability to invest a total of $13 million, which projects should it accept, and what will the firms capital budget be for the next year? PROJECT A REQUIRED INVESTMENT $4 million RATE OF RETURN 14.0% RISK High
B
C D E F
$5 million
$3 million $2 million $6 million $5 million
11.5%
9.5% 9.0% 12.5% 12.5%
High
Low Average High Average
G
H
$6 million
$3 million
7.0%
11.5%
Low
Low
Required:
Ziege Systems is considering the following independent projects for the next year. The company estimates that its WACC is currently 10%. The company adjusts for risk by adding 2 percentage points to the WACC for high-risk projects and subtracting 2 percentage points from the WACC for low-risk projects. Suppose that Ziege can raise additional funds in order to increase its capital budget from the level determined in the previous question. However, for every $5 million of new capital raised by Ziege, the firms WACC is expected to increase by 1%. If Ziege proceeds to use the same method of risk adjustment, which projects will it accept, and how much in additional funds must be raised to complete its capital budget?
PROJECT A
RISK High
B
C D E F
$5 million
$3 million $2 million $6 million $5 million
11.5%
9.5% 9.0% 12.5% 12.5%
High
Low Average High Average
G
H
$6 million
$3 million
7.0%
11.5%
Low
Low
Risk L
Risk A
Risk H
Risk
How are risk-adjusted costs of capital determined for specific projects or divisions?
Subjective adjustments to the firms composite COC or WACC.
Attempt to estimate what the cost of capital would be if the project/division were a standalone firm. This requires estimating the projects beta.
Finding a divisional cost of capital: Using similar stand-alone firms to estimate a projects cost of capital Comparison firms have the following characteristics: Target capital structure consists of 40% debt and 60% equity. rd = 12% rRF = 7% MRP = 6% DIV = 1.7 Tax rate = 40%
Typical projects in this division are acceptable if their returns exceed 13.2%.
Nothing follows