Fundamentals of Financial ManagementCHAPTER 10 The Cost of Capital

1、10 - 1 copyright 2001 by harcourt, inc.all rights reserved. chapter 10 the cost of capital ncost of capital components naccounting for flotation costs nwacc nadjusting cost of capital for risk nestimating project risk 10 - 2 copyright 2001 by harcourt, inc.all rights reserved. what types of capital

2、do firms use? debt preferred stock common equity: retained earnings new common stock 10 - 3 copyright 2001 by harcourt, inc.all rights reserved. stockholders focus on a-t cfs. therefore, we should focus on a-t capital costs, i.e., use a-t costs in wacc. only kd needs adjustment. should we focus on b

3、efore-tax or after-tax capital costs? 10 - 4 copyright 2001 by harcourt, inc.all rights reserved. the cost of capital is used primarily to make decisions that involve raising new capital. so, focus on todays marginal costs (for wacc). should we focus on historical (embedded) costs or new (marginal)

4、costs? 10 - 5 copyright 2001 by harcourt, inc.all rights reserved. a 15-year, 12% semiannual bond sells for $1,153.72. whats kd? 6060 + 1,00060 01230 i = ? 30 -1153.72 60 1000 5.0% x 2 = kd = 10% ni/yrpvfvpmt -1,153.72 . inputs output 10 - 6 copyright 2001 by harcourt, inc.all rights reserved. compo

5、nent cost of debt ninterest is tax deductible, so kd at = kd bt(1 t) = 10%(1 0.40) = 6%. nuse nominal rate. nflotation costs small. ignore. 10 - 7 copyright 2001 by harcourt, inc.all rights reserved. whats the cost of preferred stock? pp = $111.10; 10%q; par = $100. use this formula: %.0.9090.0 10.1

6、11$ 10$ p d k p p p 10 - 8 copyright 2001 by harcourt, inc.all rights reserved. picture of preferred stock 2.502.50 012 kp = ? -111.1 . 2.50 $111.10 = = . kper = = 2.25%; kp(nom) = 2.25%(4) = 9%. dq kper $2.50 kper $2.50 $111.10 10 - 9 copyright 2001 by harcourt, inc.all rights reserved. note: npref

7、erred dividends are not tax deductible, so no tax adjustment. just kp. nnominal kp is used. nour calculation ignores flotation costs. 10 - 10 copyright 2001 by harcourt, inc.all rights reserved. is preferred stock more or less risky to investors than debt? nmore risky; company not required to pay pr

8、eferred dividend. nhowever, firms try to pay preferred dividend. otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, (3) preferred stockholders may gain control of firm. 10 - 11 copyright 2001 by harcourt, inc.all rights reserved. why is yield on preferred lower than

9、kd? ncorporations own most preferred stock, because 70% of preferred dividends are nontaxable to corporations. ntherefore, preferred often has a lower b-t yield than the b-t yield on debt. nthe a-t yield to an investor, and the a-t cost to the issuer, are higher on preferred than on debt. consistent

10、 with higher risk of preferred. 10 - 12 copyright 2001 by harcourt, inc.all rights reserved. example: kp = 9% kd = 10% t = 40% kp, at = kp kp (1 0.7)(t) = 9% 9%(0.3)(0.4) = 7.92%. kd, at = 10% 10%(0.4) = 6.00%. a-t risk premium on preferred = 1.92%. 10 - 13 copyright 2001 by harcourt, inc.all rights

11、 reserved. why is there a cost for retained earnings? nearnings can be reinvested or paid out as dividends. ninvestors could buy other securities, earn a return. nthus, there is an opportunity cost if earnings are retained. 10 - 14 copyright 2001 by harcourt, inc.all rights reserved. nopportunity co

12、st: the return stockholders could earn on alternative investments of equal risk. nthey could buy similar stocks and earn ks, or company could repurchase its own stock and earn ks. so, ks is the cost of retained earnings. 10 - 15 copyright 2001 by harcourt, inc.all rights reserved. three ways to dete

13、rmine cost of common equity, ks: 1. capm: ks = krf + (km krf)b. 2. dcf: ks = d1/p0 + g. 3. own-bond-yield-plus-risk premium: ks = kd + rp. 10 - 16 copyright 2001 by harcourt, inc.all rights reserved. whats the cost of common equity based on the capm? krf = 7%, rpm = 6%, b = 1.2. ks = krf + (km krf )

14、b. = 7.0% + (6.0%)1.2 = 14.2%. 10 - 17 copyright 2001 by harcourt, inc.all rights reserved. whats the dcf cost of common equity, ks? given: d0 = $4.19; p0 = $50; g = 5%. d1 p0 d0(1 + g) p0 $4.19(1.05) $50 ks= + g = + g = + 0.05 = 0.088 + 0.05 = 13.8%. 10 - 18 copyright 2001 by harcourt, inc.all righ

15、ts reserved. suppose the company has been earning 15% on equity (roe = 15%) and retaining 35% (dividend payout = 65%), and this situation is expected to continue. whats the expected future g? 10 - 19 copyright 2001 by harcourt, inc.all rights reserved. retention growth rate: g = (1 payout)(roe) = 0.

16、35(15%) = 5.25%. here (1 payout) = fraction retained. close to g = 5% given earlier. think of bank account paying 10% with payout = 100%, payout = 0%, and payout = 50%. whats g? 10 - 20 copyright 2001 by harcourt, inc.all rights reserved. could dcf methodology be applied if g is not constant? nyes,

17、nonconstant g stocks are expected to have constant g at some point, generally in 5 to 10 years. nbut calculations get complicated. 10 - 21 copyright 2001 by harcourt, inc.all rights reserved. find ks using the own-bond-yield-plus- risk-premium method. (kd = 10%, rp = 4%.) nthis rp capm rp. nproduces

18、 ballpark estimate of ks. useful check. ks = kd + rp = 10.0% + 4.0% = 14.0% 10 - 22 copyright 2001 by harcourt, inc.all rights reserved. whats a reasonable final estimate of ks? methodestimate capm 14.2% dcf 13.8% kd + rp 14.0% average 14.0% 10 - 23 copyright 2001 by harcourt, inc.all rights reserve

19、d. 1. when a company issues new common stock they also have to pay flotation costs to the underwriter. 2. issuing new common stock may send a negative signal to the capital markets, which may depress stock price. why is the cost of retained earnings cheaper than the cost of issuing new common stock?

20、 10 - 24 copyright 2001 by harcourt, inc.all rights reserved. two approaches that can be used to account for flotation costs: ninclude the flotation costs as part of the projects up-front cost. this reduces the projects estimated return. nadjust the cost of capital to include flotation costs. this i

21、s most commonly done by incorporating flotation costs in the dcf model. 10 - 25 copyright 2001 by harcourt, inc.all rights reserved. new common, f = 15%: g )f1(p )g1(d k 0 0 e %.4.15%0.5 50.42$ 40.4$ %0.5 15.0150$ 05.119.4$ 10 - 26 copyright 2001 by harcourt, inc.all rights reserved. comments about

22、flotation costs: nflotation costs depend on the risk of the firm and the type of capital being raised. nthe flotation costs are highest for common equity. however, since most firms issue equity infrequently, the per-project cost is fairly small. nwe will frequently ignore flotation costs when calcul

23、ating the wacc. 10 - 27 copyright 2001 by harcourt, inc.all rights reserved. whats the firms wacc (ignoring flotation costs)? 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%. 10 - 28 copyright 2001 by harcourt, inc.all rights reserved. what factors in

24、fluence a companys composite wacc? nmarket conditions. nthe firms capital structure and dividend policy. nthe firms investment policy. firms with riskier projects generally have a higher wacc. 10 - 29 copyright 2001 by harcourt, inc.all rights reserved. wacc estimates for some large u. s. corporatio

25、ns, nov. 1999 companywacc intel12.9% general electric11.9 motorola11.3 coca-cola11.2 walt disney10.0 at&t 9.8 wal-mart 9.8 exxon 8.8 h. j. heinz 8.5 bellsouth 8.2 10 - 30 copyright 2001 by harcourt, inc.all rights reserved. should the company use the composite wacc as the hurdle rate for each of its

26、 projects? nno! the composite wacc reflects the risk of an average project undertaken by the firm. therefore, the wacc only represents the “hurdle rate” for a typical project with average risk. ndifferent projects have different risks. the projects wacc should be adjusted to reflect the projects ris

27、k. 10 - 31 copyright 2001 by harcourt, inc.all rights reserved. risk and the cost of capital rate of return (%) wacc rejection region acceptance region risk l b a h 12.0 8.0 10.0 10.5 9.5 0risklriskariskh 10 - 32 copyright 2001 by harcourt, inc.all rights reserved. divisional cost of capital rate of

28、 return (%) wacc project h division hs wacc risk project l composite wacc for firm a 13.0 7.0 10.0 11.0 9.0 division ls wacc 0risklriskaverageriskh 10 - 33 copyright 2001 by harcourt, inc.all rights reserved. what are the three types of project risk? nstand-alone risk ncorporate risk nmarket risk 10

29、 - 34 copyright 2001 by harcourt, inc.all rights reserved. how is each type of risk used? nmarket risk is theoretically best in most situations. nhowever, creditors, customers, suppliers, and employees are more affected by corporate risk. ntherefore, corporate risk is also relevant. 10 - 35 copyrigh

30、t 2001 by harcourt, inc.all rights reserved. nsubjective adjustments to the firms composite wacc. nattempt to estimate what the cost of capital would be if the project/division were a stand-alone firm. this requires estimating the projects beta. what procedures are used to determine the risk-adjuste

31、d cost of capital for a particular project or division? 10 - 36 copyright 2001 by harcourt, inc.all rights reserved. methods for estimating a projects beta 1. 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. 10 - 37 copyright 2001 by harcourt, inc.all rights reserved. 2. accounting beta. run regression between projects roa and s&p index roa. accounting