cost of capital
A firm's cost of equity capital
A firm's cost of debt
A firm's overall cost of capital
Understand pitfalls of overall cost of capital and how to manage them
cost of capital basic
The cost to a firm for capital funding = the return to the providers of those funds
The return earned on assets depends on the risk of those assets
A firm's cost of capital indicates how the market views the risk of the firm's assets
A firm must earn at l
Cost of Equity
The cost of equity is the return required by equity investors given the risk of the cash flows from the firm
Two major methods for determining the cost of equity
- Dividend growth model (RE)
- SML or CAPM
Dividend growth model (RE)
RE = D 1/P 0 + g
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 aren't growing at a reasonably constant rate
Extremely sensitive to the estimated growth rate
Does not explicitly cons
The SML Approach
Use the following information to compute the cost of equity
Risk-free rate, Rf
Market risk premium, E(RM) - Rf
Systematic risk of asset , @
RE = Rf + @ * (E(RM) - Rf)
Advantages and Disadvantages of SML
Advantages
Explicitly adjusts for systematic risk
Applicable to all companies, as long as beta is available
Disadvantages
Must estimate the expected market risk premium, which does vary over time
Must estimate beta, which also varies over time
Relies on t
Cost of Debt
The cost of debt = the required return on a company's debt
Method 1 = Compute the yield to maturity on existing debt
Method 2 = Use estimates of current rates based on the bond rating expected on new debt
The cost of debt is NOT the coupon rate
Component Cost of Debt
Use the YTM on the firm's debt
Interest is tax deductible, so the after-tax (AT) cost of debt is:
If the corporate tax rate = 40%:
Cost of Preferred Stock
Preferred pays a constant dividend every period
Dividends expected to be paid forever
Preferred stock is a perpetuity
Example:
Preferred annual dividend = $10
Current stock price = $111.10
RP = 10 / 111.10 = 9%
Weighted Average Cost of Capital
Use the individual costs of capital to compute a weighted "average" cost of capital for the firm
This "average" = the required return on the firm's assets, based on the market's perception of the risk of those assets
The weights are determined by how much
Determining the Weights for the WACC
Weights = percentages of the firm that will be financed by each component
Always use the target weights, if possible
If not available, use market values
Capital Structure Weights
Notation
E = market value of equity
= # outstanding shares times price per share
D = market value of debt
= # outstanding bonds times bond price
V = market value of the firm = D + E
Weights
E/V = percent financed with equity
D/V = percent financed with de
WACC
WACC = (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
Estimating Weights
Given:
Stock price = $50
3m shares common stock
$25m preferred stock
$75m debt
40% Tax rate
Weights:
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
Factors that Influence a Company's WACC
Market conditions, especially interest rates, tax rates and the market risk premium
The firm's capital structure and dividend policy
The firm's investment policy
Firms with riskier projects generally have a higher WACC
Risk-Adjusted WACC
A firm's WACC reflects the risk of an average project undertaken by the firm
"Average" * risk = the firm's current operations
Different divisions/projects may have different risks
The division's or project's WACC should be adjusted to reflect the appropri
Pure Play Approach
Find one or more companies that specialize in the product or service being considered
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
Pure play companies can be
Subjective Approach
Consider the project's risk relative to the firm overall
If the project is riskier than the firm, use a discount rate greater than the WACC
If the project is less risky than the firm, use a discount rate less than the WACC