1、Chapter 14Chapter 14Cost of CapitalCost of CapitalMcGraw-Hill/IrwinCopyright 2013 by The McGraw-Hill Companies,Inc.All rights reserved.Key Concepts and Skills Know how to determine a firms cost of equity capital Know how to determine a firms cost of debt Know how to determine a firms overall cost of
2、 capital Know how to handle flotation costs Understand pitfalls of overall cost of capital and how to manage them14-2Chapter Outline The Cost of Capital:Some Preliminaries The Cost of Equity The Costs of Debt and Preferred Stock The Weighted Average Cost of Capital Divisional and Project Costs of Ca
3、pital Flotation Costs and the Weighted Average Cost of Capital14-3Why Cost of Capital Is Important We know that the return earned on assets depends on the risk of those assets The return to an investor is the same as the cost to the company Our cost of capital provides us with an indication of how t
4、he market views the risk of our assets Knowing our cost of capital can also help us determine our required return for capital budgeting projects14-4Required Return The required return is the same as the appropriate discount rate and is based on the risk of the cash flows We need to know the required
5、 return for an investment before we can compute the NPV and make a decision about whether or not to take the investment We need to earn at least the required return to compensate our investors for the financing they have provided14-5Cost of Equity The cost of equity is the return required by equity
6、investors given the risk of the cash flows from the firmBusiness riskFinancial risk There are two major methods for determining the cost of equity Dividend growth model SML,or CAPM14-6The Dividend Growth Model Approach Start with the dividend growth model formula and rearrange to solve for RE14-7Exa
7、mple:Dividend Growth Model Suppose 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?14-8Example:Estimating the Dividend Gr
8、owth Rate One method for estimating the growth rate is to use the historical averageYearDividendPercent Change20081.23-20091.3020101.3620111.4320121.50(1.30 1.23)/1.23=5.7%(1.36 1.30)/1.30=4.6%(1.43 1.36)/1.36=5.1%(1.50 1.43)/1.43=4.9%Average=(5.7+4.6+5.1+4.9)/4=5.1%14-9Advantages and Disadvantages
9、of Dividend Growth Model Advantage easy to understand and use Disadvantages Only applicable to companies currently paying dividends Not applicable if dividends arent growing at a reasonably constant rate Extremely sensitive to the estimated growth rate -an increase in g of 1%increases the cost of eq
10、uity by 1%Does not explicitly consider risk14-10The SML Approach Use the following information to compute our cost of equity Risk-free rate,Rf Market risk premium,E(RM)Rf Systematic risk of asset,14-11Example-SML Suppose your company has an equity beta of.58,and the current risk-free rate is 6.1%.If
11、 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 good about our estimate14-12Advantages and Disadvantages of SML AdvantagesExplicitly adjus
12、ts for systematic riskApplicable to all companies,as long as we can estimate beta Disadvantages Have to estimate the expected market risk premium,which does vary over time Have to estimate beta,which also varies over time We are using the past to predict the future,which is not always reliable14-13E
13、xample Cost of Equity Suppose 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
14、 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%14-14Cost of Debt The cost of debt is the required return on our companys debt We usually focus on the cost of long-term debt or bonds The required return is best estimated by computing th
15、e yield-to-maturity on the existing debt We may also use estimates of current rates based on the bond rating we expect when we issue new debt The cost of debt is NOT the coupon rate14-15Example:Cost of Debt Suppose we have a bond issue currently outstanding that has 25 years left to maturity.The cou
16、pon rate is 9%,and coupons are paid semiannually.The bond is currently selling for$908.72 per$1,000 bond.What is the cost of debt?N=50;PMT=45;FV=1000;PV=-908.72;CPT I/Y=5%;YTM=5(2)=10%14-16Cost of Preferred Stock RemindersPreferred stock generally pays a constant dividend each periodDividends are ex
17、pected to be paid every period forever Preferred stock is a perpetuity,so we take the perpetuity formula,rearrange and solve for RP RP=D/P014-17Example:Cost of Preferred Stock Your company has preferred stock that has an annual dividend of$3.If the current price is$25,what is the cost of preferred s
18、tock?RP=3/25=12%14-18The Weighted Average Cost of Capital We can use the individual costs of capital that we have computed to get our“average”cost of capital for the firm.This“average”is the required return on the firms assets,based on the markets perception of the risk of those assets The weights a
19、re determined by how much of each type of financing is used14-19Capital Structure Weights NotationE=market value of equity=#of outstanding shares times price per shareD=market value of debt=#of outstanding bonds times bond priceV=market value of the firm=D+E Weights wE=E/V=percent financed with equi
20、ty wD=D/V=percent financed with debt14-20Example:Capital Structure Weights Suppose 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 million wE=E/V=500/975=.5128=51.28%wD=D/V=475
21、/975=.4872=48.72%14-21Taxes and the WACC We are concerned with after-tax cash flows,so we also need to consider the effect of taxes on the various costs of capital Interest expense reduces our tax liabilityThis reduction in taxes reduces our cost of debtAfter-tax cost of debt=RD(1-TC)Dividends are n
22、ot tax deductible,so there is no tax impact on the cost of equity WACC=wERE+wDRD(1-TC)14-22Extended Example:WACC-I Equity Information 50 million shares$80 per share Beta=1.15 Market risk premium=9%Risk-free rate=5%Debt Information$1 billion in outstanding debt(face value)Current quote=110Coupon rate
23、=9%,semiannual coupons15 years to maturity Tax rate=40%14-23Extended Example:WACC-II What is the cost of equity?RE=5+1.15(9)=15.35%What is the cost of debt?N=30;PV=-1,100;PMT=45;FV=1,000;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%14-24Extended Examp
24、le:WACC-III What 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=.2157 What is the WACC?WACC=.7843(15.35%)+.2157(4.712%)=13.06%14-25Eastman Chemical I Click on the web surfer to go to Yahoo!Finance to get in
25、formation on Eastman Chemical(EMN)Under Profile and Key Statistics,you can find the following information:#of shares outstandingBook value per sharePrice per shareBeta Under analysts estimates,you can find analysts estimates of earnings growth(use as a proxy for dividend growth)The Bonds section at
26、Yahoo!Finance can provide the T-bill rate Use this information,along with the CAPM and DGM to estimate the cost of equity14-26Eastman Chemical II Go to FINRA to get market information on Eastman Chemicals bond issuesEnter Eastman Ch to find the bond informationNote that you may not be able to find i
27、nformation on all bond issues due to the illiquidity of the bond market Go to the SEC website to get book value information from the firms most recent 10Q14-27Eastman Chemical III Find the weighted average cost of the debtUse market values if you were able to get the informationUse the book values i
28、f market information was not availableThey are often very close Compute the WACC Use market value weights if available14-28Example:Work the Web14-29Table 14.1 Cost of Equity14-30Table 14.1 Cost of Debt14-31Table 14.1 WACC14-32Divisional and Project Costs of Capital Using the WACC as our discount rat
29、e is only appropriate for projects that have the same risk as the firms current operations If we are looking at a project that does NOT have the same risk as the firm,then we need to determine the appropriate discount rate for that project Divisions also often require separatediscount rates14-33Exam
30、ple:Using WACC for All Projects What would happen if we use the WACC for all projects regardless of risk?Assume the WACC=15%ProjectRequired ReturnIRRA20%17%B15%18%C10%12%14-34The Pure Play Approach Find one or more companies that specialize in the product or service that we are considering Compute t
31、he beta for each company Take an average Use that beta along with the CAPM to find the appropriate return for a project of that risk Often difficult to find pure play companies14-35Subjective Approach Consider the projects risk relative to the firm overall If the project has more risk than the firm,
32、use a discount rate greater than the WACC If the project has less risk than the firm,use a discount rate less than the WACC You may still accept projects that you shouldnt and reject projects you should accept,but your error rate should be lower than not considering differential risk at all14-36Exam
33、ple:SubjectiveApproach Risk LevelDiscount RateVery Low RiskWACC 8%Low RiskWACC 3%Same Risk as FirmWACCHigh RiskWACC+5%Very High RiskWACC+10%14-37Flotation Costs The required return depends on the risk,not how the money is raised However,the cost of issuing new securities should not just be ignored e
34、ither Basic Approach Compute the weighted average flotation cost Use the target weights because the firm will issue securities in these percentages over the long term14-38Example:NPV and Flotation Costs Your company is considering a project that will cost$1 million.The project will generate after-ta
35、x cash flows of$250,000 per year for 7 years.The WACC is 15%,and the firms target D/E ratio is.6 The flotation cost for equity is 5%,and the flotation cost for debt is 3%.What is the NPV for the project after adjusting for flotation costs?fA=(.375)(3%)+(.625)(5%)=4.25%PV of future cash flows=1,040,1
36、05 NPV=1,040,105-1,000,000/(1-.0425)=-4,281The project would have a positive NPV of 40,105 without considering flotation costsOnce we consider the cost of issuing new securities,the NPV becomes negative14-39Quick Quiz What are the two approaches for computing the cost of equity?How do you compute th
37、e 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 isnt a
38、ppropriate?How should we factor flotation costs into our analysis?14-40Ethics Issues How could a project manager adjust the cost of capital(i.e.,appropriate discount rate)to increase the likelihood of having his/her project accepted?Is this ethical or financially sound?14-41Comprehensive Problem A c
39、orporation has 10,000 bonds outstanding with a 6%annual coupon rate,8 years to maturity,a$1,000 face value,and a$1,100 market price.The companys 100,000 shares of preferred stock pay a$3 annual dividend,and sell for$30 per share.The companys 500,000 shares of common stock sell for$25 per share and h
40、ave a beta of 1.5.The risk free rate is 4%,and the market return is 12%.Assuming a 40%tax rate,what is the companys WACC?14-42End of Chapter14-43加强做责任心，责任到人，责任到位才是长久的发展。22.7.2822.7.28Thursday,July 28,2022弄虚作假要不得，踏实肯干第一名。5:53:405:53:405:537/28/2022 5:53:40 AM安全象只弓，不拉它就松，要想保安全，常把弓弦绷。22.7.285:53:405:53
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