Topic 7: Cost of CapitalLearning Outcomes introduction to cost of capital cost of debt cost of equity weighted average cost of capital (WACC) WACC and NPV project-based cost of capital when raising external capital is costly Topic 7 Cost of Capital M K Lai Page 2 Introduction to Cost of Capital capital: a firm’s sources of financing including debt, equity and other securities that it has outstanding capital structure: relative proportions of debt, equity and other securities that a firm has outstanding Topic 7 Cost of Capital M K Lai Page 3 Introduction to Cost of Capital to attract investor’s capital, a firm must offer potential them an expected return equal to what they could expect to earn elsewhere for assuming the same level of risk (opportunity cost) cost of capital of a firm = expected return of investor by assuming the same risk of the firm similarly, the NPV of a project is positive only if its return exceeds what the financial markets offer on investments with similar risk Topic 7 Cost of Capital M K Lai Page 4 Introduction to Cost of Capital the cost of capital is the minimum required return for an asset given its risk level sources stock: cost of equity of funds preferred stock: cost of preferred stock for a firm debt: cost of debt real assets/projects/firms: weighted average uses of funds for a firm cost of capital (rWACC) common Topic 7 Cost of Capital M K Lai Page 5 Introduction to Cost of Capital Statement of Financial Position current assets debt long term assets preferred stock common stock uses of funds Topic 7 Cost of Capital sources of funds M K Lai Page 6 . Introduction to Cost of Capital in other words. rWACC is the discount rate we use in capital budgeting and it reflects time value of money risk Topic 7 Cost of Capital M K Lai Page 7 . the rWACC must lie above the security market line (SML) (why?) minimize rWACC so that the firm value can be maximized (why?) Topic 7 Cost of Capital M K Lai Page 8 . weighted by fractions of firm’s value that correspond to equity and debt respectively the capital asset pricing model shows the positive relationship between expected return and systematic risk of a financial security from the perspective of an investor for a project with positive NPV.Weighted Average Cost of Capital (WACC): First Look weighted average cost of capital: average of firm’s equity and debt costs of capital. i. rather than sources of funds. the capital structure is given although the rWACC is a mixture of the returns needed to compensate its creditors and stockholders. in capital budgeting Topic 7 Cost of Capital M K Lai Page 9 .Weighted Average Cost of Capital (WACC): First Look assume that the firm has a target and fixed debtequity ratio that it would like to maintain.e. it is not affected by the fixed capital structure still assume there is a separation of investment and financing decisions the (weighted average) cost of capital (rWACC) only reflects the uses of funds. Weighted Average Cost of Capital (WACC): First Look leverage: the relative amount of debt on a firm’s balance sheet unlevered firm: a firm that does not have debt outstanding rWACC of an unlevered firm is the cost of equity given no debt (why?) levered firm: a firm that has debt outstanding rWACC = fraction of firm financed by equity * cost of equity + fraction of firm financed by debt * cost of debt = cost of assets (given no preferred stock) Topic 7 Cost of Capital M K Lai Page 10 . 3. 2. Topic 7 Cost of Capital M K Lai Page 11 .Cost of Debt the cost of debt is the return that lenders require on a firm’s debt the prevailing interest rate the firm just pays on new borrowing methods to estimate the prevailing interest rate 1. but interest expenses are tax deductible and hence a firm should consider its after-tax (effective) cost of debt = before-tax cost of debt*(1-tax rate) or after-tax cost of debt = rD*(1-TC) where TC = corporate tax rate which tax rate to use? marginal tax rate = additional tax paid for per $1 additional taxable income effective tax rate = income tax/pre-tax income statutory tax rate = rate stated by government Topic 7 Cost of Capital M K Lai Page 12 .Cost of Debt the observed or calculated cost of debt rD is on a before-tax basis. what is the after-tax cost of debt of the firm? 7 107 96 = + 2 (1 + yield) (1 + yield) yield = 9.35%) = 6.tax cost of debt = 9. Given that the marginal tax rate is 35%.28% * (1 .03% Topic 7 Cost of Capital M K Lai Page 13 . The bond is currently selling for 96% of its face value.Example: Cost of Debt A firm issued a 10-year.28% before . 7% bond with annual coupons 8 years ago.tax cost of debt = 9.28% after . Cost of Preferred Stock preferred stock has a fixed dividend paid every year indefinitely and hence its future cash flow stream is a non-growing perpetuity rpfd = Divpfd/Ppfd where rpfd = cost of preferred stock. Divpfd = fixed dividend of preferred stock and Ppfd = current preferred stock price Topic 7 Cost of Capital M K Lai Page 14 . 75 per share. The issue paid $2.63% Topic 7 Cost of Capital M K Lai Page 15 .04 annually per share and sold for $30.75 = 6.Example: Cost of Preferred Stock A company had an issue of preferred stock that is traded on the exchange. What is the company’s cost of preferred stock? rpdf = $2.04/$30. Cost of Equity/Common Stock the cost of equity/common stock is the return that common stock investors require on their investment in the firm two ways to determine the cost of equity capital asset pricing model constant Topic 7 Cost of Capital dividend growth model M K Lai Page 16 . βE = beta of common stock i. RMkt = expected market return (proxied by stock market index return) in other words. rE depends on risk free rf market/equity risk premium RMkt– rf systematic risk βE Topic 7 Cost of Capital M K Lai Page 17 . rf = risk-free rate.Cost of Equity/Common Stock: CAPM rE = rf + βE * (RMkt − rf ) where re = expected return on common stock I or cost of equity. 95*(15%-2%) = 14. A stock has a beta of 0.95.Example: CAPM The risk-free rate is 2% and the expected market return is 15%. What is the cost of equity? rE = 2% + 0.35% Topic 7 Cost of Capital M K Lai Page 18 . PE = current common stock price. Div1 = common stock annual dividend in year 1.Cost of Equity/Common Stock: Constant Growth Model rE = Div1/PE + g where rE = cost of equity. g = constant growth rate of dividends PE can be observed directly in the stock market given that the firm is listed Div1 can be estimated as Div0*(1+g) where Div0 = current annual dividend assumed to grow at g Topic 7 Cost of Capital M K Lai Page 19 . 3. Topic 7 Cost of Capital M K Lai Page 20 . 2.Cost of Equity/Common Stock: Constant Growth Model the most difficult part is to estimate the growth rate method to estimate the growth rate 1. Cost of Equity/Common Stock: Constant Growth Model source: Reuters Topic 7 Cost of Capital M K Lai Page 21 . the recently announced dividend per share is $3. rE = $3.Example: Constant Growth Model If the current common stock price is $52. calculate the cost of equity.5% Topic 7 Cost of Capital M K Lai Page 22 .25 and the expected constant dividend growth rate is 4%.25*(1+4%)/52 + 4% = 10. Comparison Between CAPM and Constant Dividend Growth Model CAPM constant dividend growth model equity beta current stock price risk-free rate expected dividend next year market risk premium future dividend growth rate correct estimated beta correct dividend estimate accurate market risk premium growth rate matches market expectations valid CPMA constant growth inputs assumptions Topic 7 Cost of Capital M K Lai Page 23 . TC = marginal corporate tax rate notice: in many cases. rD = (before-tax) cost of debt. D% fraction of firm financed by debt. P% fraction of firm financed by preferred stock. P% = 0 (no preferred stock) Topic 7 Cost of Capital M K Lai Page 24 .WACC: Second Look rWACC = rE*E% + rpfd*P% + rD*(1-TC)*D% where rWACC = weighted average cost of capital. E% = fraction of firm financed by common stock. rE = cost of equity. rpfd = cost of preferred stock. preferred stock and common stock assets = debt + preferred stock + common stock (accounting equation) Topic 7 Cost of Capital M K Lai Page 25 . preferred stock and common stock market value of assets = market value of debt + market value of preferred stock + market value of common stock estimated through book value of debt.WACC: Second Look capital structure weights (which to use?) target capital structure announced by firm estimated through market value of debt. Example 1: WACC Consider the following information about Li & Fung source: Li & Fung AR Topic 7 Cost of Capital M K Lai Page 26 . stern.nyu.Example 1: WACC source: quamnet source: AsianBondson line source: http://pages.359% Page 27 .edu/~adamodar/ source: BOCI Topic 7 Cost of Capital M K Lai average = 6. 15%*(135%) = 11.15% yield on bond = 6.Example 1: WACC effective tax rate = 9.17 risk-free rate = 1.17*6.4% optimal debt ratio = 35% beta = 2.86% Topic 7 Cost of Capital M K Lai Page 28 .359%*(1-9.5647% market risk premium = 6.4%)*35% + 15.564% + 2.35% rE = 1.35% = 15.359% rWACC = 6. trading at a price of $5 cost of preferred stock = 15% number of common stock outstanding is 5 million shares. Topic 7 Cost of Capital M K Lai Page 29 .Example 2: WACC A company has the following financial data: debt with a book value of $10 million. trading at a price of $8 cost of equity = 18% marginal corporate tax rate = 35% Calculate the WACC of the company. trading at 96% at a yield of 6% number of preferred stock outstanding is 1 million shares. 0916 E% = $40 million/$54.6 million/$54.1758 P% = $5 million/$54.6 million = 0.25% Topic 7 Cost of Capital M K Lai Page 30 .6 million D% = $9.7326 + 15%*0.7326 rWACC = 18%*0.6 million + $5 million + $40 million = $54.0916 + 6%*(135%)*0.01758 = 15.6 million = 0.6 million = 0.6 million MV of preferred stock = $5*1 million = $5 million MV of common stock = $8*5 million = $40 million market value of assets = $9.Example 2: WACC MV of debt = $10 million*96% = $9. WACC in Practice use net debt rather than total debt and use enterprise value (EV = equity plus net debt) as basis for calculating weights net debt = debt – cash and risk-free securities E% = MV of equity/EV and D% = net debt/EV risk-free rate = yield on government bond but which maturity? correspond to investment horizon of firm’s investors – survey shows that usually 10 year government bond Topic 7 Cost of Capital M K Lai Page 31 . WACC in Practice market risk premium: some financial managers that market risk premium has been declining and it is the future market risk premium matters and they should adjust it downward because of the downward trend (?) Topic 7 Cost of Capital M K Lai Page 32 . WACC in Practice Topic 7 Cost of Capital M K Lai Page 33 . Using WACC to Value a Project use rWACC as discount rate in capital budgeting levered value: project value includes the benefit of interest tax deduction given the firm’s leverage policy (assuming the capital structure is fixed) WACC method: discount future incremental free cash flows (FCF) using the firm’s rWACC to produce the levered value (V0L) of a project with a life of n years n FCFt V =∑ t t = 0 (1 + rWACC ) L 0 Topic 7 Cost of Capital M K Lai Page 34 . e.Using WACC to Value a Project key assumptions project risk is the same as firm’s assets (why?) fixed capital structure with constant debtequity ratio limited leverage effects. no financial distress Topic 7 Cost of Capital M K Lai Page 35 .g. The initial investment is $50 million and it is expected to generate an even cash flow of $12 million in each of the coming six years. What is the NPV of the project? Topic 7 Cost of Capital M K Lai Page 36 .65%.Example: Using WACC to Value a Project A company is carrying out a capital budgeting exercise on an expansion project by increasing the size of its production facility. The WACC of the firm is 16. 65%) NPV = $43. we believe that the project risk is similar to the existing assets of the firm and the appropriate discount rate is its WACC.Example: Using WACC to Value a Project As this is an expansion project. reject the project. 6 $12m levered value = ∑ = $43.47m t t =1 (1 + 16. Topic 7 Cost of Capital M K Lai Page 37 .47m .$50mm = −6.53m As NPV < 0. etc. launching a new product. e. in practice. entering a new market. if the similar firm has a different capital structure from the subject firm. we should look for a firm which has similar characteristics as our project and use the similar firm’s data to calculate its rWACC which reflects the risk of the project (pure play approach) furthermore.g.Project Risk Different from Firm’s Risk rWACC does not necessarily reflect the risk of the project. need to make adjustment for the different debt-equity ratios (out of scope) Topic 7 Cost of Capital M K Lai Page 38 . Project Risk Different from Firm’s Risk discount rate on project SML WACC beta of existing assets of firm beta of project Topic 7 Cost of Capital M K Lai Page 39 . after-tax rd.Exercise Which is the appropriate discount rate for the following projects? (re. own firm’s WACC. similar firm’s WACC) a company acquires the control over a target company a company carries out a research and development project for a new product a company expands its business to a new market a company invests in the shares of another company Topic 7 Cost of Capital M K Lai Page 40 . Exercise a company expands its production facilities a company carries out a cost reducing program a company uses a new technology to produce a product a company buys the bonds issued by another company Topic 7 Cost of Capital M K Lai Page 41 . company B’s rWACC should be used because it reflects the risk of the project. company A’s rWACC is not appropriate because it cannot reflect the risk of company B. Topic 7 Cost of Capital M K Lai Page 42 . To determine the NPV of this acquisition project.Example: WACC for a New Acquisition Company A wants to acquire the control over company B which carries out unrelated business to company A. Given that the two companies have similar capital structure. a conglomerate the company’s rWACC reflects its overall risk and cannot accommodate the different risk levels of these business lines a divisional cost of capital should be determined for each business line with the objective to reflect its risk level pure play approach: use of rWACC that is unique to a particular project based on companies in similar lines of business as the project Topic 7 Cost of Capital M K Lai Page 43 . i.Divisional Cost of Capital consider a company with several divisions of different risk nature.e. is 16% still the appropriate discount rate for the project? Topic 7 Cost of Capital M K Lai Page 44 .Example: Divisional Cost of Capital A conglomerate has a division in producing household products. The rWACC of the conglomerate is 20%. The rWACC of a household product manufacturer is 16%. What is the (weighted average) cost of capital of the division? The divisional cost of capital is 16%. If the division wants to launch a new household product. 2.When Raising External Capital is Costly flotation costs: costs associated with new issue of debt or equity 1. zero flotation costs for internal equity (retained earnings) Topic 7 Cost of Capital M K Lai Page 45 . When Raising External Capital is Costly how to include them in rWACC method 1: adjust rWACC through the weighted average cost of flotation method 2: when carrying out the capital budgeting exercise. consider the flotation cost as an initial investment Topic 7 Cost of Capital M K Lai Page 46 . 300. The present value of the future cash flows generated by the project is $3.221 as the NPV < 0. The flotation costs are $456.$456.000 .221.300. Calculate the NPV of the project after adjusting for flotation costs.221 = −$156.$3. reject the project Topic 7 Cost of Capital M K Lai Page 47 .000.000.Example: When Raising External Capital is Costly A company decides to issue new equity to finance a project. NPV = $3. The estimated initial investment (before flotation costs) for the project is $3.000.000.000 . What is the relationship between the required return on an investment and the cost of capital associated with that investment? 2. Discuss whether the CFO of a company should use the WACC of the company to evaluate the following projects: Topic 7 Cost of Capital M K Lai Page 48 .Challenging Questions 1. What are the likely consequences if a company uses its rWACC to evaluate all proposed investments from different divisions? 3. Hopefully. it can take advantage of the huge population in the Mainland to enhance its sales revenue.Challenging Questions A. An expansion project that the company will expand its production facilities to enlarge its output level of the existing products in Hong Kong. it can take advantage of the economy of scale to reduce the production costs. B. Topic 7 Cost of Capital M K Lai Page 49 . An expansion project that the company will build up new distribution channels in Mainland China. Hopefully. the capital structure is 45% debt and 55% equity. According to the values in the statement of financial position. Given that the project has the same risk as the existing assets of the company. The company intends to use 100% equity to finance a project.Challenging Questions 4. According to the values in the financial market. Topic 7 Cost of Capital M K Lai Page 50 . what weights of debt and equity should be used in calculating the rWACC? Explain. A company has announced a target capital structure of 40% debt and 60% equity. the capital structure is 35% debt and 65% equity. Challenging Questions 5. which of the following is the appropriate discount rate for this “acquisition” project? Explain. Topic 7 Cost of Capital M K Lai Page 51 . If the investment bank has to determine the value of the target company as a whole. An investment bank is appointed to be the financial advisor to an acquiring company. The acquiring company wants to take control over a target company by buying more than 50% of its shares from the shareholders. the cost of equity of the acquiring company B. the weighted average cost of capital of the target company Topic 7 Cost of Capital M K Lai Page 52 .Challenging Questions A. the weighted average cost of capital of the acquiring company C. the cost of equity of the target company D.