Professional Documents
Culture Documents
5 - Cost of Capital
5 - Cost of Capital
5 - Cost of Capital
+
=
g
P
D
R
E
0
1
+ =
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-7
ExampleCost of Equity Capital:
Dividend Approach
Reno Co. recently paid a dividend of 15 cents per
share. This dividend is expected to grow at a rate
of 3 per cent per year into perpetuity. The current
market price of Renos shares is $3.20 per share.
Determine the cost of equity capital for Reno Co.
( )
7.8% or 0.078
0.03
$3.20
1.03 $0.15
=
+ =
E
R
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-8
Estimating g
( )
9.025%
/4 7.62 10.53 7.95 10.00 rate growth Average
=
+ + + =
One method for estimating the growth rate is to use the historical
average.
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-9
The Dividend Growth Model
Approach
Advantages
Easy to use and understand.
Disadvantages
Only applicable to companies paying dividends.
Assumes dividend growth is constant.
Cost of equity is very sensitive to growth estimate.
Ignores risk.
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-10
The SML Approach
Required return on a risky investment is dependent on three
factors:
the risk-free rate, R
f
the market risk premium, E(R
M
) R
f
the systematic risk of the asset relative to the average, |
| |
f M E f E
R R R R + = |
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-11
ExampleCost of Equity Capital:
SML Approach
Obtain the risk-free rate (R
f
) from financial press
many use the 1-year Treasury note rate, say, 6 per cent.
Obtain estimates of market risk premium and security beta:
historical risk premium = 7.94 per cent (Officer, 1989)
betahistorical
investment information services
estimate from historical data
Assume the beta is 1.40.
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-12
ExampleCost of Equity Capital:
SML Approach (continued)
| |
( )
% .
% . . %
R R R R
f M E f E
12 17
94 7 40 1 6
=
+ =
| + =
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-13
The SML Approach
Advantages
Adjusts for risk.
Accounts for companies that dont have a constant dividend.
Disadvantages
Requires two factors to be estimated: the market risk
premium and the beta co-efficient.
Uses the past to predict the future, which may not be
appropriate.
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-14
The Cost of Debt
The cost of debt, R
D
, is the interest rate on new borrowing.
R
D
is observable:
yields on currently outstanding debt
yields on newly-issued similarly-rated bonds.
The historic cost of debt is irrelevantwhy?
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-15
ExampleCost of Debt
Ishta Co. sold a 20-year, 12 per cent bond 10 years
ago at par. The bond is currently priced at $86.
What is our cost of debt?
( )
( )
( )
( )
14.4%
/2 $86 $100
/10 $86 $100 $12
/2 NP PV
/ NP PV
=
+
+
=
+
+
=
n I
R
D
The yield to maturity is 14.4 per cent, so this is used
as the cost of debt, not 12 per cent.
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-16
The Cost of Preference Shares
Preference shares pay a constant dividend every period.
Preference shares are a perpetuity, so the cost is:
Notice that the cost is simply the dividend yield.
0
P
D
R
p
=
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-17
ExampleCost of Preference Shares
An $8 preference share issue was sold 10 years ago. It sells
for $120 per share today.
The dividend yield today is $8.00/$120 = 6.67 per cent, so
this is the cost of the preference share issue.
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-18
The Weighted Average Cost of Capital
Let: E = the market value of equity = no.
of outstanding shares share
price
D = the market value of debt = no. of
outstanding bonds price
Then: V = E + D
So: E/V + D/V = 100%
That is: The firms capital structure weights
are E/V and D/V.
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-19
The Weighted Average Cost of
Capital
Interest payments on debt are tax deductible, so the after-tax
cost of debt is:
Dividends on preference shares and ordinary shares are not
tax-deductible so tax does not affect their costs.
The weighted average cost of capital is therefore:
( )
C D
T R 1 debt of cost tax - After =
() () ( )
C D E
T R
V
D
R
V
E
1 WACC + =
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-20
ExampleWeighted Average Cost of
Capital
Zeus Ltd has 78.26 million ordinary shares on
issue with a book value of $22.40 per share and a
current market price of $58 per share. The
market value of equity is therefore $4.54 billion.
Zeus has an estimated beta of 0.90. Treasury
bills currently yield 4.5 per cent and the market
risk premium is assumed to be 7.94 per cent.
Company tax is 30 per cent.
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-21
ExampleWeighted Average Cost of
Capital (continued)
The firm has four debt issues outstanding:
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-22
ExampleCost of Equity
(SML Approach)
| |
( )
% .
% . . % .
R R R R
f M E f E
65 11
94 7 90 0 5 4
=
+ =
| + =
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-23
ExampleCost of Debt
The weighted average cost of debt is 7.15 per cent.
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-24
ExampleCapital Structure Weights
Market value of equity = 78.26 million $58 = $4.539 billion.
Market value of debt = $1.474 billion.
( ) ( )
9.32% or 0.0932
0.30 1 0.0715 0.245 0.1165 0.755 WACC
75.5% or 0.755
$6.013b
$4.539b
24.5% or 0.245
$6.013b
$1.474b
billion $6.013 billion $1.474 billion $4.539
=
+ =
= =
= =
= + =
V
E
V
D
V
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-25
WACC
The WACC for a firm reflects the risk and the target capital
structure to finance the firms existing assets as a whole.
WACC is the return that the firm must earn on its existing
assets to maintain the value of its shares.
WACC is the appropriate discount rate to use for cash flows
that are similar in risk to the firm.
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-26
Divisional and Project Costs of
Capital
When is the WACC the appropriate discount rate?
When the projects risk is about the same as the firms
risk.
Other approaches to estimating a discount rate:
divisional cost of capitalused if a company has more
than one division with different levels of risk
pure play approacha WACC that is unique to a
particular project is used
subjective approachprojects are allocated to specific
risk classes which, in turn, have specified WACCs.
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-27
The SML and the WACC
Expected
return (%)
Beta
SML
WACC = 15%
= 8%
Incorrect
acceptance
Incorrect
rejection
B
A
16
15
14
R
f
=7
A
= .60
firm
= 1.0
B
= 1.2
If a firm uses its WACC to make accept/reject decisions for all types of projects, it will have a
tendency towards incorrectly accepting risky projects and incorrectly rejecting less risky
projects.
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-28
ExampleUsing WACC for all
Projects
What would happen if we use the WACC for all
projects regardless of risk?
Assume the WACC = 15 per cent
Project Required Return IRR Decision
A 15% 14% Reject
B 15% 16% Accept
Project A should be accepted because its risk is low (Beta =
0.60), whereas Project B should be rejected because its risk
is high (Beta = 1.2).
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-29
The SML and the Subjective
Approach
Expected
return (%)
Beta
SML
20
WACC = 14
10
R
f
= 7
Low risk
(4%)
Moderate risk
(+0%)
High risk
(+6%) A
With the subjective approach, the firm places projects into one of several risk classes. The discount
rate used to value the project is then determined by adding (for high risk) or subtracting (for low risk)
an adjustment factor to or from the firms WACC.
= 8%
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-30
Flotation Costs
The issue of debt or equity may incur flotation costs such as
underwriting fees, commissions, listing fees.
Flotation costs are relevant expenses and need to be
reflected in any analysis.
D E A
f
V
D
f
V
E
f + =
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-31
ExampleProject Cost including
Flotation Costs
Saddle Co. Ltd has a target capital structure of 70
per cent equity and 30 per cent debt. The
flotation costs for equity issues are 15 per cent of
the amount raised and the flotation costs for debt
issues are 7 per cent. If Saddle Co. Ltd needs
$30 million for a new project, what is the true
cost of this project?
( )( )
12.6%
0.07 0.30 0.15 0.70
=
+ =
A
f
The weighted average flotation cost is 12.6 per
cent.
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-32
ExampleProject Cost including
Flotation Costs (continued)
( )
( )
million $34.32
0.126 1
$30m
project of cost True
million $30 costs flotation ignoring cost Project
=
=
=
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-33
ExampleFlotation Costs and NPV
Apollo Co. Ltd needs $1.5 million to finance a new project
expected to generate annual after-tax cash flows of $195 800
forever. The company has a target capital structure of 60 per
cent equity and 40 per cent debt. The financing options
available are:
An issue of new ordinary shares. Flotation costs of equity
are 12 per cent of capital raised. The return on new
equity is 15 per cent.
An issue of long-term debentures. Flotation costs of debt
are 5 per cent of the capital raised. The return on new
debt is 10 per cent.
Assume a corporate tax rate of 30 per cent.
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-34
ExampleNPV (No Flotation Costs)
( ) ( )
322 $159
000 500 $1
0.118
800 $195
NPV
11.8% or 0.118
0.30 1 0.1 0.4 15% 0.6 WACC
=
=
=
+ =
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
18-35
ExampleNPV (With Flotation Costs)
( ) ( )
( )
$7340
982 651 $1 -
0.118
800 $195
NPV
982 651 $1
0.092 1
000 500 $1
cost True
9.2% or 0.092
0.05 0.4 0.12 0.6
=
=
=
=
=
+ =
A
f
Flotation costs decrease a projects NPV and
could alter an investment decision.