AC4331 Topic 5

Corporate Financial Policy Semester A 2012-13 City University of Hong Kong

Topic 5

Introduction to Financial Management Free Cash Flow Financial Planning and Forecasting Financial Assets and Time Value of Money Risk and Return Bond and Stock Valuation Cost of Capital Cash Flow Estimation and Risk Analysis Capital Structure and Leverage Treasury and Valuation Enterprise Risk Management Dividends and Share Repurchase Merger and Acquisitions Working Capital Management

1-2

Cost of Capital

Topic 5:

Extra Ref:
Brigham

Financial Management, Theory and Practice, 12e Eugene and

Chapter 11

Sources of Capital Component Costs WACC Adjusting for Flotation Costs Adjusting for Risk
11-4

Long-Term Capital
Long-Term Debt Preferred Stock Common Stock New Common Stock

Retained Earnings

11-5

WACC = wdrd(1 T) + wprp + wcrs

The

ws refer to the firms capital structure weights. The rs refer to the cost of each component.

11-6

Stockholders focus on A-T CFs. Therefore, we should focus on A-T capital costs, i.e. use A-T costs of capital in WACC. Only rd needs adjustment, because interest is tax deductible.

11-7

The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on todays marginal costs (for WACC).

11-8

WACC = wdrd(1 T) + wprp + wcrs

Use accounting numbers or market value (book vs. market weights)? Use actual numbers or target capital structure?

11-9

WACC = wdrd(1 T) + wprp + wcrs

rd is the marginal cost of debt capital. The yield to maturity on outstanding L-T debt is often used as a measure of rd. Why tax-adjust; i.e., why rd(1 T)?

11-10

Remember, the bond pays a semiannual coupon, so rd = 5.0% x 2 = 10%.

INPUTS

30 N I/YR 5

-1153.72 PV

60 PMT

1000 FV

OUTPUT

11-11

Interest is tax deductible, so A-T rd = B-T rd(1 T) = 10%(1 0.40) = 6% Use nominal rate. Flotation costs are small, so ignore them.

11-12

WACC = wdrd(1 T) + wprp + wcrs

rp is the marginal cost of preferred stock, which is the return investors require on a firms preferred stock. Preferred dividends are not tax-deductible, so no tax adjustments necessary. Just use nominal rp. Our calculation ignores possible flotation costs.
11-13

The cost of preferred stock can be solved by using this formula:

rp

= Dp/Pp = $10/$111.10 = 9%

11-14

More risky; company not required to pay preferred dividend. However, 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.

11-15

Preferred stock will often have a lower B-T yield than the B-T yield on debt.
Corporations own most preferred stock, because 70% of preferred dividends are excluded from corporate taxation.

The A-T yield to an investor, and the A-T cost to the issuer, are higher on preferred stock than on debt. Consistent with higher risk of preferred stock.

11-16

WACC = wdrd(1 T) + wprp + wcrs

rs is the marginal cost of common equity using retained earnings. The rate of return investors require on the firms common equity using new equity is re.

11-17

Earnings can be reinvested or paid out as dividends. Investors could buy other securities, earn a return. If earnings are retained, there is an opportunity cost (the return that stockholders could earn on alternative investments of equal risk).
Investors could buy similar stocks and earn rs. Firm could repurchase its own stock and earn rs.

11-18

CAPM:
DCF:

rs = rRF + (rM rRF)b

rs = (D1/P0) + g

Own-Bond-Yield-Plus-Risk-Premium: rs = rd + RP

11-19

The rRF = 7%, RPM = 6%, and the firms beta is 1.2.
rs = rRF + (rM rRF)b = 7.0% + (6.0%)1.2 = 14.2%

11-20

Find the Cost of Common Equity Using the DCF Approach

D0 = $4.19, P0 = $50, and g = 5.
D1 = D0(1 + g)

= $4.19(1 + 0.05) = $4.3995

rs = (D1/P0) + g = ($4.3995/$50) + 0.05 = 13.8%

11-21

Yes, nonconstant growth stocks are expected to attain constant growth at some point, generally in 5 to 10 years. May be complicated to compute.

11-22

Find rs Using the Own-Bond-YieldPlus-Risk-Premium Method

rd = 10% and RP = 4.

This RP is not the same as the CAPM RPM. This method produces a ballpark estimate of rs, and can serve as a useful check.

rs = rd + RP rs = 10.0% + 4.0% = 14.0%

11-23

Method Estimate CAPM 14.2% DCF 13.8% rd + RP 14.0% Average 14.0%

11-24

When a company issues new common stock they also have to pay flotation costs to the underwriter. Issuing new common stock may send a negative signal to the capital markets, which may depress the stock price.

11-25

D 0 (1 g) re g P0 (1 F) $4.19(1.05) 5.0% $50(1 0.15) $4.3995 5.0% $42.50 15.4%

11-26

Flotation costs depend on the firms risk and the type of capital being raised. Flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small. We will frequently ignore flotation costs when calculating the WACC.

11-27

WACC = = = =

wdrd(1 T) + wprp + wcrs 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) 1.8% + 0.9% + 8.4% 11.1%

11-28

Market conditions. The firms capital structure and dividend policy. The firms investment policy. Firms with riskier projects generally have a higher WACC.

11-29

NO! 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. Different projects have different risks. The projects WACC should be adjusted to reflect the projects risk.

11-30

Q11-1 (part a-f) Q11-4 P11-6 P11-9 P11-13 P11-15 P11-17 P11-18 P11-19

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