CHAPTER9

TheCostofCapitalSourcesofcapitalComponentcostsWACCAdjustingforflotationcostsAdjustingforriskWhatsourcesoflong-termcapitaldofirmsuse?Calculatingtheweightedaveragecostofcapital WACC=wdkd(1-T)+wpkp+wcks

Thew’srefertothefirm’scapitalstructureweights.Thek’srefertothecostofeachcomponent.Shouldouranalysisfocusonbefore-taxorafter-taxcapitalcosts?StockholdersfocusonA-TCFs.Therefore,weshouldfocusonA-Tcapitalcosts,i.e.useA-TcostsofcapitalinWACC.Onlykdneedsadjustment,becauseinterestistaxdeductible.Shouldouranalysisfocusonhistorical(embedded)costsornew(marginal)costs?Thecostofcapitalisusedprimarilytomakedecisionsthatinvolveraisingnewcapital.So,focusontoday’smarginalcosts(forWACC).Howaretheweightsdetermined? WACC=wdkd(1-T)+wpkp+wcks

Useaccountingnumbersormarketvalue(bookvs.marketweights)?Useactualnumbersortargetcapitalstructure?Componentcostofdebt WACC=wdkd(1-T)+wpkp+wcks

kdisthemarginalcostofdebtcapital.TheyieldtomaturityonoutstandingL-Tdebtisoftenusedasameasureofkd.Whytax-adjust,i.e.whykd(1-T)?A15-year,12%semiannualcouponbondsellsfor$1,153.72.Whatisthecostofdebt(kd)?Remember,thebondpaysasemiannualcoupon,sokd=5.0%x2=10%.INPUTSOUTPUTNI/YRPMTPVFV305601000-1153.72ComponentcostofdebtInterestistaxdeductible,so A-Tkd=B-Tkd(1-T) =10%(1-0.40)=6%Usenominalrate.Flotationcostsaresmall,soignorethem.Componentcostofpreferredstock WACC=wdkd(1-T)+wpkp+wcks

kpisthemarginalcostofpreferredstock.Therateofreturninvestorsrequireonthefirm’spreferredstock.Whatisthecostofpreferredstock?Thecostofpreferredstockcanbesolvedbyusingthisformula:

kp=Dp/Pp =$10/$111.10 =9%ComponentcostofpreferredstockPreferreddividendsarenottax-deductible,sonotaxadjustmentsnecessary.Justusekp.Nominalkpisused.Ourcalculationignorespossibleflotationcosts.Ispreferredstockmoreorlessriskytoinvestorsthandebt?Morerisky;companynotrequiredtopaypreferreddividend.However,firmstrytopaypreferreddividend.Otherwise,(1)cannotpaycommondividend,(2)difficulttoraiseadditionalfunds,(3)preferredstockholdersmaygaincontroloffirm.Whyistheyieldonpreferredstocklowerthandebt?Corporationsownmostpreferredstock,because70%ofpreferreddividendsarenontaxabletocorporations.Therefore,preferredstockoftenhasalowerB-TyieldthantheB-Tyieldondebt.TheA-Tyieldtoaninvestor,andtheA-Tcosttotheissuer,arehigheronpreferredstockthanondebt.Consistentwithhigherriskofpreferredstock.IllustratingthedifferencesbetweenA-TcostsofdebtandpreferredstockRecall,thatthefirm’staxrateis40%,anditsbefore-taxcostsofdebtandpreferredstockarekd=10%andkp=9%,respectively.

A-Tkp=kp–kp(1–0.7)(T)=9%-9%(0.3)(0.4) =7.92%A-Tkd=10%-10%(0.4) =6.00%A-TRiskPremiumonPreferred =1.92%Componentcostofequity WACC=wdkd(1-T)+wpkp+wcks

ksisthemarginalcostofcommonequityusingretainedearnings.Therateofreturninvestorsrequireonthefirm’scommonequityusingnewequityiske.Whyisthereacostforretainedearnings?Earningscanbereinvestedorpaidoutasdividends.Investorscouldbuyothersecurities,earnareturn.Ifearningsareretained,thereisanopportunitycost(thereturnthatstockholderscouldearnonalternativeinvestmentsofequalrisk).Investorscouldbuysimilarstocksandearnks.Firmcouldrepurchaseitsownstockandearnks.Therefore,ksisthecostofretainedearnings.Threewaystodeterminethecostofcommonequity,ksCAPM: ks=kRF+(kM–kRF)βDCF: ks=D1/P0+gOwn-Bond-Yield-Plus-RiskPremium: ks=kd+RPIfthekRF=7%,RPM=6%,andthefirm’sbetais1.2,what’sthecostofcommonequitybasedupontheCAPM?ks=kRF+(kM–kRF)β =7.0%+(6.0%)1.2=14.2%IfD0=$4.19,P0=$50,andg=5%,what’sthecostofcommonequitybasedupontheDCFapproach?D1 =D0(1+g)D1 =$4.19(1+.05)D1 =$4.3995ks =D1/P0+g =$4.3995/$50+0.05 =13.8%Whatistheexpectedfuturegrowthrate?Thefirmhasbeenearning15%onequity(ROE=15%)andretaining35%ofitsearnings(dividendpayout=65%).Thissituationisexpectedtocontinue. g =(1–Payout)(ROE) =(0.35)(15%) =5.25%Veryclosetothegthatwasgivenbefore.CanDCFmethodologybeappliedifgrowthisnotconstant?Yes,nonconstantgrowthstocksareexpectedtoattainconstantgrowthatsomepoint,generallyin5to10years.Maybecomplicatedtocompute.Ifkd=10%andRP=4%,whatisksusingtheown-bond-yield-plus-risk-premiummethod?ThisRPisnotthesameastheCAPMRPM.Thismethodproducesaballparkestimateofks,andcanserveasausefulcheck. ks=kd+RP ks=10.0%+4.0%=14.0%Whatisareasonablefinalestimateofks?

Method

Estimate CAPM 14.2% DCF 13.8% kd+RP 14.0% Average 14.0%Whyisthecostofretainedearningscheaperthanthecostofissuingnewcommonstock?Whenacompanyissuesnewcommonstocktheyalsohavetopayflotationcoststotheunderwriter.Issuingnewcommonstockmaysendanegativesignaltothecapitalmarkets,whichmaydepressthestockprice.Ifissuingnewcommonstockincursaflotationcostof15%oftheproceeds,whatiske?FlotationcostsFlotationcostsdependontheriskofthefirmandthetypeofcapitalbeingraised.Theflotationcostsarehighestforcommonequity.However,sincemostfirmsissueequityinfrequently,theper-projectcostisfairlysmall.WewillfrequentlyignoreflotationcostswhencalculatingtheWACC.Ignoringfloatationcosts,whatisthefirm’sWACC?WACC =wdkd(1-T)+wpkp+wcks

=0.3(10%)(0.6)+0.1(9%)+0.6(14%) =1.8%+0.9%+8.4% =11.1%Whatfactorsinfluenceacompany’scompositeWACC?Marketconditions.Thefirm’scapitalstructureanddividendpolicy.Thefirm’sinvestmentpolicy.FirmswithriskierprojectsgenerallyhaveahigherWACC.ShouldthecompanyusethecompositeWACCasthehurdlerateforeachofitsprojects?NO!ThecompositeWACCreflectstheriskofanaverageprojectundertakenbythefirm.Therefore,theWACConlyrepresentsthe“hurdlerate”foratypicalprojectwithaveragerisk.Differentprojectshavedifferentrisks.Theproject’sWACCshouldbeadjustedtoreflecttheproject’srisk.RiskandtheCostofCapitalWhatarethethreetypesofprojectrisk?Stand-aloneriskCorporateriskMarketriskHowiseachtypeofriskused?Marketriskistheoreticallybestinmostsituations.However,creditors,customers,suppliers,andemployeesaremoreaffectedbycorporaterisk.Therefore,corporateriskisalsorelevant.ProblemareasincostofcapitalDepreciation-generatedfundsPrivatelyownedfirmsMeasurementproblemsAdjustingcostsofcapitalfordifferentriskCapitalstructureweightsHowarerisk-adjustedcostsofcapitaldeterminedforspecificprojectsordivisi