Capital structure_Cost of Capital

Lecture 9

12-0

Agendas
Capital structure Weighted Average Cost of Capital (WACC) Calculating WACC Measuring Capital Structure Calculating Required Rates of Return Firm vesus Project

12-1

Whats the Big Idea?

Earlier lectures on capital budgeting focused on the appropriate size and timing of cash flows.
This lecture discusses the appropriate discount rate when cash flows are risky.

12-2

Capital structure Capital Structure - The firms mix of long term debt financing and equity financing.
Cost of Capital - The return the firms investors could expect to earn if they invested in the securities having comparable degrees of risk.

Cost of equity

Cost of preferred stock

Cost of debts (bank loans)

Cost of debts (bonds)

12-3

WACC (Weighted average cost of capital Weighted Average Cost of Capital (WACC)

Company cost of capital = Weighted average of debt and equity returns.

WACC =

D V

x (1 - Tc)rdebt +

] [

E V

x requity

12-4

WACC The Weighted Average Cost of Capital (WACC) is given by:

rWACC = Equity Debt rEquity + rDebt (1 TC) Equity + Debt Equity + Debt

S B rWACC = rS + rB (1 TC) S+B S+B

It is because interest expense is tax-deductible that we multiply the last term by (1 TC)
12-5

WACC (Cont.)
Taxes are an important consideration in the company cost of capital because interest payments are deducted from income before tax is calculated.

WACC (Cont.) Three Steps to Calculating Cost of Capital

WACC =

D V

x (1 - Tc)rdebt

]+ [

E V

x requity

1. Calculate the weight of each financing sourse as a proportion of the firms market value.
2. Determine the required rate of return on each security (financing source). 3. Calculate a weighted average of these required returns (WACC).

12-7

WACC (Cont.)
Example - Executive Fruit has issued debt, preferred stock and common stock. The market value of these securities are $4mil, $2mil, and $6mil, respectively. The required returns are 6%, 12%, and 18%, respectively. Q: Determine the WACC for Executive Fruit, Inc.

12-8

WACC (Cont.) Example - continued Step 1 Firm Value = 4 + 2 + 6 = $12 mil Step 2 Required returns are given Step 3

WACC =

4 12

x(1-.35).06 +

] (

2 12

x.12 +

) (

6 12

x.18
12-9

=.123 or 12.3%

Measuring Capital Structure In estimating WACC, do not use the Book Value of securities. In estimating WACC, use the Market Value of the securities. Book Values often do not represent the true market value of a firms securities.
12-10

Measuring Capital Structure (Cont.)

Market Value of Bonds - PV of all coupons and par value discounted at the current interest rate.

Market Value of Equity - Market price per share multiplied by the number of outstanding shares.
12-11

Measuring Capital Structure (Cont.)

Big Oil Book Value Balance Sheet (mil) Bank Debt $ 200 25.0% LT Bonds $ 200 25.0% Common Stock $ 100 12.5% Retained Earnings $ 300 37.5% Total $ 800 100%

If the long term bonds pay an 8% coupon and mature in 12 years, what is their market value assuming a 9% YTM?

16 16 16 216 PV .... 2 3 1.09 1.09 1.09 1.0912 $185.70

12-12

Measuring Capital Structure (Cont.)

Big Oil MARKET Value Balance Sheet (mil) Bank Debt (mil) $ 200.0 12.6% LT Bonds $ 185.7 11.7% Total Debt $ 385.7 24.3% Common Stock $ 1,200.0 75.7% Total $ 1,585.7 100.0%

12-13

Cost of Capital
Cost of equity

Cost of Capital - The return the firms investors could expect to earn if they invested in the securities having comparable degrees of risk.

Cost of preferred stock Cost of debts (bank loans) Cost of debts (bonds)
12-14

The Cost of Equity

From the firms perspective, using CAPM to estimate the expected return that is the Cost of Equity Capital:

Ri RF i ( RM - RF )
To estimate a firms cost of equity capital, we need to know three things: 1. The risk-free rate, RF

2. The market risk premium, R M - R F

3. The company beta,
Cov ( R , R ) i M i,M i Var ( R ) 2 M M

12-15

The Cost of Equity - Example

Suppose the stock of Stansfield Enterprises, a publisher of PowerPoint presentations, has a beta of 2.5. Assume a riskfree rate of 5-percent and a market risk premium of 10percent. What is the appropriate discount rate for an expansion of this firm?

R RF i ( R M - RF )
R 5 % 2 . 5 10 % R 30 %
12-16

Cost of equity (Cont.)

Dividend Discount Model Cost of Equity
Perpetuity Growth Model =

Div1 P0 = re - g

solve for re

Div1 re = + g P0

Cost of preferred stocks

Expected Return on Preferred Stock
Price of Preferred Stock =

P0 =

Div1 rpreferred

solve for preferred

rpreferred Div1 = P0

Cost of debts
Bonds

rd = YTM

Bank loans: interest rate banks charge

The Firm versus the Project Any projects cost of capital depends on the use to which the capital is being putnot the source, meaning that take risk into account Therefore, it depends on the risk of the project and not the risk of the company.

12-20

Capital Budgeting & Project Risk

Suppose the Conglomerate Company has a cost of capital, based on the CAPM, of 17%. The risk-free rate is 4%; the market risk premium is 10% and the firms beta is 1.3. 17% = 4% + 1.3 [14% 4%] This is a breakdown of the companys investment projects:
1/3 Automotive retailer b = 2.0

1/3 Computer Hard Drive Mfr. b = 1.3

1/3 Electric Utility b = 0.6 average b of assets = 1.3 When evaluating a new electrical generation investment, 12-21 which cost of capital should be used?

Relationship Between Risk & Expected Return

CAPM - Theory of the relationship between risk and return which states that the expected risk premium on any security equals its beta times the market risk premium. Expected return

Ri RF i ( RM - RF ) RM RF
1.0 b
10-22

Security market line (SML)

Capital Budgeting & Project Risk (Cont.)

Project IRR 24% 17% 10% SML Investments in hard drives or auto retailing should have higher discount rates. Projects risk (b)

0.6

1.3

2.0

r = 4% + 0.6(14% 4% ) = 10% 10% reflects the opportunity cost of capital on an investment in electrical generation, given the unique risk of the project. 12-23

Capital Budgeting & Project Risk (Cont.)

Project IRR

The SML can tell us why:

SML
Incorrectly accepted negative NPV projects

WACC
rf

RF FIRM ( R M - RF )
Incorrectly rejected positive NPV projects Firms risk (beta)

bFIRM

A firm that uses one discount rate for all projects may over time increase the risk of the firm while decreasing its value.
12-24

Capital Budgeting & Project Risk (Cont.)

Suppose Stansfield Enterprises is evaluating the following nonmutually exclusive projects. Each costs $100 and lasts one year.
Project Project b Projects Estimated Cash Flows Next Year $150 IRR NPV at 30%

A B
C

2.5 2.5
2.5

50% 30%
10%

$15.38 $0
-$15.38
12-25

$130
$110

Capital Budgeting & Project Risk (Cont.)

Project

IRR

Good A project B C Bad project

SML

30% 5%

Firms risk (beta)

2.5
An all-equity firm should accept a project whose IRR exceeds the cost of equity capital and reject projects whose IRRs fall 12-26 short of the cost of capital.

Estimating IPs Cost of Capital (WACC)

The industry average beta is 0.82; the risk free rate is 8% and the market risk premium is 8.4%. rS = RF + bi ( RM RF) Thus the cost of equity capital is = 3% + 0.828.4% = 9.89%
12-27

Estimating IPs Cost of Capital (WACC)

The yield on the companys debt is 8% and the firm is in the 37% marginal tax rate. The debt to value ratio is 32%

S B rWACC = rS + rB (1 TC) S+B S+B = 0.68 9.89% + 0.32 8% (1 0.37) = 8.34%

8.34% is Internationals cost of capital. It should be used to discount any project where one believes that the projects risk is equal to the risk of the firm as a whole, and the project has 12-28 the same leverage as the firm as a whole.