Professional Documents
Culture Documents
ASSIGNMENT -1
TOPIC-: COST OF
CAPITAL
SUBMITTED ON -: 11/01/2016
SUBMITTED TO-:
SUBMITTED BY-:
PROF. JEEVAN NAGARKAR
GOSWAMI(15020241023)
1) ANKIT
2) ABHISHEK
3)ABHISHEK
4) ADITI
5)
6) AASHNA
GUPTA(15020241001)
COST OF CAPITAL
INTRODUCTION
Investment decision is major decision for an organization. Under
investment decision process, the cost and benefit of prospective projects
is analyzed and the best alternative is selected on the basis of the result
of analysis. The benchmark of computing present value and comparing
the profitability of different investment alternatives is cost of capital. Cost
of capital is also known as minimum required rate of return, weighted
average cost of capital, cut off rate, hurdle rate, standard return etc. Cost
of capital is determined on the basis of component cost of financing and
proportion of these sources in capital structure. Capital structure is a mix
of a company's long-term debt, specific short-term debt, common equity
and preferred equity. The capital structure represents how a firm finances
its overall operations and growth by using different sources of funds.
Debt comes in the form of bond issues or long-term notes payable, while
equity is classified as common stock, preferred stock or retained earnings.
Short-term debt such as working capital requirements is also considered
to be part of the capital structure.
A company's proportion of short and long-term debt is considered when
analyzing capital structure. When people refer to capital structure they are
most likely referring to a firm's debt-to-equity ratio, which provides insight
into how risky a company is. Usually a company more heavily financed by
debt poses greater risk, as this firm is relatively highly levered.
Optimal capital structure is the best debt-to-equity ratio for a firm that
maximizes its value and minimizes the firm's cost of capital. In
theory, debt financing generally offers the lowest cost of capital due to its
tax deductibility. However, it is rarely the optimal structure since a
company's risk generally increases as debt increases. A healthy proportion
of equity capital, as opposed to debt capital, in a company's capital
structure is an indication of financial fitness.
MEANING
The cost of capital is the required rate of return that a firm must achieve
in order to cover the cost of generating funds in the marketplace. Based
on their evaluations of the riskiness of each firm, investors will supply new
funds to a firm only if it pays them the required rate of return to
compensate them for taking the risk of investing in the firms bonds and
stocks. If, indeed, the cost of capital is the required rate of return that the
firm must pay to generate funds, it becomes a guideline for measuring the
profit abilities of different investments. When there are differences in the
degree of risk between the firm and its divisions, a risk-adjusted discountrate approach should be used to determine their profitability.
From the view point of return, cost of capital is the minimum required rate
of return to be earned on investment. In other words, the earning rate of a
firm which is just sufficient to satisfy the expectation of
the contributors of capital is called cost of capital. Shareholders and
debenture holders are the contributors of the capital. For example, a firm
needs $ 5, 00,000 for investing in a new project. The firm can collect
$3,00,000 from shares on which it must pay 12% dividend and $ 2,00,000
from debentures on which it must pay 7% interest. If the fund is raised
and invested in the project, the firm must earn at least $50,000 which
becomes sufficient to pay $36,000 dividend (12% of $3, 00,000) and
$14000 interest (7% of $2, 00,000). The required earning $50,000 is 12%
of the total fund raised. This 12% rate of return is called cost of capital.
In this way, cost of capital is only minimum required rate of return to earn
on investment and it is not the actual earning rate of the firm. As per
above example, if the firm is able to earn only 10%. All the earnings will
go in the hands of contributors of capital and nothing will be left in the
business. Therefore, any business firm should try to maximize the earning
rate by investing in the projects that can provide the rate of return which
is more than the cost of capital.
Equation used to determine net present value, and therefore internal rate
of return. DPV = discounted net present value, N = total number of
periods in which a cash flow occurs, t = the specific period of the cash
flow, FV = the value of the future cash flow, and i = internal rate of return.
FINANCIAL
SOUNDNESS OF
THE FIRM
INTEREST RATE
LEVELS IN THE
US/GLOBAL
MARKETPLACE
The cost of capital becomes a guideline for measuring the profit abilities
of different investments.
Another way to think of the cost of capital is as the opportunity cost of
funds, since this represents the opportunity cost for investing in assets
with the same risk as the firm. When investors are shopping for places in
which to invest their funds, they have an opportunity cost. The firm, given
its riskiness, must strive to earn the investors opportunity cost. If the
firm does not achieve the return investors expect (i.e. the investors
opportunity cost), investors will not invest in the firms debt and equity.
As a result, the firms value (both their debt and equity) will decline.
Dividend Policy:
Given that the firm has control over its pay-out ratio, the breakpoint
of the marginal cost of capital schedule can be changed. For
Investment Policy:
It is assumed that, when making investment decisions, the company
is making investments with similar degrees of risk. If a company
changes its investment policy relative to its risk, both the cost of
debt and cost of equity change.
Tax Rates
Tax rates affect the after-tax cost of debt. As tax rates increase, the
cost of debt decreases, decreasing the cost of capital.
The firms WACC is the cost of Capital for the firms mixture of debt and
stock in their capital structure.
EXAMPLE
If the cost of debt for ABC Energy Services is 10% (effective rate) and its
tax rate is 40% then:
Kd after taxes = Kd (1 tax rate)
= 10 (1 0.4) = 6.0 %
We use the effective annual rate of debt based on current market
conditions (i.e. yield to maturity on debt). We do not use historical rates
(i.e. interest rate when issued; the stated rate).
Preferred stock holders receive a fixed dividend and usually cannot vote
on the firms affairs.
Unlike the situation with bonds, no adjustment is made for taxes, because
preferred stock dividends are paid after a corporation pays income taxes.
Consequently, a firm assumes the full market cost of financing by issuing
preferred stock. In other words, the firm cannot deduct dividends paid as
an expense, like they can for interest expenses.
Example
If ABC Energy Services is issuing preferred stock at $100 per share, with a
stated dividend of $12, and a flotation cost of 3%, then:
Kp =
3 Ways to Calculate
1.
2.
3.
Use CAPM
(GORDON MODEL) The constant dividend growth model same as
DCF method
Bond yield plus risk premium
VALUE
Book Value
Debt
2,000 bonds at par, or $1000
Preferred stock
4,500 shares at $100 par value
Common equity
500,000 shares outstanding at $5.00
par value
Total book value of capital
Market Value
Debt
2,000 bonds at $900 current market
price
Preferred stock
4,500 shares at $90 current market
price
Common equity
500,000 shares outstanding at $75
current market price
Total market value of capital
DOLLAR
AMOUNT
WEIGHTS
OR % OF
TOTAL
VALUE
ASSUMED
COST OF
CAPITAL
(%)
2,000,000
40.4
10
450,000
9.1
12
2,500,000
50.5
13.5
4,950,000
100
11.24 is the
WACC
1,800,000
30.2
10
405,000
6.8
12
3,750,000
63.0
13.5
5,955,000
100
What is the
WACC?
Note that the book values that appear on the balance sheet are usually
different from the market values. Also, the price of common stock is
normally substantially higher than its book value. This increases the
weight of this capital component over other capital structure components
(such as preferred stock and long-term debt). The desirable practice is to
employ market weights to compute the firms cost of capital. This
rationale rests on the fact that the cost of capital measures the cost of
Hurdle rates:
Hurdle rates are the required rate of return used in capital budgeting.
Simply put, hurdle rates are based on the firms WACC. Projects the firm is
considering must jump the hurdle exceed the firms borrowing costs (i.e.
WACC). If the project does not clear the hurdle, the firm will lose money
on the project if they invest in it and decrease the value of the firm. The
hurdle rate is used by firms in capital budgeting analysis (one of the next
topics we will be studying). Large companies, with divisions that have
different levels of risk, may choose to have divisional hurdle rates.
Divisional hurdle rates are sometimes used because firms are not
internally homogeneous in terms of risk. Finance theory and practice tells
us that investors require higher returns as risk increases.
COST OF DEBT
The primary meaning of cost of capital is simply the cost an entity must
pay to raise funds. The term can refer, for instance, to the financing cost
(interest rate) a company pays when securing a loan.
The cost of raising funds, however, is measured in several other ways, as
well, most of which carry a name including "Cost of".
Very briefly, these similar-sounding terms are defined as follows:
Cost of capital is the cost an organization pays to raise funds, e.g.,
through bank loans or issuing bonds. Cost of capital is expressed as an
annual percentage.
Cost of borrowing simply refers to the total amount paid by a debtor to
secure a loan and use funds, including financing costs, account
maintenance, loan origination, and other loan-related expenses. A cost of
borrowing sum will most likely be expressed in currency units such as
dollars, pounds, euro, or yen.
Cost of debt is the overall average rate an organization pays on all its
debts, typically consisting primarily of bonds and bank loans. Cost of debt
is expressed as an annual percentage.
BOND -:
In finance, a bond is an instrument of indebtedness of the bond issuer to
the holders. It is a debt security, under which the issuer owes the holders
a debt and, depending on the terms of the bond, is obliged to pay
them interest (the coupon) and/or to repay the principal at a later date,
termed the maturity date. Interest is usually payable at fixed intervals
In the case of an underwritten bond, the underwriters will charge a fee for
underwriting. An alternative process for bond issuance, which is
commonly used for smaller issues and avoids this cost, is the private
placement bond. Bonds sold directly to buyers and may not be tradable in
the bond market.
Historically an alternative practice of issuance was for the borrowing
government authority to issue bonds over a period of time, usually at a
fixed price, with volumes sold on a particular day dependent on market
conditions. This was called a tap issue or bond tap.
Principal
Nominal, principal, par, or face amount is the amount on which the issuer
pays interest, and which, most commonly, has to be repaid at the end of
the term. Some structured bonds can have a redemption amount which is
different from the face amount and can be linked to performance of
particular assets.
Maturity
The issuer has to repay the nominal amount on the maturity date. As long
as all due payments have been made, the issuer has no further
obligations to the bond holders after the maturity date. The length of time
until the maturity date is often referred to as the term or tenor or maturity
of a bond. The maturity can be any length of time, although debt
securities with a term of less than one year are generally designated
money market instruments rather than bonds. Most bonds have a term of
up to 30 years. Some bonds have been issued with terms of 50 years or
more, and historically there have been some issues with no maturity date
(irredeemables). In the market for United States Treasury securities, there
are three categories of bond maturities:
short term (bills): maturities between one to five year; (instruments
with maturities less than one year are called Money Market Instruments)
medium term (notes): maturities between six to twelve years;
long term (bonds): maturities greater than twelve years.
Coupon
The coupon is the interest rate that the issuer pays to the holder. Usually
this rate is fixed throughout the life of the bond. It can also vary with a
money market index, such as LIBOR, or it can be even more exotic. The
name "coupon" arose because in the past, paper bond certificates were
issued which had coupons attached to them, one for each interest
payment. On the due dates the bondholder would hand in the coupon to a
bank in exchange for the interest payment. Interest can be paid at
different frequencies: generally semi-annual, i.e. every 6 months, or
annual.
Yield
The yield is the rate of return received from investing in the bond. It
usually refers either to
the current yield, or running yield, which is simply the annual interest
payment divided by the current market price of the bond (often the clean
price),
the yield to maturity or redemption yield, which is a more useful
measure of the return of the bond, taking into account the current market
price, and the amount and timing of all remaining coupon payments and
of the repayment due on maturity. It is equivalent to the internal rate of
return of a bond.
Credit quality
The quality of the issue refers to the probability that the bondholders will
receive the amounts promised at the due dates. This will depend on a
wide range of factors. High-yield bonds are bonds that are rated below
investment grade by the credit rating agencies. As these bonds are more
risky than investment grade bonds, investors expect to earn a higher
yield. These bonds are also called junk bonds.
Market price
The market price of a tradable bond will be influenced amongst other
things by the amounts, currency and timing of the interest payments and
capital repayment due, the quality of the bond, and the available
redemption yield of other comparable bonds which can be traded in the
markets.
The issue price at which investors buy the bonds when they are first
issued will typically be approximately equal to the nominal amount. The
net proceeds that the issuer receives are thus the issue price, less
issuance fees. The market price of the bond will vary over its life: it may
trade at a premium (above par, usually because market interest rates
have fallen since issue), or at a discount (price below par, if market rates
have risen or there is a high probability of default on the bond).
TYPES OF BONDS -:
Corporate Bonds
A company can issue bonds just as it can issue stock. Large corporations
have a lot of flexibility as to how much debt they can issue: the limit is
whatever the market will bear. Generally, a short-term corporate bond has
a maturity of less than five years, intermediate is five to 12 years and long
term is more than 12 years.
Corporate bonds are characterized by higher yields because there is a
higher risk of a company defaulting than a government. The upside is that
they can also be the most rewarding fixed-income investments because of
the risk the investor must take on. The company's credit quality is very
important: the higher the quality, the lower the interest rate the investor
receives.
Variations on corporate bonds include convertible bonds, which the holder
can convert into stock, and callable bonds, which allow the company to
redeem an issue prior to maturity.
Convertible Bonds
A convertible bond may be redeemed for a predetermined amount of the
company's equity at certain times during its life, usually at the discretion
of the bondholder. Convertibles are sometimes called "CVs."
Issuing convertible bonds is one way for a company to minimize negative
investor interpretation of its corporate actions. For example, if an already
public company chooses to issue stock, the market usually interprets this
as a sign that the company's share price is somewhat overvalued. To
avoid this negative impression, the company may choose to issue
convertible bonds, which bondholders will likely convert to equity should
the company continue to do well.
From the investor's perspective, a convertible bond has a value-added
component built into it: it is essentially a bond with a stock option hidden
inside. Thus, it tends to offer a lower rate of return in exchange for the
value of the option to trade the bond into stock.
Callable Bonds
Callable bonds, also known as "redeemable bonds," can be redeemed by
the issuer prior to maturity. Usually a premium is paid to the bond owner
case, the company will be liquidated, and the company's value will be
spread among its creditors. However, creditors will generally only receive
a fraction of their original loans to the company. Creditors and the
company will work together to recapitalize debt obligations so that the
company is able to meet its obligations and continue operations, thus
increasing the value that creditors will receive.
DEBENTURES -:
In corporate finance, a debenture is a medium- to long-term
debt instrument used by large companies to borrow money, at a fixed rate
of interest. The legal term "debenture" originally referred to a document
that either creates a debt or acknowledges it, but in some countries the
term is now used interchangeably with bond, loan stock or note. A
debenture is thus like a certificate of loan or a loan bond evidencing the
fact that the company is liable to pay a specified amount with interest and
although the money raised by the debentures becomes a part of the
company's capital structure, it does not become share capital. Senior
debentures get paid before subordinate debentures, and there are varying
rates of risk and payoff for these categories.
Debentures are generally freely transferable by the debenture holder.
Debenture holders have no rights to vote in the company's general
meetings of shareholders, but they may have separate meetings or votes
e.g. on changes to the rights to the debentures. The interest paid to them
is a charge against profit in the company's financial statements.
Debentures have no collateral. Bond buyers generally purchase
debentures based on the belief that the bond issuer is unlikely to default
on the repayment. An example of a government debenture would be any
government-issued Treasury bond (T-bond) or Treasury bill (T-bill). T-bonds
and T-bills are generally considered risk free because governments, at
worst, can print off more money or raise taxes to pay these type of debts.
Features of debentures -:
A movable property.
To do this, the model relies on a risk multiplier called the beta coefficient,
which we will discuss in the next section.
Like all financial models, the CAPM depends on certain assumptions.
Originally, there were nine assumptions, although more recent work in
financial theory has relaxed these rules somewhat. The original
assumptions were:
1 Investors are wealth maximises who select investments based on
expected return and standard deviation.
2 Investors can borrow or lend unlimited amounts at a risk-free (or
zero risk) rate.
3 There are no restrictions on short sales (selling securities that you
don't yet own) of any financial asset.
4 All investors have the same expectations related to the market.
5 All financial assets are fully divisible (you can buy and sell as much
or as little as you like) and can be sold at any time at the market
price.
6 There are no transaction costs.
7 There are no taxes.
8 No investor's activities can influence market prices.
9 The quantities of all financial assets are given and fixed.
Overview:
CAPM is a mathematical model which is used to determine required rate
of return of a particular asset, if that asset is to be added to an already
diversified portfolio. Beauty of this model is that it takes into account
assets sensitivity to non-diversifiable risk(Mostly known as systematic risk
or market risk) which is known as (Beta) and also takes into account the
expected return if market of risk-free asset(theoretical).
CAPM suggests that an investors cost of equity capital is determined by
beta or risk that he undertakes while making an investment. CAPM is still
very popular due to its simplicity and utility for very different situations.
There does exist some flaws due to the certain assumptions made while
deriving the theory and that paves the way for other theories as arbitrage
pricing theory and Mertons portfolio theory.
The capital asset pricing model provides a formula that calculates the
expected return on a security based on its level of risk. The formula for
the capital asset pricing model is the risk free rate plus beta times the
difference of the return on the market and the risk free rate.
How it works:
10 year time horizon, you'll want to use the 10-year U.S. Treasury
bond rate as your measure of rrf.
Beta (Ba): The risk premium is beta times the difference between the
market return and a risk free return. In the capital asset pricing model
formula, by subtracting the market return from a risk free return, the risk
of the overall market can then be determined. By multiplying beta times
this risk of the market, the risk of the individual stock can then be
determined. As previously stated, beta is the risk of an individual security
relative to the market. A beta of 2 would be twice as risky as the market.
In practice, risk is synonymous with volatility. A stock with a beta larger
than the market beta of 1 will generally see a greater increase than the
market when the market is up and see a greater decrease than the market
when the market is down.
The risk premium is beta times the difference between the market return
and a risk free return. In the capital asset pricing model formula, by
subtracting the market return from a risk free return, the risk of the overall
market can then be determined. By multiplying beta times this risk of the
market, the risk of the individual stock can then be determined. As
previously stated, beta is the risk of an individual security relative to the
market. A beta of 2 would be twice as risky as the market. In practice, risk
is synonymous with volatility. A stock with a beta larger than the market
beta of 1 will generally see a greater increase than the market when the
market is up and see a greater decrease than the market when the market
is down.
SML:
The straight line is known as Security market line (SML) which signifies
that even at zero beta means at zero risk even there does exist some
return which is known as risk-free rate of return.
.
SML is also used in relating expected return and systematic risk which
shows how market prices individual securities relative to their security
class.
The X-axis represents risk (beta) and Y-axis represents expected return.
The market risk premium can be determined by slope of SML. The
intercept on Y-axis is nominal risk free rate available in the market.
SML is very useful in deciding whether an investment should be
considered for expected rate of return. If for particular investment if
expected return line is plotted below SML then that particular investment
is considered to be overvalued as investor will receive less return
compared to risk that is being put.
Ease-of-use: CAPM is a simplistic calculation that can be easily stresstested to derive a range of possible outcomes to provide confidence
around the required rates of return.
This model also assumes that all the investors have perfect knowledge
about market in which they are investing.
This model also assumes that all the investors expect the same as
beta for that particular investment remains the same despite of their
proportion of investment. But, exposure and capacity to consume risk
varies with each investor.
This model in free use also assumes that there are no taxes or
transaction costs.
This model does not include all the assets while calculating portfolio
diversification of particular investment.
Market portfolio consists of all type of assets & model assumes that all
the customer will consider their all assets and will optimize and
enhance their portfolio. But, Individual investors mainly have
fragmented portfolios according to their needs.
EXAMPLE 1:
The current risk free-rate is 5%, and the S&P 500 is expected to return
to 12% next year. You are interested in determining the return that
Joe's Oyster Bar Inc (JOB) will have next year. You have determined
that its beta value is 1.9. The overall stock market has a beta of 1.0,
so JOB's beta of 1.9 tells us that it carries more risk than the overall
market; this extra risk means that we should expect a higher potential
return than the 12% of the S&P 500. We can calculate this as the
following:
Rf = 5%
Rm = 12%
= 1.9
Re = Rf + (Rm-Rf)
= 5% + (12% - 5%)*1.9
=18.3%
Solution: What CAPM tells us is that Joe's Oyster Bar has a required rate
of return of 18.3%. So, if you invest in JOB, you should be getting at least
18.3% return on your investment.
EXAMPLE 2:
Find the beta on a stock given that its expected return is 16%, the riskfree rate is 4%, and the expected return on the market portfolio is 12%.
Rf = 4%
Rm = 12%
Re = 16%
Re = Rf + (Rm-Rf)
= 16% - 4% / 12% - 4%
= 1.5
EXAMPLE 3:
Suppose CAPM works, and you know that the expected returns on ABC
and XYZ are estimated to be 12% and 10%, respectively. You have just
calculated extremely reliable estimates of the betas of ABC and XYZ to be
1.30 and 0.90, respectively. Given this data, what is a reasonable estimate
of the risk-free rate (the return on a long-term government bond)?
Re = Rf + (Rm-Rf)
Now for company ABC
0.12= Rf + 1.3(Rm-Rf)
Now for company XYZ:Re = Rf + (Rm-Rf)
0.10= Rf + 0.9(Rm-Rf)
Now since Rf is going to be the same over both the business we will
replace (Rm-Rf) of XYZ into the equation.
0.12 = Rf + 1.3[(0.1-Rf)/0.9]
0.12 = Rf + 0.144-1.444 Rf
Rf =0.0540 = 5.4%
Formula :
Advantages
Justification: The primary advantage of the dividend discount model is that
it is grounded in theory. The justifications are rock solid and indisputable.
The logic is simple. A business is a perpetual entity. When an investor
buys a share of the business, they are basically paying a price today
which entitles them to enjoy the benefits of all the dividends that the
corporation will pay throughout its lifetime. Hence, the value of the firm is
basically the value of a perpetual never ending stream of dividends that
the buyer intends to receive later with the passage of time. Hence, many
analysts believe that there is absolutely no subjectivity involved in this
model and the logic is crystal clear.
Consistency: A second advantage of the dividend discount model is the
fact that dividends tend to stay consistent over long periods of time.
Companies experience a lot of volatility in measures like earnings and free
cash flow. However, companies usually ensure that dividends are only
paid out from cash which is expected to be present with the company
every year. They do not set up unnecessarily high dividend expectations
because not living up to those expectations makes the stock price
plummet at a later date. Companies are very specific and announce any
additional dividend as a one-time dividend.
No Subjectivity: There is no ambiguity regarding the definition of
dividends. Whereas there is subjectivity as to what constitutes earnings
and what constitutes free cash flow. Therefore, even if different analysts
are asked to come up with a valuation for a company using a discounted
dividend model, it is likely that they will come up with more or less the
same valuation. This lack of subjectivity makes the model more reliable
and hence more preferred.
No Requirement of Control: Dividends are the only measure of valuation
available to the minority shareholder. While institutional investors can
acquire big stakes and actually influence the dividend pay-out policies,
minority shareholders have no control over the company. Thus, the only
thing that they can be sure about is that fact that they will receive
dividend year on year because they have been receiving it consistently in
the past. Hence, as far as minority shareholders are concerned, dividends
are really the only metric that they can use to value a corporation.
Mature Businesses: The regular payment of dividends is the sign that a
company has matured in its business. Its business is stable and there is
not much expectation of turbulence in the future unless something drastic
happens. This information is valuable to many investors who prefer
stability over possibility of quick gains. Thus, from a valuation point of
view, it is far easier to arrive at a discount rate. Since consistency
eliminates risk, dividends are generally discounted at a lower rate as
compared to other metrics that can be used in valuation.
To sum it up, dividend discount models are preferred by two kinds of
investor groups. One investor group consists of retail investors who prefer
it because of their lack of control to influence the payout policies. The
other investor group consists of risk averse investors who prefer it
because of the stability and risk aversion which are built into this model.
Disadvantages
Limited Use: The model is only applicable to mature, stable companies
who have a proven track record of paying out dividends consistently.
While, prima facie, it may seem like a good thing, there is a big trade-off.
Investors who only invest in mature stable companies tend to miss out
high growth ones.
May Not Be Related To Earnings: Another major disadvantage is the fact
that the dividend discount model implicitly assumes that the dividends
paid out are correlated to earnings. This means that higher earnings will
translate into higher dividends and vice versa. But, in practice, this is
almost never the case. Companies strive to maintain stable dividend
payouts, even if they are facing extreme variations in their earnings.
There have been instances where companies have been simultaneously
EXAMPLE 1:
The dividend just about to be paid by a company is $0.24. The current
market price of the share is $2.76 cum div. The historical dividend growth
rate, which is expected to continue in the future, is 5%. What is the
estimated cost of capital?
Solution
re = D0(1 + g) + g = 0.24(1 + 0.05) + 0.05 = 15%
P0 2.52
P0 must be the ex-dividend market price, but we have been supplied with
the cum-dividend price.
The ex-dividend market price is calculated as the cum-dividend market
price less the impending dividend. So here:
P0 = 2.76 - 0.24 = 2.52
The cost of equity is, therefore, given by:
re = D0(1 + g) + g
EXAMPLE 2:
WACC
Weighted average cost of capital, defined as the overall cost of capital for
all funding sources in a company, and is used as commonly in private
businesses as it is in public businesses.
A company can raise its money from three sources: equity, debt,
and preferred stock. The total cost of capital is defined as the weighted
average of each of these costs.
Weighted average cost of capital means an expression of the overall
requited return on the companys investment. It is useful for investors to
see if projects or investments or purchases are worthwhile to undertake. It
is equally as useful to see if the company can afford capital or to indicate
which sources of capital will be more or less useful than others. It has also
been explained as the minimum return a company can make to repay
capital providers.
EXAMPLE
Example: a company finances its business 70% from equity, 10% from
preferred stock, and 20% from debt. Ke is 10%, Kd is 4%, and Kps is 5%.
The tax rate is 30%. The required rate of return of this company according
to the WACC is:
(70% * 10%) + (20% * 4%) + (10% * 5%) = 8.3%
That means the required return on capital is 8.3%. A company pays 8.3%
interest for every dollar it finances.
Assume newly formed Corporation ABC needs to raise $1 million
in capital so it can buy office buildings and the equipment needed to
conduct its business. The company issues and sells
6,000shares of stock at $100 each to raise the first $600,000. Because
shareholders expect a return of 6% on their investment, the cost of equity
is 6%.
Corporation ABC then sells 400 bonds for $1,000 each to raise the other
$400,000 in capital. The people who bought those bonds expect a 5%
return, so ABC's cost of debt is 5%.
Corporation ABC's total market value is now ($600,000 equity + $400,000
debt) = $1 million and its corporate tax rate is 35%. Now we have all the
ingredients to calculate Corporation ABC's weighted average cost of
capital (WACC).
WACC = (($600,000/$1,000,000) x .06) + [(($400,000/$1,000,000)
x .05) * (1-0.35))] = 0.049 = 4.9%
Corporation ABC's weighted average cost of capital is 4.9%.
This means for every $1 Corporation ABC raises from investors, it must
pay its investors almost $0.05 in return.
Also in terms of weights we can say
Cost
or
Return
NUMERICALS
Question 1
Suppose a company uses only debt and internal equity to finance its
capital budget and uses CAPM to compute its cost of equity. Company
estimates that its WACC is 12%. The capital structure is 75% debt and
25% internal equity. Before tax cost of debt is 12.5 % and tax rate is 20%.
Risk free rate is rRF = 6% and market risk premium (rm - rRF) = 8%: What
is the beta of the company.
Solution:
WACC = WD*rd*(1 T) + we*re
0.12=0.75*(0.125)*(1-0.20) +0.25*re
0.12=0.075+0.25*re
re= 18%
18%=6% + Beta (8%)
Beta=1.5
Question 2
A company finances its operations with 50 percent debt and 50 percent
equity. Its net income is I = $30 million and it has a dividend payout ratio
of x = 20%. Its capital budget is B = $40 million this year. The interest
rate on companys debt is rd = 10% and the companys tax rate is T =
40%. The companys common stock trades at P0 = $66 per share, and its
current dividend of D0 = $4 per share is expected to grow at a constant
rate of g = 10% a year.
The flotation cost of external equity, if issued, is F = 5% of the dollar
amount issued.
a) Will the company have to issue external equity?
Solution:
We B = 0:50(40M) = 20M
I (1- x) = $30(1 0:2) = 24M
Since I (1- x) > we B =) Internal Equity
b) What is the companys WACC?
Question 3:
A company finances its operations with 40 percent debt and 60 percent
equity. Its net income is I = $16 million and it has a dividend payout ratio
of x = 25%. Its capital budget is B = $15 million this year. The annual
yield on the companys debt is rd = 10% and the companys tax rate is T
= 30%. The companys common stock trades at P0 = $55 per share, and
its current dividend of D0 = $5 per share is expected to grow at a
constant rate of g = 10% a year. The flotation cost of external equity, if it
is issued, is F = 5% of the dollar amount issued. What is the companys
WACC?
We B = 0:60(15M) = 9M
I*(1 x) = $16(1 0:25) = 12M
Since I*(1 x) > weB =) Internal Equity
b) What is the companys WACC?
r internal e = D0*(1 + g) P0 + g = 5(1 + 0:10) 55 + 0:10 = 20%
WACC = WD*rd (1-T) + we*r internal
= 0:40(0:10)*(1 - 0:30) + 0:60(0:20)
= 14:8%
The following points will explain why WACC is important and how it is used
by investors and the company for their respective purposes:
1. Investment Decisions by Company: WACC is widely used for
making investment decisions in the corporate by evaluating their
projects. Let us categorize the investments in projects in the
following 2 ways:
a. Evaluate of Projects with Same Risk: When the new projects are
of similar risk like existing projects of the company, it is an
appropriate benchmark rate to decide the acceptance or rejection of
these projects. For example, a furniture manufacturer wishes to
expand its business in new locations i.e. establishing new factory for
same kind of furniture in different location. To generalize it to some
extent, a company entering new projects in its own industry can
reasonably assume similar risk.
b. Evaluation of Projects with Different Risk: WACC is appropriate
measure to be used to evaluate a project provided two underlying
assumptions are true. The assumptions are same risk and same
capital structure. What to do in this situation? Still, WACC can be
used with certain modification with respect to the risk and target
capital structure. Risk adjusted WACC, adjusted present value etc.
are the concepts to circumvent the problems of WACC assumptions.
2. Discount Rate in Net Present Value Calculations: Net present
value (NPV) is widely used method of evaluating projects to
determine the profitability of the investment. WACC is used as
discount rate or the hurdle rate for NPV calculations. All the free
cash flows and terminal values are discounted using the WACC.
3. Calculate Economic Value Added (EVA): EVA is calculated by
deducting the cost of capital from the net profits of the company. In
calculating the EVA, WACC serves as the cost of capital of the
company. This is how WACC may also be called a measure for value
creation.
4. Valuation of Company: Any rational investor will invest time
before investing money in any company. The investor will try to find
out the valuation of the company. Based on the fundamentals, the
investor will project the future cash flows and discount them using
the WACC and divide the result by no. of equity shareholders. He will
get the per share value of the company. He can simply compare this
value and the current market price (CMP) of the company and
decide whether it is investable or not. If the valuations are more
than the CMP, the scrip is underpriced and if it is less than CMP, it is
overpriced. If the value is $25 and CMP is 22, the investor will invest
at 22 expecting the prices to rise till 25 and vice versa.
5. Important Inferences from WACC: Some important inferences
from WACC can be drawn to understand various important issues
that the management of the company should address.
a. Effect of Leverage: Considering the Net Income Approach
(NOI) by Durand, the effect of leverage is reflected in WACC.
So, the WACC can be optimized by adjusting the debt
component of the capital structure. Lower the WACC, higher
will be the valuations of the company. Lower WACC also
widens the scope of the company by allowing it to accept low
return projects and still create value.
b. Optimal Capital Budgets: The increase in the magnitude of
capital tends to increase the WACC as well. With the help of
WACC schedule and project schedule, an optimal capital
budget can be worked out for the company.
CAPITAL STRUCTURE
The capital structure concerns the proportion of capital that is obtained
through debt and equity. There are tradeoffs involved: using debt capital
increases the risk associated with the firm's earnings, which tends to
decrease the firm's stock prices. At the same time, however, debt can
lead to a higher expected rate of return, which tends to increase a firm's
stock price. As Brigham explained, "The optimal capital structure is the
one that strikes a balance between risk and return and thereby maximizes
the price of the stock and simultaneously minimizes the cost of capital."
Capital structure decisions depend upon several factors. One is the firm's
business riskthe risk pertaining to the line of business in which the
company is involved. Firms in risky industries, such as high technology,
have lower optimal debt levels than other firms. Another factor in
determining capital structure involves a firm's tax position. Since the
interest paid on debt is tax deductible, using debt tends to be more
advantageous for companies that are subject to a high tax rate and are
not able to shelter much of their income from taxation.
A third important factor is a firm's financial flexibility, or its ability to raise
capital under less than ideal conditions. Companies that are able to
maintain a strong balance sheet will generally be able to obtain funds
under more reasonable terms than other companies during an economic
downturn. Brigham recommended that all firms maintain a reserve
borrowing capacity to protect themselves for the future. In general,
companies that tend to have stable sales levels, assets that make good
collateral for loans, and a high growth rate can use debt more heavily
than other companies. On the other hand, companies that have
conservative management, high profitability, or poor credit ratings may
wish to rely on equity capital instead.
SOURCES OF CAPITAL
DEBT CAPITAL
Small businesses can obtain debt capital from a number of different
sources. These sources can be broken down into two general categories,
private and public sources. Private sources of debt financing, according to
W. Keith Schilit in The Entrepreneur's Guide to Preparing a Winning
Business Plan and Raising Venture Capital, include friends and relatives,
banks, credit unions, consumer finance companies, commercial finance
companies, trade credit, insurance companies, factor companies, and
leasing companies. Public sources of debt financing include a number of
loan programs provided by the state and federal governments to support
small businesses.
There are many types of debt financing available to small businesses
including private placement of bonds, convertible debentures, industrial
development bonds, and leveraged buyoutsbut by far the most common
type of debt financing is a regular loan. Loans can be classified as longterm (with a maturity longer than one year), short-term (with a maturity
shorter than two years), or a credit line (for more immediate borrowing
needs). They can be endorsed by co-signers, guaranteed by the
government, or secured by collateralsuch as real estate, accounts
receivable, inventory, savings, life insurance, stocks and bonds, or the
item purchased with the loan.
When evaluating a small business for a loan, Jennifer Lindsey wrote in her
book The Entrepreneur's Guide to Capital, lenders ideally like to see a twoyear operating history, a stable management group, a desirable niche in
the industry, a growth in market share, a strong cash flow, and an ability
to obtain short-term financing from other sources as a supplement to the
loan. Most lenders will require a small business owner to prepare a loan
proposal or complete a loan application. The lender will then evaluate the
request by considering a variety of factors. For example, the lender will
examine the small business's credit rating and look for evidence of its
ability to repay the loan, in the form of past earnings or income
projections. The lender will also inquire into the amount of equity in the
business, as well as whether management has sufficient experience and
competence to run the business effectively. Finally, the lender will try to
ascertain whether the small business can provide a reasonable amount of
collateral to secure the loan.
EQUITY CAPITAL
Equity capital for small businesses is also available from a wide variety of
sources. Some possible sources of equity financing include the
The cost of debt is higher than the cost of share capital and retained
earnings and the behaviour of the weighted-average-cost of capital is
influenced by the proportion of debt in the capital.
What is the nature of the relationship between capital structure
and the cost of capital?
The relationship between the capital structure and the overall cost of
capital is that the overall cost of capital increases as the proportion of
debt in the capital structure increases. But as the proportion of debt
increases, the overall cost of capital also starts rising. The association
between these two variables is tested by simple correlation.
First, the use of debt in capital structure affects the overall cost of capital
and thus the cost of capital is a function of leverage.
The need for funds is the first factor which has a direct influence on the
capital structure of a firm. A firm requires for initial investment to start its
manufacturing operations. The amount of initial investment depends upon
the proposed installed capacity and social investments when the firm is
established. Initially, a cooperative firm may not be able to mobilize
adequate equity capital from its members because of their poor socioeconomic background. Therefore, it has to rely on debt for financing its
assets. The need for additional funds arises when a firm has steady
growth rate. When a firm takes up expansion or modernization, it involves
a huge capital outlay. This could not entirely be met out of owned funds.
Hence a firm has to resort to debt to meet the additional investment.
Apart from this a firm has its social obligations. The cost of welfare
measures such as education, health care facilities for members and
employees and housing for employees, etc. is called social cost. Social
cost is unproductive in nature.
Internal Financing:
Yet another factor which has a direct bearing on the capital structure is
internal financing. A firm with steady profitability could easily meet and
settle its fixed obligations at a quicker pace and could generate its own
internal funds. This would not only help such firms to reduce the
proportion of debt in their capital structure but also, would obviate the
need for external financing. Further a cooperative which anticipates a
stable profitability can boldly resort to debt capital to finance its assets,
for it may not have any difficulty in honouring its future fixed obligations.
Thus, profitability enables a cooperative to generate its own internal funds
and therefore it can modify its capital structure to its best advantage.
Profitability of a cooperative, in turn, depends on its degree of operating
profit to changes in sales. The profit of a highly leveraged (operating) firm
is likely to increase at a faster rate than the increase in sales. But if sales
fall, it will suffer a greater loss. Thus the degree of operating leverage
represents a firm's business risk. A cooperative with a high degree of
operating leverage resorting to debt capital to finance its assets will
expose itself to greater risk .This has an impact on the profitability.
The degree of operating leverage is influenced by several factors. One
major determinant of operating leverage is the variability of sales
revenue. The variability in sales generally depends on the characteristics
of industry, effectiveness of market efforts, technological developments
and general economic condition.
Another major determinant of operating leverage is the variability in
operating expenses. An increase in "supply-price" of raw material and
labour contributes to the variability of operating expenses. The extent of
the firm's fixed costs in operation also influences the degree of operating
leverage. The Capacity Utilization plays a crucial role in determining the
unleveraged firm, plus an added premium for financial risk. That is, as
leverage increases, risk is shifted between different investor classes, while
total firm risk is constant, and hence no extra value created.
Their analysis was extended to include the effect of taxes and risky debt.
Under a classical tax system, the tax deductibility of interest makes debt
financing valuable; that is, the cost of capital decreases as the proportion
of debt in the capital structure increases. The optimal structure, then
would be to have virtually no equity at all, i.e. a capital structure
consisting of 99.99% debt.
(As the Debt equity ratio (i.e. leverage) increases, there is a trade-off
between the interest tax shield and bankruptcy, causing an optimum
capital structure, D/E*)
AGENCY COSTS
There are three types of agency costs which can help explain the
relevance of capital structure.
Free cash flow: unless free cash flow is given back to investors,
management has an incentive to destroy firm value through empire
building and perks etc. Increasing leverage imposes financial discipline
on management.
Modigliani and Miller Approach further states that the market value of a
firm is affected by its future growth prospect apart from the risk involved
in the investment. The theory stated that value of the firm is not
dependent on the choice of capital structure or financing decision of the
firm. If a company has high growth prospect, its market value is higher
and hence its stock prices would be high. If investors do not see attractive
growth prospects in a firm, the market value of that firm would not be that
great.
Proposition
where
is the value of an unlevered firm = price of buying a firm composed
only of equity, and
is the value of a levered firm = price of buying a
firm that is composed of some mix of debt and equity. Another word for
levered is geared, which has the same meaning.
To see why this should be true, suppose an investor is considering buying
one of the two firms U or L. Instead of purchasing the shares of the
levered firm L, he could purchase the shares of firm U and borrow the
same amount of money B that firm L does. The eventual returns to either
of these investments would be the same. Therefore the price of L must be
the same as the price of U minus the money borrowed B, which is the
value of L's debt.
This discussion also clarifies the role of some of the theorem's
assumptions. We have implicitly assumed that the investor's cost of
borrowing money is the same as that of the firm, which need not be true
here
With taxes
Proposition I
where
This means that there are advantages for firms to be levered, since
corporations can deduct interest payments. Therefore leverage
lowers tax payments. Dividend payments are non-deductible.
Proposition II
where:
on earnings after
The tradeoff theory assumes that there are benefits to leverage within a
capital structure up until the optimal capital structure is reached. The
theory recognizes the tax benefit from interest payments - that is,
because interest paid on debt is tax deductible, issuing bonds effectively
reduces a company's tax liability. Paying dividends on equity, however,
does not. Thought of another way, the actual rate of interest companies
pay on the bonds they issue is less than the nominal rate of interest
because of the tax savings. Studies suggest, however, that most
companies have less leverage than this theory would suggest is optimal.
In comparing the two theories, the main difference between them is the
potential benefit from debt in a capital structure, which comes from the
tax benefit of the interest payments. Since the MM capital-structure
irrelevance theory assumes no taxes, this benefit is not recognized, unlike
the tradeoff theory of leverage, where taxes, and thus the tax be
recognised.
The risk of bankruptcy increases with the increased debt load. Since the
cost of debt becomes higher, the WACC is thus affected. With the addition
of debt, the WACC will at first fall as the benefits are realized, but once the
optimal capital structure is reached and then surpassed, the increased
debt load will then cause the WACC to increase significantly.
Optimal Capital Structure
Is there an optimal debt-equity relationship? In financial terms, debt is a
good example of the proverbial two-edged sword. Astute use of leverage
(debt) increases the amount of financial resources available to a company
for growth and expansion. The assumption is that management can earn
more on borrowed funds than it pays in interest expenses and fees on
these funds. However, as successful as this formula may seem, it does
require that a company maintain a solid record of complying with its
various borrowing commitments.
A company considered too highly leveraged (too much debt versus equity)
may find its freedom of action restricted by its creditors and/or may have
its profitability hurt as a result of paying high interest costs. Of course, the
worst-case scenario would be having trouble meeting operating and debt
liabilities during periods of adverse economic conditions. Lastly, a
company in a highly competitive business, if hobbled by high debt, may
find its competitors taking advantage of its problems to grab more market
share.
Unfortunately, there is no magic proportion of debt that a company can
take on. The debt-equity relationship varies according to industries
involved, a company's line of business and its stage of development.
However, because investors are better off putting their money into
companies with strong balance sheets, common sense tells us that these
companies should have, generally speaking, lower debt and higher equity
levels.
The extended pie model draws upon Modigliani and Miller's capital
structure irrelevance theory. This model considers both corporate taxes
and bankruptcy costs to be a claim on the firm's cash flows and illustrates
the proportion of each entity's claim on the company's cash flows using
pie charts. These pie charts also show how an increase or decrease in the
company's debt relative to its equity increases or decreases each entity's
claim. Under the extended pie model, stockholders, bondholders, the
Firms with a higher risk of financial distress are well advised to issue
bonds with caution since they may struggle to repay the debt. Financial
distress does not just harm bondholders and stockholders who stand to
lose their investments; it also harms the firm in ways that make a bad
situation worse. As we mentioned above, a firm in financial distress will
find it more difficult and more expensive to borrow. Difficulty in borrowing
or in obtaining credit from suppliers can diminish inventory and make it
harder to make sales and to retain and attract customers. Existing and
potential customers may seek alternatives with companies that have
better inventories and that they are confident they can return to for
repeat business. Financial distress can also cause the firm to lose key
talent to more stable job opportunities. Finally, filing for bankruptcy
requires expensive legal assistance.
The costs of financial distress and bankruptcy thus illustrate once again
why choosing an optimal capital structure and not taking on too much
long-term debt are crucial to a firm's vitality and longevity.