Capital components

1
Chapter 5 The Cost of Capital

• Capital components
• Debt
• Preferred
• Common Equity
• Equity cost approaches
• CAPM
• DCF
• Bond Yield Plus Risk Premium
• WACC

2
What capital should be included in the WACC?

• 1. Long Term Debt
• 2. Preferred Stock
• 3. Common Equity
• Retained earnings
• New common stock

3
Why Calculate the Cost of Capital?

• Cutoff Rate for Capital Investments
• Minimize Cost of Capital in Order to Maximize
  Firms Value
• Other Decisions such as Leasing, Bond Refunding
  and Testifying before Utility Regulatory Agencies

4
Concept of WACC

• Firms obtain capital in lumps but use many
  different types at the same time.
• The different types of financing are
  inter-related. (e.g. adding debt may increase the
  cost of other types of financing as well.)
• We are concerned only with the cost of
  nonspontaneous capital.

5
Focus on before-tax orafter-tax capital costs?

• The WACC used to discount cashflows is after-tax.
• Therefore, use A-T WACC.
• Only kd needs adjustment. Use k i .

6
Why adjust kd?

• The cost of debt is deductible.
• Costs of preferred and common are not deductible.

7
Historical vs. Marginal Cost?

• What is marginal cost?
• Decisions are being made regarding new capital
  investment and raising new capital.
• Therefore, the cost of the next dollar of capital
  is the relevant question (i.e. marginal cost).
  Thus, focus on marginal costs.

8
Calculate kd Coupon 10 semiannual Price
1,081.44 15 years
0 1 2 30
-1,081.44 50 50 501,000
9
Component Cost of Debt
ki kd BT (1-T) 9 (1-0.40) 5.4 Use
nominal rate.
10
Should flotation costs be considered?

• Total costs of issuing and selling a security
  reduce the net proceeds from the sale
• These costs are typically small on public debt
  issues.
• Most debt is privately placeddirectly with large
  investors. So flotation costs might be
  nonexistent.

11
Should the nominal or effective annual cost of
debt be used?

• Semiannual
• EAR (1.045) 2 - 1 9.2
• Nominal (non-compounded) rates are generally
  used.
• Capital budgeting CFs assumed to occur at year
  end undervalues CFs.
• The two offset each other.

12
Would a kd estimate based on 15-year bonds be
valid if the firm actually planned to issue
30-year bonds?

• Only if the yield curve were flat.
• Differences are typically small
  over longer-term maturities hence yield curve
  adjustments are seldom made.

13
What is the component cost of preferred
stock? PPS115 9Q Par100 F2.50
DPS PNet
Formula
kPS
0.09(100)
9


115.00 - 2.50
112.50
0.080 8.0
14
Preferred Stock Cashflows per Quarter
8
0 1 2
-112.50 2.25 2.25
Dps 2.25
112.50

kps kps
kPer 2.25/112.50 2.00 kNom 2 x 4 8
15
Notes on preferred

• Flotation costs for preferred aresignificant, so
  they are included. Use net price.
• Preferred dividends are not deductible, so no tax
  adjustment.Just kPS.
• Nominal kPS is used.
• Many preferred issues have a maturity and are not
  perpetual
• Trust-Oriented Preferred Stock (TOPS)

16
Is preferred stock more or less risky to
investors than debt?

• More risky company is not required to pay
  preferred dividends.
• However, firms try to pay preferreddividends.
  Otherwise
• Cannot pay common dividends,
• Difficult to raise additional funds,
• Preferred stockholders may gain control of the
  firm.

17
Why is kPS lower than kd?

• Corporations own most preferred stock, because
  70 of preferred dividends are nontaxable
  (Dividends Received Deduction) to corporations.
• Therefore, preferred often has a lower B-T yield
  than debt.
• The A-T yield to an investor, and the A-T cost to
  the issuer, are higher on preferred than on debt.
  That is consistent with the higher risk of
  preferred.

18
Example for a Corporate Investor

• kd BT 9 kd AT 9(1-.4) 5.4 k I
• kPS 8
• kPS AT kPS - kPS(1-.7)T 8 - 8(.3)(.4)
  7.04
• A-T risk premium on preferred kd AT - kPS AT
  7.04 - 5.40 1.64

19
What would kps be if the preferred stock had a
mandatory redemptionprovision so the issue would
be redeemed in five years at 110/share?
Yield to investor (not considering taxes)
0 1 2 3 4 5
-115 9 9 9 9
9 110
20
Cost to corporation (after flotation)
0 1 2 3 4 5
112.50 -9 -9 -9 -9
-9 -110
21
What are the two primary ways that companies can
raise common equity?

• Companies can issue new shares of common stock.
• Companies can reinvest earnings.

22
Why is there a cost for retained earnings?

• Earnings can be reinvested or paid out as
  dividends.
• Investors could use dividends to buy other
  securities and earn a return.
• Thus, there is an opportunity cost if earnings
  are reinvested.

23

• Opportunity cost is the return stockholders
  could earn on alternative investments of equal
  risk.
• They could buy similar stocks and earn ks, or the
  company could repurchase its own stock and earn
  ks. So ks is the cost of reinvested earnings, and
  it is the cost of equity.
• Also, please think of EVA.

24
Three approaches to determine the cost of
retained earnings ks

• 1. Capital Asset Pricing Model (CAPM)(incorporate
  s historical market risk)
• 2. Discounted Cash Flow (DCF)
• (incorporates expectations for future earnings)
• 3. Bond Yield Plus Risk Premium(BYRP)(incorporate
  s known relationships between methods of
  financing)

25
Three approaches to determine the cost of
retained earnings ks
1. CAPM kS kRF (kM - kRF)b kRF
(RPM)b. 2. DCF kS D1/P0 g 3.
Bond-Yield-Plus-Risk Premium (BYRP) kS
kd RP
26
What is the cost of retained earnings based on
the CAPM?
kS kRF (kM - kRF)?
7.0 (5.0)(1.25) 13.25
? can be obtained from the computers in the
Trading Room (406 Sirrine)
27
How to Obtain Beta from Bridge System

• Double Click on Telerate
• Double click in the gray area
• Double click on Analytics Pages
• Then type the symbol of the firm that you want
  and open bracket and beta
• For instance IBMbeta
• The x value is the beta

28
Why is the T-bond rate a better measure of kRF
than the T-bill?
The T-bond rate

• Embodies long-term inflation expectations.
• Is influenced less by Federal Reserve actions,
  currency flows, etc.
• Is the more logical investment alternative to
  stocks.
• However, this rate is affected when the federal
  budget surplus is used to pay off the debt.

29
What is the DCF cost of retained earnings kS?
Given D0 5.00 P0 76 g 6?
D0 (1 g)
D1
kS
g

g
P0
P0
5.00(1.06)

13.0
0.06
76
30
How do we estimate g?

• Point to point
• Average to average
• Regression
• Retention Growth Formula
• Use analysts predictions
• IBES
• Zacks

31
Suppose the company has been earning 15.5 on
equity (ROE 15.5) and retaining 40 (dividend
payout 60), and this situation is expected to
continue. Whats the expected future g?
32
Retention growth rate model
g b(ROE) 0.40 (15.5) 6.20 Here b
fraction retained. This g is close to g 6 as
given.
33
Could the 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 require a simple spreadsheet
  model. Actually, you can do it with a financial
  calculator.

34
Find kS using the bond-yield- plus-risk premium
method.
kS kd RP 9.0 4.0 13.0

• Use current RP of about 4.
• Produces ballpark estimate of kS.
• This RP is not equal to CAPM RPm
• Useful check on the DCF and and CAPM methods.
  Maybe the only method possible for
  small firm.

35
Whats a reasonable final estimate of kS ?
Method CAPM DCF kd RP Average
Estimate 13.25 13.00 14.00 13.42
Usually not so close.
36
How do we find the cost of new common stock, ke?

• Use the DCF formula, but must adjust P0 for
  flotation cost.
• End up with ke gt ks.

In your Finance 312 text, you would have ke gt
ke.
37
Why is ke gt kS?

• Investors expect to earn kS.
• If company gets money as retained earnings and
  earns kS, then everything is okay.
• But if investors put up money to buy new stock,
  flotation costs are pulled out, so net funds must
  earn gt kS to provide kS on investors money.

38
Summary of Component Costs of Capital
kd (1-t) 5.4 kp 8 ks 13.1 ke
13.85
Optimal (Target) Mix 30 debt, 10
preferred 60 equity
39
What is the WACC using retained earnings for the
equity component?
WACC1 Wdkd (1-t) WPskPs WcekS
WACC1 Wi ki Wpskps Wce ks
.3 (5.4) .1(8) .6(13.1)
10.3 Cost of new capital until the
retained earnings is used up.
40
WACC with new common equity?
WACC2 Wdkd (1-t) WPskPs Wceke
.3(5.4) .1(8) .6(13.85)
10.7
41
Summary to this point
kS or ke WACC
13.10 10.3 13.85 10.7 The WACC is the
weighted cost of each new dollar of capital
raised at the margin.
42
Find retained earnings breakpoint.

• Optimal proportion of equity 60
• Amount of retained earnings available 300,000

Dollars of RE Equity Fraction
BPRE
300,000/.60 500,000
43
How would the company raise the 500,000 of new
capital?
.3(500K) 150,000 Debt .1(500K) 50,000
Preferred .6(500K) 300,000 Retained Earnings
500,000 Total
44
What is the MCC schedule?
A plot of the firms WACC versus new dollars of
capital raised. Shows the cost of each
additional, or marginal, dollar raised. Remember
use Target Weights or Market Weights, Not Book
Weights.
45
WACC
WACC1 10.3
WACC2 10.7
12 10
of New Capital (000)
500K
46
Would the MCC schedule remain constant beyond the
RE breakpoint regardless of the amount of
capital required? Why?

• NO. As more and more new capital is required in
  any year, the companys WACC would eventually
  rise above 10.7.
• Reasons
• Floatation Costs
• Need for Outside Investors
• Concern of Current Investors

47
What would the company have planned to do with
the money it raised have any effect on the WACC?

• It might. We have implicitly assumed that the
  company would invest in assets with equal risk as
  existing assets.
• If the company planned to invest in riskier
  assets, this would raise the cost of capital.

48
What effect does depreciation have on the MCC
schedule?

• Depreciation reduces tax liability
• These funds therefore have an opportunity cost
  equal to the WACC using retained earnings, 10.3.
• This will shift the MCC schedule outward by the
  of depreciation.

49
Would depreciation affect the acceptability of
proposed capital budgeting projects and the
size of the total capital budget?

• Possibly. If the lower cost MCC is shifted to
  the right, the cost of capital used to evaluate
  projects may be lower.
• If lots of good projects are available, then the
  shift will affect project selection.

50
Factors that Affect the Weighted Average Cost of
Capital

• Factors the Firm Cannot Control
• Level of Interest Rates
• Taxes
• Factors the Firm Can Control
• Capital Structure Policy (Financing Policy)
• Dividend Policy
• Investment (Capital Budgeting) Policy

51
Some Problem Areas in Cost of Capital

• Privately Owned Firms
• Tax Issues - May consider personal taxes
• Small Businesses
• Measurement Problems
• What really is the k e ?
• Cost of Capital for Projects of Differing
  Riskiness
• Risk Adjusted Discount Rates
• Capital Structure Weights

52
Four Common Mistakes to Avoid

• 1. When estimating the cost of debt, use the
  current interest rate on new debt, not the coupon
  rate on existing debt.
• 2. When estimating the risk premium for the CAPM
  approach, dont subtract the current long-term
  T-bond rate from the historical average return on
  common stocks.

53

• For example, if the historical kM has been about
  12.7 and inflation drives the current kRF up to
  10, the current market risk premium is not 12.7
  - 10 2.7!

(More ...)
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3. Use the target capital structure to determine
the weights. If you dont know the target
weights, then use the current market value of
equity, and never the book value of equity. If
you dont know the market value of debt, then the
book value of debt often is a reasonable
approximation, especially for short-term debt.
(More...)
55
4. Capital 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.
56
Three Types of Risk

• Stand-alone risk
• Corporate risk
• Market risk

Market, or beta, risk is most relevant for
estimating the WACC.
57
Methods for estimating a divisions or a
projects beta

• Pure play. Find several publicly traded
  companies exclusively in projects business. Use
  average of their betas as proxy for projects
  beta.Hard to find such companies.

58

• Accounting beta. Run regression between
  projects ROA and SP index ROA. Accounting
  betas are correlated (0.5-0.6) with market
  betas.But normally cant get data on new
  projects ROAs before the capital budgeting
  decision has been made.

59
Should the firm use the same WACC for all
projects?

• Not typically
• The company should estimate divisional WACCs
  based on divisional betas and divisional debt
  capacities.
• The company might consider further adjustments to
  divisional WACCs for particularly risky or safe
  projects.

60
Conclusion

• Capital Components
• Debt
• Preferred
• Common Equity
• Equity Calculations
• CAPM
• DCF
• Bond Yield Plus Premium
• WACC
• MCC Schedule
• Problem Areas