Tài chính doanh nghiệp - Chapter 12: Cost of capital

Cost of CapitalChapter 120Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerKey Concepts and SkillsKnow how to determine a firm’s cost of equity capitalKnow how to determine a firm’s cost of debtKnow how to determine a firm’s overall cost of capitalUnderstand pitfalls of overall cost of capital and how to manage themUnderstand the impact of an imputation tax system 1Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerChapter OutlineThe Cost of Capital: Some PreliminariesThe Cost of EquityThe Costs of Debt and Preferred StockThe Weighted Average Cost of CapitalDivisional and Project Costs of Capital2Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerWhy Cost of Capital is ImportantWe know that the return earned on assets depends on the risk of those assetsThe return to an investor is the same as the cost to the companyOur cost of capital provides us with an indication of how the market views the risk of our assetsKnowing our cost of capital can also help us determine our required return for capital budgeting projects3Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerRequired ReturnThe required return is the same as the appropriate discount rate and is based on the risk of the cash flowsWe need to know the required return for an investment before we can compute the NPV and make a decision about whether or not to take the investmentWe need to earn at least the required return to compensate our investors for the financing they have provided4Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerCost of EquityThe cost of equity is the return required by equity investors given the risk of the cash flows from the firmThere are two major methods for determining the cost of equityDividend growth modelSML or CAPM5Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerThe Dividend Growth Model ApproachStart with the dividend growth model formula and rearrange to solve for RE6Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerDividend Growth Model ExampleSuppose that your company is expected to pay a dividend of $1.50 per share next year. There has been a steady growth in dividends of 5.1% per year and the market expects that to continue. The current price is $25. What is the cost of equity?7Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExample: Estimating the Dividend Growth RateOne method for estimating the growth rate is to use the historical averageYear Dividend Percent Change2003 1.23 2004 1.30 (1.30 – 1.23) / 1.23 = 5.7% 2005 1.36 (1.36 – 1.30) / 1.30 = 4.6%2006 1.43 (1.43 – 1.36) / 1.36 = 5.1%2007 1.50 (1.50 – 1.43) / 1.43 = 4.9%Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%8Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerAdvantages and Disadvantages of Dividend Growth ModelAdvantage – easy to understand and useDisadvantagesOnly applicable to companies currently paying dividendsNot applicable if dividends are not growing at a reasonably constant rateExtremely sensitive to the estimated growth rate – an increase in g of 1% increases the cost of equity by 1%Does not explicitly consider risk9Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerThe SML ApproachCompute cost of equity using the SMLRisk-free rate, RfMarket risk premium, E(RM) – RfSystematic risk of asset, 10Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExample – SMLSuppose your company has an equity beta of 0.58 and the current risk-free rate is 6.1%. If the expected market risk premium is 8.6%, what is your cost of equity capital?RE = 6.1 + .58(8.6) = 11.1%Since we came up with similar numbers using both the dividend growth model and the SML approach, we should feel pretty good about our estimate11Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerAdvantages and Disadvantages of SMLAdvantagesExplicitly adjusts for systematic riskApplicable to all companies, as long as we can compute betaDisadvantagesHave to estimate the expected market risk premium, which does vary over timeHave to estimate beta, which also varies over timeWe are relying on the past to predict the future, which is not always reliable12Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExample – Cost of EquitySuppose our company has a beta of 1.5. The market risk premium is expected to be 9% and the current risk-free rate is 6%. We have used analysts’ estimates to determine that the market believes our dividends will grow at 6% per year and our last dividend was $2. Our stock is currently selling for $15.65. What is our cost of equity?Using SML: RE = 6% + 1.5(9%) = 19.5%Using DGM: RE = [2(1.06) / 15.65] + .06 = 19.55%13Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerCost of DebtThe cost of debt is the required return on our company’s debtWe usually focus on the cost of long-term debt or bondsThe required return is best estimated by computing the yield-to-maturity on the existing debtWe may also use estimates of current rates based on the bond rating we expect when we issue new debtThe cost of debt is NOT the coupon rate14Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerCost of Debt ExampleSuppose we have a bond issue currently outstanding that has 25 years left to maturity. The coupon rate is 9% and coupons are paid semiannually. The bond is currently selling for $908.72 per $1000 bond. What is the cost of debt?N = 50; PMT = 45; FV = 1000; PV = -908.75; CPT I/Y = 5%; YTM = 5(2) = 10%15Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerCost of Preference SharesRemindersPreference shares generally pay a constant dividend every periodDividends are expected to be paid every period foreverPreference share valuation is an annuity, so we take the annuity formula, rearrange and solve for RPRP = D/P016Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerCost of Preference Shares – ExampleYour company has preference shares that have an annual dividend of $3. If the current price is $25, what is the cost of a preference share?RP = 3 / 25 = 12%17Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerWeighted Average Cost of CapitalWe can use the individual costs of capital that we have computed to get our “average” cost of capital for the firmThis “average” is the required return on our assets, based on the market’s perception of the risk of those assetsThe weights are determined by how much of each type of financing that we use18Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerCapital Structure WeightsNotationE = market value of equity = # outstanding shares times price per shareD = market value of debt = # outstanding bonds times bond priceV = market value of the firm = D + EWeightswE = E/V = percent financed with equitywD = D/V = percent financed with debt19Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExample – Capital Structure WeightsSuppose you have a market value of equity equal to $500 million and a market value of debt equal to $475 million.What are the capital structure weights?V = 500 million + 475 million = 975 millionwE = E/D = 500 / 975 = .5128 = 51.28%wD = D/V = 475 / 975 = .4872 = 48.72%20Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerTaxes and the WACC Classical tax systemWe are concerned with after-tax cash flows, so we need to consider the effect of taxes on the various costs of capitalInterest expense reduces our tax liabilityThis reduction in taxes reduces our cost of debtAfter-tax cost of debt = RD(1-TC)Dividends are not tax deductible, so there is no tax impact on the cost of equityWACC = wERE + wDRD(1-TC)21Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExtended Example – WACC IEquity Information50 million shares$80 per shareBeta = 1.15Market risk premium = 9%Risk-free rate = 5%Debt Information$1 billion in outstanding debt (face value)Current quote = 110Coupon rate = 9%, semiannual coupons15 years to maturityTax rate = 40%22Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExtended Example – WACC IIWhat is the cost of equity?RE = 5 + 1.15(9) = 15.35%What is the cost of debt?N = 30; PV = -1100; PMT = 45; FV = 1000; CPT I/Y = 3.9268RD = 3.927(2) = 7.854%What is the after-tax cost of debt?RD(1-TC) = 7.854(1-.4) = 4.712%23Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExtended Example – WACC IIIWhat are the capital structure weights?E = 50 million (80) = 4 billionD = 1 billion (1.10) = 1.1 billionV = 4 + 1.1 = 5.1 billionwE = E/V = 4 / 5.1 = .7843wD = D/V = 1.1 / 5.1 = .2157What is the WACC?WACC = .7843(15.35%) + .2157(4.712%) = 13.06%24Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerTaxes and the WACC Imputation tax systemIn an imputation system shareholders (if residents) are given a tax credit for the local taxes paid. This will alter the cost of equity for the firmWe have to adjust the WACC formula to take into account the tax advantage of imputationWACC = wERE(1-TC) + wDRD(1-TC)This adjustment assumes all shareholders can take advantage of the tax credits25Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerTable 12.126Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerDivisional and Project Costs of CapitalUsing the WACC as our discount rate is only appropriate for projects that are the same risk as the firm’s current operationsIf we are looking at a project that is NOT the same risk as the firm, then we need to determine the appropriate discount rate for that projectDivisions also often require separatediscount rates27Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerUsing WACC for All Projects – ExampleWhat would happen if we use the WACC for all projects regardless of risk?Assume the WACC = 15%Project Required Return IRRA 20% 17%B 15% 18%C 10% 12%28Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerPure Play ApproachFind one or more companies that specialise in the product or service that we are consideringCompute the beta for each companyTake an averageUse that beta along with the CAPM to find the appropriate return for a project of that riskOften difficult to find pure play companies29Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerSubjective ApproachConsider the project’s risk relative to the firm overallIf the project is more risky than the firm, use a discount rate greater than the WACCIf the project is less risky than the firm, use a discount rate less than the WACCYou may still accept projects that you shouldn’t and reject projects you should accept, but your error rate should be lower than not considering differential risk at all30Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerSubjective Approach – ExampleRisk LevelDiscount RateVery Low RiskWACC – 8%Low RiskWACC – 3%Same Risk as FirmWACCHigh RiskWACC + 5%Very High RiskWACC + 10%31Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerQuick QuizWhat are the two approaches for computing the cost of equity?How do you compute the cost of debt and the after-tax cost of debt?How do you compute the capital structure weights required for the WACC?What is the WACC?What happens if we use the WACC for the discount rate for all projects?What are two methods that can be used to compute the appropriate discount rate when WACC isn’t appropriate?32Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan Trayler