Kế toán, kiểm toán - Chapter 10: Determining the cost of capital

CHAPTER 10Determining the Cost of Capital1Topics in ChapterCost of Capital ComponentsDebtPreferredCommon EquityWACC2What types of long-term capital do firms use?Long-term debtPreferred stockCommon equity3Capital ComponentsCapital components are sources of funding that come from investors.Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the cost of capital.We do adjust for these items when calculating the cash flows of a project, but not when calculating the cost of capital.4Before-tax vs. After-tax Capital CostsTax effects associated with financing can be incorporated either in capital budgeting cash flows or in cost of capital.Most firms incorporate tax effects in the cost of capital. Therefore, focus on after-tax costs.Only cost of debt is affected.5Historical (Embedded) Costs vs. New (Marginal) CostsThe cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we should focus on marginal costs.6Cost of DebtMethod 1: Ask an investment banker what the coupon rate would be on new debt.Method 2: Find the bond rating for the company and use the yield on other bonds with a similar rating.Method 3: Find the yield on the company’s debt, if it has any.7A 15-year, 12% semiannual bond sells for $1,153.72. What’s rd? 6060 + 1,0006001230I = ?-1,153.72... 30 -1153.72 60 1000 5.0% x 2 = rd = 10% NI/YRPVFVPMTINPUTSOUTPUT8Component Cost of DebtInterest is tax deductible, so the after tax (AT) cost of debt is: rd AT = rd BT(1 - T) rd AT = 10%(1 - 0.40) = 6%.Use nominal rate.Flotation costs small, so ignore.9Cost of preferred stock: Pps = $113.10; 10%Q; Par = $100; F = $2.Use this formula:rps =DpsPps (1-F)=0.1($100)$116.95(1-0.05)=$10$111.10=0.090 = 9.0%10Time Line of Preferred2.502.502.50012∞rps=?-111.1...$111.10=DQrPer=$2.50rPerrPer =$2.50$111.10= 2.25%; rps(Nom) = 2.25%(4) = 9%11Note:Flotation costs for preferred are significant, so are reflected. Use net price.Preferred dividends are not deductible, so no tax adjustment. Just rps.Nominal rps is used.12Is preferred stock more or less risky to investors than debt?More risky; company not required to pay preferred dividend.However, firms want to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, and (3) preferred stockholders may gain control of firm.13Why is yield on preferred lower than rd?Corporations own most preferred stock, because 70% of preferred dividends are nontaxable to corporations.Therefore, preferred often has a lower B-T yield than the B-T yield on debt.The A-T yield to investors and A-T cost to the issuer are higher on preferred than on debt, which is consistent with the higher risk of preferred.14Example:rps = 9%, rd = 10%, T = 40%rps, AT = rps - rps (1 - 0.7)(T)= 9% - 9%(0.3)(0.4) = 7.92%rd, AT = 10% - 10%(0.4) = 6.00%A-T Risk Premium on Preferred = 1.92%15What are the two ways that companies can raise common equity?Directly, by issuing new shares of common stock.Indirectly, by reinvesting earnings that are not paid out as dividends (i.e., retaining earnings).16Why is there a cost for reinvested earnings?Earnings can be reinvested or paid out as dividends.Investors could buy other securities, earn a return.Thus, there is an opportunity cost if earnings are reinvested.17Cost for Reinvested Earnings (Continued)Opportunity cost: The return stockholders could earn on alternative investments of equal risk.They could buy similar stocks and earn rs, or company could repurchase its own stock and earn rs. So, rs, is the cost of reinvested earnings and it is the cost of equity.18Three ways to determine the cost of equity, rs: 1. CAPM: rs = rRF + (rM - rRF)b = rRF + (RPM)b.2. DCF: rs = D1/P0 + g.3. Own-Bond-Yield-Plus-Risk Premium: rs = rd + Bond RP.19CAPM Cost of Equity: rRF = 7%, RPM = 6%, b = 1.2.rs = rRF + (RPM )b.= 7.0% + (6.0%)1.2 = 14.2%.20Issues in Using CAPMMost analysts use the rate on a long-term (10 to 20 years) government bond as an estimate of rRF. More21Issues in Using CAPM (Continued)Most analysts use a rate of 5% to 6.5% for the market risk premium (RPM)Estimates of beta vary, and estimates are “noisy” (they have a wide confidence interval). 22DCF Cost of Equity, rs: D0 = $4.19; P0 = $50; g = 5%.rs = D1P0+ g =D0(1+g)P0+ g=$4.19(1.05)$50+ 0.05=0.088 + 0.05= 13.8% 23Estimating the Growth RateUse the historical growth rate if you believe the future will be like the past.Obtain analysts’ estimates: Value Line, Zacks, Yahoo!Finance.Use the earnings retention model, illustrated on next slide.24Earnings Retention ModelSuppose the company has been earning 15% on equity (ROE = 15%) and retaining 35% (dividend payout = 65%), and this situation is expected to continue.What’s the expected future g?25Earnings Retention Model (Continued)Growth from earnings retention model:g = (Retention rate)(ROE) g = (1 - payout rate)(ROE) g = (1 – 0.65)(15%) = 5.25%.This is close to g = 5% given earlier. Think of bank account paying 15% with retention ratio = 0. What is g of account balance? If retention ratio is 100%, what is g?26Could DCF methodology be applied if g is not constant?YES, nonconstant g stocks are expected to have constant g at some point, generally in 5 to 10 years.But calculations get complicated. See the Web 10B worksheet in the file IFM10 Ch10 Tool Kit.xls.27The Own-Bond-Yield-Plus-Risk-Premium Method: rd = 10%, RP = 4%.rs = rd + RP rs = 10.0% + 4.0% = 14.0%This bond RP  CAPM RPM.Produces ballpark estimate of rs. Useful check.28What’s a reasonable final estimate of rs?MethodEstimateCAPM14.2%DCF13.8%rd + RP14.0%Average14.0%29Determining the Weights for the WACCThe weights are the percentages of the firm that will be financed by each component.If possible, always use the target weights for the percentages of the firm that will be financed with the various types of capital. 30Estimating Weights for the Capital StructureIf you don’t know the targets, it is better to estimate the weights using current market values than current book values.If you don’t know the market value of debt, then it is usually reasonable to use the book values of debt, especially if the debt is short-term.(More...)31Estimating Weights (Continued)Suppose the stock price is $50, there are 3 million shares of stock, the firm has $25 million of preferred stock, and $75 million of debt.(More...)32Estimating Weights (Continued)Vce = $50 (3 million) = $150 million.Vps = $25 million.Vd = $75 million.Total value = $150 + $25 + $75 = $250 million.33Estimating Weights (Continued)wce = $150/$250 = 0.6wps = $25/$250 = 0.1wd = $75/$250 = 0.334What’s the WACC?WACC = wdrd(1 - T) + wpsrps + wcersWACC = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)WACC = 1.8% + 0.9% + 8.4% = 11.1%. 35What factors influence a company’s WACC?Market conditions, especially interest rates and tax rates.The firm’s capital structure and dividend policy.The firm’s investment policy. Firms with riskier projects generally have a higher WACC.36Is the firm’s WACC correct for each of its divisions?NO! The composite WACC reflects the risk of an average project undertaken by the firm.Different divisions may have different risks. The division’s WACC should be adjusted to reflect the division’s risk and capital structure.37The Risk-Adjusted Divisional Cost of CapitalEstimate the cost of capital that the division would have if it were a stand-alone firm. This requires estimating the division’s beta, cost of debt, and capital structure.38Pure Play Method for Estimating Beta for a Division or a ProjectFind several publicly traded companies exclusively in project’s business.Use average of their betas as proxy for project’s beta.Hard to find such companies.39Accounting Beta Method for Estimating BetaRun regression between project’s ROA and S&P index ROA.Accounting betas are correlated (0.5 – 0.6) with market betas.But normally can’t get data on new projects’ ROAs before the capital budgeting decision has been made.40Divisional Cost of Capital Using CAPMTarget debt ratio = 10%.rd = 12%.rRF = 7%.Tax rate = 40%.betaDivision = 1.7.Market risk premium = 6%.41Divisional Cost of Capital Using CAPM (Continued)Division’s required return on equity:rs = rRF + (rM – rRF)bDiv.rs = 7% + (6%)1.7 = 17.2%.WACCDiv. = wd rd(1 – T) + wc rs = 0.1(12%)(0.6) + 0.9(17.2%) = 16.2%.42Division’s WACC vs. Firm’s Overall WACC?Division WACC = 16.2% versus company WACC = 11.1%.“Typical” projects within this division would be accepted if their returns are above 16.2%.43What are the three types of project risk?Stand-alone riskCorporate riskMarket risk44How is each type of risk used?Stand-alone risk is easiest to calculate.Market risk is theoretically best in most situations.However, creditors, customers, suppliers, and employees are more affected by corporate risk.Therefore, corporate risk is also relevant.45A Project-Specific, Risk-Adjusted Cost of CapitalStart by calculating a divisional cost of capital.Use judgment to scale up or down the cost of capital for an individual project relative to the divisional cost of capital.46Costs of Issuing New Common StockWhen 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 stock price.47Cost of New Common Equity: P0=$50, D0=$4.19, g=5%, and F=15%.re =D0(1 + g)P0(1 - F)+ g=$4.19(1.05)$50(1 – 0.15)+ 5.0%=$4.40$42.50+ 5.0% = 15.4%48Cost of New 30-Year Debt: Par=$1,000, Coupon=10% paid annually, and F=2%.Using a financial calculator:N = 30PV = 1000(1-.02) = 980PMT = -(.10)(1000)(1-.4) = -60FV = -1000Solving for I/YR: 6.15%49Comments about flotation costs: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.50Four Mistakes to AvoidCurrent vs. historical cost of debtMixing current and historical measures to estimate the market risk premiumBook weights vs. Market WeightsIncorrect cost of capital componentsSee next slides for details.(More ...)51Current vs. Historical Cost of DebtWhen estimating the cost of debt, don’t use the coupon rate on existing debt. Use the current interest rate on new debt.(More ...)52Estimating the Market Risk PremiumWhen estimating the risk premium for the CAPM approach, don’t subtract the current long-term T-bond rate from the historical average return on common stocks.For example, if the historical rM has been about 12.2% and inflation drives the current rRF up to 10%, the current market risk premium is not 12.2% - 10% = 2.2%!(More ...)53(More...)Estimating WeightsUse the target capital structure to determine the weights.If you don’t know the target weights, then use the current market value of equity, and never the book value of equity. If you don’t know the market value of debt, then the book value of debt often is a reasonable approximation, especially for short-term debt. 54Capital components are sources of funding that come from investors.Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the WACC.We do adjust for these items when calculating the cash flows of the project, but not when calculating the WACC.55