COST OF CAPITAL

Key Concepts and Skills

Know how to determine a firms cost of equity capital Know how to determine a firms cost of debt Know how to determine a firms overall cost of capital Understand pitfalls of overall cost of capital and how to manage them

15-2

Chapter Outline
The Cost of Capital: Some Preliminaries The Cost of Equity The Costs of Debt and Preference shares The Weighted Average Cost of Capital Divisional and Project Costs of Capital Flotation Costs and the Weighted Average Cost of Capital

15-3

Why Cost of Capital Is Important

We know that the return earned on assets depends on the risk of those assets The return to an investor is the same as the cost to the company Our cost of capital provides us with an indication of how the market views the risk of our assets Knowing our cost of capital can also help us determine our required return for capital budgeting projects

15-4

Required Return
The required return is the same as the appropriate discount rate and is based on the risk of the cash flows We need to know the required return for an investment before we can compute the NPV and make a decision about whether or not to take the investment We need to earn at least the required return to compensate our investors for the financing they have provided

15-5

COST OF EQUITY

Cost of Equity
The cost of equity is the return required by equity investors given the risk of the cash flows from the firm
Business risk Financial risk

There are two major methods for determining the cost of equity
Dividend growth model CAPM* (capital asset pricing method)
*A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities
15-7

The Dividend Growth Model Approach

Start with the dividend growth model formula and rearrange to solve for KE

D1 P0 ! KE  g K
E

P0 : market price of equity share KE : cost of equity D1 : dividend g : Growth

D1 !  g P0
15-8

Dividend Growth Model Example

Suppose that your company is expected to pay a dividend of 1.50 per share next year. There has been a steady growth in dividends of 5.1% per year and the market expects that to continue. The current price is Rs 25. What is the cost of equity?

1 .50 KE !  .051 ! .111 ! 11 .1 % 25

15-9

One method for estimating the growth rate is to use the historical average
Year 2000 2001 2002 2003 2004 Dividend 1.23 1.30 1.36 1.43 1.50 Percent Change -

Example: Estimating the Dividend Growth Rate

(1.30 1.23) / 1.23 = 5.7% (1.36 1.30) / 1.30 = 4.6% (1.43 1.36) / 1.36 = 5.1% (1.50 1.43) / 1.43 = 4.9%

Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%

15-10

Advantages and Disadvantages of Dividend Growth Model

Advantage easy to understand and use Disadvantages

Only applicable to companies currently paying dividends Not applicable if dividends arent growing at a reasonably constant rate Extremely sensitive to the estimated growth rate an increase in g of 1% increases the cost of equity by 1% Does not explicitly consider risk

15-11

The CAPM Approach

Use the following information to compute our cost of equity
Risk-free rate, Rf Market risk premium, RM Rf Systematic risk of asset, F

KE ! Rf  FE (RM  Rf )
15-12

Rf - Risk-Free Rate - This is the amount obtained from investing in securities considered free from credit risk, such as government bonds. The interest rate of Treasury bills or the long-term bond rate is frequently used as a proxy for the risk-free rate.

13

 - Beta - This measures how much a company's share price moves against the market as a whole. A beta of one, for instance, indicates that the company moves in line with the market. If the beta is in excess of one, the share is exaggerating the market's movements; less than one means the share is more stable. For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the market. Occasionally, a company may have a negative beta
(e.g. a gold mining company), which means the share price moves in the opposite direction to the broader market.

14

Rm Rf) = Equity Market Risk Premium The equity market risk premium (EMRP) represents the returns investors expect, over and above the risk-free rate, to compensate them for taking extra risk by investing in the stock market. In other words, it is the difference between the risk-free rate and the market rate. It is a highly contentious figure. Many commentators argue that it has gone up due to the notion that holding shares has become riskier

15

Once the cost of equity is calculated, adjustments can be made to take account of risk factors specific to the company, which may increase or decrease the risk profile of the company. Such factors include the size of the company, pending lawsuits, concentration of customer base and dependence on key employees. Adjustments are entirely a matter of investor judgment and they vary from company to company.

16

Example - CAPM
Suppose your company has an equity beta of .58 and the current risk-free rate is 6.1%. If the expected market risk premium is 8.6%, what is your cost of equity capital?
KE = 6.1 + .58(8.6) = 11.1%

Since we came up with similar numbers using both the dividend growth model and the CAPM approach, we should feel pretty good about our estimate

15-17

Advantages and Disadvantages of CAPM

Advantages
Explicitly adjusts for systematic risk Applicable to all companies, as long as we can estimate beta

Disadvantages
Have to estimate the expected market risk premium, which does vary over time Have to estimate beta, which also varies over time We are using the past to predict the future, which is not always reliable

15-18

Example Cost of Equity

Suppose our company has a beta of 1.5. The market risk premium is expected to be 9% and the current risk-free rate is 6%. We have used analysts estimates to determine that the market believes our dividends will grow at 6% per year and our last dividend was Rs 2. Our stock is currently selling for Rs15.65. What is our cost of equity?

Using CAPM : KE = 6% + 1.5(9%) = 19.5% Using DGM: KE = [2(1.06) / 15.65] + .06 = 19.55%
15-19

COST OF DEBT

20

Cost of Debt
The cost of debt is the required return on our companys debt We usually focus on the cost of long-term debt or bonds The required return is best estimated by computing the yield-to-maturity on the existing debt We may also use estimates of current rates based on the bond rating we expect when we issue new debt The cost of debt is NOT the coupon rate

15-21

Cost of Debt
Compared to cost of equity, cost of debt is fairly straightforward to calculate. The rate applied to determine the cost of debt (Kd) should be the current market rate the company is paying on its debt. If the company is not paying market rates, an appropriate market rate payable by the company should be estimated.

22

As companies benefit from the tax deductions available on interest paid, the net cost of the debt is actually the interest paid less the tax savings resulting from the tax-deductible interest payment. Therefore, the after-tax cost of debt is Kd (1 - corporate tax rate).

23

Tax effects of financing with debt

With Equity EBIT Interest EBT 4,00,000 0 4,00,000 With Debt 4,00,000 50,000 3,50,000

TAXES 34% PAT DIVIDENDS RETAINED EARNINGS

1,36,000 2,64,000 50,000 2,14,000

1,19,000 2,31,000

2,31,000

24

Example: Cost of Debt

Suppose we have a bond issue currently outstanding that has 25 years left to maturity. The coupon rate is 9% and coupons are paid semiannually. The bond is currently selling for Rs 908.72 per Rs1000 bond. What is the cost of debt?
N = 50; PMT = 45; FV = 1000; PV = -908.75; CPT I/Y = 5%; YTM = 5(2) = 10%

15-25

Short cut method to compute Kd

Cost of Debt = (INT+ (F- Bo)/n) / (F + Bo) / 2 Bo= issue price of bond INT= the amount of interest F= Maturity Value n = years Example= 7 year ,15 % bond, each bond is sold below par for Rs 94 (15 + (100-94)/7 )/ (100+94)/2 =15.86/97 or 16.4%

26

COST OF PREFERENCE SHARES

27

Preference Shares or Preferred stock

A class of ownership in a corporation that has a higher claim on the assets and earnings than equity shares . Preferred shares generally has a dividend that must be paid out before dividends to equity shareholders and the shares usually do not have voting rights.

28

The precise details as to the structure of preference shares is specific to each corporation. However, the best way to think of preference shares is as a financial instrument that has characteristics of both debt (fixed dividends) and equity (potential appreciation). Also known as "preferred shares

29

Cost of Preferred Shares

Reminders
Preferred shares generally pays a constant dividend each period Dividends are expected to be paid every period forever

Preferred shares is a perpetuity, so we take the perpetuity formula, rearrange and solve for kP kP = D / P0

15-30

Example: Cost of Preferred Stock

Your company has preferred shares that has an annual dividend of Rs 3. If the current price is Rs 25, what is the cost of preferred shares? kP = 3 / 25 = 12%

15-31

WEIGHTED AVERAGE COST OF CAPITAL

32

The Weighted Average Cost of Capital

We can use the individual costs of capital that we have computed to get our average cost of capital for the firm. This average is the required return on our assets, based on the markets perception of the risk of those assets The weights are determined by how much of each type of financing we use

15-33

Capital Structure Weights

Notation
E = market value of equity = # of outstanding shares times price per share D = market value of debt = # of outstanding bonds times bond price V = market value of the firm = D + E

Weights
wE = E/V = percent financed with equity wD = D/V = percent financed with debt

15-34

Example: Capital Structure Weights

Suppose you have a market value of equity equal to Rs 500 million and a market value of debt = Rs 475 million.
What are the capital structure weights?
V = 500 million + 475 million = 975 million wE = E/V = 500 / 975 = .5128 = 51.28% wD = D/V = 475 / 975 = .4872 = 48.72%

15-35

36

Taxes and the WACC

We are concerned with after-tax cash flows, so we need to consider the effect of taxes on the various costs of capital Interest expense reduces our tax liability
This reduction in taxes reduces our cost of debt After-tax cost of debt = KD(1-TC)

Dividends are not tax deductible, so there is no tax impact on the cost of equity WACC = wEKE + wDKD(1-TC)

15-37

Extended Example WACC - I

Equity Information
50 million shares Rs 80 per share Beta = 1.15 Market risk premium = 9% Risk-free rate = 5%

Debt Information
Rs 1 billion in outstanding debt (face value) Current quote = 1100 Coupon rate = 9%, semiannual coupons 15 years to maturity

Tax rate = 40%

15-38

Extended Example WACC - II

What is the cost of equity?
KE = 5 + 1.15(9) = 15.35%

What is the cost of debt?

N = 30; PV = -1100; PMT = 45; FV = 1000; CPT I/Y = 3.9268 KD = 3.927(2) = 7.854%

What is the after-tax cost of debt?

KD(1-TC) = 7.854(1-.4) = 4.712%

15-39

Extended Example WACC - III

What are the capital structure weights?
E = 50 million (80) = 4 billion D = 1 billion (1.10) = 1.1 billion V = 4 + 1.1 = 5.1 billion wE = E/V = 4 / 5.1 = .7843 wD = D/V = 1.1 / 5.1 = .2157

What is the WACC?

WACC = .7843(15.35%) + .2157(4.712%) = 13.06%

15-40

Example WACC - IV
Lohia chemicals Ltd has the following book value capital structure on 31st March 2004
Source of finance Share capital Reserve and surplus Preference share capital Debt Amount Rs000 4,50,000 1,50,000 1,00,000 3,00,000 Proportion (%) 45 15 10 30

Total

1,000,000

100

41

The expected after tax component of the various sources of finance for lohia chemicals Ltd are as follows :

Source Equity Reserve and surplus

Cost % 18 18

Preference share capital

11

Debt

42

Source 1

Amount 2

Proportion 3

After tax cost Weighted 4 cost % 5= 3X4 18 18 8.1 2.7

Share capital Reserve and surplus Preference share capital Debt Total

4,50,000 1,50,000

45 15

1,00,000

10

11

1.1

3,00,000 1,000,000

30 100

8 WACC

2.4 14.3

43

PROBLEM
The servex Company has the following capital structure on 30th June 2009
(Rs 000) Ordinary shares (200,000 shares) 10% Preference shares 14 % Debentures 4000 1000 3000 8000

The shares of the company sells for Rs 20/-. It is expected that company will pay next year a dividend of Rs 2/- per share , which will grow at 7% forever. Assume 50 % tax rate

44

You are required to :

(a) Compute the WACC on the existing capital structure (b) Compute the new WACC if the company raises an additional Rs 2,000,000 debt by issuing 15 % debentures. This will result in increasing the expected dividend to Rs 3/- and leave the growth rate unchanged , but the share will fall to Rs 15/per share. (c) Compute the cost of capital if in (b) above the growth rate increase to 10%
45

Weights Ordinary shares 4000 50%

After tax cost 17%

WACC 8.5 %

10% Preference shares

1000

12.5%

10%

1.25%

14 % Debentures 3000

37.5%

7%

2.62%

8000

100 %

12.37%

Rs 2  . 07 Rs 20

.10+.07=.17=17%

Kd= 14 %( 1-.5)= 7%
46

Weights Ordinary shares 10% Preference shares 14 % Debentures 15% Debentures 4000 1000 40% 10%

After tax cost WACC 27% 10% 10.8 % 1%

3000 2000 10000

30% 20% 100 %

7% 7.5%

2.1% 1.5% 15.4%

KE

Rs 3 !  . 07 Rs 15

.20+.07= 27%

47

Weights Ordinary shares 10% Preference shares 14 % Debentures 15% Debentures 4000 1000 40% 10%

After tax cost WACC 30% 10% 12 % 1%

3000 2000 10000

30% 20% 100 %

7% 7.5%

2.1% 1.5% 16.6%

Rs 3  . 10 Rs 15

.20+.10= 30%

48

Divisional and Project Costs of Capital

Using the WACC as our discount rate is only appropriate for projects that have the same risk as the firms current operations If we are looking at a project that does NOT have the same risk as the firm, then we need to determine the appropriate discount rate for that project Divisions also often require separate discount rates

15-49

Using WACC for All Projects - Example

What would happen if we use the WACC for all projects regardless of risk? Assume the WACC = 15%
Project A B C Required Return 20% 15% 10% IRR 17% 18% 12%

15-50

The Pure Play Approach

Find one or more companies that specialize in the product or service that we are considering Compute the beta for each company Take an average Use that beta along with the CAPM to find the appropriate return for a project of that risk Often difficult to find pure play companies

15-51

Subjective Approach
Consider the projects risk relative to the firm overall If the project has more risk than the firm, use a discount rate greater than the WACC If the project has less risk than the firm, use a discount rate less than the WACC You may still accept projects that you shouldnt and reject projects you should accept, but your error rate should be lower than not considering differential risk at all
15-52

Subjective Approach - Example

Risk Level Very Low Risk Low Risk Same Risk as Firm High Risk Very High Risk
15-53

Discount Rate WACC 8% WACC 3% WACC WACC + 5% WACC + 10%

Flotation Costs
The required return depends on the risk, not how the money is raised However, the cost of issuing new securities should not just be ignored either Basic Approach
Compute the weighted average flotation cost Use the target weights because the firm will issue securities in these percentages over the long term

15-54

NPV and Flotation Costs - Example

Your company is considering a project that will cost $1 million. The project will generate after-tax cash flows of $250,000 per year for 7 years. The WACC is 15% and the firms target D/E ratio is .6 The flotation cost for equity is 5% and the flotation cost for debt is 3%. What is the NPV for the project after adjusting for flotation costs?
fA = (.375)(3%) + (.625)(5%) = 4.25% PV of future cash flows = 1,040,105 NPV = 1,040,105 - 1,000,000/(1-.0425) = -4,281

The project would have a positive NPV of 40,105 without considering flotation costs Once we consider the cost of issuing new securities, the NPV becomes negative
15-55

Quick Quiz
What are the two approaches for computing the cost of equity? How do you compute the cost of debt and the aftertax cost of debt? How do you compute the capital structure weights required for the WACC? What is the WACC? What happens if we use the WACC for the discount rate for all projects? What are two methods that can be used to compute the appropriate discount rate when WACC isnt appropriate? How should we factor in flotation costs to our 15-56 analysis?

What Does Treasury Stock (Treasury Shares) Mean? The portion of shares that a company keeps in their own treasury. Treasury stock may have come from a repurchase or buyback from shareholders; or it may have never been issued to the public in the first place. These shares don't pay dividends, have no voting rights, and should not be included in shares outstanding calculations

57

A pure play is a company that invests its resources in only one line of business. As such, this type of stock has a performance that correlates highly to the performance of the stock's particular industry. For example, many electronic retailers or "e-tailers" are pure plays. All they do is sell one particular type of product over the internet. Therefore, if internet buying declines even slightly, these companies are negatively affected.

58

A company devoted to one line of business, or a company whose stock price is highly correlated with the fortunes of a specific investing theme or strategy. For example, a startup R&D company developing a new technology would be considered pure play because its success depends upon a single product. Coca-Cola would also be considered a pure play in the beverage business. Whereas Pepsi wouldn't be pure play, because it has activities in the food business.
59

Back up slides

60

PROBLEM
The kay Company has the following capital structure as at 31st march 2003
14% Debentures 3,00,000

11% Preference shares

1,00,000

Equity (1,00,000 Shares)

16,00,000

20,00,000

The Company s share has a current market price of Rs 23.6 per share. The expected dividend per share next year is 50% of the the 2003 EPS
61

The following are the earnings per share figure for the company during The preceding ten years . The past trends are expected to continue.
YEAR 1994 1995 1996 1997 1998 EPS Rs 1.00 1.10 1.21 1.33 1.46 YEAR 1999 2000 2001 2002 2003 EPS Rs 1.61 1.77 1.95 2.15 2.36
62

The company can issue 16% per cent new debentures . The company s debenture is currently selling at Rs 96. The new preference shares can be sold at a net price of Rs 9.20 paying a dividend of Rs 1.1 per share . The company tax rate is 50 % Calculate the after tax cost of (1) of new debt (2) of new preference capital (3) of ordinary equity

63