Tài chính doanh nghiệp - Chapter 12: Cost of capital

12-1Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin12-2Key Concepts and SkillsKnow how to determine: A firm’s cost of equity capitalA firm’s cost of debtA firm’s overall cost of capitalUnderstand pitfalls of overall cost of capital and how to manage them12-3Chapter Outline12.1 The Cost of Capital: Some Preliminaries12.2 The Cost of Equity12.3 The Costs of Debt and Preferred Stock12.4 The Weighted Average Cost of Capital12.5 Divisional and Project Costs of Capital12-4Cost of Capital BasicsThe cost to a firm for capital funding = the return to the providers of those fundsThe return earned on assets depends on the risk of those assetsA firm’s cost of capital indicates how the market views the risk of the firm’s assetsA firm must earn at least the required return to compensate investors for the financing they have providedThe required return is the same as the appropriate discount rate12-5Cost of EquityThe cost of equity is the return required by equity investors given the risk of the cash flows from the firmTwo major methods for determining the cost of equity- Dividend growth model- SML or CAPMReturn to Quick Quiz12-6The Dividend Growth Model Approach Start with the dividend growth model formula and rearrange to solve for RE12-7Example: Dividend Growth ModelYour company is expected to pay a dividend of $4.40 per share next year. (D1)Dividends have grown at a steady rate of 5.1% per year and the market expects that to continue. (g)The current stock price is $50. (P0)What is the cost of equity?12-8Example: Estimating the Dividend Growth RateOne method for estimating the growth rate is to use the historical averageYear Dividend Percent Change2003 1.232004 1.30 2005 1.36 2006 1.43 2007 1.50(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%12-9Advantages and Disadvantages of Dividend Growth ModelAdvantage – easy to understand and useDisadvantagesOnly applicable to companies currently paying dividendsNot applicable if dividends aren’t growing at a reasonably constant rateExtremely sensitive to the estimated growth rate Does not explicitly consider risk12-10The SML ApproachUse the following information to compute the cost of equityRisk-free rate, RfMarket risk premium, E(RM) – RfSystematic risk of asset, 12-11Example: SMLCompany’s equity beta = 1.2 Current risk-free rate = 7% Expected market risk premium = 6% What is the cost of equity capital?12-12Advantages and Disadvantages of SMLAdvantagesExplicitly adjusts for systematic riskApplicable to all companies, as long as beta is availableDisadvantagesMust estimate the expected market risk premium, which does vary over timeMust estimate beta, which also varies over timeRelies on the past to predict the future, which is not always reliable12-13Example: Cost of EquityData:Beta = 1.5 Market risk premium = 9% Current risk-free rate = 6%. Analysts’ estimates of growth = 6% per year Last dividend = $2. Currently stock price =$15.65 Using SML: RE = 6% + 1.5(9%) = 19.5%Using DGM: RE = [2(1.06) / 15.65] + .06 = 19.55%12-14Cost of DebtThe cost of debt = the required return on a company’s debtMethod 1 = Compute the yield to maturity on existing debtMethod 2 = Use estimates of current rates based on the bond rating expected on new debtThe cost of debt is NOT the coupon rate12-15Example: Cost of DebtCurrent bond issue:15 years to maturity Coupon rate = 12% Coupons paid semiannuallyCurrently bond price = $1,253.72 30 ,1253.72 S.1000 060 /%- 4.45% YTM = 4.45%*2 = 8.9%12-16Component Cost of DebtUse the YTM on the firm’s debtInterest is tax deductible, so the after-tax (AT) cost of debt is:If the corporate tax rate = 40%:Return to Quick Quiz12-17Cost of Preferred StockPreferred pays a constant dividend every periodDividends expected to be paid foreverPreferred stock is a perpetuity Example:Preferred annual dividend = $10 Current stock price = $111.10 RP = 10 / 111.10 = 9%12-18Weighted Average Cost of CapitalUse the individual costs of capital to compute a weighted “average” cost of capital for the firmThis “average” = the required return on the firm’s assets, based on the market’s perception of the risk of those assetsThe weights are determined by how much of each type of financing is usedReturn to Quick Quiz12-19Determining the Weights for the WACCWeights = percentages of the firm that will be financed by each componentAlways use the target weights, if possibleIf not available, use market values12-20Capital Structure WeightsNotationE = market value of equity = # outstanding shares times price per shareD = market value of debt = # outstanding bonds times bond priceV = market value of the firm = D + EWeightsE/V = percent financed with equityD/V = percent financed with debtReturn to Quick Quiz12-21WACCWACC = (E/V) x RE + (P/V) x RP + (D/V) x RD x (1- TC)Where: (E/V) = % of common equity in capital structure (P/V) = % of preferred stock in capital structure (D/V) = % of debt in capital structure RE = firm’s cost of equity RP = firm’s cost of preferred stock RD = firm’s cost of debt TC = firm’s corporate tax rateWeightsComponent costs12-22Estimating Weights Given:Stock price = $503m shares common stock$25m preferred stock$75m debt40% Tax rateWeights:E/V = $150/$250 = 0.6 (60%)P/V = $25/$250 = 0.1 (10%)D/V = $75/$250 = 0.3 (30%)Component Values: VE = $50 x (3 m) = $150m VP = $25m VD = $75m VF = $150+$25+$75=$250m 12-23WACCWACC = 0.6(14%)+0.1(9%) +0.3(10%)(1-.40)WACC = 8.4% + 0.9% + 1.8% = 11.1%ComponentWRDebt (before tax)0.3010%Preferred Stock0.109%Common equity0.6014%WACC = E/V x RE + P/V x RP + D/V x RD (1- TC)12-24Table 12.112-25Factors that Influence a Company’s WACCMarket conditions, especially interest rates, tax rates and the market risk premiumThe firm’s capital structure and dividend policyThe firm’s investment policy Firms with riskier projects generally have a higher WACC12-26Eastman Chemical – 1EquitySource: Chemical – 2Dividend Growth12-28Eastman Chemical - 3 Beta and DividendsSource: Risk Premium = 7% (assumed)T-Bill rate = 0.07% (90 day)Tax rate (assumed) = 35%Beta (Reuters): Source: Chemical – 4Other Data12-30Eastman Chemical - 5Cost of Equity - SMLBeta Yahoo.Finance 2.01 Reuters 1.92 Average 1.965T-Bill rate 0.07%Market Risk Premium 7%Cost of Equity (SML) = .07% + (7%)(1.965) = 13.83% 12-31Eastman Chemical - 6 Cost of Equity - DCFGrowth rate 7%Last dividend $1.76Stock price $52.99Cost of Equity (DCF) = 12-32Eastman Chemical - 7 Cost of EquityCost of EquityIn TextbookIn SlideshowSML Method10.29%13.83%DCF Method14.91%10.55%Average12.60%12.19%12-33Eastman Chemical - 8 BondsSource: Chemical - 9Bonds Since market values are deemed more relevant, we use only market value weightsAverage YTM = 6.772% versus 8.70% in the textbook12-35Capital structure weights:E = 72.67 million x $52.99 = $3.851 billionD = 1.404 billionV = $3.851 + 1.404 = 5.255 billionE/V = 3.851 / 5.255 = .7328D/V = 1.404 / 5.255 = .2672WACC = .7328(12.19%) + .2672(6.772%)(1-.35) = 10.11% (versus 9.79% in text)Eastman Chemical - 10WACC12-36Risk-Adjusted WACCA firm’s WACC reflects the risk of an average project undertaken by the firm“Average”  risk = the firm’s current operationsDifferent divisions/projects may have different risks The division’s or project’s WACC should be adjusted to reflect the appropriate risk and capital structureReturn to Quick Quiz12-37Using WACC for All ProjectsWhat would happen if we use the WACC for all projects regardless of risk?Assume the WACC = 15%12-38Using WACC for All ProjectsAssume the WACC = 15%Adjusting for risk changes the decisions12-39Divisional Risk & the Cost of Capital Rate of Return (%) WACC Rejection Region Acceptance Region Risk WACCH WACCL WACCF 0 RiskL RiskH Acceptance RegionRejection RegionREPLACE WITH FIGURE 12.112-40Divisional Risk & the Cost of Capital12-41Pure Play ApproachFind one or more companies that specialize in the product or service being consideredCompute the beta for each companyTake an averageUse that beta along with the CAPM to find the appropriate return for a project of that riskPure play companies difficult to findReturn to Quick Quiz12-42Subjective ApproachConsider the project’s risk relative to the firm overallIf the project is riskier than the firm, use a discount rate greater than the WACCIf the project is less risky than the firm, use a discount rate less than the WACCReturn to Quick Quiz12-43Subjective Approach - ExampleRisk LevelDiscount RateVery Low RiskWACC – 8% 7%Low RiskWACC – 3% 12%Same Risk as FirmWACC 15%High RiskWACC + 5% 20%Very High RiskWACC + 10% 25%12-44Quick QuizWhat are the two approaches for computing the cost of equity? (Slide 12.5)How do you compute the cost of debt and the after tax cost of debt? (Slide 12.16)How do you compute the capital structure weights required for the WACC? (Slide 12.20)What is the WACC? (Slide 12.18)What happens if we use the WACC as the discount rate for all projects? (Slide 12.36)What are two methods that can be used to compute the appropriate discount rate when WACC isn’t appropriate? (Slide 12.41 and Slide 12.42)Chapter 12END