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A Ch 09 Mini Case

I J 5/23/2003

Chapter 9. Mini Case

Situation During the last few years, Harry Davis Industries has been too constrained by the high cost of capital to make many capital investments. Recently, though, capital costs have been declining, and the company has decided to look seriously at a major expansion program that had been proposed by the marketing department. Assume that you are an assistant to Leigh Jones, the financial vice-president. Your first task is to estimate Harry Davis' cost of capital. Jones has provided data that she believes is relevant to your task. (1) The firm's tax rate is 40% (2) The current price of Harry Davis' 12 percent coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,153.72. Harry Davis does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation costs. (3) The current price of the firm's 10 percent, $100 par value, quarterly dividend, perpetual preferred stock is $113.10 Harry Davis would incur a flotation cost of $2.00 per share on a new issue.

17 (4) Harry Davis' common stock is currently selling at $50 per share. Its last dividend (Do) was $4.19, and dividends are 18 expected to grow at a constant rate of 5% in the foreseeable future. Harry Davis' beta is 1.2, the yield on T-bonds is 7 percent, and the market risk premium is estimated to be 6 percent. For the bond-yield-risk-premium approach, the firm 19 uses a 4 percentage point risk premium. 20 (5) Harry Davis' target capital structure is 30 percent long-term debt, 10 percent preferred stock, and 60 percent 21 common equity. 22 23 To structure the task somewhat, Jones has asked you to answer the following questions. 24 25 a. (1.) What sources of capital should be included when you estimate Harry Davis' weighted average cost of capital 26 (WACC)? Answer: See Chapter 9 Mini Case Show 27 (2.) Should the component costs be figured on a before-tax or an after-tax basis? Answer: See Chapter 9 Mini Case 28 29 Show 30 31 32 (3.) Should the costs be historical (embedded) costs or new (marginal) costs? Answer: See Chapter 9 Mini Case Show 33 34 b. What is the market interest rate on Harry Davis' debt and its component cost of debt? 35 36 COST OF DEBT, rd 37 38 0 1 2 30 39 40 N 30 41 PV 1,091.96 42 PMT 40 rd = 43 FV 1000 7% 44 45 46 The relevant cost of debt is the after-tax cost of new debt, taking account of the tax deductibility of interest. The after47 tax calculated by multiplying the interest rate (or the before-tax cost of debt) times one minus the tax rate. 48 49 PROBLEM 50 51 B-T rd 7% 52 Tax rate 35% 53 54 A-T rd = (1-Tax rate) x (B-T rd) 55 A-T rd = 65% x 7% 56 A-T rd = 57 4.6% 58 59 COST OF PREFERRED STOCK, rp 60 c. (1.) What is the firm's cost of preferred stock?

A 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120

The cost of preferred stock is simply the preferred dividend divided by the price the company will receive if it issues new preferred stock. No tax adjustment is necessary, as preferred dividends are not tax deductible. PROBLEM Pref. Dividend Pref. Price Flotation costs $10.00 $113.10 $2.00 (Pref. Price $113.10 Flotation Costs) $2.00

rps = Pref. Dividend rps = $10.00 rps = 9.0%

(2.) Harry Davis' preferred stock is riskier to investors than its debt, yet the preferred's yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a mistake? (Hint: Think about taxes.)

Preferred stock carries a higher risk to investor than debt. Companies are not required to pay preferred dividends Although, firms typically want to pay preferred dividends. Otherwise, they cannot pay common dividends, there will be difficulty raising additional funds, and preferred stockholders main gain control of the firm.

Corporations own most preferred stock, because 70% of preferred dividends are non-taxable to corporations. Therefore, preferred stock often has a lower before tax yield than the before tax yield on debt. But, the after tax costs to the issuer are higher on preferred stock than debt. This is consistent with the higher risks of preferred stock. Example rps rd T

9% 10% 40% A-T rps = A-T rps = A-T rps = A-T rd = A-T rd = A-T rd = rps 9% 7.92% (1-Tax rate) 60% 6.0% 1.92% x x (B-T rd) 10% rps 9% x x (1-.7) *T 0.12

A-T Risk Premium on Preferred

COST OF EQUITY (INTERNAL), rs d. (1.) What are the two primary ways companies raise common equity? Answer: See Chapter 9 Mini Case Show (2.) Why is there a cost associated with reinvested earnings? Answer: See Chapter 9 Mini Case Show (3.) Harry Davis doesnt plan to issue new shares of common stock. Using the CAPM approach, what is Harry Davis' estimated cost of equity? The CAPM Approach rs = risk-free rate + (Market risk premium) (Beta) rs = rrf + (RPm) bi (Note: RPM is the expected return on the market minus the risk-free rate.) PROBLEM

A B C D E F G H I 121 Assuming the risk-free rate (i.e., the current yield on a long-term Treasury bond) equals 7%, the expected market 122 return is 13%, and the firm's beta is 1.2, what is the company's cost of equity from internal funds? 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151 152 Risk-free rate Expected market return Beta rs = rs = rs = rs = rrf 7.0% 7.0% 14.2% + + + 7% 13% 1.2 (RPm) 6.0% 7.2% (bi) 1.2

THE DISCOUNTED CASH FLOW APPROACH e. (1.) What is the estimated cost of equity using the discounted cash flow (DCF) approach? The simplest DCF model assumes that growth is expected to remain constant, and in this case: rs = D1/P0 + g. The next expected dividend is easy to estimate, and the stock price can be determined readily. However, it is not easy to determine the marginal investor's expected future growth rate. Three approaches are commonly used: (1) historical growth rates, (2) retention growth model, and (3) analysts' forecasts.

PROBLEM Suppose a firm's stock trades at $50 and its dividend is $4.19. If the expected growth rate is 5%, what is the firm's cost of equity? P0 = D1 = g= $50.00 $4.40 5%

rs = D1 P0 + g rs = 153 $4.40 $50.00 + 5% rs = 154 13.8% 155 156 2. Retention Growth Model 157 158 PROBLEM 159 e. (2.) Suppose the firm has historically earned 15 percent on equity (ROE) and retained 35 percent of earnings, and 160 investors expect this situation to continue in the future. How could you use this information to estimate the future 161 dividend growth rate, and what growth rate would you get? Is this consistent with the 5 percent growth rate given 162 earlier? 163 164 Find g 165 166 Payout rate = 65% 167 ROE = 15.00% 168 169 g = (1-Payout rate)(ROE) 170 g= 35% 15.00% 171 g= 5.25% 172 173 (3.) Could the DCF method be applied if the growth rate was not constant? How? 174 175 APPLICATION OF THE DISCOUNTED CASH FLOW APPROACH WHEN GROWTH IS NOT CONSTANT 176 177 As we noted earlier, analysts often provide non-constant estimates of future growth. We can use a modification of the 178 discounted cash flow valuation procedure for non-constant growth from Chapter 7 to estimate the cost of equity. 179 180 PROBLEM

181 182 183 184 185 186 187 188 189 190 191 192 193 194 195 196 197 198 199 200 201 202 203 204 205 206 207 208 209 210 211 212 213 214 215 216 217 218 219 220

A B C D E F G H I J Suppose the current dividend is $2.16 per share and the current actual price that we observe is $32.00 per share. Analysts forecast growth of 11 percent the first year, 10 percent the second year, 9 percent the third year, 8 percent the fourth year, and 7 percent thereafter. Estimate the cost of equity. Step 1: Create a time-line showing the expected future dividend payments. These are based on the current dividend and the estimated growth rates. Year Growth Dividend 0 2.16 1 11% 2.40 2 10% 2.64 3 9% 2.87 4 8% 3.10 5 7% 3.32

Step 2: Using the constant growth formula from Chapter 5 to estimate the price at Year 4: P 4 = D5 / (rs - g). Notice that D5 and g are given in the time-line above, but the estimate for rs is shown below. Price at Year 4 = $42.20

Step 3: Calculate the current price of the stock, based on the estimate of rs below. To do this, find the present value of the price at Year 4, P4, and then find the present value of the dividends from Year 1 through Year 4. Use the cost of equity, rs, shown below, as the discount rate. Calculated Current Price $32.00

Step 4: Use Goal Seek to determine the cost of equity, rs, shown below. Click Tools, Goal Seek and set the value of the Calculated Current Price, cell C204, equal to the actual current stock price of $32 by changing the cost of equity, rs, in cell B211. rs= 14.9%

Note that if rs is not equal to 14.9%, then the Calculated Current Price will not be equal to the actual current price of $32. In other words, 14.9% is the only correct value for rs, given the current stock price, the expected future dividends, and the long-term constant growth rate of 7%. f. What is the cost of equity based on the bond-yield-plus-risk-premium method? THE BOND-YIELD-PLUS-RISK-PREMIUM APPROACH

A 221 222 223 224 225 226 227 228 229 230 231 232 233 234 235 236 237 238 239 240 241 242 243 244 245 246 247 248 249 250 251 252 253 254 255 256 257 258 259 260 261 262 263 264 265 266 267 268 269 270 271 272 273 274 275 276 277 278 279 280

This approach consists of adding a judgmental risk premium to the yield on the firm's own long-term debt. It is logical that a firm with risky, low-rated debt would also have risky, high-cost equity. Historically, we have observed that risk premium for equity is in the range of 3 to 5 percentage points. This method provides a ballpark estimate, and it is generally used as a check on the CAPM and DCF estimates. This method is used primarily in utility rate case hearings. Equity RP = Bond yield = 4% 10.0% rs = (Equity RP) (Bond yield) rs = 4% 10.0% rs = 14.0% g. What is your final estimate for the cost of equity, rs? THE COST OF EQUITY ESTIMATE It is common to use several methods to estimate the cost of equity, and then find the average of these methods. Method Cost of Equity CAPM rs = 14.2% Constant growth DCF rs = 13.8% Bond-yield-plus-risk-premium rs = 14.0% Average rs= 14.0%

THE WEIGHTED AVERAGE COST OF CAPITAL The weighted average cost of capital (WACC) is calculated using the firm's target capital structure together with its after-tax cost of debt, cost of preferred stock, and cost of common equity. PROBLEM h. What is Harry Davis' weighted average cost of capital (WACC)? wd = wp = ws = 30% 10% 60% rd = rp = rs = 4.6% 9.0% 14.0%

WACC =

10.67%

i. What factors influence a companys WACC? Answer:See Chapter 9 Mini case Show j. Should the company use the composite WACC as the hurdle rate for each of its divisions? Answer:See Chapter 9 Mini case Show k. What procedures are used to determine the risk-adjusted cost of capital for a particular division? What approaches are used to measure a divisions beta? Answer:See Chapter 9 Mini case Show l. Harry Davis is interested in establishing a new division, which will focus primarily on developing new Internetbased projects. In trying to determine the cost of capital for this new division, you discover that stand-alone firms involved in similar projects have on average the following characteristics: -Their capital structure is 10 percent debt and 90 percent common equity -Their cost of debt is typically 12 percent. -The beta is 1.7. Given this information, what would your estimate be for the divisions cost of capital? ADJUSTING THE COST OF CAPITAL FOR RISK PROBLEM Risk-free rate Market risk premium Beta 7% 6.0% 1.7

rs =

17.2%

A 281 282 283 284 285 286 287 288 289 290 291 292 293 294 295 296 297 298 299 300 301 302 303 304 305 306 307 308 309 310 311 312 313 314 315 316 317 318

B Target Debt Ratio rd Tax Rate WACC = WACC = WACC =

C 10% 12% 40% (wd *rd) 1.2% 16.2% 16.2% 10.67%

x x check this

(1-T) 60%

+ +

(wc *rs) 15.5%

Division WACC Company WACC

This indicates that the division's market risk is greater than the firm's average division. Typical projects within this division would be accepted is their returns are above 16.2%. m. What are three types of project risk? How is each type of risk used? Answer:See Chapter 9 Mini case Show n. Explain in words why new common stock that is raised externally has a higher percentage cost than equity that is raised internally by reinvesting earnings. Answer:See Chapter 9 Mini case Show o. (1.) Harry Davis estimates that if it issues new common stock, the flotation cost will be 15 percent. Harry Davis incorporates the flotation costs into the DCF approach. What is the estimated cost of newly issued stock, taking into account the flotation cost? ADJUSTING THE COST OF CAPITAL FOR FLOTATION COSTS Flotation costs are the fees charged by investment bankers plus the accounting an legal expenses associated with the issuance of new securities. A company cannot use the entire proceeds of a new security issuance, because it must use some of the proceeds to pay the flotation costs. PROBLEM: Flotation Costs and the Cost of New Equity P0 = $50.00 D1 = $4.40 g= 5% rs = rs = rs = D1 $4.40 13.8% 15% $50.00 (Stock Price) $50.00 $42.50 $42.50 $4.40 5%

319 320 321 322 Flotation percentage cost (F) = 323 Stock price = 324 325 326 327 328 329 330 331 332 333

P0 $50.00

+ +

g 5%

Net proceeds after flotation costs = Net proceeds after flotation costs = Net proceeds after flotation costs = Net proceeds after flotation costs = D1 = g=

(1-F) 85%

rs = D1 Net Proceeds + g rs = 334 $4.40 $42.50 + 5% rs = 335 15.4% 336 337 Notice that this cost of stock is quite different than the cost of stock without flotation costs. To find the cost of 338 perpetual preferred stock, simply use the procedure above with g=0. If the preferred stock has a fixed maturity, then use the same procedure as for debt, except that the preferred dividend is not tax deductible.

Notice that this cost of stock is quite different than the cost of stock without flotation costs. To find the cost of A B C D E F H perpetual preferred stock, simply use the procedure above with g=0. If the preferred G stock has a fixed maturity, Ithen 339 use the same procedure as for debt, except that the preferred dividend is not tax deductible. 340 341 Suppose Harry Davis issues 30-year debt with a par value of $1,000 and a coupon rate of 10 percent, paid annually. If 342 flotation costs are 2 percent, what is the after-tax cost of debt for the new bond issue? 343 344 PROBLEM: Flotation Costs and the Cost of Debt 345 346 (2.) A company can issue a 30-year, $1,000 par value bond with a coupon rate of 10 percent, paid annually. The tax 347 rate is 40%, and the flotation costs are 15% of the value of the issue. Find the after-tax percentage cost of the bond 348 issue. 349 40% 350 Tax rate = 2% 351 Flotation percentage cost (F) = $1,000 352 Par value = $1,000 353 Maturity payment = $100 354 Pre-tax coupon payment = 355 356 First, calculate the after-tax coupon payments and the net proceeds after the flotation costs. 357 (Coupon (1-Tax pmt.) rate) 358 After-tax coupon payment = $100 60% 359 After-tax coupon payment = 360 After-tax coupon payment = $60 361 (1-F) 362 Net proceeds after flotation costs = (Par value) $1,000 98% 363 Net proceeds after flotation costs = 364 Net proceeds after flotation costs = $980 365 366 Now find the rate that the company pays, based on its net proceeds after flotation costs and its after-tax payments. 367 368 Number of coupon payments = N= 30 369 After-tax coupon payment = PMT= 60 370 Net proceeds after flotation costs = PV= 980 371 Payment of face value at maturity= FV= 1000 372 373 After tax cost of debt = Rate = 6.15% Note: use the Rate function. 374 375 Notice that this after-tax cost of debt is only slightly higher than the after-tax cost of debt for which flotation costs are 376 ignored. Therefore, analysts often ignore the flotation costs of debt. 377 378 p. What four common mistakes in estimating the WACC should Harry Davis avoid? 379 Answer:See Chapter 9 Mini case Show